Limits of Arbitrage

Inflation and Fiscal Conditions

limitsofarbitrage — Sat, 28 Nov 2009 20:03:46 +0000

A friend of mine referred me to this presentation by the Tresasury Borrowing Advisory Committee. The committee is comprised of a number of financial grey beards that advise the Treasury and the Fed on financial conditions. This particular presentation outlines fiscal conditions and touches on the Fed “exit strategy”. It is a sobering read. But I found this chart particularly interesting.

And Hussman has found similar:

Much to chew on here…

Too Much Debt: A True Cynic Might Think…

limitsofarbitrage — Wed, 25 Nov 2009 17:06:27 +0000

“Well, the US government is too indebted. Perhaps the USG could maintain a healthy fiscal surplus for many years but this is both daunting and unlikely. But we could remedy this situation via outright default or via inflation.”

And let us suppose that our cynic is young.

“I’ve worked hard and paid my fair share of taxes. And I certainly never approved of the ham fisted spending measures that got us into this mess in the first place.”

Being young, the cynic has many years of earnings potential ahead of him. Similarly, the young cynic does not hold any fixed income investments. Why? Because his long time horizon and high risk tolerance lead him to hold earning assets (real estate, equity, etc)which benefit from a growing economy and even some inflation.

Our cynic continues:

“These idiotic fiscal policies are leading to a bloated, cloying government which discourages innovation and growth. Even worse, to actually pay for all this stupid stimulus will require egregious tax rates in the future. Those taxes hurt me doubly because my earning assets will be worth less and any income I really do earn will suffer from confiscation by said egregious taxes.”

And now the cynic sits over a drink and becomes increasing agitated and distempered.

“Well, who holds all the fixed income product and will thus suffer most from inflation? The Chinese, the Japanese, the oil exporters and domestic savers (ie retirees or near retirees).”

The cynic now becomes morose.

“Well, the chinese chose to keep the RMB too low. That was their choice. As a result of those choices, they accumulated a lot of USD fixed income obligations. Same with the Japanese. So let them deal with the inflation that will cure the disease that they helped spread. Fiat Justitia.

And the oil exporters? They are lucky enough - I need not worry about them.”

And then the painful part…

“But the retirees? They fought two world wars. The greatest generation etc. Doesn’t seem fair that they suffer unduly from a sky rocketing price level…

But the current situation is one of their design. We all must live with the consequences of our choices. And I shall care for my own.”

And so he concludes…

“So be it, monetize the debt. Increase the monetary base. Bring on the inflation. Perhaps it is the least evil of the demons that torment us.”

An Observation on Fed Actions

limitsofarbitrage — Sat, 21 Nov 2009 01:27:17 +0000

The announcement of quantitative easing led many to trot out the Helicopter Ben references. The opinions were varied (just google “helicopter ben” or “fed printing “).

I’ve read many pieces including very technical papers. I do not know why but I’ve never seen the crucial difference articulated.

Pretend the Federal Reserve were to actually fill Sikorskys (or 747s or Suezmax tankers, I mean, just how stimulative do we wish to be?) with fresh $100′s and distributed them in one manner or another. Fine, but that is very different from what they are doing now. Why? Because in that case the Fed’s balance sheet wouldn’t balance. The liability side would increase in the amount of the printed currency, but there would be no growth in the asset side. That would certainly smell like dilution/devaluation…

And that makes me think: what are the accounting entries when the Fed conducts permanent market operations?

Gold as the Denominator

limitsofarbitrage — Tue, 17 Nov 2009 16:38:35 +0000

Gold bugs hate the dollar. And they hate it reflexively. They have to. If you listen to them you will almost never hear quantitative talk of marginal supply or demand, ie traditional commodity fundamentals. Instead it is all fiat currency debasement, Exeter’s pyramid, printing presses, fiscal Armageddon, reserve diversification etc etc etc.

Now when one buys stocks and bonds, one underwrites risk. All sorts of risk (liquidity, default, business etc). Prospectively bonds and equities have positive returns because one must be compensated for accepting all that risk. Doesn’t it seem that when we buy gold we are purchasing insurance, ie avoiding risk? Why should we expect a positive return then? But anyways, I digress.

So, the USD is the denominator to the gold bug’s long trade. For just now, I want to be indifferent towards the USD. So let us take a look at the gold price using different denominators.

Although they certainly hate the dollar, I presume that gold bugs have no particular view about wheat…

And yet, gold is more expensive vs wheat that at any point in the last thirty years. Aside: If we really hate the USD, wouldn’t it be better to buy farmland financed via a long term fixed mortgage (and thus be short the USD) and farm wheat?

And the same thing in lean hogs – a big, big bull move in the gold price.

While not at similar highs, gold is now more expensive vs US homes then at any time in the last 20 years. Big question: Is it going to 30 year highs?

