Treasuries' True Risk

“A ship is safe in harbor, but that's not what ships are for.”
-- William Shedd

The majority of analysts today believe Treasury prices will fall when the appetite for risk returns. That is certainly one way to justify the fact that the price of Treasuries hovers at historical -- and dangerous -- highs. But there is another more volatile, yet less scrutinized potential outcome to this tale: Treasury prices may succumb, not because an appetite for risk drives capital to other asset-classes, but because Treasuries -- the yields of which are commonly referred to as the "risk-free rate of return" -- are finally exposed as, perhaps, the riskiest assets around.

Treasury prices move inversely to their yields, which are at record lows. How can a "risk-free" asset that returns, at best, 3% for 30 years be considered "risk free" if that asset's value will fall dramatically should interest rates even approach the historical average? Said another way: why would investors place capital in an asset that only pays a maximum of 3% per year, for 30 years, with almost no possibility of capital appreciation?

Shouldn't that mean yields are almost certainly going higher?

I'm going to digress a bit. A few days ago, a reader commented that she didn't understand why I keep insisting that inflation is not defined as rising prices, but that it is the result of rising prices. To some of you, this might seem difficult to comprehend -- probably because you are so used to the usage popularized by media and government propagandists. Let me assure you, however that rising prices are not inflation; rising prices are resultant -- universally-rising prices are merely the products of inflation, which is defined as an increase in the supply of money in an economy.

Paper money is not scarce -- governments can print it at will, and therefore it is inherently inflationary. It is difficult, however, to increase the supply of gold in the world. Yes, the supply increases marginally each year, but it cannot be created out of thin air; it must be discovered and mined, which carries tremendous costs, thereby contributing to gold's scarcity.

Let's suspend disbelief for a moment and pretend we have an economy whose base currency is gold only. In this hypothetical economy, while it might be conceivable that prices could rise because of the immutable laws of supply and demand -- within asset-classes -- it is inconceivable that gold could become less valuable because of increased supply (it is very difficult to increase the supply of gold, as we said). And this is the heart of my point: currencies -- whether based on gold, paper, or pigs -- are not immune to the laws of supply and demand. If gold is the base currency, It can certainly become more valuable with increased demand and/or decreased supply, but it cannot become less valuable because of increased supply (or not much, anyway).

When fiat paper money is printed, however, it can and does become less valuable as supply increases, because it is easy and relatively cheap to print money -- especially electronic money.

Let's put it another way. Let's say Apple (AAPL) cut the supply of iPhones in the economy over the course of a month, and the price of an iPhone doubled. Would you say that the iPhone was inflationary? Of course not! You'd say the the supply had been halved, so the price doubled!

If gold were our currency (or if we issued currency carefully backed by some appropriate amount of gold), rising prices would be strictly a product of supply and demand. "Inflation" would cease to exist -- for all intents and purposes -- because there would be no way to increase the supply of money. And this is why I say that universally rising prices in an economy based on fiat currency are not "inflation;" they are the product of increasing the supply of money. It's true that some goods and services might become more valuable as demand increases, or as supply diminishes, but universally, prices would not increase as a result of increased money supply, because there is no way to meaningfully increase the supply of gold in the world!

There is an argument that credit is part of the money supply -- that is to say, every time a person or institution uses credit, more money is created because no cash has actually changed hands. On the surface, the proposition seems sound; after all, when you use your credit card, for instance, to buy a television, the money goes into the vendor's account, and yet you haven't actually given the store any of your money, per se. You still have your money. The store has its money. More money.

This, however, is nothing more than the abuse of an obscure form of accounting called cash basis, which says that revenue is earned only when cash is received, and expenses are incurred only when cash is paid out. I'm sure cash-basis accounting has a place somewhere in the world, but the vast majority of businesses adhere to another convention called accrual-basis, which says that revenue is earned and expenses are generated at the moment of the transaction -- not when cash changes hands. The reason this is important is that it allows for convenient accounting of receivables and payables, and if you've ever tried to run a business, you know how incredibly difficult it would be to survive if you weren't using receivables and payables.

This is why I think it's absurd to say credit increases the money supply. Going back to our example above: when you pay for a television with your credit card, you are actually incurring debt at the same time you acquire the television, and that balances the equation. No wealth has been created out of thin air -- the debt you owe is balanced by the equity you received when you purchased the television.

Now I'm not going to sit here and tell you that leverage isn't dangerous -- even in an economy whose currency is backed by gold. But leverage does not increase the money-supply. Leverage increases debt. Thus, I will make the argument that inflation only exists when a government prints money. And just to hammer the point home, I will remind you that the imminent subsequent rise in prices and interest rates are not inflation, but rather they are the results of inflation.

In this crisis, the Fed is printing money at an unprecedented rate to battle what it is calling "deflation." But it's not deflation; it's de-leveraging. Just like inflation is defined by the printing of money, deflation can only be defined as the removal of money from the economy. The Fed, however, wants to print enough money to stimulate prices and get people spending again. In effect, the Fed is, yet again, encouraging exactly the type of behavior that causes bubbles in the first place. It's a vicious cycle: create cheap money out of thin air, thereby encouraging spending and investment, which in turn creates artificially inflated prices, which ultimately results in a bust, which the Fed battles by creating cheap money out of thin air... and so on and so forth.

So here's the real question: how many times can the carousel go around before it falls off its axis and destroys itself with its own momentum?

