| 2020 | 2021 | ||||||
| Price: | 1.60 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 1 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 1 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | 0 | 0 | |||
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There is a very asymmetrical risk/reward opportunity for the options on the 5-, 7-, and 10-year forward US 10-year Treasury. If rates merely mean revert back to recent levels of 2-3% (the 10-year was as high as ~3.2% in October 2018), then one stands to return ~2-4x. If rates rise to 4-6% (around the long-term average), then swaptions could return 6-10x. 8-10+% rates would result in a 13-17x+ return. You would breakeven if the 10-year was ~1.6% in 5-10 years from now, which would be an unlikely scenario. Before 2020, ~1.4%/1.5% is around the all-time historic lows for the 10-year going back to 1790.
The thesis here is simple: nearly inevitable inflation will force rates to rise. Inflation can take anywhere from ~6-24 months to set in from March when massive monetary policies leaked into M2, so long dated payer swaptions will allow cushion for timing (this idea may be early: rates and breakeven points may fall before rising). Even the Fed is now hinting at rising inflation. Yesterday, the WSJ posted an article on the 10-year mentioning: “Now the central bank is preparing to abandon its three-decade-old-practice of pre-emptively lifting rates to tamp down inflation, allowing periods in which prices rise at a faster pace than its 2% target.” The Fed has opened the inflationary Pandora’s box and thinks it is okay to let it run amuck (it will be hard to stop once it starts). Similar to the 1970s, if inflation spirals out of control, the Fed would be forced to raise rates. Currently, government intervention has disconnected both the equity and bond markets, especially the 10-year, for the time being and provided short-term, temporary boosts in economic activities that mask the long-term reality. This swaptions opportunity exists because of this illusion and from people’s misunderstandings of inflation that led them to question whether it will come. For example, there are disconnects between what investors remember historical inflation rates as and what they actually were, and what causes inflation. Data near the end of this idea shows 3-4% (maybe even 5%) inflation being quite common relative to the past 20 years while most people might think we have barely had any inflation. I will heavily incorporate my stagflation published topic in this idea along with some of its commentary.
The old adage, “History doesn’t repeat itself, but it often rhymes,” rings true as our current economic situation echoes the early 1970s when relatively massive monetary policies gave birth to stagflation (high unemployment, high inflation and a stagnant economy) and a rising rates environment. Today, unemployment is well into the double digits and our government is printing money like it’s nobody’s business. Milton Friedman puts it simply: “There has never been in history an inflation that was not accompanied by an extremely rapid increase in the quantity of money. There has never in history been an extremely rapid increase in the quantity of money without inflation…. There are no exceptions.” Evidencing over 100 years of US and over 200 years of UK and Sweden data, Dr. Friedman made these statements in the late 1970s (in the 1950s and 1960s, he was dismissed as an economic “flat-earther” for his ideas, including his prediction of stagflation before it occurred and before it was even coined a term.) Moreover, the more confident people and investors are becoming in the Fed as a safety net, the more confident the Fed is in vocalizing and then printing additional dollars, which in turn makes me more certain that stagflation is likely in the near future.
People view inflation as a black box, mysterious, and therefore blame many things for it, but inflation is ultimately a monetary phenomenon. Inflation is always caused by a more rapid increase in the quantity of money than the quantity of goods. Significant changes in the latter (productivity) have a marginal impact on inflation. An example of this misunderstanding is the widely accepted concept that the stagflation of the 1970s was substantially caused by the oil supply shock. Many professionals and websites write that: “Stagflation is often caused by a rise in the price of commodities, such as oil. Stagflation occurred in the 1970s following the tripling in the price of oil.” However, this is wrong. Dr. Friedman excellently explains how the oil shock had a “negligible” impact on inflation here: Stagflation Was Not Caused by Cost-Push Factors (skip to 9:52 for his explanation, but I highly recommend watching its entirety). This disconnect may be a result of the Fed rewriting history. Dr. Friedman’s demoralizing assessment of the Fed in his book, Monetary History of the United States, 1867-1960, aggravated the Fed so much so that it stopped making its meetings public and offered a counter history.
