Re: Inflation/USD/USTs – “Risk-Free” Riskiness & Austrian Pipe Dreams.
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Re: Inflation/USD/USTs – “Risk-Free” Riskiness & Austrian Pipe Dreams.
An explanation of what it means to be "Risk-Free" and why US Treasury securities will remain the most liquid and trusted reserve asset for the foreseeable future.
In recent weeks, I have read many incorrect and misleading takes on Twitter by folks who are decrying recent interest rate volatility as some kind of “false advertising” of the term “Risk-Free” when it comes to US Treasury securities (USTs). These takes go something like this:
Didn’t the good folks at Silicon Valley Bank just buy ‘Risk-Free' USTs that got them into trouble? Isn’t this the Fed’s fault?
If USTs are truly ‘Risk-Free,’ why did they drop 20+% in 2022? Why are other Central Banks selling them? Why have they been so volatile? Isn’t this a sure sign of loss of faith in the US government?
Whether these takes are based upon a deliberately pre-ordained narrative to mislead or simply based upon a gross misunderstanding of finance is unclear, but I felt compelled to write this thread to debunk these insinuations and to show why USTs are likely to remain the most trusted and most liquid reserve asset in the world.
It seems that there is a fundamental misunderstanding of what the term “Risk-Free” means.
For those of you who have not taken Corporate Finance, the term “Risk-Free Rate” comes from the work of professors Modigliani and Miller, who developed the CAPM (Capital Asset Pricing Model) in the 1950’s.
See chart from the article below:
https://corporatefinanceinstitute.com/resources/valuation/what-is-capm-formula/
This is the foundational principle behind all of modern corporate finance.
Note that the “Risk-Free Rate” is just the “base rate” to which one must add a “Credit Spread” or “Risk Premium” to arrive at a “Risky Rate” which is then used to discount cashflows to value an asset.
To oversimplify, Risky Rate = Risk-Free Rate + Risk Premium. I’m not going to get into the intricacies of calculating WACC (Weighted Average Cost of Capital) as a proxy for what I call the “Risky Rate” for the purposes of this discussion.
Because the Risk-Free Rate is the foundational interest rate used in all discount rates to value assets, I often call it the “Linchpin of all Financial Assets”:
The term “Risk-Free” refers specifically to “DEFAULT Risk-Free” and is typically assumed to be the SOVEREIGN interest rate of a creditworthy country like the US. If you buy a Risk-Free security like a UST, you are GUARANTEED to receive the advertised YIELD TO MATURITY.
However a “Risk-Free” security does NOT mean that there won’t be mark-to-market volatility from the time of purchase to final maturity. In fact, like ANY security that pays out a stream of cashflows over time, it necessarily fluctuates in price as discount rates fluctuate over time; not only that, the longer the time horizon the more volatile the present value of those cashflows will be — this is a concept known as DURATION.
To understand how this works, please see this Mental Model thread I wrote in 2021 in which I explain the concept of DURATION:
What complicates matters even further is that there is a subjective choice of which Risk-Free Rates to use because there is an entire YIELD CURVE of Risk-Free Rates associated with different tenors. For valuing Equities and other long-lived Risk Assets, many analysts arbitrarily pick the US 10-Year Treasury yield as their Risk-Free Rate because it is a widely traded and observed global benchmark for a longer-dated Risk-Free Rate.
What if you wanted to value a US 10-Year Treasury Bond itself? What Risk-Free Rate do you use to discount the coupon cashflows? Most people would use some proxy for a short-term Risk-Free Rate, like perhaps the Fed Funds Rate or the 3-Month Treasury Bill yield.
If you now assimilate this last paragraph with my Mental Model thread above, you will appreciate why an aggressively hawkish Fed, hell-bent on raising short-term interest rates, will do the most damage to longer-duration securities by making the net present value of those cashflows worth less.
In fact, the very objective of raising interest rates is to dampen asset prices and to “discharge” speculative froth in ALL asset classes. Longer duration USTs themselves are NOT exempt from this basic law of finance; any banker, analyst, investor, fund manager, and even financial newsletter writer that is worth his salt should know better!
I have been warning since 2021 about how the longest duration assets (I call them “Inflation Capacitors”) would discharge the most:
Given the recent chaos in the banking sector, there has been unprecedented volatility in the expectations of the Risk-Free Rate itself given conflicting market interpretations of future Fed Policy:
If I’ve convinced you by now that the Risk-Free Rate is the BEDROCK upon which ALL asset valuations are built and that the bedrock itself is shifting like crazy, do you see now why I call the crazy volatility of all other assets (whose values are all derived from the Risk-Free Rate) the TIP OF THE WHIP?
Remember that longer-duration USTs themselves are NOT exempt from this kind of volatility despite being “Risk-Free” securities themselves if HELD TO MATURITY. The ONLY “Risk-Free” instrument that is ALSO devoid of duration risks is USD CASH (which is basically a zero-duration UST); alternatively, think of USTs as interest-bearing “forward promises” of USD.
The doomsayers that are ascribing the recent UST losses in 2022, the increased volatility of USTs, and the pickup in UST sales by foreign CBs as unmistakable signs of the decline of US CREDITWORTHINESS have literally forgotten one of the most basic laws of finance: WHEN RATES GO UP, ASSET PRICES GO DOWN!
