The Fate of Treasuries in the Upcoming Ka-Poomification

[spunky]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

For the folks on this thread advocating buying physical gold and nothing else, there are plenty of proplems with gold that other forms of investment do not have and gold does have the same problem that other investments have: it does go down dramatically sometimes.

One problem with owning physical gold is where to put it. If anyone knows you have it, you could be robbed. And some people will know you have it. The place you bought it from, the shipper, the deliverer. And if you store it in a safe deposit box, is that better than paper ownership?

Another problem is selling physical gold. You will have to pay to have it verified/assayed, right? Pay to have it shipped, insured to whomever buys it. Transaction costs are higher than stocks/bonds.

So you folks that are advocating just buy gold, how much gold do you have in your stash? You aren't really 100% in gold are you? If so, how do you solve the above problems with it?

Just my 2cents here

This type of investment takes alot more real " footwork " than simply buying and selling equities, bonds etc.

Owning physcial gold is also a mindset that ones need to develop and hone.

I guess all the civilizations that came before us didnt know squat.


Every household should have a good safe, even if you dont hold PM's

[raja]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

Then I guess you won't buy it over a certain point regardless of whether it goes to $1,000 or $100,000 and will miss out on any mania action or hyperinflation/chronic inflation action, currency devaluation effects, etc.?

I would love to cash in on a gold bubble, and I believe it’s possible under certain conditions. However, as jk says, there are many possible futures, and in my opinion some of them don’t include profiting from gold.

The Ka-Poom theory makes a lot of sense to me, and think the EJ is actually the smartest guy in the room . . . way more knowledgable than I am. However, I've got a nagging feeling about his gold predictions in one respect. As a result of thinking things over while writing in this thread, the main change in my investment strategy will probably be regarding paper versus physical gold.

For some time I have been used a multi-tiered approach, trying to prepare for several possible scenarios according to their likely probability, as best as I can predict.
Here are the financial scenarios and my guess at their probability:

Scenario 1. Things get better — probability 5%
Scenario 2. Things stay the same — probability 10%
Scenario 3. Things get worse — probability 45%
Scenario 4. Things get much worse — probability 35%
Scenario 5. Things collapse. Fiat money is worthless and people trade on the local level when they are not killing each other— probability less than 5%

Scenario 3 would include a dollar crash affecting mostly the US, and Scenario 4 mean a worldwide economic depression.

During these scenarios, gold may behave as follows:

Scenario 1. Gold goes down or stagnates.
Scenario 2. If things stay the same for a prolonged period, gold goes down or stagnates.
Scenario 3. Physical and paper gold go up dramatically.
Scenario 4. A gold bubble forms and collapses extremely fast, perhaps within weeks. Traditional channels for buying and selling physical gold cannot handle the traffic, and most people holding physical gold can’t sell in time. Gold ETFs or other paper gold, however, can be unloaded for a profit if one's timing is right.
Scenario 5. Those holding large physical gold become fantastically rich . . . if they survive the initial chaos and have guns and strong, nasty friends.

Since the original topic of this thread was government securities, I should add that I believe TIPS will be good to have in Scenarios 3 and 4, since they hedge inflation and carry no risk of dramatic losses. (I will respond to the global issue brought up by jk in my next post). It would be a mistake but not a disaster to hold TIPS in Scenarios 1 and 2; but they would be totally worthless in Scenario 5.

In conclusion, to be prepared for 85% of the probable future, a mix of physical gold, paper gold, non-dollar denominated assets and TIPS makes sense to me. Of course, if one’s portfolio is large enough, it allows for a broader mix of investments.

This is my take on things. I am eager to hear how others see the future unfolding, and what their investments strategies are . . . .

(Re: Argentina) Of course, but those who did move in to gold actually gained purchasing power and as I recall that's much of your goal. Do check and see what happened to the gold price in British pounds from the '20s through the '40s and into '70s etc.

If we have a dollar crash, but the world economy otherwise continues to function well, then you are absolutely right — gold is the place to be.
However, if we have a global collapse, I wouldn’t want to be in physical gold, for the reasons outlined above. A gold ETF or other paper gold would be great, as long as one gets out in time.

Do also note that, with few exceptions, gold is moving up rather smartly worldwide now too, and for over a year. And printing presses are not running slow worldwide either.

I agree. There’s no question there’s money to be made in gold right now.

[Tocqueville]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

According to the link provided by dbarberic in another thread, http://www.financialsense.com/fsu/editorials/2007/0416.html
the DOW is already crashing against all measures other than the inflating dollar. Compared against gold it is down 58%. Compared with silver it is down 65% and compared with base metals, it is down 73%.

So how does one invest in base metals? Are there mutual funds or ETFs that deal in just base metals and not the precious metals?

[raja]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

Are there mutual funds or ETFs that deal in just base metals and not the precious metals?

Check here: http://www.etftopics.com/commodities-etf/
and http://www.etftopics.com/more-commodity-etfs/

[Finster]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

My question is:
Would TIPS or continually reinvested short-term T-bills also protect against inflation?

