Inflationary Implications of the Yuan/Dollar Currency Realignment

In my final Macroeconomics lecture given in May 2009 (I was on sabbatical this year) I predicted that this global debt crisis will be "solved" by a substantial inflation beginning in three to five years.

Now that a year has passed I can restate that I believe that we will see a few years of double-digit inflation within, now, two to four years. Some of the reasons I stated can be found by looking at the final few slides of that presentation, found here.

The European austerity programs that are now emerging in countries like Greece and Spain and will eventually be necessary in most other European nations, won't work. In the short run they will make the recession worse and are politically unpopular.

In the United States our annual budget deficits are so huge (around $2 trillion) and the prospects for reducing them so bleak, especially politically, that we collectively refuse to address the issue at any level. Essentially we are Portugal without a plan and without any recognition that we need a plan (or more accurately, without admitting that no plan is possible). In fact it appears this year that federal budget reconciliation, which normally takes place about now and is required by law will not even be attempted for the first time in our history.

The Chinese Contribution

The decision announced by the People's Bank of China over the weekend to effectively appreciate the Yuan relative to the Dollar will help contribute to the first leg of this inflationary impulse.

(The PCB press release actually said "... the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility," but that clearly implies allowing the Yuan to appreciate manageably against the Dollar. In effect they are returning to the managed currency policies of the years indicated on the graph).

The recent history of the exchange rate is shown in the graph and is currently at 6.8275 Yuan to the Dollar.

Although it is yet unclear when and to what degree the Chinese government allow the exchange rate to drift, it is going lower on net. The PCB has made it clear that if the Dollar strengthens substantially as it recently did versus the Euro, then the Yuan may be temporarily devalued relative to the Dollar (but appreciated relative to the Euro), but none of this makes sense unless the exchange rate above falls.

This implies of course that the Dollar cost of goods and services manufactured in China and sold in the United States will rise. For example, if the Dollar devalues from its current level to, say, 6.00, that would be a devaluation of about 14%, and although collapsing margins could absorb some of this, prices of imported goods from China would likely rise by at least double digits.

The Size of the Chinese Trade

How important is the Chinese trade?

In 2009 in we imported $297 billion worth of merchandise goods alone (while exporting only $70 billion), down from $339 billion in 2008 but recovering in 2010. That only nets to 2% of GDP but is a much higher percentage of discretionary outlays by lower income consumers (the WalMart shoppers).

By itself it is not enough to turn a period of price stability into a galloping inflation but it will probably be remembered as one of the early catalysts.

In an earlier blog I suggested, without much evidence, that some speculation in the United States, including the creeping bull market that ended a few weeks back, was partly financed by a new Chinese carry trade. I still believed that happened. This currency realignment would damage any such carry trade and makes its continuation unlikely. Although the Chinese carry trade is initiated with U.S. Dollars (the first step does not require the conversion of Yuan to Dollars), the Yuan-value of the proceeds of such trade plunges as the currency plunges. Therefore, if I am right about the presence of a Chinese carry trade during the creeping bull market, it's removal now is bearish for the U.S. equity market.

Trading Treasury Rates with ETFs - Part 2

In Trading Treasury Rates Part 1 I established a good reason for devising ways to trade U.S. Treasury interest rates without using the futures markets. In that article I offered two candidate ETFs, the iShares Barclays 20+ Year Treasury Bond Fund (TLT) and the Proshares Ultrashort 20+ Year Treasury Fund (TBT).

TLT is a long bond fund - it's value rises when the market value of long-term U.S. Treasury securities (USTS) rise (which happens when their market yields fall).

TBT in contrast is a short fund which does the opposite - it's value rises when the market value of long-term USTS falls. Further, unlike TLT, TBT is a leveraged fund and it is also a delta fund. A delta fund is designed to track the change in the value of an underlying security (rather than track the long-run value of the fund over time) day by day, percent by percent. If the fund is 2X short-leveraged like TBT, if on any given day TLT were to rise by X%, then TBT should fall by about 2X%.

The benchmark for both funds is the Barclays Capital 20+ Year U.S. Treasury Index, which is discussed in the next part of this series. TLT tries to follow the index exactly. TBT attempts to track two times (2X) the inverse of the daily change in this index each day.

Criteria for Choosing the ETFs

Now let me justify these two choices.

