ask Dcifrths...well, anything...about finance/mkts/ports that is.

[DcifrThs]

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Various DCF treatments of the nation's debt and other obligations (future medicare & drug payments, etc.) have indicated a $60-$70 trillion deficit. The country's entire capital stock is only like $45 trillion.

Cutting benefits enough to ever make a dent in this deficit will not be politically feasible anytime soon. Inevitably they'll pay for some of it with tax increases, and the rest through an inflation tax.

Questions:
1) I think a severe economic crisis, including double-digit inflation, is inevitable at some point in the next 10 years. Do you believe this? If not, why not?

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given what you said, and assuming nothing changes, then yes, that is likely.

however, adaptation is unestimable and you can't capture that in a cash flow model.

people said for decades that we'd run out of oil. no way we can demand as much oil as we are given the current stock and rate of extraction. well, we still have tons of oil, and our extraction methods have improved far more than predicted. further, as the price rises, the demand will fall via substitution & less use. a shock predicted by "peak oil" i think is a similar story to what you're telling here.

the facts as they are laid out now prevent a calm and reasonable outcome. what will most likely occur, is that when politician have to choose between finally NOT turning a blind eye to the facts of the situation vs. risk being booted from their position, they'll deal with the former. i think a combination of tax hikes & benefit cuts will eventually occur.

monetizing that debt would be the last choice since that would severely damage the US's ability to finance future deficeits efficiently in the financial mkt. that would be devastating...more so than tax hikes & benefit cuts.

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2) At what point does the willingness of foreign creditors to hold our debt begin to erode, and the dollar seriously tank?

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well that depends on a number o fhtings but i can't possibly estimate WHEN that will occur. the easy answer is it will occur when the faith that the us govt won't print money to pay a debt they can otherwise not pay decreases & that decrease in faith will cause selling & increases in rates.

how this will play out i can't say, but it is obviously a major problem.

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3) How high does inflation go? How much does the dollar fall relative to major currencies?

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inflation will not, in all likelihood, vastly increase. conversely, i think inflation will remain relatively stable but interest rates will be the thing to jump. i don't think we'll get to where we were in the late 70s early 80s though.

the dollar is structurally overvalued as it is right now. the only reason it is where we see it is a result of our ability to efficiently finance our deficit via a disproportional desire to hold US assets (and thus loan us money). when that desire wanes, the dollar will fall.

a good look of how this might possibly play out is via the fall of the bretton woods system.

in 1965, it appeared certain that the US would run out of reserves pumping up the dollar. it was giving out claims on gold it didn't have.

in 1968, france said "no more claims. give us the gold." for years it was clear the US had no ability to pay the claims if asked with the gold it had (and it had like 80% of the world's gold stock).

despite this, the currency system functioned, via a few tinkerings, until 1971. finally, central bankers and politicians got together to argue about small % increases in exchange rates and how they'd be managed, hilariously thinking they could direct the markets. these meetings happened time and again throughout the 70s and 80s.

nobody could have predicted it would play out as it did, and even in a closed solid case that the US could not deliver on the claims on its reserves, the world still functioned and the devaluation of the dollar came not as it was expected.

the difference, is that the US couldn't monetize a gold claim. it CAN monetize the deficit so that problem may cause irrational (or partly rational) panic at some point in the future if we continue as we have.

the thing is, we are very unlikely to continue as we have, nor continue in some fashion as we can predict today with or without models.

good discussion topic though as there is a lot there to think about.

Thanks,
Barron

[Dazarath]

I'm not sure if this the type of question you were looking to answer, but I'll ask anyways. Could you explain to me how pegging a currency to a different currency works? I have little to no understanding of the currency markets, but this has always kind of made me wonder, because it seems like arbitrage opportunities would open up somewhere or something. Thanks.

[DcifrThs]

[ QUOTE ]
I'm not sure if this the type of question you were looking to answer, but I'll ask anyways. Could you explain to me how pegging a currency to a different currency works? I have little to no understanding of the currency markets, but this has always kind of made me wonder, because it seems like arbitrage opportunities would open up somewhere or something. Thanks.

