From One Sinking Ship to Another: Principles of Circular Valuation, Part 2

Seeking “real” interest rates in an unreal world.

In an earlier post, I commented on the fact that “artificially low treasury rates ripple out through the market to produce generally lower yield expectations for virtually every income producing asset under the sun.”  

The point of this observation was that treasury rates are used as benchmarks throughout the market and that lower yield expectations effectively “justify” higher asset prices than could be otherwise supported at higher yields.

But, where do interest rates come from?  In theory, at least, they are established by the market through the forces of supply and demand. 

The problem:  When the government chooses to borrow (rather than raise taxes), they quickly deplete the nation’s pool of savings, the “supply” of money available for borrowing.  This should cause interest rates to rise, but that will have an adverse (cooling) effect on the economy. 

The (government) solution:  If they print more money, it will increase the supply and, (Voilà!), rates will drop and everything is dandy, at least for a while.  Unfortunately, our political leaders, for whom “tomorrow never comes”, can never quite stop the need for such printing.  They like to promise us political goodies without the need to raise taxes.  Sadly, we seem to like it too.  

And, like most government “solutions”, this one produces a vast array of “unintended (long-term) consequences”. 

To the Austrian economist (and is there any other kind?), this process simply produces inflation, whether or not you see this effect in the government’s Consumer Price Index.  Simply put, the increased supply of money dilutes the existing supply which, of course, debases it’s value.  And, for the record, so-called “pricing bubbles” are manifest evidence of this process.

Savvy investors (probably an oxymoron) “know” this and make appropriate adjustments, seeking “real” rates of return that are adjusted higher than the “artificial” low rates produced by this process.  As money is like water, it will seek the lowest price (and highest yield) for any given asset.  The problem for them (and for us) is that the market’s normal “price discovery” process has been manipulated to the point where it becomes very difficult to know what “real” is anymore.

Enough theory.  (Frankly, most of you should know all of this by now anyway.)

Let’s just consider this one, single, enormous, disquieting fact:  Government bonds have been paying “real” negative interest rates for a long, long time.  This becomes “self-evident”, by the way, when our “fearless leaders”, at risk of default, commence to printing money just to pay the accrued interest carry on past debt.    Better that, they think, than reducing the budget or, “worse yet”, raising taxes to the level needed to keep the ship afloat.  

When the market (belatedly) discovers this ugly truth, well the ship starts springing leaks at every seam, as is now happening in Greece.  The risks associated with Greek sovereign debt, it should be noted, now requires a 300+ basis point yield premium over comparable German debt, and ironically, only a 200+ BP premium over US bonds.        

In fact, money has been moving so quickly out of Greek (and other questionable European) debt, it has actually driven yields down on the “comparatively safe” German and US debt.  

I ask you:  Should we interpret these money flows as implicit endorsements of US treasuries?  Or, is it a bit like rats deserting one sinking ship for another that, for the moment, appears to be riding a bit higher in the water?

Harry Tuttle

Ruinis inminentibus musculi praemigrant.
“When ruin is imminent, the little rodents move away beforehand.” – Pliny the Elder


One response to “From One Sinking Ship to Another: Principles of Circular Valuation, Part 2

  1. Pingback: “The Enemy is Us”: Principles of Circular Valuation, Part 3 « A Reasonable Life

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