And now, finally, we can complete our own little rotation and return to Treasuries. Perhaps the most unfathomable part of this game is the newest tactic the Fed is employing: quantitative easing. Essentially, the Fed intends to escalate its printing spree in order to buy longer-maturity Treasuries. The idea is this: Treasury prices are inversely related to yield, so if the Fed buys those bonds, it can drive yields lower, thereby encouraging yet more cheap loans, followed by more spending and investment. But here's the rub: the Fed -- which is nothing more than an illegitimate wing of the government -- is printing money which it will use to buy debt issued by the Treasury -- yet another wing of the government. Are you starting to see what I'm getting at?

Here, I'll simplify it: your government, through Legal Tender laws, is forcing you to use dollars to navigate the economy in which you reside. It is then printing this currency with reckless abandon. Finally, the same government is issuing more debt than ever before in history, which it will loan to itself (or borrow from itself, depending on how you look at it) by employing the nearly innumerable dollars it has printed.

It used to be that a dishonest person had to rob Peter to pay Paul if he wanted to get ahead in life. But times have changed; the old way of doing things just isn't sophisticated enough to fool, say, an entire globe. No, these days, apparently Peter must first print a bunch of cash, then borrow it from himself, and finally dump it from a helicopter in Paul's front yard.

Do you still think Treasuries are "risk-free?"

I'm done here. I'm going to go buy some gold.

Disclosures: Paco is short U.S. Treasuries through the Proshares Ultra Short 20+ Treasuries ETF (ticker: TBT). He is long physical gold, and the Proshares Ultra long gold ETF (ticker: UGL).

Copyright 2009, Paco Ahlgren. All Rights Reserved.

Comments

[SW Richmond:]

I'd like to add something to your early discussion of prices. A free market economy uses price signals to allocate resources. This system relies on currency stability to send accurate price information. If the value of the currency fluctuates then it is impossible to develop an accurate understanding of actual pricing. Also, governments try to tamper further with prices through regulations and the tax code, further confusing the free market system's pricing mechanism.

As you point out, gold is a stable currency and solves the first part of this problem. The solution to the second part is a little harder.

Jan 18 02:07 PM

[kubilai:]

Say John Doe has 1M. He buys a house for that amount. Then he takes out a 800k home equity loan and buys another house with that. Then he takes out a 600k home equity loan on the second house and buys a third house. Although we started with 1M of hard currency, the end result is there were 2.4M of cash out there chasing real estate. This is how the use of credit increases the aggregate buying power out in the world. This buying power is what they mean by the loose definition of money supply. So loose credit standards increases loose money supply growth the same way as reducing bank reserve ratios.

Jan 18 03:26 PM

[Paco Ahlgren:]

Again, that's leverage, not new money. The accounting equation is:

Unless you're printing money, it's zero-sum. You don't create money by employing leverage. You only create money by printing it.




On Jan 18 03:26 PM kubilai wrote:

> Say John Doe has 1M. He buys a house for that amount. Then he takes
> out a 800k home equity loan and buys another house with that. Then
> he takes out a 600k home equity loan on the second house and buys
> a third house. Although we started with 1M of hard currency, the
> end result is there were 2.4M of cash out there chasing real estate.
> This is how the use of credit increases the aggregate buying power
> out in the world. This buying power is what they mean by the loose
> definition of money supply. So loose credit standards increases
> loose money supply growth the same way as reducing bank reserve ratios.

Jan 18 03:50 PM

[Paco Ahlgren:]

Sorry... the accounting equation is A = L + OE.


On Jan 18 03:26 PM kubilai wrote:

> Say John Doe has 1M. He buys a house for that amount. Then he takes
> out a 800k home equity loan and buys another house with that. Then
> he takes out a 600k home equity loan on the second house and buys
> a third house. Although we started with 1M of hard currency, the
> end result is there were 2.4M of cash out there chasing real estate.
> This is how the use of credit increases the aggregate buying power
> out in the world. This buying power is what they mean by the loose
> definition of money supply. So loose credit standards increases
> loose money supply growth the same way as reducing bank reserve ratios.

Jan 18 03:51 PM

[Paco Ahlgren:]

Yes, this is the heart of Mises' "Economic Calculation Argument" -- that we can't know the relative scarcity of goods and services if prices are manipulated. Scarcity is determined by pure money transactions, and any interference by any entity or entities other than the interested parties in the transaction distort prices, and with them our ability to determine the scarcity of the good or service in question.


On Jan 18 02:07 PM SW Richmond wrote:

> I'd like to add something to your early discussion of prices. A
> free market economy uses price signals to allocate resources. This
> system relies on currency stability to send accurate price information.
> If the value of the currency fluctuates then it is impossible to
> develop an accurate understanding of actual pricing. Also, governments
> try to tamper further with prices through regulations and the tax
> code, further confusing the free market system's pricing mechanism.
>
>
> As you point out, gold is a stable currency and solves the first
> part of this problem. The solution to the second part is a little
> harder.

Jan 18 03:53 PM

[kubilai:]

Ok, you're right only printing hard currency creates inflation by the original definition of inflation. It's so easy to be confused what people mean thanks to the meaning of the word being changed over the years. All I meant to say is that leverage creates a widespread increase in prices, just as printing currency does.

Jan 18 03:56 PM

[Paco Ahlgren:]

I'm not sure that's an absolute. Unless you have a central bank manipulating the money supply and encouraging people to use leverage, rates should remain high enough to prevent the abuse of credit, and asset-prices shouldn't increase, economy-wide.

