Can the PP perform well when two of its asset classes are falling

[moda0306]

I can count on one hand how many politicians understand that spending isn't constrained by taxation or borrowing.

[Lone Wolf]

I guess you're right,  when the Clinton surpluses occured, the treasury offset the excess taxation by selling fewer treasuries and so reducing the debt in the form of treasuries rather than reducing the monetary base.

Right, that's pretty much how I view it as well.  Of course, I'm simplifying by setting aside the fact that net debt still went up due to the rise in intragovernmental debt (thus not achieving a true "surplus".)

All of this still leaves us with the conundrum of how COULD a Volker style rate hike be operationally enacted even if for whatever reason they wanted to? Wouldn't it entail both massive surplus taxation over and above taxation AND issuing of treasuries?

I think that a Volcker-style sharp rise in interest rates would be orthogonal to taxation, wouldn't it?

The Volcker playbook IIRC was to raise the federal funds rate target very sharply (close to 20%, I believe.)  The Fed typically does this by raising the discount rate (the rate at which a bank may borrow from the Fed) and by selling assets.  For Volcker this was Treasury securities.  For us it could be those damned mortgage-backed securities. 

It seems that operationally this could be done by the Fed at any time.  (I of course make no comment as to whether or not it is necessarily advisable to do this!)

I can count on one hand how many politicians that I would trust to not spend every single cent they collect, plus borrow an additional $.40 on the dollar to boot.

Indeed!  I can't even get through my whole hand.  I've got Gary Johnson, Ron Paul, and perhaps his sons Rand Paul and RuPaul. 

I can count on one hand how many politicians understand that spending isn't constrained by taxation or borrowing.

Such a pity that Weimar hogged up all the politicians that "understood" this. 

[moda0306]

LW,

When we have foreign denominated debt, then we will be constrained.

If we have our productive capacity partially destroyed by war or confiscation, then we will be constrained.

When the very legitimacy of our government and/or its ability to enforce tax & legal tender laws is questioned, then we will be constrained.

Those all come from aspects well-outside a nation's currency management.  Weimar's hyperinflation would have manifested itself in default because there were debts they simply couldn't pay with their foreign debts and productive capacity considerations.  There were issues in the real world that paper could not fix.

Right now, we're worrying about paper problems instead of real ones.

Hey, at least we can agree that taxes should be cut, and that RuPaul knows his...er... her... macro!

[moda0306]

Tenn, 

Just saw your sig.  I am honored.

[stone]

All of this still leaves us with the conundrum of how COULD a Volker style rate hike be operationally enacted even if for whatever reason they wanted to? Wouldn't it entail both massive surplus taxation over and above taxation AND issuing of treasuries?

I think that a Volcker-style sharp rise in interest rates would be orthogonal to taxation, wouldn't it?
The Volcker playbook IIRC was to raise the federal funds rate target very sharply (close to 20%, I believe.)  The Fed typically does this by raising the discount rate (the rate at which a bank may borrow from the Fed) and by selling assets.  For Volcker this was Treasury securities.  For us it could be those damned mortgage-backed securities. 
It seems that operationally this could be done by the Fed at any time. 

Volcker had very little in the way of monetary base to mop up before he managed to create "tight money" as HB described it resulting in the banks needing to borrow at the discount window at the high rate he set. Anyone wanting to emulate him now would have a very different scale of task ahead of them. Let's say the Fed sold all of its MBS. What are they going to sell for ? It then has to try and sell off it's stock of treasuries, reversing QE. Operation twist will have left it with longer dated treasuries such that the more it sold the less it could sell them for. Wouldn't the end result be that the Fed was all out of ammo before any of the banks even considered borrowing at the discount rate? The Fed would be left impotent whilst a massive glut of bank reserves still lurked out there. That is why I guess taxation over and above government spending would be required to cut the mountain of bank reserves down to size before the Fed had the capability to achieve a target rate anything like what people are worried about.

[MediumTex]

Looks like Lone Wolf got a new avatar.

Nice.

[stone]

Basically the Fed would be asking the banks to voluntarily reverse the post-2008 bankster bailouts. Am I in a muddle about this?

[AdamA]

Looks like Lone Wolf got a new avatar.

