Wednesday, February 17, 2010


According to EWI, the top in the stock market occurred on January 19th. I believe they are correct. If so, then we have also seen tops in oil, gold and "risk" currencies. The safe currencies are therefore now the US dollar and Swiss Franc. The Japanese Yen perhaps as well, but I wouldn't bet that way due to that country's enormous debt load, which on a relative-to-GDP basis makes the U.S. debt look puny by comparison.

Humpty Dumpty
Therefore, the long anticipated 3rd wave meltdown is (very likely) underway. This next leg down in the ongoing financial crisis is starting as a slow motion train wreck, but will soon accelerate as the point of recognition occurs and panic spreads. Panic is inevitable, because everyone will come to realize that the government authorities are completely powerless to stop the meltdown. All of the stimulus, liquidity, credit and facilities put in place in 2008 will fail catastrophically. In the end, the only thing the 2008 bailout will have done is leverage up Wall Street one last time, and give the Greedbots one more bag of easy bonus money just before the house of cards collapses and stays collapsed.

Tallest Midget in the Circus
As expected, the dollar has been rallying for weeks now, especially vis-a-vis the Euro, because the Eurozone (Greece, Spain, Portugal, Italy, Eastern Europe) is likely the next source of financial chaos. So, for likely the last time, the unloved U.S. dollar will once again be the safe haven of choice during the ensuing panic. This will no doubt come as a great surprise to many people, especially the "tea baggers" and the Peter Schiff acolytes, but as EWI have carefully explained, a dollar shortage is exactly what we should expect in a credit deflation, as the supply of dollar-based credit collapses. I say for the LAST TIME, because this will likely be the dollar's last and greatest hurrah, as we eventually transition through deflation to the great printing of paper dollars that will undoubtedly lie somewhere down the road...

From an investment standpoint, EWI/Prechter has long advocated moving the majority of one's assets to short-term Treasuries, and I have advocated the same position on this blog. However, just this week, the self-anointed god of Finance and Economics, Nassim Taleb, recently told Blooomberg that it is a "no brainer" to short (sell) U.S. Treasuries. You may recall, that Taleb is most famous for his "Black Swan" theory, which postulates that rare and unpredictable events cause most Wall Street investment strategies to fail over the longer-term (I paraphrase). Obviously from an outcome standpoint, he has been proven correct, however, I disagree that the turmoil in the financial markets is at all rare or unpredictable i.e. these are more white swan events than black swan events. If anything, extreme volatility has become much more common in the past decade(s) and the inherent short-term/highly leveraged nature of Wall Street strategies makes the inevitable catastrophic outcomes very predictable. The reality is that most Wall Street trading strategies (hedge funds etc.) are like call options - heads I win and take home a massive bonus - tails I walk away and leave the investors, tax payers and system at large holding the bag. Taleb is very naive to think that Wall Street bankers are unaware of the underlying risks they take, considering the short-term incentives that are in place to take huge risks with other people's money i.e. they don't care. Therefore not withstanding Taleb's penchant for profound insight, I was not fazed when he made the "no-brainer" comment, because to believe Treasury interest rates will rise, is an implicit belief in reflation, which as I stated recently, is extremely improbable, if not impossible. If we have learned only one thing in the past 10 years it should be that any time a Ph.D tells us that an investment strategy is a "no brainer", you should run the other way, quickly, before a Black Swan swoops out of nowhere and shits on your head. Yet, magnanimous as always, I will agree to call Taleb's a "no brain" strategy.

Back to investing, the reason for advocating a long Treasury position is the same reason for being long the dollar - as a safe haven during deflation. When money flows out of risk assets and carry trades it will come back to dollars (the funding currency) and it has to be "parked" somewhere. It won't be parked in risky assets such as stocks or "spread products" (corporate bonds, municipals) etc. so that leaves Treasuries. Yes, the national debt and deficit are large, but relative to other countries (e.g. Japan) the debt load is still manageable (short-term) and in addition, the U.S. has options that the Euro countries do not have (e.g. monetizing the debt), explained in more detail below.

There are 3 major types of risks related to owning Treasuries:

1) Default Risk: Risk that the borrower (U.S. Government in this case) will simply not repay bonds at face value. I see Default Risk for Treasuries as being ZERO. The U.S. government's debt is all dollar denominated, which gives it the option to monetize its debt by having the U.S. Fed buy Treasury debt directly. If you think this can't happen, you are wrong, because it already happened last year to the tune of $300 billion under the aegis of "Quantitative Easing".

Keep in mind that if there is default risk, then it should be the same for all maturities of debt i.e. if the U.S. government decides not to repay its bonds, then logic dictates that all bonds will be affected not just select maturities. If anything, short-term bonds "could" be more at risk, since they need to be "rolled over" (re-paid) far more often than long-term debt.

2) Purchasing Power Risk: aka. inflation risk. The risk that market yields will rise, causing bond prices to fall. In a deflationary environment, inflation risk will be ZERO and if anything, nominal interest rates could be negative and still provide a positive real return. Imagine a scenario where GDP is down -20% year over year and prices decline by the same amount -20%. In that case, a market yield of -15%, would still net the holder 5% adjusted for "inflation" (deflation).

3) Rollover Risk: Rollover risk is the opposite of inflation risk, it's actually deflation risk. As indicated under the hyper-deflationary scenario above (-20% inflation) it's very possible that yields would go negative across the entire yield curve (all maturities). At that point you would be PAYING the U.S. government to borrow your money !!! At one point during the Lehman crisis in 2008 T-bills went briefly negative, so this is more than a hypothetical scenario. Now, would short-term yields go 15% (annualized) negative? That seems unlikely, but who wants to pay the Government to borrow their money? Fortunately, there is an easy way to protect against rollover risk, by simply buying longer dated maturities that do not roll over as often. Also, longer dated bonds will actually increase in value (potentially substantially) as yields fall, and you don't have to hold longer-dated bonds through to maturity (nor would you want to), you can sell them at any time i.e. they are highly liquid...

In summary, though I have long "advocated" the EWI party line of owning only short-term Treasury debt only during the deflation phase, I personally also own longer dated maturities to guard against Rollover Risk and provide some upside in the event of an anticipated major move down in yields. Given that Default Risk is assumed to be zero and/or at least the same for all maturities, Inflation Risk is zero (assuming deflation), and Rollover Risk favours long-dated, maturities, I cannot explain EWI's preference for short-dated Treasuries.

That said, the easiest way to own Treasury debt of all maturities is through the iShare ETFs which trade like stocks:

SHY: 1-3 year maturities
IEI: 3-7 year (probably the best compromise between long and short-term)
IEF: 7-10 year
TLT: 20+ year (most volatile/speculative, but most upside if yields fall)

Good luck !