Short Treasuries: Natural disasters should cause rates to rise, not fall

 

Can Hurricane Harvey trigger a financial crisis? Probably not. But it may spark some unexpected inflation.  

I came back to Houston last Sunday after vacationing in Montevideo for 2 weeks. Houston seems unchanged in many parts, but certain highways were still under water and many traffic lights aren’t working. Traffic is terrible. Many are still living in temporary shelters in the stadiums and it will take a long time for life to come back to normal for them.  

Moody’s puts Harvey losses at about $80 billion, Warren Buffett threw out a rough estimate at $150 billion, and Governor About announced damages were expected to be $180 billion. These figures are about 0.4%, 0.8%, and 1% of GDP, respectively. For scale, the San Francisco Earthquake of 1906, which set off a chain of events leading to the Panic of 1907, resulted in damage estimated at 1.3-1.8% of GNP at that time. The losses from Hurricane Irma have yet to be tallied.  

Losses from a natural disaster don’t always lead to financial panic. Hurricane Andrew in 1992 led to losses around 1% of GDP, but no crisis followed – in fact, the economy began to recover from a recession immediately after the hurricane struck.  

But the hurricanes are still big enough to tighten money. Affected areas will need loans to rebuild, and this ought to drive interest rates higher.  

Inflation ought to go up as well. Affected areas will demand more materials to rebuild, and this demand ought to drive prices higher.

The majority of losses in Houston are estimated to be uninsured, so a lot of the rebuilding will have to be funded by the Federal Government. FEMA is running low on funds and the Trump Administration has authorized more funds on an emergency basis. All of these funds will come from issuing more treasuries.  

The Fed is likely to start shrinking its balance sheet this fall. This also will directly increase the supply of treasuries in the market.  

I think treasuries are setting up to be a good short. And yet, treasuries have rallied after the hurricane, on the logic that Harvey and Irma have reduced the odds for the Fed to hike rates or shrink its balance sheet.  

Consider the Fed’s response to Hurricane Katrina. Immediately after the hurricane, the market expected the Fed to “pause” its rate hiking cycle to make funds available for the rebuilding effort. However, the Fed continued with its 11th consecutive rate hike in September 2005 

This is appropriate. The standard Taylor rule response to a natural disaster is to increase rates. This is because with a Taylor framework, inflation is more important than output in determining the appropriate rate. And inflation ought to go up.  

If anything, the odds that the Fed will hike this year have gone up since the hurricane, not down. The treasury market is getting this wrong. I went short a treasury position at about 30% of my account equity. I’ll keep adding to this position until the yield breaches its 2016 low, at which point I would cut my losses. I’ll also add to the position if the yield exceeds the post-election high.

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