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  • "The market can remain irrational longer than you can remain solvent" - John Maynard Keynes

    Monday, November 10, 2003

    Taxation and Inflation
    There has been a lot of talk lately around how the federal government is going to fund the deficit. One of the easiest ways is to inflate their way out of trouble by debasing the currency. Debasing of currency's has been going on since coins have been around . Basically the Federal Reserves current actions make dollars less valuable. This can most simply be seen by the devaluing of the dollar against other major currencies. It can also be seen in dollar based commodity prices. The dollar is worth 15% less against the Euro today than it was one year ago and over 20% in the last two years. Commodities are up 15% since January 1st this year.

    The Federal government gains additional tax receipts in two main ways from inflation. In the first case it receives capital gains taxes even if you made no money in real terms; that is if inflation is 15% and your portfolio goes up by 15% you have to pay tax on that 15%. The second way it benefits is by borrowing money in today's dollars and repaying in 10 years with debased or inflated dollars. At 4% inflation they only have to pay back 70k on a 100k loan. The difference doesn't come from interest payments either (unless you have inflation protected securities). The yield on a 10 year treasury today is 4.45%, this is unlikely to provide any real return over 10 years.

    The best ways to benefit from this are to be short treasuries (taking the same side of the trade that the Federal Government takes), long other strong currencies and long commodities. I recommend a way to short treasuries here and I will post more on commodities over the next few days. A basket of currencies is a great idea, I would recommend the Thai Bhat (45%), Singapore Dollar(25%), Czech Koruna(15%), Australian Dollar(15%) and Some Euros(-25%); discount on a Purchasing Power Parity (PPP) basis. Euro's are actually overvalued on the using the simplest PPP metric (the Economist Big Mac Index).

    Stocks are generally a good long term hedge against inflation but are a poor sort term hedge according to Stocks for the Long Run. Stocks have historically produced real returns (that is returns even after factoring in inflation). Long term bonds are very poor in inflationary times, short term bonds offer poor yields in all times but are better than long term bonds in times of high inflation.

    On this basis I would reverse my previous oil call. Though there are many good reasons why oil is overpriced, there are also good reasons why it will not come down. The dollar pricing of oil is one reason and Chinese demand in another significant one. I suspect that oil is not going to be the strongest long commodity play for all the reasons I outlined in my last oil post, but I'm no longer convinced that it will drop 25% either.


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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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