What’s more telling to me is that both USD and USTs still consistently exhibit SAFE HAVEN qualities in times of great financial uncertainty. While US Debt/GDP is higher than decades past, the “full faith and credit of the United States” is based upon much more than just one metric.
I won’t delve into why the US is still the best relative credit of all the major economic blocs since I already wrote a full treatise about the NATIONAL POWER roots of the faith and trust in the USD/UST system here:
However, I do want to talk about why USTs are likely to remain the world’s most liquid and trusted reserve asset. In short, it’s about SUPPLY ELASTICITY. You heard right, SUPPLY ELASTICITY — the very bogeyman of the fiat monetary system as portrayed by the Hard-Money advocates of the Austrian School of Economics — is the very reason for the UST’s success as global reserve asset and unprecedented ADOPTION.
To see what I mean above, please refer to this thread from last year in which I play out what would happen to BTC once its supply curve becomes infinitely INELASTIC. You will see immediately why an asset like that could never function as a liquid reserve asset.
I am very fond of saying that “the Sword of Inelastic Supply cuts both ways,” and the extreme example of PERFECTLY INELASTIC SUPPLY shown above illustrates why an asset with these characteristics could never serve as a liquid reserve asset. If you think UST volatility has been heightened recently, can you imagine if BTC or Gold were the reserve assets of choice?
Gold Bugs may legitimately ask the question:
Why has Gold successfully acted as medium of exchange and reserve asset for millennia before the advent of fiat money?
Depends on your measure of success. Consider the chart below:
The exponential growth in World GDP Per Capita resulted not just from the Industrial Revolution of the 19th Century but also from the Fiat Money Revolution of the 20th Century given the greatly increased supply elasticity of money and credit as a result of untethering the monetary base from Gold. Richard Duncan has written the aptly named The Money Revolution which details exactly this thesis.
Now that the Fiat Genie has been let out of the bottle, I would argue that no government would ever find itself politically able to enforce an inelastic supply curve back onto money and credit. The sudden restraint on credit-driven growth would be too painful to bear. Does it result in monetary debasement over long periods of time? Yes, but it also results in far greater economic growth.
This Currency Strength/Adoption Matrix is a framework we introduced in our West Point Paper. The accompanying verbiage shows how the USD/UST system occupies the enviable Quadrant IV.
Quadrant I (low adoption/low strength) conveys the quandary of many EM countries: very little trade/finance is conducted in their home currency (low adoption), and when this corresponds to a period of home currency weakness, it can lead to credit crises especially when debts are US- denominated. The Asian Financial Crisis of 1998 is an example of this, and the German Weimar Hyperinflation of the 1920’s is an extreme example of what happens when there is complete loss of faith in one’s home currency. If it weren’t for China’s capital controls, the Chinese Yuan (CNY) would likely be in Quadrant I.
Quadrant II (high adoption, low strength) illustrates the current challenges facing the Euro (EUR) and Japanese Yen (JPY), the two largest components of the US Dollar Index (DXY), a weighted geometric mean of the convertible currencies of the most significant trade partners of the US (Figure 6). Note the exclusion of the Chinese Yuan (CNY) due to its lack of convertibility. The EUR and JPY both have relatively high global adoption but are experiencing currency weakness due to cyclical and structural reasons.
Quadrant III exemplifies a small cadre of currencies like the Swiss Franc (CHF) that have traditionally served as “safe-haven” currencies and maintained relative strength despite very low global adoption.
Quadrant IV describes the current state of the USD. Although USD exchange rate strength ebbs and flows with cyclical factors, its adoption remains dominant in the world by almost any measure.
Boom/bust cycles can and will still happen but within the confines of the fiat money system — the current bout of interest-rate induced volatility and hysteria is one such example, but it is a CYCLICAL CRISIS AND NOT AN EXISTENTIAL CRISIS. Periods of Inflation necessitate the raising of Risk-Free Rates to prick asset bubbles and bring down aggregate demand curves for all goods and services. We have been living through an extended period of quiescent Inflation which enabled low interest rates for so long that we have forgotten what happens when this cycle reverses. This is the chief reason why pundits mistakenly extrapolate linear tangents off CYCLICAL processes as SECULAR trends.
In summary, the so-called “Exorbitant Privilege” of GRC status is not something that is just granted willy-nilly to any currency; it is EARNED through a combination of National Power and Liquidity/Elasticity that no other fiat or commodity can match.
Don’t believe the shrill, hyperbolic voices that are erroneously conflating DURATION RISKS with CREDIT/SOVEREIGN RISKS. The specter of the world fleeing USTs in droves is as much of a pipe dream as is the Austrian Economics “Hard Money” Utopia.
Re: Inflation/USD/USTs – “Risk-Free” Riskiness & Austrian Pipe Dreams.
Your content is so far above the pack, so consistently centered...just had to say what a huge fan I am of your fintwit feed, musings, and videos. You share intelligence whereas most others agitate, propagandize & indoctrinate. Thank you.
Thank you for this very cogent discussion regarding both Risk-free rates, but in my world of FX, the discussion of the mooted end of the USD hegemony. I am in complete agreement that there is a very limited probability that the BRICS nations will be able to make a meaningful dent in the dollar's use case. highlighting your liquidity story is the fact that if you combine the capital markets in all the nations discussed, they are a tiny fraction of that of the dollar, and when anybody, country or company, needs liquidity and the ability to borrow, the BRICS coin will not be a solution.