And aluminum? Aluminium is power. The Chinese subsidize power. And in perfect accordance with the textbook, the Chinese make a lot of aluminum. (Hugh Hendry mentions it in his interesting quarterly letter. ) The result is that gold is extraordinarily expensive compared to aluminum.*

So, it seems that gold’s move is not purely a reflection of the USD. Gold is also in a bull market move against these commodities.

Ah…but I must admit to being a bit disingenuous. I know that the above commodities have poor fundamentals. So I suspected that these charts would look like they do. There are other commodities though that have much better fundamentals (ie China is short of them), like copper, crude, met coal. How have these better positioned commodities performed vs gold?

Vs these other little angels, gold’s move looks much more muted. Where does that leave us? Like I mentioned before, I am long of gold. But it is a low conviction trade because everyone I know LOVES gold. But I suspect that if inflation fears reach a fevered pitch, gold may go into a bull move against all denominators. So in a very soft way, I guess these charts leave me thinking that gold has more headroom to advance.

But this is all just charting. We need to explore the gold market more deeply. Which means addressing the USD directly. So while I am long gold now I think that the truly exciting and profitable opportunities will be on the short side. To get comfortable though, we need better tools then just some silly charts…

** I think there will be a great shake out in aluminum. Where there is, you might want to pick up a nice bauxite mine on the cheap.

Einhorn is Finkle, Finkle is Einhorn

limitsofarbitrage — Fri, 13 Nov 2009 18:50:34 +0000

Daivd Einhorn used his last presentation at the Value Investment Congress to, among other things, bag on Japanese sovereign debt. You can find the presentation at clusterstock here.

David Einhorn is fine investor and received well-deserved praise for his crushing of Lehman Brothers at the Ira Sohn Conference in 2008. (That was an excellent presentation, it is here).

He notes that:

Japan’s demographic situation is grim
The country has a sovereign debt to GDP ratio of 1.9x
The government is running 10% deficits
Yet the government can borrow at “too low” interest rates of <2%

He then concludes that Japan is at risk of a funding crisis qualitatively similar to the one that felled the investment banks he was short one year ago. And so he is short of Japanese Government bonds (JGBs, in the parlance). I do not really disagree with any of his of findings. Yet, I would fade his trade right now.

Take a look at the chart.

Since Einhorn made his speech the CDS spread has nearly doubled from ~40bps wide to ~80bps. Japan now trades wider then the UK, Portugal and Deutsche Bank.

And why would one take the other side of his trade?

Even if Einhorn is right, there is no reason to think that a funding crisis would happen just now. (For some reason this makes me think of J. Richard Gott’s method of estimating longevity based purely on knowing an item’s existing age.) In other words, the trade moved in his favor simply because he talked it up and not due to any fundamental cause. So I surmise that his trade recommendation will fade from memory and the factors that conspired to keep yields low in the first place will reassert themselves.

This phenomena happens all the time in the market.

FT Alphaville discusses the trade further here.

Gold Thought Experiment

limitsofarbitrage — Thu, 12 Nov 2009 21:32:52 +0000

And now the aliens say, "Where Da Gold At?"

Let us pretend for a moment. Suppose that a very advanced alien race came to visit our planet. Using their alien technology, the Centauris transport every ounce of gold on Earth onto their powerful spaceship. Then they leave.

What do we suppose might happen?

As Was Foretold: Gold

limitsofarbitrage — Wed, 11 Nov 2009 23:10:28 +0000

Indeed

Disclosure: I am long gold right now. I am not particularly happy about it, but market action compels one to be on the long side. I think there are excellent arguments for inflation. I also think there are excellent arguments for a generally stable price level.

PTJ is long of gold. Dealbook mentions it and links to his letter here.

The Texans at Von Hoisington are bond bulls and thus gold bears. Here is how they get there.

I feel comfortable valuing securities. Its expectations first and arithmetic second. The inputs can be fiendish but everything else thereafter is trivial. Commodities are trickier. Industrial commodities are all marginal cost and incremental demand and substitution and David Ricardo and China. Gold is a different panda bear though. Unlike other commodities, gold is never consumed, it is simply transferred. How shall we think about it?

And folks say: Gold is money. Well I suppose, but I very seriously doubt that I could go into my local bodega and buy a six pack of tasty Modelo and get change back by cashing in a Kruggerand. I dont know of any retails trades that settle via gold (maybe in India, they love gold in India). Gold may be nice but it sure ain’t convenient. I think that money should be convenient. There are no gold ATMs. Cash in the bank yields interest. But gold costs money to store. If you wanted to spend right away, you would prefer zero maturity, zero coupon US federal liabilities*, ie cold hard cash. And if I were starving and wanted to buy food very quickly, I would very, very much prefer cold hard cash to gold.

Now you may say: “Wait, take your gold to a jeweler or to a pawn shop and then you can get cash!”

