Aug. 25 (Bloomberg) — Treasuries rose the most in almost two weeks on speculation credit-market turmoil may be widening.

The gains pushed yields on U.S. 10-year notes to the lowest since May 13 as financial stocks fell amid speculation American International Group Inc. will post a loss and Korea Development Bank may be reconsidering a possible bid for Lehman Brothers Holdings Inc. Interest-rate derivatives imply banks are becoming more hesitant to lend.

Oh boy…here we go. I’m struggling to even figure out where to start. First of all, any idiot who buys a U.S. Treasury Bond should be taken out back and shot. Instead of filling your retirement fund with government debt, you could simply give me your money and I’ll burn it. Net-net, the scenarios are pretty much even.

Dear reader, I apologize. Sometimes financial stupidity aggravates me being that I have very little patience for such things. I understand if someone does their due diligence, and still ends up with a losing investment. It’s part of the game, and it’s impossible to pick 100% winners. Our goal is to simply put ourselves in a position that gives us a statistical advantage over the rest of the players. It’s sort of like poker. If you can get your money in the pot with the best hand prior to the final card or cards being dealt, you will win more than you lose. For any who are interested, it’s called the law of large numbers.

Negative Real Rates: The House Wins

What I don’t get is why anyone would want to give themselves a guaranteed loss. Look at it this way. Currently, a 10-year Treasury Bond gives the holder a 3.75% yield. That means you have a NOMINAL return of 3.75% on your investment. If inflation is 1% you will also receive a net 2.75% REAL return.

The problem is that a majority of investors, active or otherwise, don’t get the concept of nominal versus real returns. As mentioned above, the only difference is that real returns are inflation adjusted.
So what happens if inflation is above 3.75%? Well, it doesn’t take a mathematician to realize that you would be receiving a negative real return. In other words, the money you invested, although it grows nominally, actually loses purchasing power over the duration of your investment.

This also works the other way around. According to Bloomberg, today’s national average for a 15-year mortgage is 5.84%. Just as we have negative real returns on our T-Bonds, we actually have negative real interest rates. Translation:

A bank gives out a loan with an interest rate of 6%. I will look a little more specifically into real inflation numbers in just a second, but for argument sake, let’s say inflation is running at 10% per annum. So the bank gives a lump sum of cash away in return for interest on the money. In actuality, the money plus the interest is worth less than the initial lump sum the bank gave out. The bank actually loses 4% of its purchasing power over the life of the loan. Don’t forget that the bank assumes all of the risk in this transaction as well. Not a very good deal if you ask me.

How about the lendee side? This may sound crazy, but if you take out a loan and do absolutely NOTHING with it, you would be making money.

It’s crazy to think about negative real interest rates, but the best way to do so is denominate the money in something other than dollars.

Let’s look at it from the banks perspective. I’m going to keep the numbers simple, so let’s say one year ago the bank dishes out a loan of $10k to be paid back today at a 6% yield. So the lendee has to pay back $10.6k.

Now let’s convert everything into the truest form of a currencies value: gold. $10k would have bought you 14.8 oz of gold one year ago ($675 /oz). One year later, $10.6k will buy 12.8 oz of gold. So you can the loan has actually lost 13% of its value.

You could adjust the numbers with crude, wheat, corn, or even the Euro and you will get numbers that are even more extreme.

Real Inflation and the U.S. Banking System

What I’m trying to get at is inflation is higher than many people who use the credit markets even know. THIS IS A LARGE REASON FOR TIGHTNESS IN LENDING MARKETS. Who wants to give out a loan when it’s a guaranteed net loss for the lender? It’s the same question as, who in the world would buy a T-Bill when it’s a guaranteed net loss for the investor. The end game is frozen LIBOR markets.
I mean, even government reported inflation statistics show that inflation is higher than interest rates show, and statistics like the CPI, PPI, and GDP deflator are a complete joke. Here’s the two best ways to judge inflation: money supply growth and the price of gold.

You think the government and the Fed don’t know that? Listen to this. Just a couple of years ago, the government stopped reporting M3 money supply. M3 is the broadest and most accurate measure of money supply. The U.S. is now the only developed country in the world that doesn’t report M3. I guess they didn’t want the world to know that they have been and are continuing to run the printing presses on overdrive.

So I just want to end this article with a little food for thought. We are starting to see the effects of negative real interest rates in the credit squeeze, but how do negative real interest rates effect inflation itself? Who are the people and institutions that have access to discount lending in order to take advantage of the low interest rates? Last, but definitely not least, who gets pinched by this sort of monetary policy? I will answer these questions both inadvertently and intentionally going forward, so stay tuned.

In the mean time, I encourage you to look back and analyze other financial markets like I did with the $10k loan scenario. Denominate the DOW in gold or Euros to see the real performance of domestic equities. You might be surprised.

Nicholas Jones
Bourbon & Bayonets