Jan 18 04:15 PM

[kubilai:]

If markets were perfectly efficient, I would agree. But it's not. I think business cycles do exist even in absence of a central bank. Central banking just makes it worse, much worse in this case. Though, if you wield that much power, would you be tempted to give it up before the whole thing collapses?

Jan 18 04:32 PM

[Lonestar1:]

Treasury yields were pushed down so low by institutional investors, not by individual investors. Yes, it makes no sense for individual investors to buy Treasuries of any maturity at such radiculous yields. One can get better rates on bank CDs. If anybody is arguing about the risk of the banks, then one can argue about the risk of brokerage accounts used for holding Treasuries.

Institutions, with multi-billions dollars to park somewhere, have no choice but buying Treasury bills, even at slightly negative yields. No other instruments can offer such convenience and liquidity at $ billion levels.

That being said, I am holding all positions the author holds. But the near term breakdown on Treasuries can not be expected.

The first Trigger for such break should be from institutional investors when risk taking activities rise more forcefully. So far, such activities can only be observed at a moderate pace in corporates bonds, MBS and some distressed assets. These insititutional investors are acting as vultures.

More decisive break would be after Stock market reaches the cycle bottom. Frankly, we don't know where is the bottom.

The final blow would be the dumping by foreigners. But this is not an economic event. It is a partial phaseout of $ and would imply geopolitical realignment. There may be some clue at the next G20 meeting.

Jan 18 05:37 PM

[Stephen Ros...:]

If the Federal Reserve buys long term Treasuries to bring down interest rates, doesn't that work against your short position. Don't they bury you in the end? After all, as you say in your piece, they have unlimited firepower (the printing press).

Jan 18 05:45 PM

[Chris Ferna...:]

Hey Paco,

I loved your article above and the analysis, and would love to reprint it on my website PeakStocks.com

Since there is no way for me to contact you via Seeking Alpha other than this posting, can you please visit my website: PeakStocks.com, and simply use the contact form at the bottom of each page, to email me, and we can discuss republishing this article on the site with full attribution of course.

Chris Fernandez

Jan 18 06:18 PM

[Glen Bradford:]

Looks like Chris Fernandez beat me to the punch here. Good work, glad you back it up with your ownership of TBT.

Jan 18 06:42 PM

[Hefaistos:]

I agree with most of your analysis, Paco, but not with your conclusion and trade! I wouldn't take those short positions at this point in time - it's way premature. It will take a long time for the treasury bond market to crash. The Fed is already monetizing long bonds (buying them in the market), thus keeping rates down at extremely low levels, and bond prices high. This will continue as long as the housing market needs support by low rates, which most certainly is Obama policy. And that support will be needed for at least another year.
In the end, yes, there will be some inflation and maybe a crash in bond prices, but it will only happen when asset deflation in houses has stopped.

Jan 18 07:23 PM

[Jonny P:]

First,where did you get your definition of inflation?

I don't quite follow you, the author, here. I have been trying to understand how money is "created" for a while now. Are you saying that fractional reserve banking does not create new money? Because I thought it did, however, when the debt is paid off, the money "goes away."

Also, with fiat money, isn't there no fixed supply of money? I thought that inflation is caused when people are actually spending money, not by merely printing money. So, the money supply only rises when the money is flowing in the market, right?

Jan 18 07:31 PM

[Apple:]

The lack of trust in USD means it is either gold or santa cruz red feather money (see below) as a store of weath. a roll of red feather money purchased for US$30 in 1990 now is valued at US$15,000. red feather money has out performed.

Unique Red Feather Money of Temotu
BY GINA MAKA'A
Before introduction of money in Solomon Islands, the currency came in different forms for the nine provinces of the country.
Of the many examples is the famous red feather money from Santa Cruz Islands of Temotu Province.
The red feather money is two inch wide and 30 feet long made out of glued fiber feathers, particularly the downy red feathers plucked from the breast, head and back of a tropical forest bird.
The bird which the money is made out from is a small scarlet colored honey eater, which in scientific term is called the myzomela carnalis of the rain forest.
In an interview with Solomon Times, Patricia Luilamo who works at the National Museum of Solomon Islands, and from Temotu Province, said that the money is produced by the natives of Santa Cruz and used mainly by their people for bride price, compensation and land.

She told Solomon Times that in the ancient days, the money is distributed to other islands in Temotu Province like the reef islands.

"One special thing about the red feather money in the olden days is that once our people in Santa Cruz give the money to neighbouring islands, sometimes the islanders will have to export some of their women to Santa Cruz as concubines, unlike today women go to other islands as wives only."

Mrs. Luilamo said that today, the red feather money is no longer practiced because changes taking place in the country now.

"But as a person from Temotu, I am proud to say that our traditional money is unique and has a very special feature unlike other traditional money from other provinces."

Jan 18 07:51 PM

[Paco Ahlgren:]

Again, think of the accounting equation. Leverage does NOT create money or wealth...

As for the definition of inflation, well, I'm an Austrian. You're right...rising prices and rates can only occur after printed money makes its way into the economy. My article yesterday (or any of the past week) should explain to you why inflation can only be defined as an increase in the money supply.

Thank you for the feedback.

Jan 18 07:55 PM

[tdillian:]

to the author:

very interesting article.. I must admit.. I am one of those people who looked at inflation as the cost of food ,for example, rising... but you are correct.. the food costs more b/c of a lack of supply.. and as a result needs more fiat currency, which can be printed out of thin air and therefore there is really an endless supply..
and as food supply dminishes, it will require more gold (if that was the only currency),...

hmm.. very interesting article.. thank you.

Jan 18 09:25 PM

[kubilai:]

I'm Austrian too.

