Saturday, February 09, 2008

Stop What You Are Doing Moment

The financial markets seem extremely unstable. I find the data around what is happening unsettling, yet some of the things you would expect to happen with it seem to defy gravity and remain supported as if by magic.

Today I was reading a piece on Safehaven by Peter Schiff and how he describes treasury bills as the mother of all bubbles. He outlines his thesis:

"For years I have predicted that the falling dollar, persistent trade deficit, and the lack of domestic savings would combine to send long-term interest rates sharply higher. The effects of these fundamental drivers would undermine the Fed's efforts to lower short-term rates and compound the problems for the housing market and the U.S. economy. Yet as of today, the yield on the thirty-year Treasury bond still stands below 4.5%, within 40 basis points of a generational low. Either this is the one piece of the puzzle that I somehow got wrong, or other factors are working to temporarily confound fundamental economics and prop up the bond market. As you might imagine, I am confident that it is the latter and consider the U.S. Treasury market to be the mother of all bubbles."

It makes sense to me, Americans have little savings these days and are dependent on others to borrow from. Currently I wouldn't touch anything US as I have so little trust in their currency. Being Canadian and knowing what Canada has been through to get our debt under control, well that is the path the US must follow and to me it means the US dollar will weaken. Our dollar declined about 25% relative to the US dollar from when we first started working on our debt problem in 84 to the hardest years when taxes were so high, 54.9% in the highest tax bracket, which was reached at a mere $80k/year. I have no doubt that Canada is going to go through a rough time as well, but we get to start with a surplus budget, better savings and less debt.

Every time I look at the US debt it looks as bad as Canada looked in 84. It took us more than 10 years to balance the budget. Canada's economy is 1/10th of the US. Our weak dollar meant tourism expanded. A weak US dollar can increase tourism there as well, but they need 10x as much expansion for the same effect, yet the tourism market is fairly fixed. That they are a bigger economy to me means that they will hardly feel increased tourism from Canada. We have 1/10th of their population for travel and they have 10 times as many to split it into. Between our two countries, we got 100 times the tourism benefit of a weaker dollar than Americans will get. Say 1% take vacations per year, well, that would mean we got 3 million visitors, or about 10% of our population. To go the other way, 1% of Canada is 300,000 and that is 0.1% of the US population. Probably the same could be said for our exports.

So, the level of debt means the dollar has to decline further, and going down to about half of where it is now would not surprise me. It means that I need a 5-10% premium, depending on the number of years, just to maintain my investment. I wonder if I have just been breezing over treasury bonds in my reading list, or if everyone is all of a sudden noticing something about treasury bonds. Accrued Interest looks at yesterday's 30-year Auction. The "coupon" rate of interest is 4 and 3/8th.

With the auction, if you were buying a 30-year treasury bond priced to pay $100 in 30 years at the current 4.449% yield you'd pay $98.780998 today according to the press release. A lot can happen in 30 years and I can't imagine buying such a thing for under 10%. At 10% interest the purchase price for such a bond declines to $46.76, a 53.24% decline in today's purchase price.

Consider what was posted:

"Consider the facts. The Treasury announces to the entire galaxy that its selling $9 billion in 30-year bonds. They get a yield of 4.449%. According to Bloomberg News, the pre-auction trading had indicated the yield would be 4.41%, indicating the actual results were a 4bps miss. Did the auction go poorly? It sure did. Not only was it a 4bps miss in yield, but 89% of it was purchased by dealer firms, which indicates that actual end buyers only stepped up for 11% of the sale.

But what happened next can't fully be explained by those auction results. The 30-year continued to sell off, rising another 10bps in yield to 4.558, or -1.6% in price, over the next hour. It strains logic to say that the Treasury holds an auction, the price is somewhat disappointing, so therefore the price should be an additional 1.6% lower."

Minute changes in the 30 year yield has enormous changes for the bond price, and these long term rates are unnaturally low right now. I think the price going lower is perfectly logical. A yield of 4 and 3/8th percent is grossly inadequate for pricing the risk for tying the money up for 30 years.

If currency declines by 20% and inflation goes to 5% the loss of buying power is enormous, and this is not an excessive example of possibilities. At the very least, this ought to be the bench mark minimum for pricing risk into a 30 year treasury bond. At this modest realm of possibilities you would lose 27.72% of your buying power over 30 years when you finally got you $100 back. The $100 would actually only buy $18.18 worth of goods, but the interest payments over the years would amount to $54.09 of buying power. In order for such a treasury bill to actually pay this level of risk it would have to be priced at 5.85% or 5 and 7/8th percent is the closest. This ought to have been the floor investors insisted upon.

These are the kinds of investments that pension plans can hold because they are "safe" and government guaranteed. The problem is that they have grossly inadequate risk for inflation and currency declines priced into them.

Today the markets are a very risky place with a shadow banking system that simply makes it impossible for investor to be making informed choices. Treasuries are a safe place to park while the markets are working through the financial losses, and that inflates their price and keeps a level of demand for them. Thirty year bonds have considerable risk to trading down on the purchase price due to the excessively low yields, so although they have a perception of being safe, they have high risk of losing enormous buying power and being repriced downwards. Once investors feel the markets are safe again, the return demanded on these is likely to increase back to reasonable levels.


mark said...

When comparing Canada to the US you are not comparing apples to apples. The budget deficit of $400 B, while large, could be eradicated by reductions in military spending alone. The current military budget for 2008 is $515 Billion, not including the cost for Iran and Iraq. Not trying to get political here I only bring this up for economic debate.

Also, Canada's debt level is 75% of GDP, while the US debt level is 70% of GDP (they have a $13 trillion GDP). I really don't think you can say conclusively, based on that data, that the US dollar MUST depreciate. Canada has never really conquered the debt, it just isn't growing as much.

Deborah said...

US could dramatically drop both the GDP and there spending by withdrawing from the war. The money that is spent on the war goes to businesses, so you'd have a decline in both.

You need to back your position that Canada's debt is 75% of GDP because I've never found anything to support that. Page 6 of the following has a graph to 2005, when Canada's debt was reduced to about 45%. It is now down to about 40% of GDP.

mark said...

Well I don't agree with you that military spending would have that big an effect on GDP. Even if you were to cut it down by $400 Billion, that's only 3% of the GDP. That would certainly halt or slow growth right down for a year but no big effect on debt to GDP ratio.

You are correct on canada's ratio. My apologies, it turns out the study I was looking at was from '95.

Still, if you consider that the dollar was strongest somewhere in '01/'02, Canada actually had a higher debt to GDP ratio. I have included a link to back that, So from then until now, the Canadian dollar has strengthened despite Canada starting with higher relative debt. What has changed, in my opinion, is a massive repricing of commodities across the board. Canada is very strong in commodities and hence we have boomed. In the late 90's IT was the rage and the US was very strong in that sector so they boomed. In my opinion this is the primary cause to the shift in dollar strengths. In the past few months, for instance, the american dollar has strengthed relative to Canada while at the same time many commodity prices have came off their peaks.

So my point is, if the dollar strengthens and weakens based on market cycles as does the debt to some extent as tax revenues change then you can't really cite debt levels as the ultimate guiding light for whether or not the dollar's value will change. Commodities have been very strong in the past but there are no guarantees this will continue to be the case.

Deborah said...


All indications are that the business cycle is declining, so that debt is likely to look a lot higher once tax revenue comes in lower than expected and employment benefits come in higher...

I certainly didn't talk about that in the post, but having that level of debt and deficit going into an economy that is slowing and has credit contracting is very bad.

Deborah said...

Deborah said...

This is another article on US treasuries.