Wednesday, September 2, 2009 4 comments ++[ CLICK TO COMMENT ]++

Hugh Hendry August commentary... sticking with his deflation playbook

I hate scribd since it doesn't print properly (it crops the page for some reason) and it's hard to copy & paste. So it took a while before I found a PDF version of Hugh Hendry's August commentary. Thanks to Phil's Stock World, who credits GreenLight Advisors, for linking to the PDF version of Hugh Hendry's August Eclectica Fund commentary.

The first portion covers his thesis, suggesting that the current situation is similar to the 1920's and 1930's. Near the end of the commentary, he says how he is trying to profit by using interest rate derivatives. Hugh Hendry takes very extreme positions, like Marc Faber, so one needs to figure out if he is overdoing it.

The Present = The Great Depression... Sort Of

Most of the commentary is consistent with my views and follows themes I have discussed before. In particular, Hugh Hendry suggests that the present situation may be similar to the 1920's, and the current account surplus countries may end up getting hit much harder. This means, China is vulnerable. I have suggested a similar thing in the past, largely influenced by Michael Pettis. I see Hugh is also reading Pettis' blog :) (A few years ago, no one even heard of Michael Pettis. I don't know if anyone hit Pettis' blog back then but its header was a memorable picture of a worker hard at work and I always remember that.)

A difference between Hendry and I is that I don't put as much weight to the Great Depression comparison. I get the feeling—it's only a feeling—that Hugh Hendry, like some bloggers I see out there, is expecting a replay of the Great Depression scenario (but without the horrible suffering at that time.) I think the fixing of the global imbalance will resemble the 1920-1940 period but the details can be significantly different. One of the big differences, of course, is the gold standard. Another is the more co-ordinated relationships between the world's central banks. My impression is that many of the central banks in the 1920's and 1930's were doing things, literally, on their own, detached from others.

Here is some of what Hendry has to say:

Once more the world has a creditor nation running a persistent trade surplus. This time, it's China and its Asian neighbours. However the amounts involved are much greater than any other comparable period. US current accounts had been range bound between minus 1% and plus 1% of GDP for the last fifty years. But in the last ten years the US has witnessed a blow- out with no historical precedent. In 2007 its deficit hit 7% of GDP. And with China recording a corresponding net current and capital account surplus, the People’s Bank of China has cornered the market in dollar reserves just like the Americans had in gold by the late 1920s.

Trade also remains mercantilist in character... Furthermore, with the tie to the dollar, they have replicated the fault line of the 1920s’ gold standard: domestic monetary policy has become pro-cyclical with real interest rates negative for most of the last ten years. As a result house prices in China have tripled between 2003 and 2008 despite their supposed high savings and a less leveraged financial sector.

I don't really know how true Hugh's suggestion that the Chinese monetary policy in the last decade acts like the gold standard in the 1920's is. In any case, I agree with him that China's real estate boom may be due to negative real rates.

As in 1929, these events are now behind us and it is their legacy which concerns me most. The global economic system is now bearing the brunt of having accumulated so much excessive private debt (275% of US GDP at its peak vs. 1929’s 175%) and has borne a contraction in economic activity which is on a par with the initial stages of the Great Depression. Worryingly for global economic bulls, the US is no longer “spewing out its green emissions”, as Warren Buffet describes the dollar, because the US current account deficit is falling rapidly. And yet the consensus is still for more dollar devaluation and more asset price inflation, i.e. for more of the last ten years.

I get the same feeling. I'm not sure why the market is pricing in such a rosy outlook. I suspect it's because market participants are placing a lot of faith on central banks and governments—a misplaced faith in my opinion.


And the Chinese fiscal expansion conjures up the fatal American mistake of 1927 when they were obliged to loosen monetary policy for international not domestic considerations. The rate cuts amplified speculation and almost certainly contributed to the harshness of the downturn. Coming on the back of five years of rapid investment-led growth, could it be that the Chinese stimulus has the same effect in 2009?