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sure thing...i'm no expert here and only have experience analyzing one type of peg (but functionally all pegs are alike). there are a number of possibilities though. the two most common i think are a currency board (like what i think argentina had in 2002), and a managed peg.

in the former, a country basically makes it part of the constitution (like argentina did), or at least irrevolkable, that the central bank/govt will do whatever necessary to fix the value of its currency to that of another country.

typically, this requires a given country with a peg to hold a large # of foreign currency reserves (assets or cash denominated in the currency to which it is pegged). China is an exception since it is trying to hold its currency down rather than propping it up. its reserves are a result of selling its yuan to buy dollars.

this brings us to how a peg actually functions.

lets say that zimbabwe has a Z$ that is at 5:1 to the US$. in order to maintain that exchange rate on a day to day basis, the zimbabwean central bank must either buy or sell Z$ vs. US$ int he open market. if the market forces push the Z$ to depreciate (because zimbabwe is importing far more than it is exporting and the desire to lend to zimbabwe isn't great enough to offset the difference in the balance of payments), the bank must sell US$ and buy Z$ to prop up the price.

obviously, in order to do that, it has to actually HAVE US$ or US$ denominated assets to sell. this is where a peg to prop up the currency has its biggest logistical issue. when a country runs out of reserves, the game is over. so if zimbabwe all of a sudden experiences capital flight, it has to keep propping up its currency by selling US$ (from its stash of reserves) and buying its own currency.

in addition, while this is happening, interest rates in zimbabwe will soar and the zimbabwean economy will be forced into a recession (if they keep the peg). as a result, zimbabwe will abandon the peg in order to gain control of its monetary policy, force a devaluation, increase the money supply, and get its economy back on track.

so that is the basic story. the difference between a currency board and a managed peg is the former is almost irrevolkable and the latter is what china has. the board is usually strict and says that the exchange rate will by X:1 where X is held 100% constant in the open market.

in a managed peg, the X:1 exchange rate is allowed to fluctuate in the market by some (typically very small) amount.

the tradeoff of a currency peg is most easily described the choice between exchange rate stability and monetary policy control (a country with a peg can't change rates while pegged).

hope this helps.

Barron

[stinkypete]

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from there, you can optimize your portfolio. most people do this with a simple mean-variance optimization (i.e. run the calcs one time). i think this is a big mistake since the optimal allocations are highly sensitive to small changes in correlations & variances. therefore, you'd want to do a 10k run monte carlo with ranges around each of those factors (and since the "expected return" is a function of "expected volatility" that will back itself out). the ranges you can tweak as well to be wider around assumptions you are not as sure about.

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it's bizarre how closely this resembles my current view of/approach to poker... i guess i'd be better off as a quant...

[stinkypete]

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30% global equities (F*CKING HEDGED)
30% global developed aggregate bonds (also hedged, but for some reason asset managers always hedge bond allocations but not equities)
15% developing world bonds (hedged)
15% global inflation linked bonds (hedged)
5% commodities
5% global real estate (hedged)


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i kind of asked this in another thread, but how would i go about setting up a portfolio like this and leveraging it without paying ridiculous interest rates?

[DcifrThs]

[ QUOTE ]
[ QUOTE ]

30% global equities (F*CKING HEDGED)
30% global developed aggregate bonds (also hedged, but for some reason asset managers always hedge bond allocations but not equities)
15% developing world bonds (hedged)
15% global inflation linked bonds (hedged)
5% commodities
5% global real estate (hedged)


[/ QUOTE ]

i kind of asked this in another thread, but how would i go about setting up a portfolio like this and leveraging it without paying ridiculous interest rates?

