Wednesday, May 19, 2010

Competitive Devaluation Draws Closer - Ari Paul

The brief summary:

-We need to start worrying about currency depreciation and inflation, although deflation is more likely over the next 6 months.

-Interest rates will likely be much, much higher in 5 years. A deflationary shock is likely to send them lower first, but we can start to slowly

scale into a short treasury position as a long-term strategy.

-Fundamentals of the EU are worse than ever, but there is now coordinated support by central banks for the Euro, so it may ignore fundamentals for the next couple of years. I

have fully closed my short Euro position.

The whole story and specific recommendations:

18 months ago the US unleashed unprecedented fiscal and monetary stimulus. A lot of pundits predicted severe inflation in short order, and the destruction of the dollar. Students of past credit crises knew better and understood that the decrease in bank lending and the drop in the velocity of money would offset the money printing, at least for a little while. Since then, inflation has been tame. Most commodities are roughly unchanged, the official measure of inflation (CPI) is up about 2%, 10-year treasury rates are near their lows at 3.4%, and the dollar basket is unchanged.

So far so good. However, the money printing will eventually have an impact, possibly even causing hyperinflation. The inflationary phase of the cycle has drawn much nearer with Europe’s announcement of $1 trillion of monetary and fiscal stimulus.

In the early 1930s, countries around the world engaged in competitive devaluation. The idea is that by devaluing our currency, our exports become more competitive which reduces unemployment. The problem is that currencies are a zero sum game. Our devaluation is another country’s appreciation. This means we’re effectively just shipping our unemployment overseas. Other countries don’t like that, so they devalue their currency in turn. This leads to cycles of competitive devaluation. Competitive devaluation may lead to very severe inflation, or, if the economy is sufficiently weak, it may simply lead to extreme depreciation.

What would extreme depreciation without inflation look like? The prices of everything would go up, but wages would lag. Inflation is a cycle that is led by wage growth. If there is sufficient unemployment, labor has little negotiating power so they can’t get significant wage increases. So for example, prices might rise by 50% while wages only rise 15%. We are all effectively much poorer.

I believe that extreme depreciation (with or without inflation) is a near certainty. The tricky question is when. If we have another deflationary shock to the system, there would likely be another flight to the dollar and another wave of deleveraging which would actually cause prices to drop. In the absence of such a shock, I believe we would get significant depreciation (and price increases) within one year. My best guess is that we will see a shock and therefore the depreciation is a couple of years away, but I have no confidence in the timing.

It is very hard to profit from depreciation. Safe haven assets like gold tend to preserve wealth, but won’t necessarily increase it. Moreoever, if we have a deflationary shock first, gold and other hard assets could plummet like they did at the end of 2008.

I believe the best way to position ourselves is to gradually scale into a long position in hard assets, hedged with short equities. Today, owning some gold is smart diversification. If we get a deflationary shock that sends gold down 25%, hard assets like gold, commodities, and real estate, will be very attractive purchases. So, begin to very slowly scale into owning hard assets, but make sure to leave plenty of cash to buy more on a deflationary shock. To be perfectly clear, my best guess is that hard assets fall over the next year, but I expect them to be a good purchase over the next decade. Given my uncertainty on the timing, it is prudent to begin scaling into a long position very slowly over the next few months.

There is no great way to wager on rising interest rates. It is very likely that interest rates will be much, much higher within 5 years. ETFs like TBT are terrible investment vehicles because they have massive hidden transaction costs. The best method I can think of is to short sell the long bond ETF TLT. The risk is that short selling may be banned on a severe market sell off, or the ETF could go “hard to borrow” which means your broker would start charging you outlandish interest to be short the ETF. A riskier and more sophisticated approach is to sell calls on TLT every few months.

There is coordinated worldwide support for the Euro by central banks. Coordinated currency interventions are rare, but usually very successful. The world supported the Euro in 2000 successfully and pushed up the Yen and the Mark versus the dollar in 1985. You can’t fight central banks in the short-term. In the long-term the fundamentals will reassert themselves but it could be a long wait.


  1. Wouldn't the trade be buy puts on TLT and even then you are better with leaps limiting your downside risk to the amount of the put?

  2. Nevermind. I'm retarded. I should read the whole thing before i talk. How crowded do you think the trade is? Its basically disaster insurance for the duration of the options.