Of the many ETF candidates that we might choose, the following criteria should be satisfied

1. The ETF must be liquid, which implies that it should have high daily volume, especially when compared to peers.
2. If the strategy requires options, as our does, then a full range of put and call options must be available for the ETF, and the options that are near the money in near-term months must have both adequate open interest and daily volume.
3. The ETF should track well - meaning that if it promises to track an underlying index or other stated value, it should have a track record of doing that with a high degree of accuracy (the criteria would vary from one context to another, but in this context for a straight tracking ETF like TLT it should be above 95% and for a delta ETF it should be above 90%).

There are more than a dozen ETFs that track U.S. Treasury securities of various maturities. Candidates can be found in online searches at dedicated sites or in the Online Wall Street Journal Market Data section.

Daily Volume

Figure 2.1 U.S. Treasury Security Exchange Traded Funds (ETFs) shows a selection of mid- to long-term funds for both longs and shorts. A quick glance shows that only TLT and TBT have the necessary liquidity, as measured by average daily volume, to qualify for the first criterion above. The daily volume eclipses that of the other ETFs. The Proshares TBF may seem like a better candidate than TBT for short trades because it is not leveraged, but at 238,000 shares a day and no listed options it must be ruled out (N means no options, I means illiquid - inadequate open interest and/or daily volume).

Adequate Options

In Part 1 when describing general strategy I stated that if we were to use options for our strategy, we would use only puts and calls on TLT. If not using options then TBT provides a direct short opportunity but if options are required then puts on TLT are more suitable than calls on TBT.

Although the argument won't be supported with data here, because delta ETFs don't track with anywhere near the integrity of a straight tracking ETF like TLT, options on delta ETFs compound the error in tracking integrity. In a word, they are too volatile.

Even the TLT options barely qualify for serious trading. They tend to be liquid with adequate open interest and daily volume only right around the money. Also there is almost always a minimum spread between best bid and best ask of five cents and it is often higher. This is a large negative, because on many of the equity index ETFs this spread is seldom more than a penny.

Figure 2.1 Near-the-Money TLT Options shows the daily volume and open interest on TLT for May 20, 2010. As can be seen both volume and open interest is adequate for small trades (say 30 contracts or so) but not really for large trades. Although not shown here, it should be noted that volume and open interest on TBT options are at least as high as TLT and in volatile markets sometimes higher.

The Tracking Record

Traditional ETFs that track a known index over the long-run, like TLT, normally have a good tracking record (at above 95%) if they are popular and liquid.

Delta ETFs, which attempt to track only the change in the target day-by-day, sometimes with leverage like 2X for TBT, don't have such a good track record. If the Delta ETF has any sizeable error on the day-by-day target, that error can accumulate over time to where the long-term performance of the target has little correlation to the long-term performance of the ETF that tracks it.

This is partly because of how these ETFs are collateralized, which is discussed in the next part.

The criteria for measuring how well an ETF tracks its target, in this case the Barclay's Capital 20+ Year U.S. Treasury Index, compares the daily Net Asset Value (NAV) of the fund to that of the underlying index. ETF fact sheets and prospectuses can always be found on their parent web sites with a simple search and the fund performance relative to the target they track can be found in either or both.[1] If untrusting, a researcher with some spare time can use regression analysis to see how they track.

TLT tracks very closely, with less than 2% error because (a) iShares collateralizes TLT by simply buying the same securities as are used in the index in the same proportions, and (b) the stock is popular and liquid enough for the daily trading price to actually track the true Net Asset Value (NAV) of the holdings.

It turns out that even though TBT is a delta ETF and is collateralized with derivatives called Treasury Swaps, because it is also liquid, in the first quarter of 2010 only on a few occasions did it track with more than a 3% error. For short term trades this is completely adequate, although because this is a delta ETF, its usefulness as a long-term short hedge (or hedge against rising interest rates) is still questionable.

NEXT: Collateralization and pricing conventions for these two ETFs.

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[1] In this case see the ProShares UltraShort 20+ Year Treasury Fact Sheet and Barclays 20+ Year Treasury Bond Fund (TLT) and once on that page, link from Related Links and Documents to the "Tracking Error Chart."

