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T-bond since Oct.10, 1998



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HI RTs,  

I wrote the following analysis on Oct. 10, 1998.  If you have any
comment, please drop me a line.  I only sent this analysis to a few
friends in Oct. 1998 because at that time, I had a very low self esteem
immediately after being destroyed when the T-bond fell apart on Oct. 8 &
Oct.9, 1998.  (Fortunately, due to this shock, I also got out of my
short positions in Dow Jones futures. )  Anyway, yen has appreciated
against USD and US T-Bond has been in a downtrend since then.  I still
believe in what I wrote in Oct. 1998.  The following old e-mail is my
personal opinion and it should be used for information only, not for
trading purpose.  

All the best!  

Mervin  


Message-ID: <361FDE74.2B93732@xxxxxxxxxxxxxx>
>Date: Sat, 10 Oct 1998 15:23:48 -0700
>From: Tin Mervin Yeung <tinyeung@xxxxxxxxxxxxxx>
>X-Mailer: Mozilla 4.02 [en] (Win95; I)
>MIME-Version: 1.0
>To: Brent Poe <brentp@xxxxxxxxxxxxxxxxx>  

Hi Brent,  
>
>I made a big fundamental mistake on my bullish outlook on US T-Bond.  I
>made money for a while but eventually, T-bond was on a free fall.
>
>1.  Market interest rates dictate bond prices.  Rising interest rate
>causes bond price to fall.  Falling interest rate causes bond price to
>rise.
>
>2.  There are 2 components for market interest rate (nominal interest
>rate):  real interest rate and inflation rate.  "market interest rate =
>real interest rate + inflation rate  "
>
>3.  Point 2 is only an approximation.  The real formula for real
>interest rate is:
>r = (n+q) / (1+q)  , where r is real interest rate; n is nominal
>interest rate and q is annual inflation rate.
>
>4.  Therefore, to predict bond price, we have to predict both the
>inflation rate and real interest rate.  If real interest rate is 
stable,
>as in most cases, we only have to predict the inflation rate.
>
>5.  I focused all my energy on future inflation rate.  I ignored real
>interest rate and assumed that it should be stable, as it was in the
>past.  Well, assumption is mother of all f--kup.
>
>6.  During massive debt liquidation, there is a strong deflationary
>pressure.  I expect this will happen in the near future.
>
>7.  It is a good idea of not having debts in deflationary period.  In a
>time of deflation you are repaying the debt with increasingly costly
>money.
>
>8.  Even holding cash is profitable in deflationary period. As the
>purchasing power of the cash increases, you are in practice earning
>interest even on dollar bills under the mattress.
>
>9.  During deflationary period, high quality bonds, debentures, and 
also
>T-bills, will be very profitable generating the face rate of interest,
>the capital gain as overall interest rates decline, and the nominal
>interest rate resulting from the increasing purchasing power of the
>dollar.
>
>10.  During deflationary period, low quality bonds, especially junk
>bonds, will be big losers. The interest rates will rise due to the
>increasing risk premium, generating large capital losses. And some
>companies will go into liquidation.
>
>11.  Thus, the spread of high quality bond and low quality bond widens.
>The flight to quality occurs.  Long Term Capital Management bet on the
>idea of narrowing spread between Italian gov't bond and German gov't
>bond.  The result is not pretty.
>
>12.  I studied point 1 to point 11 and I concluded that T-bond should 
go
>up.  It did go up for quite a while.  But, what happened to bond market
>in last week??  Why did it collapse??
>
>13.  The answer is that I forgot another component:  real interest
>rate.  Please re-read point 2.  Currently, we have a low market 
interest
>rate in the US.  The reason are low inflation rate AND low real 
interest
>rate.  Due to massive capital inflow to the US, real interest rate is
>suppressed.
>
>14.  US has such a low saving rate that it relies on foreign capital on
>investment purpose.  Without foreign capital inflow, real interest rate
>would be much much higher.  Therefore, now I expect that we will have a
>deflation and a high real interest rate environment in the future.
