Advanced Finance: Market Dynamics, Bond Ladders, and Hyperinflation History

Market Update and Economic Conditions (June)

  • Current Market Sentiment:

    • The market is experiencing high activity level despite conflicting reports regarding geopolitical resolutions (e.g., trade routes in the Red Sea/Middle East).

    • Oil Prices: Crude oil is down approximately 3%3\%, which significantly lowers expectations for future inflation.

    • Bond Market Performance:

      • Interest rates are currently down, causing bond prices to rise (a bond market "rally").

      • The market is seeing moves of approximately 77 basis points across the board. This indicates that investors are accepting lower returns due to decreased inflation expectations driven by lower energy costs.

      • The Federal Reserve heavily manipulated the short end of the yield curve, but the rally is prominent from the mid-curve onwards.

    • Stock Market Performance:

      • Stocks generally respond positively to a lower cost of debt.

      • The Dow Jones Industrial Average hit all-time highs recently.

      • Small-cap stocks are expected to challenge all-time highs shortly.

    • Precious Metals: Prices for gold and silver are currently flat.

Fixed Income Project: Building a Bond Ladder

  • Project Overview:

    • The goal is to create a definitive 55-year bond ladder to understand the risks and mechanics of fixed income outside of bond funds.

    • Submission Deadline: Wednesday, June 2024 (Specifically June 24th).

    • Requirement: A screenshot of the finalized portfolio of 55 specific bonds.

  • Step 1: Registration for Paper Trading Account:

    • Platform: Interactive Brokers (IBKR).

    • Requirements: Use your Auburn email address. Use a generic address (e.g., the Auburn University address) rather than a personal one.

    • Warning: This is a paper trading (simulated) account. You should never be asked for a Social Security Number (SSN). If you are, you are on the wrong page (the live account registration).

    • Activation: It typically takes 22 business days for the account to be configured.

  • Step 2: Software Installation:

    • Tool: Trader Workstation (TWS).

    • Selection: Always select "Classic TWS" view for consistency with course materials. Ensure "Paper Trading" is selected upon login.

  • Step 3: Constructing the Bond Ladder:

    • Definition of a Bond Ladder: A portfolio of bonds with staggered maturities (e.g., 1,2,3,4, and 51, 2, 3, 4, \text{ and } 5 years).

    • Portfolio Size: Purchase approximately $20,000\$20,000 par value for each maturity, totaling a $100,000\$100,000 portfolio.

  • Selected Assets for the Project:

    • Ford Motor Company Bond: A junk bond (non-investment grade). The instructor suggests Ford is "effectively" safe due to historical government bailouts for the auto industry.

    • Amazon Bond: An investment-grade corporate bond.

    • TIPS (Treasury Inflation-Protected Securities): Used as a hedge against inflation. The principal of a TIPS bond increases with the Consumer Price Index (CPI).

    • US Treasuries: Standard 22-year and 33-year government bonds.

  • Bond Pricing Mechanics:

    • Bonds are priced as a percentage of par (where par is usually $1,000\$1,000).

    • Example: A price of 111.20111.20 means the bond is trading at 111.20%111.20\% of par, or $1,112.00\$1,112.00.

    • Clean Price vs. Dirty Price: The clean price is the price of the bond excluding accrued interest. The dirty price includes the interest that has accumulated since the last coupon payment.

LIBOR and the SOFR Transition

  • LIBOR (London Interbank Offered Rate):

    • Historical benchmark for short-term, variable-rate loans and lines of credit.

    • It was based on a survey of banks asking what they thought they would be charged for loans. This led to massive manipulation, particularly during the 2008 financial crisis when banks "low-balled" quotes to appear healthier.

  • The LIBOR Scandal & Tom Hayes:

    • Tom Hayes: A math genius and former trader at UBS and RBC. He was the "fall guy" for the LIBOR manipulation scandal.

    • Sentencing: Originally sentenced to 1414 years in prison, later reduced to 1111 years on appeal. He served several years before his conviction was overturned by the London Court of Appeal.