This is an interesting line of thought that I hadn't encountered before. I'm not sure how true this is. My feeling is China's massive lending is for domestic reasons. I'm not sure what is so international about that policy.

In any case, Hugh provides some commentary on the real estate video he did (I linked to this a while ago):

Nevertheless it features one of the most formidable new buildings that I have ever come across. I would estimate the build cost must be in the hundreds of millions of dollars. And it wasn't located in Hong Kong or even Shanghai or Shenzhen, but in the decidedly less glamorous Wuhan in the centre of the country. And to make matters worse it was completely empty. You can tell the age of a building in China by counting the layers of pollution that the smog generates and it was obvious that this was probably a speculative new build that had outlasted its developer. I learned recently that the building now has a tenant, the $20bn Minsheng Bank, but I suspect they lent the money to the developer in the first place.

Adding to the intrigue, I have subsequently been informed that our video has now been blocked in China by the authorities. Who would have thought that I would become an enemy of the state?

China censors anyone so I don't think this is anything personal directed at Hugh Hendry. Anyway, I didn't realize that one of the buildings in the video was from the center of the country. One of the criticisms from the YouTube commentators (for the video), as well as general China bulls, is that coastal areas and big cities may be bubbly but the interior is not. Well, here, Hugh Hendry suggests that there are dubious real estate buildings in the interior as well. I have highlighte the location of Wuhan on this map:

Wuhan isn't exactly in the middle of nowhere—certainly isn't in the desert or in the west—but it isn't a major, costal, city either.

This is just anecdotal evidence but if it is widespread in other cities, it confirms that China may be sitting on a major real estate bubble.

The Theme That Unites Deflationists

I don't think it's too much of an over-simplification to say that deflationists put heavy emphasis on debt. A common feeling I get is that deflationists essentially believe that debt will overpower anyone or anything. In contrast, inflationists seem to think that debt can be ignored, inflated away, or absorbed by government and private savings. True to this point, you can get a sense of how Hendry fears the massive debt build-up (this is similar to the feeling of other deflationists like Robert Prechter):

...the international rescue mission has opened up a key battle line in the economic debate between Friedman and his intellectual followers such as Bernanke, who attribute the 1920s crash to the central banking response to the crisis and what they claim were the authorities’ anti-speculative measures, and their rivals who might be thought of as followers of the economists Irving Fisher and Hyman Minsky. They cite instead the build up of private debt preceding the drop in asset prices as the determining factor. My prejudices favour the latter interpretation which makes me sympathetic to the Australian economist Steve Keen’s observation that, “Bernanke’s dilemma is that he is living in a Minskian world while perceiving it through Friedmanite eyes.” [1] When debt is modest, Keen goes on to say, changes from one year to another can be ignored but when debt is very large it can come to play a major role in fuelling the economy. And just as the growth in private debt from one year to the next came to have a disproportionately large impact on spending so its contraction could hamper the authorities’ remedy; we will soon discover the answer.

Yep. It is important to realize that, for the inflationists to win, total money supply (credit+currency) has to expand. If credit contracts, they will have serious deflationary forces. For instance, if debtors pay back their debt, it is actually deflationary. Such an action is good for the debtors and the indebted society in the long run but is bad for the lenders who profit off debt.

The fact that the interest of the borrowers is to pay back the debt (if they are able to) or default (if unable to) makes life very difficult for the central bankers.

Investment Options

The August commentary is quite interesting because Hugh Hendry suggests that he is betting on interest rate derivatives. I have been wondering how to play deflation, if I ever decide to do it, and this provides some ideas to me (although it's extremely risky.)

The simple deflation bet would be the US long bond but that has very low upside. The 20 US Treasury bond ETF, TLT, should move around 15% if interest rates decline 1% (I'm not a bond expert but my understanding is that the price move of the bond depends on the bond's duration and convexivity. The iShares ETF website lists TLT's duration as 15.27 as of August 31st and that is a good approximation of how much the bond price will move for each percent change in yield.) I have been researching bond yields and I think a 1% decline, from around 4% now to 3%, is reasonable. If deflation was powerful, the yields will drop further (as in modern Japan) but one can't bank on such low yields.