Nice.

Congratulations on your's as well.

[Lone Wolf]

Looks like Lone Wolf got a new avatar.

Nice.

Thank you!

And yours is, I must confess, even better!  Sensei Kreese... here comes the pain!!

[stone]

I don't see how Ron Paul would manage this slashing of the stock of bank reserves. He says he wants all of the tax burden to be a sales tax. So he imposes a sales tax and slashes government spending. People sell what they can get sold and pay tax on those transactions. Somehow those bank reserves have to leave the banks and get spent on stuff before Ron Paul's sales tax can get to them. How would the bank reserves get into peoples' hands for such consumer spending??? How else are the bank reserves going to get depleted by Ron Paul

[moda0306]

Testing... my new sig & avatar.

Thought I'd get with the times.

[MachineGhost]

But if stocks are overvalued, they do not have to go up as the economy recovers or is positve.  In fact, the connection in the past between stocks and a positive economy has been tenous.  What matters more in the long run is the price you pay for the discounted stream of cash flows.

I see people thinking that mistake all the time.  It's one of those self-deluded behavioral finance thingies to justify not having to deal with the unpleasant possibilities to their greed and dreams.

MG

stone,

The economics that would force fairly positive interest rates on short-term debt are either Austrian monetary policy getting enacted, or some kind of economic recovery that creates demand for loanable funds, boosting stocks significantly.... the latter seems the only likely scenario, and the former we should be able to see coming (say, if Ron Paul were running for president and looking to have a decent chance).

So while gold and LTT's might suffer, cash will do alright and stocks will do phenominally, at least in the non-Austrian scenario.

At least that's how I see it happening.

[MachineGhost]

Oh boy.

MG

Finally, you are right that the PP has never been "battle-tested" when all three volatile assets fall hard at once; the closest I can think of would be Japan in 1990 or the US when the Fed tightened the money supply and FDR cut deficit spending and raised taxes  in 1937 (the gold price was fixed then but if you use platinum, silver, or commodities in lieu of it then the PP still loses money). Suffice it to say that in both cases the situation was not exactly wonderful for the PP.

[MachineGhost]

Since when did setting the discount rate or the fed funds rate have anyhting to do with Open Market Operations?  Is MMT assuming that the former is dependent on the latter?

MG

The Volcker playbook IIRC was to raise the federal funds rate target very sharply (close to 20%, I believe.)  The Fed typically does this by raising the discount rate (the rate at which a bank may borrow from the Fed) and by selling assets.  For Volcker this was Treasury securities.  For us it could be those damned mortgage-backed securities. 

[Lone Wolf]

Since when did setting the discount rate or the fed funds rate have anyhting to do with Open Market Operations?

The Fed uses open market operations in an attempt to guide the "real" federal funds rate toward the "target" federal funds rate that they have chosen. This is how they describe it:

Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (the federal funds rate). The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Here's the link for that.

Essentially, the Fed tries to reduce the "supply" of reserves that may be lent between banks overnight.  The idea is that the "price" (or interest rate) which banks charge to lend reserves to one another will then rise.

Is MMT assuming that the former is dependent on the latter?

Personally, I reject MMT so somebody else might have to help you out with that one.

[stone]

The discount rate is just whatever the fed chooses to pay it at. AFAIK MMT agrees with Lone Wolf's quote from the Fed that Open Market Operations are used to mop up reserves to the point where they have a scarcity value such that banks will pay each other interest in exchange for lending them. MMT says that the natural rate of interest is zero since if the Fed doesn't sell enough debt to mop up the reserves, then the interest rate falls to zero because the system gets flooded with reserves unless the Fed uses its new powers to actually pay banks to park reserves at the Fed. Currently the system is flooded with reserves. The only way the Fed can currently set the short term interest rate is by actually paying banks to park reserves at the Fed. Reserves currently have no scarcity value.

[D1984]

I guess the PP assets often see gains not from "economic conditions" really changing but rather from changes in expectations of what "economic conditions" might do shortly. Might the turbo swap idea not be able to tap into such irrational shifts in temperament? Because the turbo swops aren't something liquidly trading would they only gain if rates really rose rather than if the market simply got the fear that they would?

