|
PureBytes Links
Trading Reference Links
|
Hi RTs,
I forgot to get rid of ">" sign. So I delete ">" sign and send it
again. Remember it was written in Oct. 1998. For information only.
Here it is:
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
|