Anyway, careful with the treasury short. These short ETFs don't work as you expect them to for medium to long term holding. The Japanese experience showed how high/long government bond can get even in the face of massive quantitative easing. You can argue it was because of the yen carry trade, and I would agree. Still, this can easily last another year.

Thank you for the thoughtful articles.

Jan 18 10:17 PM

[Paco Ahlgren:]

Yeah, you know what? I actually think you're right.

Sigh...

So we're all in agreement that the Treasuries are going to fall apart! Now we just need to figure out the calculation that let's us know the price day to short them! :-)

As to your comment about TBT... many, many people have warned me against it. I'm asking this question to everyone here; is there a better alternative to better approximate short treasuries than TBT?

(Believe me when I tell you I've looked long and hard!)

Thanks for your thoughts.

Jan 18 10:42 PM

[kubilai:]

One possibility is using treasury bond futures. Looking at the monthly volume report at the CME and the spread right now on a Sunday evening, it appears liquid enough to be much more efficient the the short ETFs.

Also, the government can easily defeat a short treasuries strategy by persistently monetizing treasury debt. It's omnipotent at creating fiat currency out of thin air, but as we all know, not very good at creating real wealth, such as commodities. ;) So maybe short USD long commodities (food energy gold) is all we need? The danger though, is that commodities might go down further still, and it may take a long time for inflation (Austrian) to defeat de-leveraging. All million dollar questions hehe.

Jan 18 11:49 PM

[kubilai:]

It takes minutes to weeks to de-leverage a stock portfolio (depending on size). How long does it take to de-leverage a venture capital portfolio? A real estate portfolio? What other skeletons are hidden among the "toxic asset" closets of the world?

Jan 18 11:56 PM

[Ricard:]

Good discussion. This feels like deja vu to me - I've been through at least five or six similar discussions in the past two months looking for the same solutions.

"It used to be that a dishonest person had to rob Peter to pay Paul if he wanted to get ahead in life. But times have changed; the old way of doing things just isn't sophisticated enough to fool, say, an entire globe. No, these days, apparently Peter must first print a bunch of cash, then borrow it from himself, and finally dump it from a helicopter in Paul's front yard."

As for your printing money theme, it's not much different than a corporation diluting equity through stock issuance. This scale is much, much larger, but the theme is the same - outside assets from somewhere are needed in the corporation called the government in order to continue operations. I avoid using the debt theme because inflation is the topic, not solvency.

I had a discussion with crocodilian where he posited that perhaps the US retail investor is plowing their savings into Treasuries, thereby keeping rates low and the easing palatable. Seems it certainly is not coming from abroad.

seekingalpha.com/artic...

seekingalpha.com/artic...

Anyway, good luck with your investments.

Jan 19 05:47 AM

[Moon Kil Woong:]

Thanks for enlightening people about this. Pumping money into the system is ok if you have a corresponding production and consumption of resources. If you don' however, you should be wary about what you are doing because when the money multiplier re-expands you could be swimming in a lot of useless paper.

I am doubtful increased money supply will solve this de-leveraging since it is quite severe. And I am doubtful that the Fed and government can contract the money supply when the money multiplier expands again. Thus, things look grimmer and grimmer with each silly government stimulus action. The economy can't expand without high inflation and the economy can't purge its excesses and de-leverage properly.

So much for a free market and useful economic indicators. The only indicator left is what stupid thing the government will do next. If they say first person to build a city at the bottom of the Atlantic gets $100 billion and everyone jumps at it, can you call it a wise investment or a intelligent market driven action. OIf course not. Thus we get very stupid useless things stimulated only by random government action that leads to even more instability and corruption. And each project just adds to the problems since they need not be connected to any long term viability.

We should be funding strong banks to take over the assets of weak banks, not supporting weak banks like Citibank. We should be funding strong viable industries rather than funding weak dead end industries with bad management like GM. The argument against that is that if you fund a strong industry they often don't need the money and it will lead them to be less competitive and government dependent in the long run. This is even more strongly so with weak companies. They will get less and less competitive and more and more dependent on the taxpayers benevolence.

The auto industry has been begging for government help for 3 decades now (ever since the 1970's and Chrysler's bailout. So far they learned not to innovate unless the government funded it. They have become a hopeless basket case dependent on free handouts long before this year.

Actions that separate economic signaling from businesses is what sunk the USSR from a super power to a super messed up economy. We should learn from the m before it's too late.

Jan 19 06:11 AM

[Top Gun:]

Here's our problem. Your guy buys his houses, his buying bids up the price of each house, so his $1M house goes to $1.2M. Now his neighbor takes out a new home equity loan, for real money, and spends it in the real economy increasing velocity. Hence the creation of credit is in fact inflationary(in the sense that real economy prices are bid up) until the asset bubble pops. The neighbor owes $200k for stuff he's already bought.

This entire problem is a legal Ponzi scheme. In our current state, we need regs that severely restrict banking leverage, but those regs can't be implemented until real money replaces the over leverage of the banks, coupled with write downs.

The more write downs we have, like the RBS $41B today, the closer we come to inflation.

Jan 19 09:20 AM

[Conan the B...:]

I always thought that "write downs" meant the destruction of assets. If those assets are replaced, it would be a "zero sum game" as Paco keeps reiterating.

So, Mr. Ahlgren: whereas, leveraging will not create new money since new money has to be printed, leveraging Will allow for greater "purchasing power" where it is employed.