Might borrowing in South African Rand in order to buy the cash part of the (corrupted) PP be a route to "volatile cash". South African Rand would do very badly if gold hit a bear market and relative to the USD would do very badly if USD rates rise. Perhaps Australian dollar or some other gold producing country might diversify that but South African currency is the most gold effected one isn't it?

Stone, if the market got the fear that rates would rise but they didn't then wouldn't the PP be hurt badly with swaps or no swaps regardless? If stocks, bonds, and gold all fell simultaneously on expectations that rising rates would hurt them (bonds directly, stocks by making the opportunity cost of buying stocks-buying fixed income-more attractive by offering higher yields on both ST and LT fixed income, and gold by fear that rising rates would mean the end of negative real rates) and then rates actually DIDN'T rise so cash couldn't even help like it did in 1981 or 1969 the PP could be in for an ugly year or two...although if rates didn't rise and it was a "false alarm" as such then the other PP assets should theoretically recover very quickly once the risk had passed.

There IS a financial derivative instrument involving swaps that might work very well in the situation you are describing, though; it's called a "swaption" (which makes sense since it's an option to do a swap). For instance say LT rates are currently at 3% with ST rates at 0.25% and people expect that shortly LT rates will rise to 5% and ST rates to 3%. This means that the cost of doing a fixed-for-floating swap just went up (example: you might have only had to pay 3% LT to get whatever the floating rate would be for say 20 years but if expectations change and people expect ST floating rates to be higher and LT rates to be up as well you might find yourself in the situation of having to pay 4.5% or 5% to receive floating adjusted every month for the next 20 years if you opened a swap position currently). HOWEVER if you had entered into a swaption agreement (to pay fixed for floating...at the then-current rates and as of now much lower than present rates) say, six months prior to this happening the you would have the contractual right to enter into the fixed-for floating swap paying the lower previous LT fixed rate (3%) but receiving current ST floating rates that adjusted every month. Actually one doesn't have to enter into a swaption that pays current rates; one could conceivably enter into a swaption to exercise the right, at some point in the future, to pay any certain agreed upon rate...it could be more or less than current fixed rates (and receive commensurately higher or lowe than current or future floating rates...either that or you'd pay a higher/lower option premium depending on how much higher/lower the rate you had received the right to pay-and to be paid-was higher than current or expected rates).

The nice thing about a swaption is that it doesn't have to be used/exercised (i.e. you don't have to enter into the swap just because you have the option) but it instead can be sold for a nice capital gain if it is "in-the-money" while if it is at a loss you just lost the option premium and nothing more whereas with a swap if it goes against you can get rid of it but you have to pay someone to take it off your hands because at that point it is an obligation/liability and not an asset i.e. it has a negative value). The bad thing is that unlike a swap (which is continuing...both parties pay what they agreed to pay for as long as they agreed to pay...this can be from a few month to 30 years for vanilla f-for-f swaps) the option is for a typically limited time and if it isn't "in-the-money" at expiration (or in some cases during the whole option period...American vs Bermudan vs European style swaptions is a whole other matter I'm not going to get into) then tough luck...it expires worthless (whereas if a swap goes termporaily bad...say you were paying fixed-for floating and floating rates fall for a year or two but then rise again to above where they were when the swap started you will only lose a year or two's profit on the swap and be in the black once more as rates rise again) even if just one day after the option expires rates rise hundreds of basis points.

As to the rand/dollar carry trade as a hedge...I would never do that. One, unlike paying the fixed leg of a swap, when you borrow in one currency and buy another you are essentially "short" the former and "long" the latter because you borrowed some of the first currency, "sold" it (by converting it to a different currency...the currency you chose to invest in) and when it comes time to pay your loan back in the first currency you have to sell your "invested-in" currency for what it's worth in the first currency. Like any short play that involves borrowing, this exposes you to unlimited loss but limited upside (if the currency you borrow becomes toilet paper due to hyperinflation then you all but have to not pay it back at all* whereas if the currency you invested in becomes worthless due to said hyperinflation you basically have lost everything). Not my cup of tea and a reason why I don't short stocks-or anything else-no matter how worthless I think they will become or how low I think they will crash.