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sorry, i either missed your other post or read this one first.

there are a few ways. first off, vanguard has some funds that are close to what is above. my former CIO has a presentation where he lists the allocations to various funds that closely mimic the above but is slightly heavier on the equity side (which is fine for people liek us). i'm trying to get that slide.

even without it, Interactive Brokers i think now offers leveraged TIPS and it definitely offers leveraged nominal bonds for fairly small fees. obviously, deleveraging anything is easy (add cash or subtract capital to it or from it). other than that, nothing else i think should need leveraging.

the aggregate global allcoations should be in fund form from vanguard or similar institutions. the overall marginal fee from switching from a traditional portflio to the above should be small. and it is wayy more than made up for in the improvement of risk-adjusted-return you get.

hope this helps,
Barron

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]

30% global equities (F*CKING HEDGED)
30% global developed aggregate bonds (also hedged, but for some reason asset managers always hedge bond allocations but not equities)
15% developing world bonds (hedged)
15% global inflation linked bonds (hedged)
5% commodities
5% global real estate (hedged)


[/ QUOTE ]

i kind of asked this in another thread, but how would i go about setting up a portfolio like this and leveraging it without paying ridiculous interest rates?

[/ QUOTE ]

sorry, i either missed your other post or read this one first.

there are a few ways. first off, vanguard has some funds that are close to what is above. my former CIO has a presentation where he lists the allocations to various funds that closely mimic the above but is slightly heavier on the equity side (which is fine for people liek us). i'm trying to get that slide.

even without it, Interactive Brokers i think now offers leveraged TIPS and it definitely offers leveraged nominal bonds for fairly small fees. obviously, deleveraging anything is easy (add cash or subtract capital to it or from it). other than that, nothing else i think should need leveraging.

the aggregate global allcoations should be in fund form from vanguard or similar institutions. the overall marginal fee from switching from a traditional portflio to the above should be small. and it is wayy more than made up for in the improvement of risk-adjusted-return you get.

hope this helps,
Barron

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DUH! lol, i forgot the easiest and most cost effective way to get leverage: futures/forward mkts. i jumped to TIPS leverage b/c that is the toughest to get and IB just started offering that recently i think.

so to sum, you can get leverage reasonably priced via:

1) futures market (if it exists, which it doesn't for TIPS)
2) forward market (currencies)
3) repurchase agreements (TIPS and some special issue Govt bonds, which i think is how Interactive Brokers creates the leveraged TIPS security/fund)

4) traditional borrowing (worst option ever for reasons likely known & discussed)

Barron

[stinkypete]

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1) futures market (if it exists, which it doesn't for TIPS)


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i suspected this was the answer but i don't know how it works in practice.

how much work would this require? (the goal is to trade as little as possible, obviously)

can you estimate the effective interest rate i could expect to pay getting leverage in this way?

[DcifrThs]

[ QUOTE ]
[ QUOTE ]

1) futures market (if it exists, which it doesn't for TIPS)


[/ QUOTE ]

i suspected this was the answer but i don't know how it works in practice.

how much work would this require? (the goal is to trade as little as possible, obviously)

can you estimate the effective interest rate i could expect to pay getting leverage in this way?

[/ QUOTE ]

i don't quite know... depends on what you mean? you have to put up a margin that changes over time, but allows you leeway with the rest of your cash. so are you saying out of $100 what # of $s do you have to put up?

or what is the cost per $100 to execute this?

Barron

[stinkypete]

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]

1) futures market (if it exists, which it doesn't for TIPS)


[/ QUOTE ]

i suspected this was the answer but i don't know how it works in practice.

how much work would this require? (the goal is to trade as little as possible, obviously)

can you estimate the effective interest rate i could expect to pay getting leverage in this way?

[/ QUOTE ]

i don't quite know... depends on what you mean? you have to put up a margin that changes over time, but allows you leeway with the rest of your cash. so are you saying out of $100 what # of $s do you have to put up?

or what is the cost per $100 to execute this?

Barron

[/ QUOTE ]

i could get leverage by borrowing money or by trading futures. what interest rate would i have to borrow at to achieve the same (or very similar results) as i can obtain by trading futures (and paying the fees that come along with them)?

i guess it's a fairly complicated question and there probably isn't a simple answer.