Monday, June 1, 2009

An Option on Monetization and Inflation

You want to place a bet on future inflation? Well, an opportunity for you to bet on inflation is now in the works. The hedge fund Universa Investments L. P. is planning to open a fund in the near future that will allow you to back up your concern with the possibility that inflation is coming around the corner.

The fund will invest in options tied to commodities and Treasury bonds, among other things. The strategy is a “Black Swan” strategy aimed at taking advantage of wide swings in the prices of these assets.

Of course, the fund is connected with Nassim Nicholas Taleb, the infamous author of the best sellers “The Black Swan” and “Fooled by Randomness.” To Taleb, the probability that high rates of inflation might result from the stimulus efforts of governments around the world has substantially increased. This means that the possibility of a “fat tail” event happening, the chance that hyperinflation might occur, is a reasonable wager.

Mr. Taleb, in an interview, argued that “We think these things are going to see massive volatility.” These things being the price of corn, crude oil, copper, the stocks of oil drillers and gold miners, and the price of Treasury bonds and the value of the United States dollar. (For a more information see, “Black Swan Fund Makes a Big Bet on Inflation,”

This effort is nothing new. It is just a high profile attempt to do what international investors have done for the last fifty years. (I know, it has been done for longer than that but I am just focusing on the modern era of imprudent government budget management.) And, there has been nothing more successful than betting against large fiscal deficits that put pressure on central banks to monetize the debt. The examples are numerous; see George Soros, the British Pound, and 1992 and Fancios Mitterand, the French Franc, and 1983 and more! The currencies of countries following Keynesian policies in which government budget deficits were used to stimulate economic growth and low levels of unemployment were easy targets for the international investment community.

Of course, inflation is not a problem now. And, many would argue that deflation is the real near term threat. Yet, the United States government, among others, is following a very “Keynesian” stimulus program with deficits that dwarf anything that has been seen in the past. The Federal Reserve System has forced an enormous amount of reserves into the banking and financial systems. For example, the year-over-year rate of increase of total reserves in the banking system was over 1,900% in April. The Fed’s purchase of mortgage-backed securities stood at $428 billion at the close of business on Wednesday May 28.

Chairman Bernanke has stated that the Fed will “reverse out” of these positions once the economy begins to pick up some speed. He may believe this and be very serious about achieving this end. BUT, there still are the large government deficits. How is the Fed going to handle them?

Not very easily, as is evident from the behavior in the bond market over the past couple of weeks. In fact, history is on the side of those that believe that the Fed cannot control long term interest rates over the longer run. Central banks all over the world have tried before, but success has only come in the short run and at the expense of monetizing too much of the government debt. This is the worldwide experience of the past 50 years! Governments all over the world have not been able to successfully combat the will of international financial markets if the participants in these markets believe that the fiscal policy of a government is not being conducted in a prudent manner.

The Federal Reserve got the first real taste of this in the last two weeks. There is more to come. The cycle is that the central bank tries to keep down long term rates by buying government securities. This is successful for a while, but the market observes that the central bank is monetizing the debt and so more pressure is put on bond prices forcing long term interest rates higher. Continued central bank efforts to hold down rates only result in the purchase of more government securities which then leads to more market concern about this monetization of the debt. Another round of central bank activity can follow. This picture of the dog chasing its tail only ends in frustration for the central bank and finally resignation that its goal cannot be achieved.

And, all during this time, the value of the currency of the country falls. Sound familiar?

When does the inflation occur?

That is uncertain. It will occur some time in the future. We know, however, that with large amounts of uncertainty, volatility increases.

In the meantime, you have a good argument for buying options which is what the Universa effort is going to do.

The question then becomes one about whether or not another Black Swan will occur. How are you betting?

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