Trading Treasury Rates with ETFs - Part 1

Suppose you wanted to trade interest rates on long-term U.S. Treasury Securities, either as a hedge or a speculative position.[1]

For example, suppose you believe, as do I, that inflation will emerge as a serious problem in the next few years because of our debt excesses. If that happens, interest rates will rise on bonds in general, including U.S. Treasury notes and bonds and, for those bonds already issued before the inflation, their market values will plunge, causing large capital losses for holders. Also the stock market typically performs poorly during periods of high inflation. Therefore a trader with fixed income investments and equities might desire a strong hedge against inflation and rising interest rates.

The futures markets offer a huge selection of hedges against interest rate movements. But not all traders like to trade futures because they dislike the implied leverage and relatively high cash requirements for trading futures, or they simply feel uncomfortable in that arena.

Exchange Traded Funds (ETFs) now offer equity traders, including those operating on a very small scale with limited budgets, a full range of strategies for playing interest rates of different markets, from U.S. Treasury Securities (USTS) to commercial junk bonds, of all maturities, from less than one year to thirty years.

This series of articles will discuss trading with interest rate strategies for long-term USTS primarily using two common and liquid ETFs, iShares Barclays 20+ Year Treasury Bond Fund (TLT) and the Proshares Ultrashort 20+ Year Treasury Fund (TBT) and put and call options for TLT.

The General Strategy

Generally the strategy will be quite simple: (1) If you think that interest rates will fall on long-term USTS then you will buy TLT or buy calls on TLT or (2) if you think interest rates will rise on long-term USTS then you will buy TBT or buy puts on TLT. (I could have included options on TBT in this mix but didn't for reasons discussed in a later article).

The general strategy is easy to explain, but once we consider questions about the proper size of trades, trade timing, and the relationship between interest rate activity on long-term USTS and the market price of USTS and, hence, these two ETFs then the specific strategy becomes much more complicated.

So we will explore this in steps. The remainder of this article is dedicated to describing and understanding the mathematical relationship between the market yields and market values of USTS.

Future articles in this series will explain (1) the TLT and TBT ETFs and how they are structured and why they are suitable, (2) how TLT is securitized and how that affects TLT's price, (3) how TLT puts and calls respond to TLT volatility and interest rate volatility, and (4) the development of trading models that make use of all of this information.

The Relationship Between Interest Rates and Market Values of USTS.

For all yield-bearing (interest paying) financial assets (YBFAs) traded in the secondary markets after their original issue, including U.S. Treasury Securities of all durations, their market values move in opposite direction of their market yields.

For example, consider a 30-year bond originally issued with a par value of 100 paying a coupon rate (original issue rate) of 4% of par annually. If 10 years later newly-issued 20-year bonds were yielding 6% at par, then the 30-year bond with only 20 years remaining in its life would have to also yield 6% to remain competitive. Because the coupon rate is a fixed constant throughout the life of a bond, the only way the old bond can raise its yield is through a reduction of its market value below par. The bond would fall to a value below par and in this case would in fact fall to a value of $77.60.

Where did I get that number?

The relationship between a bond's market value and its market yield is mathematical. Figure 1 Simple Bond Valuation Formula shows that mathematical relationship, and provided the solution for our bond problem above.[2]

Figure 2 Possible Values for 30-year Bond taken from a slide used in a lecture to explain this relationship, shows all of the possible values that this 10-year-old 30-year-bond would assume given a range of possible yields offered by newly issued competitive 20-year bonds. As can be seen in the ranges shown, the old bond can trade as high as 155 (when the new market yield is 1%) and as low as 34 (when the market yield is 14%).

It should be easy to see that in an environment of volatile interest rates a long-term bond like this example can have the same degree of price volatility as some stocks. More important, in an inflationary environment, if long-term bond yields rise to reflect the inflation, then long-term bonds will suffer serious capital losses.

Consider a real example. As we will see, one of the USTS assets used the collateralize TLT is a 30-year Treasury bond that mature on November 15, 2039, has a coupon yield of 4.38%, but on April 30, 2010 had a market yield of 4.53%, slightly higher, and therefore was trading at a discount price of 97.52. Suppose that by November 15, 2013 that because of double-digit inflation this bond had a market yield of 12%. In that case this bond would be trading for 39.84!

So in an emerging inflationary environment, you would want to be short in this bond, or short in something that tracks this bond.

NEXT: The tracking stocks (ETFs) and their options that we will use to do this.

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[1] If the reader is unfamiliar with the types of U.S. Treasury Securities available on the secondary market, review The Market for U.S. Treasury Securities.