There are similarities between the earlier 1970s and now; the first to address is the recent epic step function increase in M2 on a percentage basis: it is this sudden acceleration that can cause much higher levels of inflation than people are expecting, or even thinking about. M2 growth during Nixon-Burns is nothing compared to the Trump-Powell world we live in today. During Nixon’s re-election campaign, he produced meaningful money creation policies because he insisted on focusing on unemployment**. From December 1971 to December 1972, M2 rose from $710B to $802B, a 13.0% y/y growth. Going back further, M2 on December 1970, 1969 and 1968 was roughly $627B, $588B and $567B, representing 1971, 1970 and 1969 growth rates of 13.2%, 6.6% and 3.7%, respectively. In comparison, we were growing at a healthy MSD linear growth clip until recently. On June 1, 2020, March 2, 2020 (before the rapid increase), and June 3, 2019, M2 was $18,152B, $15,598B and $14,726B, which represented a 16.4% 3-month (quasi-q/q) increase and a 23.3% y/y increase. M2 on June 4, 2018 was $14,094B, giving June 2019 a 4.5% y/y growth. If you want to see the hockey stick movement in M2, please visit FRED. Therefore, we are not only currently experiencing a huge 18.8 points acceleration – nearly triple the 6.6 points during Nixon-Burns – that will take time for people to feel (the next paragraph quantifies the time lag), but also we are already growing at a 79% faster rate than during Nixon-Burns. If that were not enough, the Fed is not done yet; ~$6T has become the new number after the ~$2.6T add, and we could see more than ~$6T. If ~$6T were completely reflected in M2, then $15,598B would become ~$21,598, pushing future q/q and y/y rates much higher towards 10s%-30s% (depending on how fast the Fed pumps) and the mid-40s%, respectively. Conversely, during the Great Depression from 1929 to 1933 in the US, we went in the opposite direction: M2 declined by ~33%, the total number of banks went down by ~33%, GDP declined by ~25%-30% from its peak, and deflation compounded down roughly mid-20s% from its peak.
You might say, “wait inflation is down meaningfully after heating up for a while and trending as such for the first five months of the year: 2.5%, 2.3%, 1.5%, 0.3% and 0.1%.” However, consider inflation has remained positive despite many companies experiencing y/y declines of ~50% to even ~90% during March and April and despite people were and are still hoarding their money in a panicked and or braced state for the economic impacts of the pandemic. Importantly, there is also a delay between printing money and its inevitable inflationary effects. At the time (late 1970s), Dr. Friedman stated that on the average in the US over the past 100 years, an increase in the quantity of money has taken 5-6 months to affect people’s spending (people just experience bigger bank accounts during this time), and then another 12-18 months until it works its way into prices. Hence, there is about a 2-year interval between the rise in the quantity of money and its full inflationary effects.
As an update, June inflation rose to 0.6% from May’s 0.1% and July is anticipated to be 0.8% (reports tomorrow).
It appears that we are going down this path of higher inflation in light of most overlooking it. The current savings rates have gone parabolic, which corresponds with people experiencing bigger bank accounts in those beginning 5-6 months. Savings rates were mostly 7% to 8% for the past few years before jumping to a record ~33% in April (recently revised down to ~32%). The previous record savings rate was almost half that: ~17% in May 1975, according to the US Bureau of Economic Analysis. May is now out at ~23% – still significantly above the previous record! At the same time, we are experiencing shortages as production has significantly declined and supply chains have been interrupted. For instance, the media has recently highlighted meat shortages. It is hard to imagine that the demand for food will decrease in line with the drop in supply, which means prices should increase. Basically, productivity has significantly decreased while the government is printing trillions, both should lead to inflation. I do not see a scenario where the quantity of money is not growing faster than the quantity of goods.
As an update, FRED claims June at ~19.0% – still above May 1975.
