The True Risk Of Treasuries

Every now and then I like to give guest authors a chance to share their views either on the stocks that I already cover, or names that I don’t, but that I feel would benefit my readers.

Some of these author’s viewpoints agree with mine, and some don’t.

I feel that the more information you have about a particular company, stock or the market in general, the better decisions you can make regarding your investments and what actions you should take in regards to those investments.

Today’s Guest:

Today’s guest author is Paco Ahlgren, he runs a blog called the Ahlgren Multiverse focused on looking at macro views as they pertain to U.S. Treasuries, inflation, currencies, and other macroeconomic factors, as well as his views on what is causing certain trends, and how to play them.

Today’s post from Paco is a wonderful piece explaining how Treasuries are in reality not risk-free, and how a currency tied to nothing can be manipulated to our detriment by the very government entrusted to help us navigate this financial crisis.

The True Risk of Treasuries

By Guest Columnist: Paco Ahlgren, Ahlgren Multiverse

“A ship is safe in harbor, but that’s not what ships are for.”
- William Shedd

The majority of analysts today believe Treasury prices will fall when the appetite for risk returns. That is certainly one way to justify the fact that Treasuries prices hover at historical - and dangerous - highs. But there is another more volatile, yet less scrutinized potential outcome to this tale: Treasury prices may succumb, not because an appetite for risk drives capital to other asset classes, but because Treasuries - the yields of which are commonly referred to as the “risk-free rate of return” - are finally exposed as, perhaps, the riskiest assets around.

Treasury prices move inversely to their yields, which are at record lows. How can a “risk-free” asset that returns, at best, 3% for 30 years be considered “risk free” if that asset’s value will fall dramatically should interest rates even approach the historical average? Said another way: why would investors place capital in an asset that only pays a maximum of 3% per year, for 30 years, with almost no possibility of capital appreciation?

Shouldn’t that mean yields are almost certainly going higher?

I’m going to digress a bit. A few days ago, a reader commented that she didn’t understand why I keep insisting that inflation is not defined as rising prices, but that it is the result of rising prices. To some of you, this might seem difficult to comprehend - probably because you are so used to the usage popularized by media and government propagandists. Let me assure you, however that rising prices are not inflation; rising prices are resultant - universally-rising prices are merely the products of inflation, which is defined as an increase in the supply of money in an economy.

Paper money is not scarce - governments can print it at will, and therefore it is inherently inflationary. It is difficult, however, to increase the supply of gold in the world. Yes, the supply increases marginally each year, but it cannot be created out of thin air; it must be discovered and mined, which carries tremendous costs, thereby contributing to gold’s scarcity.

Let’s suspend disbelief for a moment and pretend we have an economy whose base currency is gold only. In this hypothetical economy, while it might be conceivable that prices could rise because of the immutable laws of supply and demand - within asset classes - it is inconceivable that gold could become less valuable because of increased supply (it is very difficult to increase the supply of gold, as we said). And this is the heart of my point: currencies - whether based on gold, paper, or pigs - are not immune to the laws of supply and demand. If gold is the base currency, it can certainly become more valuable with increased demand and/or decreased supply, but it cannot become less valuable because of increased supply (or not much, anyway).

When fiat paper money is printed, however, it can and does become less valuable as supply increases, because it is easy and relatively cheap to print money - especially electronic money.

Let’s put it another way. Let’s say Apple cut the supply of iPhones in the economy over the course of a month, and the price of an iPhone doubled. Would you say that the iPhone was inflationary? Of course not! You’d say the the supply had been halved, so the price doubled!

If gold were our currency (or if we issued currency carefully backed by some appropriate amount of gold), rising prices would be strictly a product of supply and demand. “Inflation” would cease to exist - for all intents and purposes - because there would be no way to increase the supply of money. And this is why I say that universally rising prices in an economy based on fiat currency are not “inflation;” they are the product of increasing the supply of money. It’s true that some goods and services might become more valuable as demand increases, or as supply diminishes, but universally, prices would not increase as a result of increased money supply, because there is no way to meaningfully increase the supply of gold in the world!

There is an argument that credit is part of the money supply - that is to say, every time a person or institution uses credit, more money is created because no cash has actually changed hands. On the surface, the proposition seems sound; after all, when you use your credit card, for instance, to buy a television, the money goes into the vendor’s account, and yet you haven’t actually given the store any of your money, per se. You still have your money. The store has its money. More money.

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