Leverage was used to circumvent the actual amount of "Printed Money" in circulation. Financial institutions were creating Derivatives which allowed them, in actual fact, to issue their own Money. These Derivatives had/have Dollar values.

New Wealth/money was created without a corresponding increase in Governmental printed money. The Backers of this newly electronically Printed money were the Financial institutions.

LOL in applying GAAP standards to non-government issue paper. IMO

Jan 19 10:10 AM

[Sigmund:]

Rising prices are, indeed, generally the expression of inflation. More to the point, inflation most commonly occurs when there has been a debasement of the money supply. Now, how does one debase a fiat currency? If the response is by printing more money; then, we will be quibling about degree. Is it merely inflationary, or, is Weimar Republic? As to safe rates, the flight to safety has driven interest rates well below where prudence would otherwise dictate. What we are confronted with is a 'safe rate' that has a high probability of not being secure. Indeed, several treasury instruments are priced at premiums and should interest rates increase, even your capital will be at risk. Now, given the debt that the government is commiting to would you buy term paper from anyone that had a low interest rate. So, here we are the great constitutionally empowered federal republic looking no better than a 'banana republic'. The great problem confronting us is: who will buy the paper the government will have to sell and at what price(rate)? Wholesale bankruptcies and restructures would have been more painful, but better in that the degree of loss would have been smaller and the currency would be more credible.

Jan 19 10:44 AM

[Paco Ahlgren:]

The accounting equation illustrates that an entity cannot simply create wealth from nothing. The government isn't beyond reproach; it cannot create value out of thin air.

GAAP exists is to keep entities from trying to "report" financial conditions that violate the immutable law of scarcity -- that is to say that wealth really CANNOT be created out of thin air.

I know, I know. Enron and Worldcom tried, and sure, it worked for a while, but...

The U.S. federal government is doing the same thing. Sure, it has worked for a while, but...

In any case, Washington is depending on people who believe it is immune to the accounting equation. As long as those people keep believing that printing vast quantities of currency, and issuing vast quantities of debt is fine, then they'll get away with it.

Well, not forever, but...



On Jan 19 10:10 AM paultaut wrote:

> I always thought that "write downs" meant the destruction of assets.
> If those assets are replaced, it would be a "zero sum game" as Paco
> keeps reiterating.
>
> So, Mr. Ahlgren: whereas, leveraging will not create new money since
> new money has to be printed, leveraging Will allow for greater "purchasing
> power" where it is employed.
>
> Leverage was used to circumvent the actual amount of "Printed Money"
> in circulation. Financial institutions were creating Derivatives
> which allowed them, in actual fact, to issue their own Money. These
> Derivatives had/have Dollar values.
>
> New Wealth/money was created without a corresponding increase in
> Governmental printed money. The Backers of this newly electronically
> Printed money were the Financial institutions.
>
> LOL in applying GAAP standards to non-government issue paper. IMO

Jan 19 10:53 AM

[The Vet:]

Paco, congratulations on an excellent piece.

Many cannot understand the difference between fiat money and gold as a means of representing value because they have only been exposed to fiat as the basic unit of valuation and store of value.

The argument that the world could not advance economically due to the obvious limit in annual production of new gold is a fallacy. Under a gold standard the price (expressed as a weight of fine gold) for every good or service would adjust according to the ease or difficulty (expense in labour and energy) of producing that good or service relative to the expense incurred in producing the price of that quantity of gold.

As a result an increase of demand for a commodity or service which could not be easily met by an increase of supply at a particular price (expressed as a weight of fine gold) would result in an increase in the price of that item until the supply could meet the demand. As this increase could exceed the increase in the supply of gold the prices of all other commodities and services would have to fall slightly to maintain reasonable relative values.

Increases of demand for all commodities and services (growth) over and above increases in the supply of gold in turn would result in an increase in the "price" of gold relative to everything else but supply would always remain relatively stable, so as a result the economic system and prices would also be stable.

Jan 19 11:01 AM

[SGINSC:]

I have enjoyed reading your posts and this discussion, although not being well versed in finance or economics, I miss completely some of the more salient points both pro and con. I am simply a retail investor trying to navigate my way in times when fundamentals account for far less than emotion and mass hysteria.

I agree completely with you predictions, but alas timing is always the crux. Clearly treasuries are in a bubble, and must come down, but when?

I feel you on TBT. I have identified no better option, so I am long. The many negative comments on how the UltraShort ETF's function have made me shy away a bit, and I have reduced my TBT position somewhaht in favor of a strategy geared toward trying to predict where the money will flow first when pulled from the treasury market. I see long investment grade bonds (via LQD), and more recently junk bonds (via HYG), benefitting first as these are a relatively low risk option for battered investors currently hiding out in treasuries, if and when their risk appetitie returns. Given the uncertainty of how TBT will actually perform, this seems to me a more prudent course. Of course, when the effects of the quantitative easing finally kick in, the bonds will fall, so I watch them closely. I look for a return to levels seen during the "merely crappy" economic times of last August/September as an exit, and LQD is arguably there already.

I am long gold, formerly via GLD, and more recently via AUY calls. Also averaging into USO and UNG and other natural resources as I would expect their performance to be comparable to gold as the dollar gets hammered. I also avoid the need to predict where a resumption of growth will ultimately come from, as wherever that is raw materials will be consumed, and their prices will be up owing to a devalued dollar.

Should get a bump on these from the various stimulus packages as well why waiting to see if anything works to get money velocity up again.

It does seem clear to me that the current situation is not sustainable. The wait may be long, but I am a patient man. As soon as we see a turn in housing prices (maybe late '09?) I see the government purchases of treasuries backing off in a hurry as yields will have to rise to maintain foreign financing of the enormous debt.