Actually, 15% is not bad. Even if it takes 3 years, 15% will be pretty good. The reason is, if we get deflation, even a 0% return will be amazing. So say 5% capital gains + 4% interest = 9% per year is not bad. Not only do you actually post a positive return, all assets will decline so your purchasing power will be far more powerful than it seems. Of course, if we get positive inflation, this isn't so good.

Here is what Hendry says he is pursuing (text bolded by me):

Consider the UK interest rate market. The Bank of England seems to concur with our caution. We mentioned our trading last time. But in the swaps market we can buy more time to await our predicted outcome. We recently purchased the right, but not the obligation, to receive a rate of 2.5% on one year money starting in two years time.

Now that is a lot of time. However when you listen to the musings of the central bank and consider everything that has happened over the last year it is not outrageous to suggest that rates may actually remain on hold in the UK.
To be rewarded with ten times your money for rates on hold seems untypically generous when the alternative is to chase a stock market that has already climbed 50%. Let others fret about their investment franchise risk from not being in the market, we are going to stick to where the profit opportunities seem most attractive.

So it looks like he purchased options (or something similar) for a 2.5% rate on 1yr British government notes two years from now (I'm not sure what short-term British bonds are called so I'm just using American terminology.)

Depending on price paid, transaction costs, and a few other details, you need rates to stay below 2.5% for this to be profitable. How likely is this? The following is the yield curve for Britain, courtesy

Ideally one should look at the futures curve (if available) but I don't know where I can get that (Does anyone know where I can get a chart of interest rate futures for UK and Australia? Is there such a thing?) You want to look at the futures curve because that will tell you what the market is expecting. I don't have access to anything like that so I am going with a crude approach of looking at current rates.

It looks like the 1yr bonds have a current yield of 0.39%. The short-term central bank rate is 0.5%. Yields climb above 2.5% at the 5 year bond and beyond.

Since Hendry is suggesting that he can make 10x the money if rates stay the same, it must mean the market is projecting 1 year rates to be way beyond 2.5%, two years down the road.

Without know the full details or being a bond expert, it's hard to say how good this trade is. I personally think it is a good bet. Of all the major economies out there, the UK is probably the worst off. It has a real estate bubble far larger than USA; has leading banks that are essentially insolvent and quasi-nationalized; and has a huge financial sector, relative to their total economy.

Hendry will probably lose everything (100% loss) if inflation sets in and rates climb above 2.5% (in practice, you may be able to limit your loss by closing your position early and taking a big loss so it may be not necessarily be 100%.) If central banks jacks up the rates, the 1 year rate will likely follow. You can see from the bottom chart (above) that rates were above 2.5% as recently as November of last year. So this is a very major deflationary bet. Mild inflation or mild recovery will likely cause losses.

Hendry suggests a similar bet for Australia:

The world of Australian interest rate expectations offers perhaps even greater upside. Australia has one of the most financially leveraged private sectors in the world with private debt 238% of GDP vs. just 65% back in 1929.

Overnight rates at 3% are high by the standards of Europe, Japan and the US. But owing to its ability to sell iron ore and other commodities to the Chinese the market believes that in two years time the authorities will have to raise rates to 6%. I say, bring it on.

If on the other hand they remain at 3% then we make 5x our money. But, in the event that the China surge fails, and it dooms its local industry to a glut of overcapacity and poorly conceived infrastructure projects, the trade becomes profoundly rewarding.

Without China's heady accumulation of commodities I am sure that the Australian economy would falter. And under such straightened circumstances I could imagine that the monetary authorities might even reduce rates to British or European levels; the pay-off would be at least 25x.

I would put this trade on a par with buying $50 crude oil puts last July. Who would have thought it possible?

Yep, this is like buying oil puts last year. ContrarianDutch actually suggested it at one point and I was cool on the idea. To put it bluntly, this is a low-probability bet with large pay-offs, either way (positive or negative.) This basically a super-bearish bet on China.

