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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
>
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