To top it off the Rand doesn't always track gold very well...it was kept pegged during the 70s and only unpegged in early 1982. Furthermore, the Rand lost nearly 40% against the dollar in 2008/9 while gold at least held it's own (or more than held it's own...it had a 3-4% gain in 2008 IIRC) and still hasn't gone up as much as gold has since then.

* I said "all but have to not pay it back" but in cases of borrowing in a currency that then became worthless in some cases you might actually NOT have to pay it back at all. This doesn't have to apply to the carry trade (although it could) but can apply to borrowing to buy or purchase anything. During the Israeli hyperinflation of the early 80s, for instance, some people who had bought personal residences or second homes on fixed rates in the 60s or early 70s received letters from their banks telling them to please stop sending in their payments at all and consider the debt discharged as it was costing the bank more in labor and paperwork to process each payment than the mortgage payment itself was worth! I suppose it was this "never have to really pay it back" aspect of very high or (hyper) inflation that led to HB advocate having "borrowing in fixed rate debt" as an asset in the VP if you were expecting very high inflation.

[D1984]

The discount rate is just whatever the fed chooses to pay it at. AFAIK MMT agrees with Lone Wolf's quote from the Fed that Open Market Operations are used to mop up reserves to the point where they have a scarcity value such that banks will pay each other interest in exchange for lending them. MMT says that the natural rate of interest is zero since if the Fed doesn't sell enough debt to mop up the reserves, then the interest rate falls to zero because the system gets flooded with reserves unless the Fed uses its new powers to actually pay banks to park reserves at the Fed. Currently the system is flooded with reserves. The only way the Fed can currently set the short term interest rate is by actually paying banks to park reserves at the Fed. Reserves currently have no scarcity value.

Maybe I'm misreading what you posted but are you saying that we are so awash in excess reserves right now (i.e. banks and other corporations/individuals with so much excess cash they can't find safe places to invest it at anything ohter than very low rates) that even if the Fed raised the FFR/borrowing rate at the discount window to, say, 3% from it's current ZIRP rate but still paid nothing or next to nothing on reserves deposited with the Fed that real open market rates wouldn't go up one bit?

[MachineGhost]

I think he was saying that the amount of the bank reserves is so large it drives down real interest rates on all other asset classes under the equilibrium theory because the Fed has no room to act.  If the Fed raises short terms rate ("tight money"), it will instantly produce high inflation as everyone will not want to hold previous reserves at 0% vs new reserves at whatever the new rate is.  The only way to prevent that would be to pay interest on the reserves to keep the reserves parked.

MG

The discount rate is just whatever the fed chooses to pay it at. AFAIK MMT agrees with Lone Wolf's quote from the Fed that Open Market Operations are used to mop up reserves to the point where they have a scarcity value such that banks will pay each other interest in exchange for lending them. MMT says that the natural rate of interest is zero since if the Fed doesn't sell enough debt to mop up the reserves, then the interest rate falls to zero because the system gets flooded with reserves unless the Fed uses its new powers to actually pay banks to park reserves at the Fed. Currently the system is flooded with reserves. The only way the Fed can currently set the short term interest rate is by actually paying banks to park reserves at the Fed. Reserves currently have no scarcity value.

[stone]

Maybe I'm misreading what you posted but are you saying that we are so awash in excess reserves right now (i.e. banks and other corporations/individuals with so much excess cash they can't find safe places to invest it at anything ohter than very low rates) that even if the Fed raised the FFR/borrowing rate at the discount window to, say, 3% from it's current ZIRP rate but still paid nothing or next to nothing on reserves deposited with the Fed that real open market rates wouldn't go up one bit?

D1984, where banks are relying on inter-bank lending (although there is a glut of reserves they are not all with the same banks as have made loans), the discount window rate can have a big influence on inter-bank lending rates as and when banks don't trust each other but that is totally different from the short term treasury interest rate. My guess is that if the central banks were to now hike up the discount window lending rate, some banks would really be in trouble and interbank lending rates would soar but short term treasury rates would actually become negative or at least zero. I think for the PP what matters is risk free (ie treasury) rates. The cost of lending to people who won't be able to pay you back (eg Northern Rock or Icesave in 2008) is not what is relavent.