The following the yield curve for Australia:

Based on what Hendry is saying, it appears the market is expecting the central bank to raise rates from the present 3% to 6%. Hendry is basically betting against this. If rates stay the same, he says he will make 500% (in the extreme case where China runs into problems, he will make a lot more.)

I don't like this bet, but I honestly don't know much about Australia. Unless you were making a bearish bet on China, this seems a bit too convoluted for my taste.

For instance, Australia seems to have always had higher rates and expecting them to resemble Europe, Japan, or America seems a bit far-fetched. Furthermore, there is a difference between having a highly leveraged private sector, versus one that is almost-insolvent. I don't know Australia well enough and one has to see if the private sector (I'm not sure if the debt is held by consumers or corporations) can service it. Debt is a huge problem in America because most of the debt problems lie with consumers and their wealth never really went up (except for the wealthy.) For instance, consumer debt kept climbing in the last 20 years yet incomes barely went up (and is essentially flat to slightly negative in real terms.) Is Australia in a similar state? My impression is no, but one needs to check that.

Another reason to be careful with Australia is because, in my simplistic mind, it resembles Canada in some sense. That is, countries whose economies are partly dependent on commodities (Australia more so than Canada I believe) and whose economies aren't in that bad of a shape. If commodities collapse the situation may not be as great as 2 or 3 years ago but it's not going to be that terrible IMO. To me, making a bearish bet on Australia is sort of like betting against Canada, and that's a hard thing. I'm not saying that because I'm Canadian; I'm trying to be neutral. It's hard to see Australia running into serious problems (but, as I said, I don't know much about it.)

Having said that, Hugh does have one thing working for him. Rates in Canada were cut, almost to near-zero, whereas Australia's is still 3%.

Anyway, these are interesting strategies. I know I said I'm never investing in derivatives because they are zero-sum games, but I'm thinking about them. With the interest rate options, you are looking at around -100% to +1000% return. The return is stil skewed heavily to the downside but at least the upside is much larger here. Owning the long bond, in contrast, will probably yield between -30% and +30%. Even if I don't invest in them (I don't even know if small investors have access to them,) Hugh Hendry's letter has made me think about what the market is pricing in and how widely optimistic it is. One thing I realize is that the market may be mispricing the short-term interest rates while the long-term rates may be reasonably priced (this is likely why Hugh is going after the short-term interest rate options.)

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4 Response to Hugh Hendry August commentary... sticking with his deflation playbook

Daniel M. Ryan
September 4, 2009 at 1:56 AM

There's a double-barreled inflationist argument that I've never seen any deflationist knock down. Perhaps you can have a go at it:

No political figure wants to be the next Herbert Hoover. Consequently, there'll be a quick consensus that high inflation is a tolerable price to pay for avoiding deflationary depression.

The second part of the barrel: When the 1930s happened, no-one had any reason to suspect it would be as bad as it was. The policymakers of the time had no idea of what we know now. If anything, they were expecting a sharp but short recession. Nowadays, virtually any downturn gets sized up as another potential deflationary depression triggering event.

Summation? There will never be another deflationary depression because we now know what couldn't have been known when the original one took hold. So does every political figure with his/her hands on the levers of power. Compared to Hoover, Jimmy Carter got off lightly: his name isn't the name of shame; at worst, he's considered a joke. Every government official knows it, too. It's better to go down as a joke than as the Devil incarnate. Consequently, if there's a choice between inflating and not, governments will err on the side of inflating.

Ross Greenspan
September 4, 2009 at 7:11 PM

Re: futures curves. you could email the admin @ - he might be able to add some of the curves you're looking for. Best, Ross.

September 6, 2009 at 12:41 AM

Thanks Ross... I'll think about e-mail that site you suggested. I'm still not sure what Hugh Hendry was referring to so I need to figure that out first...

December 22, 2009 at 9:39 AM

Marc Faber three part video interview:

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