Additionally, government intervention has provided short-term, temporary boosts in economic activity that mask the long-term reality. These helped Nixon win the re-election, but soon after we all paid the price of inflation for favoring short-term indulgences over long-term developments. Some examples are:
Even though, “the average rate of inflation over a period of time has no relationship at all with the average rate of growth or the average level of unemployment,” according to Dr. Friedman, I think it is interesting to point out that GDP is noticeably worse now than during the early 1970s. Back then, GDP growth slowed to flat by 1970, then rose to nearly 6%, before declining to (0.5%) and (0.2%) in 1974 and 1975 respectively vs. an estimated ~(8%) contraction for 2020.
Coming back full circle, most people think that 3-4% (maybe even 5%) inflation is an explosion, but relative to the past 20 years, it is a much more common than you would think. Select years of inflation levels:
Specifically, the pumping of money during the last decade and the financial crisis is not nearly as extreme as you would expect.
More on this time period, the disinflationary and deflationary predictions of famous investors in the second half of 2010 did not materialize. Most people do not remember, but inflation actually rose significantly. The inflation levels of the second half of 2011 (June through Dec 2011) were 2 to 3 times or more than those from a year ago. Also, the 2011 average was 3.2% vs. 2010 average of 1.6% (https://www.usinflationcalculator.com/inflation/historical-inflation-rates/).
Randomly selected inflationary pressures across our economy:
During all of this money velocity has been trending down since ~1997, which is a headwind for inflation (in the MV=PT equation). Money velocity was hitting record lows pre-coronavirus and has only accelerated downward during coronavirus, yet inflation has risen to 0.6% in June and is expected to be 0.8% in July. If money velocity mean reverts, it can have meaningful implications. This extreme drop can be found here: https://fred.stlouisfed.org/series/M2V.
In conclusion, the Fed would not be able to let inflation spiral out of control and therefore would have to raise rates in response, similar to the 1970s. I am not saying that we will have the exact same double-digit inflation levels of the 1970s or that the world is ending, but I believe we are headed for a rough few years with much higher levels of inflation and unemployment compared to those prior to the pandemic. During many recessions and depressions, we have had bear market rallies that have lasted as long as a year. This time around does not seem different to me; I do not view the current environment as a recovery. In my opinion, this is a bear market rally where the amplitudes are greater due to quants and algos exacerbating both the peaks and troughs as well as a very high level of animal spirits and or greed. About a year or two ago, I told everyone that the next decade would be nothing like the past decade we experienced. I had no idea what would occur in 2020 and beyond, but I knew it would be a statistical anomaly to have so many years of continuous prosperity and low unemployment without any interruption.
**P.S. Back to Nixon-Burns: “Consistent with this, President Nixon, observing applause for Burns at Burns’ swearing-in, said on record: ‘That is a standing vote of approval, in advance for lower interest rates and more money,’ and noted, ‘I have very strong views, and I expect to present them to Mr. Burns. I respect his independence, but I hope that he independently will conclude that my views are the right ones’ (KCS, 02/01/70)” (https://fraser.stlouisfed.org/files/docs/meltzer/nelgre04.pdf). Later on, many accused Nixon and Burns of making a deal so that Nixon could win the re-election and Burns could keep his government position. Unsurprisingly, both of them denied these accusations. In today’s world, Trump has made it even clearer that he disrespects this independence with countless quotes, and Powell has obliged to be his marionette.
Risks
Inflation does not materialize. The government drastically cuts the money supply. Money velocity falls even further. Timing and time decay eats into the swaptions (idea does not materialize or it does materialize but at a later date). Government intervention becomes increasingly more extreme (for instance, if the movement from treasuries to investment grade transitions to high yield and or equities).
Primary catalyst: inflation.
Secondary catalysts: when printing is no longer possible because of increased inflation levels, then solvency concerns, USD depreciation or both. Replacing the 10-year with investment grade corporate debt just worsens the possible future solvency concerns, when printing is unable to save the day anymore.
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