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Q&A – The Answers

The answers from this weekend’s Q&A:

Q: Any initial thoughts on the economic impact over the next several years of thawing relations with Cuba?

CR: Good question. I think it’s a much bigger economic gain for Cuba than the USA. Cuba’s economy is about the size of New Mexico’s so we’re not talking about huge gains to be made in the grand scheme of things. I’ve read estimates that this could create a few thousand jobs in the USA and boost GDP marginally. But the change in terms could have a massive long-term impact on the Cuban economy as they will have increasing access to all of the technologies and goods and services that have long been kept out of Cuba. I suspect Cuba will be a very very different place in 50 years than it is today.

Q: Seriously, how did you become so awesome? Your logic and avoidance of the trivial and “popular” is inspiring!!

CR: I think you have me mistaken for someone else. I’ve never been described as “awesome”. By Anyone.

Q: Hi Cullen: Love the site, particularly articles like Would u rather be right or would you rather make money…spot on…Just wondering if you have a rational , unemotional view of the macro in 2015, and how it affects your asset allocation going forward….

CR: Well, I don’t know what things will look like in Q2 (my econ modeling is quarterly based), but I don’t see recession risk in Q1 of 2015. So, if you’re familiar with my cyclical approach to asset management then I remain pretty bullish. You can read my brief research note on cyclically adjusted portfolio management here.  

Q:  I was wondering if you had any thoughts on Russia potentially defaulting and whether that goes against your thinking on sovereigns defaulting? Thanks.

CR: Well, Russia is running into the problem that anyone can run into a world with endogenous money. Remember, we can all issue money, but the problem is getting others to accept it. Russia is finding that it’s difficult to get people to accept their money at high values. So the currency is being devalued relative to other currencies and inflation is going to skyrocket in the coming year. This is happening because Russia’s break-even on oil prices is estimated to be above $60 per barrel so with low oil prices the Russian government has to obtain revenues in some other way or they’re likely to print the money to spend. This isn’t like the ’98 default which I wrote about here. This is a pretty different situation. Russia can print the money they need to meet their debt obligations, but they’re going to be doing so with inflation and currency devaluation resulting. It’s a much bigger problem than oil though. Russia’s economy just isn’t diverse enough. They’re still too dependent on revenues from oil so any time that revenue source runs dry the worries over inflation will jump.

Q: Is it net capital outflow or inflow when we have trading surplus (+)? It is called net lending (+) or net borrowing (-) in NIPA/FOF account. Intuitively, it seems like net capital inflow (?) when we have more exports and get more income from the rest of world.

CR: Right, a net capital outflow is when the country has a trade deficit and is in a net borrower position.

Q: Mish, Kyle Bass, Peter Schiff and I expect hyperinflation in Japan. I think they have reached the point where nobody is buying their bonds and the central bank is forced to monetize. They have to do this because otherwise the government can’t pay for the bonds coming due or the spending that is twice taxes. Governments never default on debt in a currency they can print, they just print. But even defaulting would not solve the problem since they are spending twice what they get in taxes. So they no longer have a choice, they must print like crazy. So high inflation is coming soon to Japan. I think in the next year. Do you think I am right this time? 🙂

CR: You’re going to keep asking this question every year until you’re eventually right, huh?  🙂 I personally don’t see the risk of high inflation in Japan. The economy remains too weak to generate the aggregate demand sufficient for high inflation.

Q: Do you agree that Treasuries still look somewhat cheap compared to the rest of the sovereign world?

CR: I am very negative on long duration sovereign bonds of almost all types at present. 2015 is starting to remind me a lot of 2013 in fixed income markets.

Q: Also, I was thinking recently about how Buffett never buys technology companies. You’ve also said before that commodities is not a great long term investment. With the recent history of the Fed, I’m wondering if we should add banks to that list since monetary policy effectively pumps up assets for jobs which is eventually reversed, and (net worth)/GDP has been trading in a range for the the past 2 decades, after slowly increasing for 100 years. Are banks the new airlines?