As MG said, I also thought that the glut of reserves in themselves competed down the expected yield of all assets to zero. Where I think MG misunderstood what I was trying to say was that I wasn't thinking inflation would constrain the Fed from doing what it would take to get rates up; rather I thought that Fed solvency would be the blocking constraint. Raising the discount window rate only has any influence if banks both do not have plenty of their own reserves and also can't get reserves cheaply by inter-bank lending. The current short term interest rate is actually set by the Fed using its new power to actually pay banks to store reserves at the Fed. But the Fed simply does not have a source of funding to pay high rates for that. The traditional way to mop up reserves is for the Fed to sell treasuries but the bankster bailouts were "cash for trash" exchanges with the Fed now holding assets that aren't worth the bank reserves they exchanged them for. Operation twist has left the Fed having LTT as the high quality part of its portfolio. If the Fed tried to raise rates it would be self defeating because those LTT would lose market value. Basically from what I can see the Fed has unlimited power to create bank reserves but does have limitations on its power to withdraw reserves from the system.
Congress has unlimited power to withdraw reserves by taxation but even that would take the political will/power to actually tax the people who could get their hands on reserves to pay the tax. It is no use hoping to tax away reserves by imposing a Ron Paul style sales tax on people's grocery bills. Most people simply do not have any means to get to the bank reserves.

I have to stress though that I can't overstate just how unqualified I am to have any views on all of this . I'm basing all of this wittering on weaving together snippets I've read on the internet.

[stone]

D1984, I'm intrigued by your warning about borrowing in foreign currency (eg South African Rand). From a naive veiw point it seemed less far out than the interest rate derivatives. I wasn't imagining a large short position. I was thinking that the Rand was very much a "risk on" currency (opposit to the Yen) and so being short Rand and long for USD and gold would give a boost in panics such as 2008 as well as in 1981 type "tight money" scenarios. Wouldn't both gold and the USD have to turn worthless with the South African Rand becoming strong in order for PP catastrophe to ensue? I guess that could happen if China somehow becomes a super power with an overwhelmingly strong global reserve currency and somehow the South African currency rides along with that whilst the USD and gold vanish away??? I guess your general point about not being exposed to ruinous risks irrespective of whether you can envision the scenario is the crucial one.

The $700T of derivatives currently outstanding globally are mostly interest rate derivatives aren't they? That world is all very mysterious to me. You seem to know all about it. What I'm finding hard to imagine is how such derivatives could be honoured if things did swing away from what they are expecting. Is it just another way for bankers to ensure an income stream until such a time as a pay out is needed at which time they will just say "sorry" ?

[MachineGhost]

As MG said, I also thought that the glut of reserves in themselves competed down the expected yield of all assets to zero. Where I think MG misunderstood what I was trying to say was that I wasn't thinking inflation would constrain the Fed from doing what it would take to get rates up; rather I thought that Fed solvency would be the blocking constraint. Raising the discount window rate only has any influence if banks both do not have plenty of their own reserves and also can't get reserves cheaply by inter-bank lending. The current short term interest rate is actually set by the Fed using its new power to actually pay banks to store reserves at the Fed. But the Fed simply does not have a source of funding to pay high rates for that. The traditional way to mop up reserves is for the Fed to sell treasuries but the bankster bailouts were "cash for trash" exchanges with the Fed now holding assets that aren't worth the bank reserves they exchanged them for. Operation twist has left the Fed having LTT as the high quality part of its portfolio. If the Fed tried to raise rates it would be self defeating because those LTT would lose market value. Basically from what I can see the Fed has unlimited power to create bank reserves but does have limitations on its power to withdraw reserves from the system.
Congress has unlimited power to withdraw reserves by taxation but even that would take the political will/power to actually tax the people who could get their hands on reserves to pay the tax. It is no use hoping to tax away reserves by imposing a Ron Paul style sales tax on people's grocery bills. Most people simply do not have any means to get to the bank reserves.

I have to stress though that I can't overstate just how unqualified I am to have any views on all of this . I'm basing all of this wittering on weaving together snippets I've read on the internet.

