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Friday December 19, 2008 - 16:44:27 GMT
Black Swan Capital -

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Underestimating the power of deflation is dangerous!

Key Reports (WSJ):
No economic events are scheduled for today.

O farewell,
Farewell the neighing steed, and the shrill trump,
The spirit-stirring drum, th' ear-piercing fife;
The royal banner, and all quality,
Pride, pomp, and circumstance of glorious war!
And O you mortal engines, whose rude throats
Th' immortal Jove's dread clamors counterfeit,
Farewell! Othello's occupation's gone.

Shakespeare, Othello Act 3, scene 3, 350–357

FX Trading – Underestimating the power of deflation is dangerous!
Sometimes we are a bit absurd in this morning missive in an attempt to make a point.  Looking back at a recent issue, from the 2nd of December, titled “Can you say 1% Treasury Bond Yield?” we noticed the 30-year bond futures price has risen a bit since then; yields have fallen.  Yes, yields have plunged faster than expected—by us, and I imagine by many others.

If you pay some attention to this stuff, barely a day goes by now when you aren’t being told by someone that Treasuries are the next major bubble.  It will burst soon so it’s time to start getting short. 

Now, we can’t pretend to forecast interest rates—no one honestly can—but in our issue of 2nd December we did make reference to the Fed’s pending quantitative easing, which is now on full display, and the fact that US policy seemed to be shaping up much like Japan’s during those deflationary years. 

I remember back when Japan was in the midst of that mess (still are interestingly), because I remember that great sage from Morgan, Barton Biggs—mostly wrong but usually a lot to say—pronouncing that shorting Japan Government Bonds as they approached 1% yield would be the “trade of the decade”, if I am not mistaken.  He may have said it’s the “trade of the century.”  Well, had you been unfortunate enough to take that trade and shorted those JGBs you would have broken even in about 15-years. 

Japanese Government Bonds (JGBs) 1991-2006:

(Chart unavailable in text format.)

Source: Golden-Eagle

So, the lessons to me are: 1) Don’t ever—never—believe I can forecast interest rates; and 2) Never underestimate the power of deflation! It does strange things to markets.

This isn’t to say that maybe there isn’t a major Treasury bubble, we don’t know.  But it is to say that if Jim Grant is this excited about and investment idea, a Treasury bubble, we have to be on guard.  For as wonderful as Mr. Grant is, and as darn smart as he is, and as brilliant a writer he is, he is usually wrong on the investment stuff at the key moments—I’ve noticed.  This doesn’t detract one bit from the depth of information and knowledge one can gain from his excellent newsletter, “Grant’s Interest Rate Observer.”  We are “paid up subscribers” and will continue as long as we follow the markets.  But, Jim’s stridence here has us a bit worried.  We think he may be underestimating the power of deflation.

And if we are underestimating the power of deflation, I think it might be a good time to examine our premises on what constitutes value in here.  Junk bonds look incredibly attractive, is a new theme.  Even if one accounts for outsized default potential, goes the argument.  But, this is a different environment. And 20-50 basis points added to the all-time worst default ratios in the past for junk may be woefully conservative given the deep destruction of wealth we’ve seen and continue to see.  So just be careful when that “new” hubris-filled idea rolls your way.  It may be wonderful, we don’t know.  But bet small, you can always add. 

So, the game is this: If Helicopter Ben and friends have done what’s needed to pull the nose if this vessel up from this death spiral, then the Treasuries are in a major bubble crowd reaps. Again, the jury is still out. 

What’s our evidence the jury is still out? What is the one thing if we had to pick and choose that says wealth destruction has a lot farther to go—crude oil is it!

John Authers, in his “Short View” column appearing The Financial Times yesterday summed it up well when he said, “That oil has not responded to the huge stimuli of zero US interest rates, a much cheaper dollar, and a record output cut, suggests that there has been a drastic fall in demand.”


US$ Index vs. Oil Daily:
 (Chart unavailable in text format.)

The dollar is back under 1.40 against the euro today; after EURUSD spiked to 1.47 yesterday.  Yes, that was not a misprint.  Over an eight-cent swing in one day.  And heck, it’s early, we’ve got all day left till this crazy market closes. 





EURUSD 240-min chart: An 8-cent haircut in 31-hours!  Amazing!

(Chart unavailable in text format.)

So, enjoy your day.  Be careful out there. And have a great weekend.

Jack Crooks, Black Swan Capital LLC


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