Walter Kurtz's  Instablog

 

Back in July we've discussed the tremendous uncertainty surrounding longer-term inflation expectations for the US. This is not an academic exercise. Getting it wrong could swing the US economy into a deflationary spiral (similar to Japan) at one extreme or a hyperinflationary environment on the other.

The chart below from the San Francisco Fed shows just how divergent the economists' expectations have become.





What's unprecedented about this divergence in inflation outlook is that it also shows up in the market. The following chart shows weekly prices for GLD (a gold ETF) and IEF (iShares medium term treasuries ETF) for the last few months. A rally in gold in a normal market should correspond to declines in treasuries. But here we see stability in the treasury market in the face of rising gold prices.





This is an indication of an almost bipolar market that is betting on price stability (even deflation) from credit contraction and continuing unemployment on one hand and accelerating inflation on the other. It's hard to see both occurring, simply because slow economic growth (or further contraction) in the US can not sustain significant price appreciation due to weak demand. Over time something has to give - either commodities have to sell off or longer term rates have to come up.

 

As volatility returns to the markets, it's worth revisiting leveraged ETFs and the tracking error associated with these products. The rules of the game are simple:

1. Leveraged ETFs do well relative to the underlying index in trending markets,
2. underperform in mean-reverting markets,
3. underperform significantly in mean-reverting high volatility markets,
4. underperform over longer periods of time,
5. inverse (bear) leveraged ETFs underperform more than the equivalent leverage bull ETFs. The tracking error for a bear ETF is equivalent to a bull ETF with an extra turn of leverage. That is an inverse ETF tracking error is equivalent to that of a 2x bull ETF. The error for a 2x inverse ETF is equivalent to that of a 3x bull ETF, etc.

The chart below shows a potential underperformance (in a mean-reverting market) for leveraged bull ETFs over a one-month period (roughly) as a function of daily volatility.





The chart below shows the same for inverse ETFs (bear ETFs).





Here is an example of what happens with leveraged ETFs over a longer period of time. The chart below compares TNA, a 3x Russel 2000 ETF with the performance of Russell 2000 (small cap index). The index is up some 12% YTD, while TNA instead of being up three times that is actually up less than half for the year.





So if you really like risk, by all means take advantage of all the leverage available out there (before the SEC takes some "anti-derivatives" action against these products), but keep mindful of the nasty tracking error.

 

Some recent numbers from the US treasury a showing a continuing decline in the total amount of interest paid on residential mortgages in the US. The question is what is causing the decline. The most obvious answer is the tremendous drop in mortgage rates in 09 as well as LIBOR or Prime linked short-term rates on floating rate mortgages. Luckily the Treasury provides us with some history of average rate paid on mortgages (see chart below.)





Given that mortgage rates are at around 5% (and short-term rates are even lower), why is the average rate above 6%? This says that a large proportion of the borrowers out there are unable to refinance.

The total interest payments have dropped 5.2% from the peak in Q2 of 08. The rate drop explains 4.1% of this reduction and some would say that the remainder can be explained by de-leveraging. But the bulk of that de-leveraging is not borrowers voluntarily paying down their loans. It's the defaults.

The chart below only goes to Q2, but it more than explains the reduction in interest payments.



source: Bloomberg

In fact the drop in mortgage interest payments would have been significantly steeper if it wasn't for new home buyers (taking out new mortgages, adding to the total interest paid). The answer these days to having too much debt seems simple - if you can't refinance, just stop paying the interest.