That sounds all right to me, except for one part.  The Federal Reserve has no power to create money!  Congress via the Treasury has that power.  Since all money has to come first from the Treasury, in net effect all the Fed does is determine what form of the money is held by the Public, as currency or bank reserves.  And since apparantly, the Fed cannot directly buy Treasuries directly like the Public can and it is Unconstitutional for it to buy anything but Treasuries [indirectly], it has a very limited power in what it can do with "excess money" when Congress spends too unproductively (as per the inflation equation).  At the end of the day, all the Fed can really do is decide whether there will be "tight money" or "[high] inflation".

MG

[stone]

MG, back in 2009, Bernanke told Pelley the following: “It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. It’s much more akin to printing money than it is to borrowing.”?

I guess that that refers to lending through the discount window. If the Fed does that at zero interest rate then that is the Fed spewing out reserves that it has limited capacity to pull back earlyeven if it were to want to. The Fed also buys trash such as MBS using reserves it creates through the discount window (I think). Reversing that by selling the MBS on the open market presumably would not result in all of what they paid being retrieved.

[D1984]

D1984, I'm intrigued by your warning about borrowing in foreign currency (eg South African Rand). From a naive veiw point it seemed less far out than the interest rate derivatives. I wasn't imagining a large short position. I was thinking that the Rand was very much a "risk on" currency (opposit to the Yen) and so being short Rand and long for USD and gold would give a boost in panics such as 2008 as well as in 1981 type "tight money" scenarios. Wouldn't both gold and the USD have to turn worthless with the South African Rand becoming strong in order for PP catastrophe to ensue? I guess that could happen if China somehow becomes a super power with an overwhelmingly strong global reserve currency and somehow the South African currency rides along with that whilst the USD and gold vanish away??? I guess your general point about not being exposed to ruinous risks irrespective of whether you can envision the scenario is the crucial one.

The $700T of derivatives currently outstanding globally are mostly interest rate derivatives aren't they? That world is all very mysterious to me. You seem to know all about it. What I'm finding hard to imagine is how such derivatives could be honoured if things did swing away from what they are expecting. Is it just another way for bankers to ensure an income stream until such a time as a pay out is needed at which time they will just say "sorry" ?

Stone, the nightmare scenario that would result in "PP catastrophe" for someone doing a Rand/USD carry trade would be as follows:

US inflation rockets to say 30 or 35% (awful but not true hyperinflation IMO) and our dollar is commensurately worth just as much less in the forex markets (including against the Rand). Interest rates do rise to maybe 30 or 35% (ST and LT...maybe LT rates rise to just barely match inflation at 40% or so) but the Fed doesn't let them rise like Volcker did in 1981 to actually above the level of inflation. Negative real rates are great for gold and it at least keeps up with its former value (i.e. if the dollar falls say 50% then gold rises at least enough to counter it so that an ounce of gold will still buy the same amount of goods as it would before regardless of its value in dollars...maybe gold rises by more than the rate of inflation or rate of devaluation like it did in Iceland in 2008). HOWEVER...the stock market falls (except for maybe a few companies which report the majority of their earnings from overseas might do OK or even very well) due to the economy getting killed by oil prices that are now upwards of $220 a barrel as a consequence of the falling dollar, your LT bonds are toast because you bought them when they were yielding maybe 3 or 4% and now LT yields are at 30% or 35%; kiss upwards of 88% of you LTTs' value goodbye if they are coupon-bearing and heaven help you if you they were zeros; and your STTs that are supposed to at least offset inflation make about 5% less than inflation but lose most of their real value because you have to convert them to Rand to pay back your debt and with the dollar falling by 50% or more your Rand-denominated debt just effectively doubled so goodbye 25% STTs and whaetver else of your PP you have to liquidiate to pay back what you owe). Ask any Icelander who had a Euro-denominated loan to buy a car or ask any Eastern European (whose country didn't use Euros yet) or resident of the Baltic states who had a mortgage denominated in Swiss Francs what happens when your currency declines by half or two thirds against what you borrowed in. For anyone who borrowed in another currency to buy an asset priced in, say, Hungarian Forint or Icelandic Krona, 2008 was not pretty and said individual was in a world of hurt.