That's one man's view from below at any rate.

Best wishes and thanks for your thought-provoking articles.

On Jan 18 10:42 PM Paco Ahlgren (Bona Fide) wrote:

> Yeah, you know what? I actually think you're right.
>
> Sigh...
>
> So we're all in agreement that the Treasuries are going to fall apart!
> Now we just need to figure out the calculation that let's us know
> the price day to short them! :-)
>
> As to your comment about TBT... many, many people have warned me
> against it. I'm asking this question to everyone here; is there a
> better alternative to better approximate short treasuries than TBT?
>
>
> (Believe me when I tell you I've looked long and hard!)
>
> Thanks for your thoughts.
>

Jan 19 01:04 PM

[AJCMR:]

That all assumes the debt side of your equation is actually worth its face value (which as we are seeing today it is not) and that there is actually an ability to re-pay that debt in the future.


On Jan 18 03:50 PM Paco Ahlgren (Bona Fide) wrote:

> Again, that's leverage, not new money. The accounting equation is:
>
>
> Unless you're printing money, it's zero-sum. You don't create money
> by employing leverage. You only create money by printing it.
>
>

Jan 19 01:14 PM

[kelm:]

There have been a lot of comments on this issue in various places claiming that the destruction of wealth is not off set by the printing of money and so the net effect is deflationary. That argument has seemed wrong to me but I was struggling with the rationale.

Thanks for a great article that clarifies the point!

Of the wealth destroyed an enormous amount was simply an artifact of leverage and so did not inflate the money supply. The remainder was created out of economic activity. The dollars being printed now are out-and-out currency debasement. At some point gov't bond yields go up as the money comes out of the country and the dollar drops - hard.

Jan 19 01:36 PM

[ussmls7:]

As I read every ones view point on this very important issue,I would invite you to read a recent document uncovered by "Elaine Supkis, it"s posted on gata.org web site! James Turk has helped also by his essay also posted on Gata's site! Titled "The Feds Blueprint of Market Interventions"!! It seems the Fed has been very busy for many years & this "Secret Doc",Elaine Supkis & James Turk will help explain & define its contents & what effects its has had on this Nation & the huge loss of Wealth Americans are feeling & will continue to feel as the Fed gains more power! It's like Time Travel,when you read the Secrets of the past,that still ring true today,as the Fed has not released any data,to those that used Legal Channels to seek that data,have yet to be able to access the requested data?
The old Secret Document should be a eye opener for the bond markets & all of the Goldbugs out there! I hope it helps every one,because with a Train loaded with economic nightmares,gaining speed,understanding whats in the Feds Secret Doc from 1961 is Vital to all. Now if only there was a Real Coverage by the MSM, of the Contents of this Feds Secret Doc of 1961,and have it explained to all Americans in a simple way,that all could understand the Meanings of all the Content & what it has done to our Nation. I have read the doc many times,but when it was explained & broke down by Mr Turk,I got more involved & it angered me! Now the more I understand, I Ask Why the Congress of this Nation will not Stand Up with Ron Paul to End the Fed & all of its ties to the familys that it Supports? They are scattered World Wide,with each one them having endless resourses to Control the Money as they see fit! So any one that has put money in the markets,you are the mercy of the owners of the Fed! Watch Out!!!

Jan 19 01:41 PM

[Gedankonomist:]

"I'm going to digress a bit. A few days ago, a reader commented that she didn't understand why I keep insisting that inflation is not defined as rising prices..."

Defining inflation to be rising prices is like defining cancer to be a situation when one has a tumor.

Perhaps it's true, but it's childish and does not say much.

Jan 19 01:59 PM

[agent:]

If the government just allows the dollar to devalue to avoid the politically unpopular move of raising interest rates, and then the Fed just prints more money to buy the new debt issues of the Treasury, then shorting the long treasuries would produce little benefit in dollar terms, while the real value of the dollar (eg. against gold) declines. In that scenario, shorting treasuries would be a losing proposition and longing gold would be more profitable. Alternatively, if the government increases long treasuries rates, shorting the long treasuries would become profitable, but would gold in a high interest environment be necessarily battered to lower than today's levels, or would it still hold up because of all the reckless money printing that had already taken place? I tend to think it is less risky to bet on gold than to bet on a short trade on long treasuries, and I welcome other's opinions.

Jan 19 02:29 PM

[henarl:]

I went long TBT on 12-23 at $36.56. But, since I agree that timing is everything and the Fed can and may hold treasury yields down, thereby holding bond values up, for a long time (altho not forever), I also sold Mar. 37 calls for $4. I'm willing to take an 11% return in 3 months and look at the situation again then. I doubt that rates will go down enough in three months to pull TBT down to $32.56 but, of course, I could be wrong. So far so good.

Jan 19 03:33 PM

[iubica:]

I'm no economist either. Inflation is understood as a general rise in prices of goods and services. At least that's what the wiki page claims.

en.wikipedia.org/wiki/...

So I'm not sure I buy what is said in the article:
"... I will make the argument that inflation only exists when a government prints money."

The wiki page is much more nuanced on this. It agrees that over long term, inflation is almost always caused by money supply. But over short term, inflation can be influenced by demand, supply, also by the psychology of the masses.

The following fragment explains what's behind some people's desire to return to the gold standard:

"If gold were our currency [...], rising prices would be strictly a product of supply and demand. "Inflation" would cease to exist -- for all intents and purposes -- because there would be no way to increase the supply of money."

