Traditionally most economists have assumed the 4% guaranteed return. It is not radical to say that deviations from the 4% are norm-reverting. While many will be quick to point that we are in abnormal state, I will assume most seasoned financiers still average 4% returns on risk free assets.
Since the inception of the Vanguard Long-Term treasury fund (1986), it has averaged an annual return of 8.7%. The CPI inflation rate has averaged around 2.5-3% (note the graph below). Asset prices outside of CPI probably rose more. For simplicity we will say the real return was 4-6%. The extra return could be accounted by duration premium and stability/lower inflation. The point of this data is to show that 4% real yields are not unreasonable, and still probably exist today.
Time to make our leap… Lets assume that financiers will not loan money for less than 4% for a risk free real return. While they have little control over nominal rates (Ie. meddling by Fed/ECB/UK), they have significant control over money supply through lending standards/qualifications. They will not loan money till they get their real rate they are seeking. As a result, they can effectively control the money supply and inflation. If financiers collectively demand 4% risk-free returns, they will ultimately get it.
In order to figure out what all this means, we should examine the current interest rates. Below is today’s chart of treasuries and i-treasuries. I will be examining the 10 year and 30 year nominal.
The 10 year rate is 1.51 and the 30 year rate is 2.62.
For an omni-potent / oligopolistic financier to guarantee him/herself a 4% risk free return with the 10 year, he/she need 1.51-4 = -2.49% rate of inflation. For the 30 year he/she needs 2.62-4 = -1.38% rate of inflation.
What does this all mean?
- Although financiers may not be omni-potent, they do have the power not to lend money. This can have a strong deflationary effect. Financeers also have the power to influence austerity/tea-party/corporate layoff measures to push deflation along. Their pure goal is to get higher real rates of return, not necessarily nominal.
- When the Fed/Japan/UK/ECB claim to stimulate the economy with lower rates, they are selling snake oil. There is nothing stimulative about low rates when asset prices continue to drop. Financeers will simply push to make asset prices drop further to get their 4%.
- The only way to get financiers to invest right now is with some form of guaranteed deflation!
- The inflationary/consumption measure of financiers/investors is drastically different than the cpi. The average urban consumer behavior, is definitely not the same for the weighted average investor. For this reason we can see a CPI expected inflation of 2.21% and a expected financier inflation of -2.49%. Talk about alternative universes.