Would the interest payments on Treasuries rise in step with the dollars fall, because the Treasury would have to raise rates to keep global and domestic investors loaning them money

The answer to the first question is no. TIPS stands for "Treasury Inflation Protected Securities". But they are not indexed to inflation. They are indexed to the Consumer Price Index.

Not only that, but you pay income tax not on the return over and above inflation (assuming you are so fortunate as to get any), but on all nominal (i.e. imaginary) "gains". This often, if not usually, results in an effective tax rate above 100% - and a negative after-tax return.

If that sounds far-fetched, just imagine if inflation runs 4%. And your total nominal yield runs 5%. A tax rate of only 20% takes your ENTIRE real yield of 1%. Anything higher than that puts you squarely into the negative. Or if inflation actually ran any higher than 4%, you are likewise squarely in the negative.

That said, they are not necessarily a bad investment. The merits of an investment depend on how it does compared to the available alternatives. If it happened that they gave a real return of zero while virtually everything else was doing worse, they'd still be the best game in town. Unlikely, but not impossible.

Short term treasuries pose some of the same issues. They can easily give you negative real returns, especially when the Fed cuts rates to try and goose the economy - and inflation. Since short term treasuries closely track Fed rates, that means their yield would fall, too.

The answer to the second question is also no. Bonds are called "fixed income" because once they're issued, their coupon payments are fixed. Consequently, if interest rates rise, their prices must fall in order for their interest rates to remain with the market.

[bart]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

I would love to cash in on a gold bubble, and I believe it’s possible under certain conditions. However, as jk says, there are many possible futures, and in my opinion some of them don’t include profiting from gold.

Has there been any change in your opinions since your original post?

[raja]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

still, raja, i think i understand your concern: you are picturing a systemic crisis leading to rapid deflation with a rush for cash. and in such a scenario, tbonds and tips will certainly benefit.

jk,

I think that T-bonds would be good in an deflationary situation, but TIPS might not be quite as good, depending on the circumstances. TIPS are indexed to inflation, and their value drops as inflation approaches zero. But the principal cannot go below zero, so the greater the deflation, the better TIPS would “perform”.

TIPS are in my portfolio purely for safety, because whatever happens, they don’t lose much, and wealth is preserved for the most part. TIPS are not for making money; I rely on other investments for that.

1. In good times, TIPS almost keep up with inflation. At the present fixed coupon rate of 2.28% for 10-year, I calculated that TIPS keep up 99.28% with inflation . . . but that’s before tax.).
2. If there is deflation, the principal is protected.
3. In rising inflation, caused by either domestic or global problems, again they almost keep up with inflation.

For every other type of investment, there are scenarios in which it is possible to lose a substantial portion of that investment. This includes gold, stocks, bonds, non-TIPS government bonds, real estate and others.

As I write this, I am now wondering if foreign inflation-indexed government bonds might be a good idea, but I can’t see any advantage. Any ideas on this? Regards the likelihood of a dollar crash, I don’t see how it matters with TIPS. If the dollar falls, and imported goods go up, the CPI also will go up, and the return on TIPS will increase in step. The CPI “market basket” has many commonly imported items, like TVs, cars, clothes. So what’s the advantage of a foreign inflation-indexed bond?
It’s true that the government might manipulate the CPI even more than they already do, but I don’t believe it can get too out of whack without some repercussions that would right it again.

[raja]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

If that sounds far-fetched, just imagine if inflation runs 4%. And your total nominal yield runs 5%. A tax rate of only 20% takes your ENTIRE real yield of 1%. Anything higher than that puts you squarely into the negative. Or if inflation actually ran any higher than 4%, you are likewise squarely in the negative.

Finster,

Perhaps I’m misunderstanding your terminology . . . .
If inflation is 4%, and nominal yield is 5%, that means the fixed coupon portion of the rate would be 1%. Why use that percentage, when the TIPS coupon has never been that low . . . .

10-year TIPS rates: 1997 3.45, 1998 3.73, 1999 3.88, 2000 4.28, 2001 3.50, 2002 3.22, 2003 1.90, 2004 2.00, 2005 1.77, 2006 2.00. The last 10-year TIPS in April was 2.28%.

That said, they are not necessarily a bad investment. The merits of an investment depend on how it does compared to the available alternatives. If it happened that they gave a real return of zero while virtually everything else was doing worse, they'd still be the best game in town. Unlikely, but not impossible.

I agree. I use them as a hedge against everything else. They are my safety net.

The answer to the second question is also no. Bonds are called "fixed income" because once they're issued, their coupon payments are fixed. Consequently, if interest rates rise, their prices must fall in order for their interest rates to remain with the market.

I was thinking short-term T-bills. The 28-day T-bills are paying almost the same as the six-month ones. So if someone bought these and continually re-invested them, the rate would be adjusting on a monthly basis.
My question is how they would behave in a Ka-Poom-type scenario regards their rate compared with inflation?

[grapejelly]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

inflation is much higher than 5%. So you are losing money when you hold bonds. Compounding works against you and you lose a surprising amount of buying power the longer you hold bonds due to the significant negative real interest rates -- I would say -4% or -5% right now.

[raja]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

grapejelly,

What would you say inflation is running now?