Great, I can also do the same with a tonne of unrefined copper at a smelter or a bunch of tin cans at the recycling depot. And in all these cases, one pays a big bid/ask spread to liquify those commodity holdings. “Money” should not require a big bid/ask spread. Money is the denominator.

I am just fooling around for now. More thoughts to come…Like: Can we arbitrage inflation expectations in gold against differing inflation expectations embedded in fixed income products?

*As Hussman likes to point out, take $1 out of your wallet and read the front: “Federal Reserve Note”.

Inflation / Deflation

limitsofarbitrage — Fri, 09 Oct 2009 22:41:41 +0000

I’ve been thinking about this for a while. Not rigorously because I lack the ability to focus. But generally and sloppily.

And so it strikes me that there are two factors that affect price levels. Firstly, there are monetary factors like M1 ,M2, M3, interest rates, reserves etc. And secondly, there are economic factors like productivity and capacity utilization and marginal return on capital etc. Remember that in 2003 there were fears about deflation. Of course, this had nothing to do with the monetary environment but had everything to do with the economic one, ie the effect of cheap labor in china on the prices of exportable goods.

Generally, population grows apace and productivity marches upwards at its historical rate. So the economic factors that drive price level are obscured and people focus solely on the monetary ones. Hence the obsession with fed policy etc. And so market observers almost never make a distinction between the two factors driving price level changes.

For instance, if you invented cold fusion tomorrow, oil prices would collapse and the price level would decline. Is this “deflationary”? Well, yes I suppose so in our sloppy definition of the word, but is it bad? Of course not.

Deflating prices caused by massive productivity enhancement is good. I suppose we could refer to it as “economic deflation”. It is more commonly refered to as: “society getting wealthier.” This occurred in the US after the industrial revolution. Note that the standard of living went through the roof even though the general price level fell.

Now the monetary deflation that we had in the great depression is quite bad. But these are two totally different phenomenon.

And now everyone is confused today because we have massively inflationary monetary policy but also a massively deflationary economic environment. Our definitions are all screwed up and so we cannot communicate ideas effectively.

Let me ask you this: if the fed had not been so “proactive” (some might say “inflationary!”), where would price levels be right now? Lower, naturally. So even though the YoY price level is unchanged, is it fair to say we have lived through some “inflation”? Our words are failing us again, I think.

Now Bernanke has been so proactive because he thinks that nominal price level has an impact on real GDP.

This leaves me with thousands of new questions. But I do believe that current macroeconomic thinking is incomplete. Even our words are turned around. We need an economic Copernicus in the next generation or so.

Secondary Activity is Important

limitsofarbitrage — Fri, 25 Sep 2009 15:07:14 +0000

So is China. From Dealbook:

Shares of Metallurgical Corp. of China Fall in Hong Kong Debut

September 25, 2009, 3:51 am

Metallurgical Corporation of China, a building and engineering firm that raised $2.3 billion in Hong Kong’s biggest initial public offering this year, fell in its debut on the exchange Thursday as investors apparently tired from a deluge of such offerings and judged the stock to be too expensive given an uncertain outlook for China’s steel industry.

— Updated: 10:18 am –>

Nat Gas and Curves

limitsofarbitrage — Tue, 16 Jun 2009 15:54:38 +0000

Whenever I see parabolas in the market, I immediately take notice. Where there are parabolas there is likely action. So take a look at this little gremlin:

UNG Shares Outstanding

This is a chart of the shares outstanding on the UNG. The UNG is an ETF that is meant to track the performance of nat gas. I only noticed this because of the increasing amount of chatter about UNG on stocktwits.com.

UNG Chart. Note the rising volume.

There are currently 283mn shares out and the UNG trades at $15.85 to give the ETF a market cap of about $4.5bn. And in the futures market, there are currently 68k thousand July Nat Gas futures outstanding. Each contract is worth about $42k. So there is about $4bn of outstanding contract volume. I have not read the K-1, but per the UNG website:

The investment objective of UNG is for the changes in percentage terms of the units’ net asset value to reflect the changes in percentage terms of the price of natural gas delivered at the Henry Hub, Louisiana, as measured by the changes in the price of the futures contract on natural gas traded on the New York Mercantile Exchange that is the near month contract to expire, except when the near month contract is within two weeks of expiration, in which case it will be measured by the futures contract that is the next month contract to expire, less UNG’s expenses.

Getting a little hefty there, aren’t we UNG? Remember that we talked about the way the USO got screwed? Perhaps something is fishy here as well?

Now nat gas is a bit different from crude oil for a number of reasons. Seasonality is a big one. The Dallas Fed talks about the various factors here. But lets do a quick visual inspection of the 1 month, 3 month contango in nat gas.

3 mo NG - 1 mo NG

Nothing too unusual here. Likewise, the1mo – 12mo curve is not particularly exciting. So where does that leave us? Nowhere. For now. But the UNG, NG relationship should be watched closely.

FT Alphaville has much more extensive discussion here.