    • Personal Anecdote: The instructor hosted Tom Hayes in a London class in December 2015/January 2016, just weeks before his imprisonment. This event is documented in the book The Spider Network by David Enrich.

  • SOFR (Secured Overnight Financing Rate):

    • The modern replacement for LIBOR. Unlike LIBOR, which was survey-based, SOFR is based on actual transactions in the Treasury repurchase (repo) market.

    • It tracks closely with the Fed Funds Target Range (Interest on Reserve Balances\text{Interest on Reserve Balances} and Overnight Reverse Repo Rate\text{Overnight Reverse Repo Rate}).

Hyperinflation: Theory and History

  • Definition of Hyperinflation: An increase in the price of goods and services of at least 50%50\% within a single month.

  • The Quantity Theory of Money:

    • The relationship is defined by the formula: P=M×VQP = \frac{M \times V}{Q}

    • PP = Price Level

    • MM = Money Supply

    • VV = Velocity of Money (the rate at which money changes hands)

    • QQ = Quantity of Goods/Services (Productivity)

    • Hyperinflation is often triggered by an explosion in MM (Money Supply), which leads to a corresponding spike in VV as people rush to spend currency before it loses more value.

  • US Inflation Context:

    • June 2022: The US hit a 4040-year high CPI of 9.1%9.1\%.

    • 1980s Era (Paul Volcker): To crush inflation that reached nearly 15%15\%, the Fed raised rates to almost 20%20\%.

    • Impact of Debt: In 1981, the US could afford high rates because the national debt was relatively low. Today, extreme rate hikes are politically and fiscally difficult because the interest cost on the $34+\$34+ trillion national debt would be catastrophic for the Treasury.

  • The Weimar Republic Case Study (Germany 1919–1923):

    • Context: Following World War I, the Treaty of Versailles demanded massive reparations. Germany suspended the metallic backing of its currency (moving to Fiat currency) to print money and buy foreign currency/gold to pay reparations.

    • The Velocity Spiral: By October 1923, prices doubled every 44 days.

    • Exchange Rate Collapse ($1\$1 USD to Deutsche Marks):

      • April 1919: $1=12 Marks\$1 = 12 \text{ Marks}

      • January 1923: $1=17,000 Marks\$1 = 17,000 \text{ Marks}

      • August 1923: $1=4,600,000 Marks\$1 = 4,600,000 \text{ Marks}

      • November 1923: $1=4.2×1012 Marks\$1 = 4.2 \times 10^{12} \text{ Marks}

  • Societal Consequences:

    • Savers (The Losers): People who hoarded cash or held fixed-value assets saw their life savings become worthless. A million marks that could fund a luxury retirement in 1919 could not buy a loaf of bread by late 1923.

    • Debtors (The Winners): People in debt saw the real value of their obligations vanish. This moral hazard rewards the "irresponsible" and punishes the "responsible."

    • Political Fallout: The destruction of the middle class and the search for scapegoats (blaming bankers/minorities instead of government policy) created the vacuum that allowed the rise of extremist regimes, such as the Nazi party.

Questions & Discussion

  • Student Question on the 1980s Yield Curve: Why was the yield curve inverted in the early 1980s?

  • Instructor Response: The curve was inverted because the Federal Reserve (under Paul Volcker) jacked up short-term rates to extreme levels (nearly 20%20\%) to kill inflation. Long-term rates are more a function of future inflation expectations. Because the Fed was so aggressive, the market expected inflation to be lower in the long run, thus keeping long-term rates below short-term rates.

  • Discussion on Student Loans: The instructor compared the "debtor vs. saver" dynamic to modern debates about student loan forgiveness, arguing that bailing out debtors while ignoring those who paid their way creates social friction and devalues the concept of saving.

  • Student Impression of Tom Hayes (Surveyed in 2016): Students found him to be a "math genius" but "not sympathetic" and "sleazy," acting like a "car salesman" who refused to admit fault, which likely contributed to his harsh sentencing.