>
>15.  Capital outflow from the US may have started.  Look at the USD /
>YEN cross.  Japanese banks and hedge funds who did the Yen Carry now
>have to unwind the positions.
>
>16.  The US national debt is more than 5.5 trillion dollars.  According
>to Keynesian economy, you have deficit in bad time to stimulate economy
>and you use surplus in good time to reduce national debt.  Currently,
>the US government seems to prefer "pet projects" to "national debt
>reduction".  As debt increases in bad time and is not reduced in good
>time, credit rating (in abstract sense) of the gov't should be down
>graded.
>
>17.  Due to point 14 to point 16, I suspect that there is a possibility
>that for the first time in the US history, we will have a bear T-bond
>market in a deflationary period.  In other words, US T-Bond will behave
>like a low quality bond.  Please re-read point 10.
>
>18.  Walter Wriston of Citicorp asserted that "sovereign nations don't
>go bankrupt."  They did, they do and they will do.  Brazil, Mexico and
>some Latin American nations would have gone bankrupt in early 80s, if IMF had not 
put
>together a rescue package.  Same for Thailand, Indonesia and S.Korea in
>1997.
>
>19.  But, how about super-power?  Can we say that "super-power don't go
>bankrupt"?  Before the US, British Empire (1588-1918) and Spanish 
Empire
>(1492-1588) were the previous world super-powers.  Even before the
>destruction of Spanish Armada in British hands in 1588, Spain's finance
>was in trouble.  In 1570, Antwerp, finance capital in Spanish
>Netherlands, defaulted on its debts.  It could no longer stand aloof
>from the financial vicissitudes of the Spanish Crown.  Later, Spanish
>state bankruptcies occurred about every 20 years:  in 1607, 1627 and
>1649.  Then, Spain sank from gold standard, silver standard to a copper
>standard of currency.  Spanish state bankruptcies occurred again in 
1686
>and in 1700, throughout the 18th century, and in 1820, 1837, 1851 and
>1873.  British fared much better, but Britain had all those unpleasant
>experience of devalution of the pound.
>
>20.  This is highly speculative:  the US may be next in line.  High
>national debt, large current account deficit and low saving rate will 
be
>the cause.  Foreign debt will increase suddenly and enormously with the
>expected dollar collapse.  And the result is another Thai situation.  
At
>that time, flight to quality means "Get out of T-Bond and jump into
>German gov't bond, or even gold. "
>
>21.  If point 20 materializes, then my loss in T-Bond will be a good
>thing.  I had 2 very different fundamental views on T-Bond:  a) a bull
>T-Bond market due to deflation and massive debt liquidation; b) a bear
>T-Bond market due to high real interest rate and flight to quality.  In
>case (b), the effect of high real interest rate overwhelms that of
>deflation and T-Bond behaves like a low quality bond in a catastrophic
>capital outflow.  Before last Thursday, I strongly believed in case (a)
>because case (b) was so unthinkable.  I thought case (b) was unlikely 
to
>happen because US is the world largest, most diversified, and stable
>economy.  I was proven WRONG.  Now, I have to accept case (b).
>
>22.  Anyone who goes short in T-Bond market (if he believes in case 
(b))
>must be very careful.  If US stock market crashes, Fed will add massive
>amount of liquidity to create a very rosy environment, instantaneously.
>This will cause a short term tremendous upsurge in bond prices and
>destroy every T-Bond short-seller.  Of course, over the long run, I now
>believe in case (b)--i.e. a long run bear T-Bond market in a
>deflationary, high real interest rate, moderate nominal interest rate,
>flight to quality, massive capital outflow environment.  This must be
>unprecedent for the US if it turns out to be true.
>
>I had 3 main trades up to this point.  Long T-Bond turns into a
>disaster.  Stock index has not crashed yet.  Only long yen position
>turns out to be profitable.  In order to be a good trader, I really 
have
>to improve my skill.
>
>Please tell me your analysis.  I don't want to be wrong again.
>
>Mervin
>