Really what they are trying to do is to prevent the government from increasing or reducing the money supply. But that is a recipe for disaster. The situation is bleak as it is, but if the Treasury was not pumping money at this point in the economy, we'd be looking at soup lines right now.

Jan 19 03:45 PM

[Paco Ahlgren:]

en.wikipedia.org/wiki/...

Scroll down until you see "Inflation."

The only reason our economy is in this mess is because the government created incredibly easy money that caused artificial increases in asset prices. Throwing money at the problem again is only going to cause more mal-investment. Except it isn't going to work this time.

The dollar is broken. I know all you people who got A's in your freshman econ classes think we can keep perpetuating this cycle, but that's simply not true. We don't manufacture anything of substance. We are a debtor nation. We have committed ourselves to $8.5 trillion in programs and stimuli -- more than all other wars, projects, purchases, and endeavors in our history, in real dollars, COMBINED!

Keynes is fun and all that when you're a creditor nation on the gold-standard, full of people who want handouts. It'll work for a generation. Or maybe even three. But that was then. This is now. You can sling Keynesian theory around here until we elect a fat Filipino guy name Rufus as president. I don't care. Math is math, and the Austrians are finally being vindicated.

So far today I've heard that the U.S. government can make gold. I've heard that the velocity of money (or the lack thereof) is the reason it's okay to continue printing money with impunity. I've been told fiat dollars are more valuable than gold. I've been told it's just as easy to reel dollars back in as it is to throw them out into the world.

Seriously, people. Do you believe in the tooth fairy too? Inflation is coming, and it's going to be horrible. We can't just continue to issue debt and expect the Chinese and the Japanese to fund it. We can't maintain this standard of living as a service-based economy. We can't have starting salaries for auto-workers of $50,000 a year and expect to compete. We can't continue to fund Social Security, Medicare, and Medicaid forever.

Our budget deficit is going to top $1 trillion dollars this year or next. Are you paying attention?

Oh, and whoever it was that said I'm being irresponsible by not disclosing the fact that a 2X ETF is leveraged, will you please, please, please take a deep breath and pet your dog (or something) before you actually eject such a thought into the world for the scrutiny of your peers? Please?

Should I also disclose that ETF stands for "exchange-traded fund?" Would that make me a better person?

Thanks for the interesting discussion. :-)



On Jan 19 03:45 PM iubica wrote:

> I'm no economist either. Inflation is understood as a general rise
> in prices of goods and services. At least that's what the wiki page
> claims.
>
> en.wikipedia.org/wiki/...
>
> So I'm not sure I buy what is said in the article:
> "... I will make the argument that inflation only exists when a government
> prints money."
>
> The wiki page is much more nuanced on this. It agrees that over long
> term, inflation is almost always caused by money supply. But over
> short term, inflation can be influenced by demand, supply, also by
> the psychology of the masses.
>
> The following fragment explains what's behind some people's desire
> to return to the gold standard:
>
> "If gold were our currency [...], rising prices would be strictly
> a product of supply and demand. "Inflation" would cease to exist
> -- for all intents and purposes -- because there would be no way
> to increase the supply of money."
>
> Really what they are trying to do is to prevent the government from
> increasing or reducing the money supply. But that is a recipe for
> disaster. The situation is bleak as it is, but if the Treasury was
> not pumping money at this point in the economy, we'd be looking at
> soup lines right now.

Jan 19 04:52 PM

[Conan the B...:]

A very glib answer to a very serious question.

In the early derivative creativity process, Alan Greenspan did address the Derivate situation. The Financial Institutions Were Creating their own money through the Derivative process. The Treasury stood aside and let it happen.

You continue to quote a very simple accounting equation.
But you seem to think that only the Goverment can create new money.

You are correct, the Governments of the World are joined at the hip in creating New Replacement Money as the Valuation of the Financially created assets self destruct. Until the new money equates the destruction, it is a Zero Sum game.

At one point, World Debt was estimated at 15 times World GDP. LOL in your belief the the unwinding process is over. IMO

Jan 19 06:13 PM

[Conan the B...:]

Mr. Ahlgren: Thank you for your honest and concise answer. Using SA to posit an idea and then to have the membership present their views whether Pro or Con can be used to polish future Articles.

Very artfully done.

Jan 19 07:14 PM

[User 265729:]

You are 100 percent on the mark with this. The asset bubble created a credit bubble and then they fed off of each other. Not only used for goods... Everything under the sun... People said, Well... I want a new SUV or two and I need to put my kids through college and I think I'll do it all! You have people walking around with university degrees leveraged off the bubbles... Nothing escaped the path of this monster -- nothing.

On inflation... Suppose the black hole of debt is 3X or 4X (or more) GDP? You'd print money and toss it to the banks and there would still be no lending and there would be no inflation since you are actually only filling a hole -- or the interest on the hole. Maybe this is what's going on right now?


On Jan 19 09:20 AM Top Gun wrote:

> Here's our problem. Your guy buys his houses, his buying bids up
> the price of each house, so his $1M house goes to $1.2M. Now his
> neighbor takes out a new home equity loan, for real money, and spends
> it in the real economy increasing velocity. Hence the creation of
> credit is in fact inflationary(in the sense that real economy prices
> are bid up) until the asset bubble pops. The neighbor owes $200k
> for stuff he's already bought.
>
> This entire problem is a legal Ponzi scheme. In our current state,
> we need regs that severely restrict banking leverage, but those regs
> can't be implemented until real money replaces the over leverage
> of the banks, coupled with write downs.
>
> The more write downs we have, like the RBS $41B today, the closer
> we come to inflation.

