“Return-Free Risk”

Jim Grant, in a great interview last month, described investing in government bonds as “return-free risk” (quoting a friend). Let’s examine something I learned back in Economics 101:

Nominal interest rates include the real rate of interest plus inflation. For example, if interest rates are currently 5%, then we can subtract inflation to figure out the “real interest rate” from the nominal. If inflation is 3%, then the real rate is 2% – understand?

Here’s  the problem with government bonds today. If a 2 year bond yields below 2%, and inflation is running much higher than 3% (don’t believe government data), then what is your “real’ return for owning these things? It is NEGATIVE. On an after inflation basis, you are losing money each year even though you are earning interest.

How does this work? Pretend you have $500 in a bond. And also pretend that currently that bond pays 2%. Let’s also pretend there is 5% inflation and that currently, a cord of firewood costs $500. You decide to put away $500 in something “safe” to buy your firewood, a 2% one year bond hypothetically. Here’s how you ‘lose’ money:

Your $500 grows to $510 in one year in the bond. The Firewood, however, increases in price by 5% to $525. Now, in order to buy the wood, you need your $510, plus an extra $15 from another source. Through this inflation, you lost money. This is the new conundrum – why markets are accepting negative real rates of return (2% nominal – 5% inflation = -3% real return) is beyond me. Perhaps people are so scared of stocks, that negative real returns are more attractive to them?

Bottom line, the Fed will at some point lose the bond market entirely, and rates will rise regardless of their policy. Then you will finally see the full effect of the pain coming – massive asset revaluation, and potentially more foreclosures than any government program could ever stop. At that point, savers will finally earn a decent risk-free yield.

Here’s the interview FYI:

Jim Grant on Bloomberg 

Here is the BLS page on what the government says is current inflation (4%)

BLS.gov 

Jim Rogers has repeatedly said get out of the dollar. He believes the government has been manipulating inflation data for some time. Compare the inflation reported on the above site to what you are paying for things – is inflation only 4%?

Chris Grande

4.13.08