[2] For the curious reader, this mathematical relationship and why it exists is explored in much greater detail in the document Bond and Note Valuation and Related Interest Rate Formulas. The formula shown in Figure 1 is derived in this document and more complicated bond formulas are also developed and explained.

The New Chinese Carry Trade

The old Japanese carry trade, many a speculator’s bankroll in the glory days between 2003 and 2007, is dead, buried, and gone, a casualty of the crisis.

But I believe that it has now been replaced, on a much larger scale, having much more of an impact, helping fuel yet another asset value spec frenzy on a scale that is more dangerous than the last.

Our regulatory authorities are, of course, oblivious.

This new carry trade I will call the Chinese Carry Trade, although it may be more accurate to call it the overseas-trading-partner carry trade.

I should warn that below I am not going to make an iron-clad empirical case. Most of the evidence that I have pulled together is indirect. This will be the first of two or more posts, this one laying out the theory, later posts offering some of the evidence and more detailed support.

The Old Japanese Carry Trade

In the old Japanese carry trade, speculators with connections would borrow copious amounts of money from Japanese banks, short term (on essentially commercial paper terms), at very low interest rates (below 1%), exchange yen for the dollar, invest or lend in the U.S. at higher returns with typically longer duration, which required that short-term Japanese loans be rolled over.

Obviously speculators tapping into the Japanese carry trade faced exchange rate risk. But the Yen rose on net between 2003 and 2007. From January 2005 until June 2007, probably the hottest period for the Japanese carry trade, the Yen rose from about 103 to nearly 125, adding leverage to the gains already made on interest rate spreads.

A simple example: borrow a billion yen at 0.5%, at an exchange rate of 100, convert to 10 million dollars, lend at 4.5% for a year, convert the 10.45 million dollars at a new exchange rate of 120, receive 1.254 billion yen, pay interest charges of 5 million yen, leaving a profit of 249 million yen, a return of 25% on the borrowed money and an astronomical rate of return on the much narrower equity base used to secure the loan.

Independent of the crisis, the Japanese carry trade was doomed once the dollar began to plunge from its June 2007 high to its current level of around 95. Any interest rate spread profits would be wiped out by exchange rate losses.

Sterile Dollars in China

The China carry trade works a little differently. First, dollar-denominated financial assets flow to China in exchange for merchandise flowing this way, a consequence of our massive merchandise trade deficit with China

See the chart labeled Merchandise (Goods) Trade Deficit with China, which shows our merchandise (goods) trade deficit with China for the last 10 years. In recent years we have been running a merchandise deficit of around $250 billion annually. (We ran a services surplus with China of about $7 billion in 2009, trivial when compared to goods).

Most of those bookkeeping-entry dollars, initially in the hands of Chinese manufacturers and merchandisers, are swapped at banks and ultimately the People’s (PBC) Bank of China for the renminbi at the current fixed exchange rate of 6.83. Dollars in China in some form or another now exceed $2 trillion.

For much of it, at some point, the PBC converts the sterile dollars to low-yield U.S. Treasury Securities by indirectly participating in U.S. Treasury auctions.

But not all of it ends up held as U.S. Treasury Securities. Without doubt some of it stays in dollar bookkeeping-entry form (as a dollar-denominated bank debit in China or elsewhere) whereupon it can be leant to … well, anyone who has sufficient connections and business interests and who want to borrow dollars for whatever reason they want to borrow them.

That might include Chinese speculators, both in China and overseas, who would use this funding to buy U.S. residential real estate or stocks, either in the U.S. market or any other market that accepts dollars.

If this is happening, note that there is no exchange rate risk because the originating loans can be paid back in dollars (unlike the Japanese carry trade, where the loans had to be paid back in Yen).

The Connection to Stock Market Bull-Creep

I think this is happening, and I think that the phenomenon, in addition to funding much of the foreclosure real estate sold through auctions, is creating a steady demand flow for U.S. stocks and is contributing to the current bull-creep. (I do not believe that this is the only reason for the bull-creep).

But am I right? Is this happening? If so the evidence is all indirect and not very compelling. I admit that. For one thing the Bank of China is not very opaque. Their public data are not very good and I don’t believe all of it.

But I will continue to investigate this and will relay what I discover.

Do any of you agree with me? Have you seen any evidence of this? For those of you with China connections, do you know of any specific transactions that fit the scenario described above? If so I would sure like to hear about it, either in comments or by email.