Todd Harrison is a hedge fund manager and one of the original creators of the “real time trading diary” — his first was for the original Street.com, and more recently, for his new site, Minyanville.com. Its an educational site that is unlike anything else you have ever seen, and well worth $18 per month.
Amongst the commentators at Minyanville.com is John Succo. Before reading John’s piece, know that 46% of the U.S. debt is now owned by foreign investors. Their participation is what supports our burgeoning national debt, and the leverage that cedes to outside forces raises the possibility of some frightful scenarios.
John wrote a very sobering admonishment, imagining one such tale. (Many thanks to Todd & John for graciously giving permission to reproduce the entire piece here).
Presenting, John Succo’s Pin Prick:
Warning: the following story is fiction. It is meant as a dramatization of one possible scenario in order to illustrate the relationship between currencies and foreign capital flows.
Rea Shur (floor bond commentator for financial news): We’re waiting here for the results from the $25 billion 5 year treasury auction. There is a little more nervousness than usual as the size of these auctions continues to grow: the last auction was $16 billion, up from a previous $10 billion; this current one is the largest auction in memory.
Al Doublespeak (economist and commentator for financial news): Rea, it’s Al here. I don’t think size matters much. It seems that there is still high demand for U.S. financial assets as the stock market is climbing and rates, although a little more volatile as of late, are still relatively stable given the Fed’s assurance that they will keep rates “low for as long as necessary.”
Rea: Right, Al. Prices are off 7 ticks, but that is normal posturing ahead….wait here are the results. What? Uh, hey Al, we seem to have a little confusion here. The news must not be right, we are checking now (Pause). Prices are dropping rapidly: the 5 year is now down, uh, 2 points. What? Sorry Al, there is mass confusion here. We have the 5 year down 2 points and the 30 year down the limit of 3. Nothing is really trading and things are moving very fast.
It seems the results of the auction, which we are double checking right now, were horrific. Foreign demand seems to be somewhat non-existent when normally they participate fairly heavily. We are still trying to sort this out; perhaps we better go back to you Al.
Al: Uh, thanks Rea. Be careful down there, it looks pretty rough from up here. Well, folks, I don’t know quite what to say. Phil, do you have any idea what is happening?
Phil Ovit (head commentator and former government economist): I am sure this is an error of some type. We have quickly arranged to talk to the head economist of Tokyo Savings and Loan, one of the traditionally largest buyers of auction debt, Mr. Ito Yuso.
Good morning, Mr. Yuso. Tell us, this confusion, in your opinion, what exactly is going on?
Ito Yuso: Good morning Mr. Ovit. Unfortunately, from our perspective, there is no real confusion. We simply declined to participate in this auction.
Phil: Uh, and why would that be?
Yuso: Well, very simply, we have come to the conclusion that the dollar’s prospects are not very good for the near future. Based on the amount of new debt being issued by the U.S., the level of the current account deficit, and the Federal Reserve’s untenable position on low rates, we believe that the dollar will fall at least another 20% from current levels. This being the case, it makes little economic sense, other than for artificial reasons, to purchase U.S. notes at these prices.
Phil: But given a slow steady decline of the dollar, the current situation is certainly manageable, no? Isn’t it only the serviceability of the debt and not the actual level of debt that is important?
Yuso: Well, from our perspective, which should consequently affect yours, the level of debt is inextricably tied to its serviceability. When we, your creditors, get nervous as to the size of your country’s debt, we will demand a higher risk premium. This will affect interest rates in your country and therefore the serviceability. Since the Federal Reserve of the U.S. is attempting to keep domestic rates low in the face of mounting debts, we see this relationship manifest in a lower level of the dollar.
It is the expectation of the level of the dollar that really matters to us, not how quickly it gets there, as long as the change occurs over the anticipated investment horizon.
The central banks of the world have been buying U.S. securities, in place of private sources, for quite some time in an effort to allow the U.S. to continue to grow out of its problems. Time, however, has shown that this is at the expense of too much debt with rates held artificially too low. As businessmen, it makes no sense for us to continue to buy U.S. financial assets at these prices.
Phil: How do you mean sir?
Yuso: If we expect the dollar to decline by 20% during the life of our investment, we need higher rates or a lower investment price to compensate us for this loss. For example, the five year last night was yielding 3.4%. Over five years we will earn approximately ((1.034)^5 -1) = 18.2% gross income on our investment. If we expect to lose 20% on this dollar investment, you can see that it is an expected return of negative 1.8%. The 5 year rate in Japan at .65% is very low, but at least it is positive from our perspective.
If we were to participate in this auction we would therefore need to bid below par in order to earn a higher implicit yield on the investment. Given that we are not sure how far the dollar will fall and given the volatility of the situation, we have decided not to participate in order to evaluate the market’s reaction.
It seems that others have decided to do the same.
The Pin Prick
by John Succo
No positions in stocks mentioned.
December 3, 2003
11:00am print this page
John Succo welcomes your comments and feedback at Succo@minyanville.com and invites you to check out his explanatory series on the basics of derivatives by clicking here.
John Succo is the Chief Investment Officer and co-founder of a New York-based hedge fund concentrating in derivative strategies with approximately $175 million under management (the “Fund”). Prior to his current role, Mr. Succo was head of risk and a member of the investment allocation committee at Alpha Investment Management, a New York-based fund-of-funds. Prior to that, Mr. Succo was an options trader and head of derivatives at various Wall Street firms.
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