Even if gold went up circa 200% like it did in Iceland in 2008 I'm not sure it would be enough to bail you out in the above situation. Let's see...your assets and their returns equal the following: gold up 200%, stocks down maybe 15% as high oil prices wreck the economy, LT bonds down 90%, and STTs roughly keeping up with inflation or maybe lagging it just a little as ST rates barely keep up with inflation. If you had $100K in each at the beginning by the end of the year you'd have $300K of gold, $85K of stocks, $12K of LTTs, and if inflation was 40% then you'd have perhaps $128K of STTs as they just barely lagged inflation. That's a total of $525K when you started with $400K. Not bad except for two things:

One, inflation was actually 30% so your $525K is really only worth about $400K assuming you didn't have any debt (which is not the case since 25% of your portfolio-the STTs-was leveraged by borrowing in Rand and then using the proceeds to buy the $100K in US denominated STTs).

Two, you DID in fact have debt (in another currency; the South African Rand) and that debt in Rand that was initially equal to $100K or USD (enough to cover your 25% STTs) will now take maybe $200K or USD to pay off if the dollar fell by 50%. I'm going to be charitable and assume the dollar didn't fall by quite that much so maybe it only takes you $185K to pay back your Rand-denominated debt. That still leaves you with a PP as a whole at $345K in nominal terms which is equal to maybe $250K or $260K in real terms. Losing a third or more of your PP in real terms in one year would IMO be something one could rightfully call a "catastrophe".

Finally, there's the minor fact that even if you somehow DIDN'T lose money on a falling dollar when you borrowed in Rand to invest in USD-denominated STTs you could still lose money after paying interest rates. The prime rate on Rand-denominated borrowings in 1981 was upwards of 17% in some cases in 1981 (it was never below 11% that year). You might make enough money on your USD-denominated STTs to make up for this (in '81 US 1 year Treasuries were paying upwards of 15% much of the year) plus whatever you made/lost on the change in value between USD and Rand (there was no change that year as Rand/USD was fixed until 1982) but what if US rates suddenly dropped more quickly than Rand rates did? Plus, there is the fact that you are borrowing at a "non-risk free" rate (since even if you have an 800 FICO score you can't print money like the Treasury can) but investing in something that only pays a "risk-free" rate; common sense dictates that most of the time you will lose money on this even if USD to Rand doesn't move against you.

A fixed-for-floating swap may seem "far out" but it theoretically would actually HELP in such a situation since you'd be paying the current LT rates of sub-4% (which would be relatively painless to you ininflation-adjusted terms since inflation soared) and getting ST rates of upwards of 25% with just a plain vanilla swap (or effectively upwards of 50% if you'd swapped on twice the nominal amount at $200K instead of $100K) and if you'd done a "turbo swap" your counterparty would basically owe you the sun, moon, and inner planets (plus his soul and first-born, for good measure).

Bottom line: Don't borrow in any currency other than your own unless it's to buy assets denominated in that currency (or unless it's hedged within a fairly narrow range). It's just not worth it IMO.

[D1984]

The $700T of derivatives currently outstanding globally are mostly interest rate derivatives aren't they? That world is all very mysterious to me. You seem to know all about it. What I'm finding hard to imagine is how such derivatives could be honoured if things did swing away from what they are expecting. Is it just another way for bankers to ensure an income stream until such a time as a pay out is needed at which time they will just say "sorry"  ?

Yes, most of the $700T plus of derivatives outstanding are interest-rate swaps. Keep two things in mind, though:

One, most of these swaps are (at least in theory) by corporations, banks, or people who own either fixed-rate or floating-rate assets and want to hedge rate risk and not by those simply speculating on what rates will do while being "naked" any actual underlying assets (although there is plenty of the latter too).