[jk]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

shadowstats.com has its reconstructed unmanipulated cpi running a bit over 6%, or about 3.5% over the official cpi-u. that would mean we're in recession, of course, and have been for some time.

[raja]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

Using jk’s figures:

2.5% CPI
6% real inflation

Using 2.5% for the TIPS coupon (rough average over the last year) + 2.5% CPI = 5% yield for TIPS
Using 25% tax (no state tax on TIPS)

Over a 5-year period, $100,000 invested in TIPS would lose $13,600 against inflation, or 13.6%
________________________________

In one of his lectures posted on his website, Dr. Hudson said something to the effect of, “None of the financial people I talk to know where to invest our money now. We’ve just got it in CDs.”

Using a bank 1-year CD rate of 5.14% (national bank rate average according to money-rates.com), 6% real inflation, 30% tax (must pay state tax on CDs):

Over a 5-year period, $100,000 invested in a 5.14% would lose $14,500 against inflation, or 14.5%

Short-term CD can be re-invested at higher rates as inflation goes up, which gives them the same inflation hedge as TIPS. However, they are paying less than TIPS right now, and if that trend continues, CDs would be less desirable.

While CDs are insured up to $100,000 by the government, for some reason TIPS seem safer to me, perhaps because they are obligations of the federal government, as opposed to those of a single, comparatively small institution, albeit insured by the government.

________________________________

My Conclusion:

According to my calculations, grapejelly is correct: TIPS will lose against real inflation.

However, in all scenarios short of total societal collapse, TIPS will maintain most of their value. Than cannot be said of any other investments other than continually reinvested short-term treasuries and CDs. Therefore, I think that someone wishing to protect against almost all eventualities in the possibly turbulent future should invest a portion of their portfolio in TIPS, and another portion in investments that will profit from different scenarios, such as gold, currencies, etc. (Of course, the percentages of these various investments comprising one’s portfolio would depend upon one’s personal financial situation.)

[Finster]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

Finster,

Perhaps I’m misunderstanding your terminology . . . .
If inflation is 4%, and nominal yield is 5%, that means the fixed coupon portion of the rate would be 1%. Why use that percentage, when the TIPS coupon has never been that low . . . .

Perhaps. The "nominal yield" is the total yield.

Also note the example gave you a 100% tax rate. A larger "real" yield might give you, say, a 50%-80% tax rate. Do your own math with your own assumptions; the result is still not going to be pretty!

Then of course there's the point that the CPI has been running well short of real inflation. Try the same exercise with the SGS-CPI, or even the BLS-CPI with actual homes prices plugged in in place of that fiction called "owner's equivalent rent". Real after-tax returns have been solidly negative.

[raja]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

Finster,

Thank you for your reply.
Your post confuses me, as did the previous one . . . no doubt due to my lack of sophistication in financial matters (I am a real novice in finance matters). Perhaps you would help me understand your meaning . . . .

1. I didn't understand what you meant by "imaginary" gains, when referring to taxation.

2. Why do you refer to a 100% tax rate? For computation, I typically use a 25% rate for federal (because of decutions), and a 30% rate for federal plus state.

3. I still don't know why it's good to use a 1% coupon rate for TIPS when the rates have averaged 2 1/2% over the last year?

4. What do you think of my post using the inflation numbers jk provided? Does that seem to be a reasonable way of looking at TIPS return?

Thanks

[Finster]

Re: The Fate of Treasuries in the Upcoming Ka-Poomification

Finster,

Thank you for your reply.
Your post confuses me, as did the previous one . . . no doubt due to my lack of sophistication in financial matters (I am a real novice in finance matters). Perhaps you would help me understand your meaning . . . .

1. I didn't understand what you meant by "imaginary" gains, when referring to taxation.

2. Why do you refer to a 100% tax rate? For computation, I typically use a 25% rate for federal (because of decutions), and a 30% rate for federal plus state.

3. I still don't know why it's good to use a 1% coupon rate for TIPS when the rates have averaged 2 1/2% over the last year?

4. What do you think of my post using the inflation numbers jk provided? Does that seem to be a reasonable way of looking at TIPS return?

Thanks

The core issue here is not financial, but mathematical. I was attempting to illustrate why real, effective, tax rates are far higher than the nominal rates ordinarily cited.

Forget about the specific rates for a moment, and try to grasp the principle. Once you do that, then you can apply it to any factual assumption you choose.

Suppose inflation runs 5%. This means that one dollar one year from now is worth about 5% less than today. If you have an investment that pays 5%, you get 5% more dollars back at the end of a year. With 5% more dollars each of which is worth 5% less, you have broken even.

But wait ... we have to look at the tax impact.

If tax were levied on your real return, you would have no tax due since your real profit was zero. But that's not the way it works. Tax is due on your nominal return. If the tax rate is, say 20%, you will pay 20% of your nominal return to the IRS. Since your nominal return was 5%, that means Uncle Sam gets 1%.

What's your real tax rate? Just divide the tax you pay by the real profit. On a $1000 investment, you paid $10 tax. Your real profit was $0. So just divide $10/$0 and your tax rate is ...

... infinite.

You earned nothing and paid tax on it.