CR: I don’t see the parallels to be honest.  Banks should be more like utilities, but we still allow them to take huge risks in pursuit of profits. I don’t see much that’s changing that trend.

Q: Hi Cullen, do you think the US economy can weather the global turmoil while interest rates are already at 0%? Have a good Christmas!

CR: I don’t think the world sneezes and the USA catches a cold. It tends to be the other way around just because the USA is such a large and diverse economy. So yes, as far as I can tell, the recent turmoil is not going to have a huge impact on US growth.

Q: The idea of the fed supposedly printing money or monetizing the debt is a concept which you have discussed before. Intelligent people disagree on the use of these terms. Could you explain how the following situation is not an example of this so called money printing?

Say the Treasury has an auction and Citibank buys a 1 million dollar bond using cash they have on hand. The treasury then spends it on bills they have to pay. Now the Fed buys the 1million dollar bond from Citibank. The Fed you would agree created this 1 million out of thin air as the saying goes. Now say Citibank spends this newly created Fed cash of 1 million.

So the Treasury spent 1 million and so did Citi. So 2 million dollars was spent on the basis of a 1 million dollar bond. If 30 years later the Treasury pays back the Fed to cancel out the bond this does not cancel out the 1 million that Citi spent with the money created by the Fed.

What am I missing here? This seems like money printing. And if Citi actually used the 1 million that it got from the Fed to buy more bonds from the Treasury and then sold them to the Fed in a continuous repeating loop wouldn’t this be essentially debt monitization?

Maybe my example is not really how the system really works? Is it too simplistic?

CR: You’re describing deficit spending which is actually a very simple operation. An easier example is to just use a Treasury Direct account. If you buy a govt bond at auction then the Treasury debits your deposit account, credits its reserve account at the Fed and then the spending proceeds will debits its reserve account and credit someone else’s deposit account. The bank deposit was really just transferred from you to the Tsy to the recipient of the spending. The only thing that was “printed” in all of this was the T-bond.  Deficit spending isn’t actually money printing. It’s bond printing.

Q: A few weeks ago you were disssing Tony Robins/Ray Dalio asset allocation saying that it was great for the past 20 years but will not work for the next 20 years. What do you have to offer to replace or tweak this asset allocation?

CR: You might be interested in the most recent Orcam Report on this topic. The Robbins portfolio and Risk Parity in general is not dynamic enough in my opinion. So it tends to take bonds, extrapolate past performance and rely too heavily on fixed income returns. The last 30 years were the biggest bond bull market ever. And there’s simply no way that the next 30 years in bonds can generate the types of returns that the last 30 years did. So you have to do something more dynamic in a portfolio if you want to generate the same returns with the same high risk adjusted returns. And that means calculating for the higher level of risks in bonds at times and finding other asset classes that can contribute similar risk adjusted returns. My solution is to use a cyclically adjusted portfolio that accounts for the fact that relative asset class risks change over the course of the business cycle so you’re actually reweighting a portfolio based on relative risks rather than nominal weightings such as a static 60/40 or leveraging bonds as you might in a risk parity portfolio. My approach is basically an informed and probability based way of rebalancing portfolios that tries to overcome the obvious reality that a 60/40 in the next 30 years simply can’t generate the same risk adjusted returns that a 60/40 did in the last 30 years.

Q:  In blog posts you have said that the 10 year treasury interest rate is controlled by the Fed working with the primary dealers and potentially buying bonds, but you have also said that the bond buying of QE probably didn’t effect the rate so considering both obsevations what is your considered view overall .

CR: I’ve said that the overnight interest rate can be controlled by the Fed because they are the monopoly supplier of reserves to the banking system. But the Fed doesn’t really control the 10 year bond rate. Theoretically, they could pin the long bond at 0% by just making a market in the bonds, but that wouldn’t reflect the “market rate” necessarily. The market rate of interest is determined by economic conditions. So you could have the benchmark rate being manipulated to 0% by the Fed, but if inflation were 10% then lenders would still be setting mortgage rates much higher than 0%. I always say that the Fed can determine the price of certain things in the economy, but it can’t control the economy.