Two, that $700T+ (I've heard $750T too) is based on notional value IIRC and not on actual swapped amounts. For instance, assume we do a swap; I agree for the next year to pay you LT rates on $10,000 and you agree to pay me ST rates on it. LT rates were 3% and ST rates were 1%. The swap would be "netted" and I'd actually pay you $200 ($300 to you minus $100 paid to me equals $200 net for you)...HOWEVER, when someone was referring to this swap it would be on the notional value and not the netted amount paid between counterparties so it would be a "$10,000 swap" and not a "$200 swap". Referring to these things by notional value makes them seem a lot larger than they actually are in relation to the "real economy" (although to be fair a "turbo swap" done on, say,  LIBOR squared could conceivably have netted amounts be more than the notional value itself if LT rates were low to start and ST rates went up beyond 10 or 11%)

As far as swaps being "just another way for bankers to ensure an income stream until such a time as a pay out is needed at which time they will just say "sorry"...well....not necessarily...most simple fixed-for-floating rate swaps are collateralized by Treasuries (typically ST of less than 180 days but can be intermediate term in some cases) on at least the netted amount expected to be swapped and in some cases on sums up to the notional amount . Treasuries are the typical collateral but if both parties agreed the swap could conceivably be collateralized by commercial paper, ST corporates or even by gold bullion (although in such cases collateral would be above and beyond what would be required if Treasuries were used...ST AAA rated commercial paper might require 105% of the amount swapped wheras gold bullion might-due to its high volatilty vs STTs-require 150% of the amount swapped) .

What you were probably thinking about was AIG in 2008 and how they got in trouble. Almost all of of what they did was credit default swaps (on subprime CDO and MBS garbage and synthetic derived mortgage securities and God knows what else, no less) and not interest-rate swaps. Also, AIG at the time was one of the few major entities or corporations (IIRC there were five or six of them besides the Treasury, Federal Government, and Federal Reserve) that did not have to post collateral for swaps or for other market bets they made because they were AAA rated. It was always assumed that if a swap or leveraged trade went bad that they could pay it off by either issuing more stock, borrowing in the bond market, or borrowing in the money markets via issuing commercial paper. Needless to say, in 2008 the commercial paper markets froze, bond yields demanded soared for companies that could even get financing, and AIG couldn't float enough stock in a secondary offering to do any good because its stock price was in the toilet. Today even companies with an AAA rating are in almost all cases required to post adequate collateral for swaps.

Whiile it's possible for a "receiving fixed rate but paying floating rate" counterparty to get in deep enough excrement financially that they can't pay you your leg of the swap (ask Orange County or Jefferson County) if rates rise enough, it's not too likely to happen that such would result in any serious losses to the "fixed-rate paying but receiving floating rate" party since the former (the party paying floating rate) would be required to post more collateral each year to secure the swap net amount as rates rose and the netted amount was greater and greater. If things DID get to the point where rates were ruinous for your counterparty and he/she/it stopped paying you could either sue them and/or stop paying YOUR leg of the swap (since your counterparty violated the contract to start with by not paying the required amount and was thus guilty of unclean hands in legal terms i.e. they were being unfair to you first) or just seize their Treasuries or what have yo they had posted as collateral. To be honest, if we were in that situation it would probably mean either very high (maybe 30% or more) inflation and ST rates, or outright hyperinflation. In either scenario your LTTs would hopefully at least keep up with inflation (if rates were higher than inflation) or gold would carry the portfolio (in hyperinflation or if rates were high but not higher than inflation)...stocks can also do OK in high inflation; during several years of Brazil's or Israel's hyperinflation in the 80s they actually kept up with and even beat inflation...but they can also do very poorly (think Japan from 1945-48 or Iceland in 2008). The swaps aren't really to protect you from high or hyperinflation (although they might help as long as your counterparty didn't default) but in a period like 1950-mid 1960s in the US ( when gold-if it were to have been freely traded at market prices-and bonds fall together, cash beat inflation by less than 1%, and non-tilted stocks alone couldn't do enough to give a PP more than about 2% real returns) in order to give cash more upside volatility.

Finally, I probably don't know much more about swaps than anyone else here on this board (I don't work in finance or for an i-bank, if you were wondering); I've just spent a good bit of time analzying various techniques to help make the cash/STT portion of the PP respond as much to rising rates as gold does to negative real rates, stocks to non-inflationary prosperity, or LTTs to strongly falling long-term rates. Swaps (and other derivatives like FRAs or swaptions) aren't perfect but they are the best thing I have seen so far for the purpose unless someone can come up with something better.