Jan 19 09:07 PM

[User 265729:]

"There is an argument that credit is part of the money supply -- that is to say, every time a person or institution uses credit, more money is created because no cash has actually changed hands."

Sorta... Maybe those with accounting experience can comment more on this...

From an economics point of view, however, it creates demand, etc. If credit is abused, as it has for the last 15-20 years, it creates inflation and destroys normal basic economic functioning -- opportunity cost, for example. With abused credit people could have their cake and eat it too. That is not the way a healthy economy works.

Deflation is actually occurring primarily are asset classes that were closest to the bubble and having the government powers that be call it deflation is actually false. I would consider it a price correction. If they treat it as deflation and try to inflate one or two major asset classes, we’ll have unintended consequences like $50.00 milk and $15.00/gal gas.

People need to understand and comprehend that what they experienced for the past 15-20 years, when they could buy almost everything they wanted with their home values appreciating into the stratosphere, was, in fact, a "sick economy." People could get everything they wanted, but still, that's not the way it functions in a normal economy.

Jan 19 09:20 PM

[auto44:]

Inflation is to much money chasing to few products. Housing prices were driven to crazy heights by easy credit (money)given to folks who couldn't repay it.


On Jan 19 01:59 PM R JENSEN wrote:

> "I'm going to digress a bit. A few days ago, a reader commented that
> she didn't understand why I keep insisting that inflation is not
> defined as rising prices..."
>
> Defining inflation to be rising prices is like defining cancer to
> be a situation when one has a tumor.
>
> Perhaps it's true, but it's childish and does not say much.

Jan 19 10:16 PM

[auto44:]

Boy i think you are closer to the truth than a lot of really compicated stuff I have read that really dosen't seem to fit together when you read it.


On Jan 19 09:20 PM curbs-in wrote:

> "There is an argument that credit is part of the money supply --
> that is to say, every time a person or institution uses credit, more
> money is created because no cash has actually changed hands." <br/>
>
> Sorta... Maybe those with accounting experience can comment more
> on this...
>
> From an economics point of view, however, it creates demand, etc.
> If credit is abused, as it has for the last 15-20 years, it creates
> inflation and destroys normal basic economic functioning -- opportunity
> cost, for example. With abused credit people could have their cake
> and eat it too. That is not the way a healthy economy works.
>
> Deflation is actually occurring primarily are asset classes that
> were closest to the bubble and having the government powers that
> be call it deflation is actually false. I would consider it a price
> correction. If they treat it as deflation and try to inflate one
> or two major asset classes, we’ll have unintended consequences like
> $50.00 milk and $15.00/gal gas.
>
> People need to understand and comprehend that what they experienced
> for the past 15-20 years, when they could buy almost everything they
> wanted with their home values appreciating into the stratosphere,
> was, in fact, a "sick economy." People could get everything they
> wanted, but still, that's not the way it functions in a normal economy.
>
>
>

Jan 19 10:23 PM

[NYCDart25:]

Great article. I agree with almost all of the points. I went long TBT in early January and was lucky to catch the lackluster auctions and slight rise. I took my 15% and sold. I REALLY do not like any leveraged fund for intermediate-long term holds. The constant leverage trap is too frightening.

Best approximation of TBT that I have (other than shorting a true long term treasury ETF, and good luck finding any to short, I found none at any of my brokerages) is RYJUX. I know the duration is not quite as long, and they employ some strategies I don't 100% like, but I like it much better then a long term leveraged ETF hold.

Best approximation of a TBT hold using RYJUX as a vehicle is a $2.17 ratio in RYJUX to a $1 in TBT. I know this requires more capital to attain the same net $ return and thus lower return rates, but timing this one could be VERY painful in a leveraged fund. Besides, my money is sitting around doing nothing anyways.

There have been some interesting days when RYJUX is up and TBT is down...still trying to figure that out.

Anyways, that is my two cents and I would love comments or a lead if anyone has a better vehicle to short long-term Treasuries without a leveraged fund....if I want leverage on something this open ended, I will go to Vegas.

Jan 31 05:57 PM

[Stephen Bur...:]

The accounting equation is inadequate to explain what's going on. While it is true that wealth cannot be borrowed into existence, buying power can. Borrowing money may create a counterbalancing debt but the debt is owed in the future and the money borrowed can be used to buy now so effectively money now is created by creating future debt (the debt exists now but is not due now).

Further, it is exactly this trick that the government is using to "create" the money. They give a promise to pay in the future to the Federal Reserve in exchange for cash now (which the Federal Reserve will create to counterbalance the debt offered).

Also, I was under the impression that the Federal Reserve is not an arm of the government but is actually privately held. Therefore the government still robs Peter (all the tax payers) to pay Paul (the owners of the Federal Reserve) which then lends it back to Peter so as to rob him a second time, with interest that cannot be paid because the money does not exist until the Federal Government issues more promises to the Federal Reserve so they will create the money to do so. The money supply under this system must always increase just to cover the interest ... until such time as the issuers of money chose to stop, at which point all the real wealth which underwrites the currency is forfeit to those who created the "money" in the first place.

Feb 27 06:03 PM

[ChrisL:]

Is debt creation and repayment really a zero sum game? If I borrow $100 and have to pay back $110, where does the additional $10 come from? It comes from printing more money. Does borrowing money force the need to print additional money to pay the interest thus causing inflation?

Excellent article!
Thanks

Feb 27 10:09 PM