I received a barrage of emails after last week’s letter asking which ETF or fund is best to short US Treasuries. Judging by the alphabet soup in the emails there must be numerous mutual funds and ETFs that simulate a short position in treasuries; however, asking me which one you should buy won’t help as I don’t invest in any of them, I don’t know the various different funds or ETFs, and, most importantly, I cannot give anyone specific investment advice. I am shorting US Treasuries on the futures market: it’s simple, I understand how it works and it’s a liquid market.

This week’s letter is a follow-up on last week’s letter since interest rates are still on my mind. Last week I said that I believed interest rates are going to soar, and that I’m going to bet big on rising interest rates. This week I want to show you a chart to further illustrate why I think interest rates are going to somewhere between 15% and 20%, if not higher.

The chart compares the annual percentage increase in dollars as measured by M3 (inflation), the Federal Funds Rate (the interest banks charge each other for overnight loans) and the yield on a one-year US Treasury Bond. Notice that the one-year rate at which the government borrows money is very similar to the rate that banks charge each other for overnight loans – you can think of this interest rate as the most basic “cost of money” to the banking system and the government.

Next, notice that even though M3 and the cost of money are almost never the same, they move in similar directions and have, more-or-less, similar values. Whenever the cost of money and inflation pull significantly apart the financial system undergoes severe stress.

During the 1960s the high rates of inflation put tremendous pressure on the US dollar and strained the Bretton Woods system to the point of collapse. In 1971 Bretton Woods was over, the US reneged on its promise to back the dollar with gold and floating exchange rates were introduced.

The high inflation rates continued throughout the 1970s until the cost of money eventually stopped the creation of new money. Even though inflation peaked in June 1971 you can see that that was merely a spike. The average inflation rate during the 1970s was 11% and it wasn’t until interest rates reached 15% that inflation was brought under control.

The reason interest rates exert such influence on inflation is that money in today’s monetary system is created when debt is created. When you go to a bank to take out a loan the bank doesn’t really have the money that you are about to borrow – they just create it. When the cost of money is low many people can afford to borrow and therefore want to borrow lots of it, and so a lot of new money is created and inflation runs high. Conversely, when the cost of money is high fewer people can afford to borrow and the demand for loans is low, hence the inflation rate is lower.

However, inflation and the cost of money are a bit like the chicken and an egg: it’s almost always difficult to assess which is the cause and which is the effect. But what matters is that they are related and affect each other in a very material and fundamental way.

Another thing we can see from the chart is that for most of the 1960s and 1970s, with the exception of a short period around 1970, US interest rates were negative in real terms. The inflation rate for most of those twenty years was higher than short term interest rates meaning if you held bonds during those twenty years you actually lost money in real (inflation adjusted) terms.

During the early 1980s interest rates were essentially neutral (if you held bonds you neither made nor lost much) in spite of being between 5% and 10%. Then, for about ten years, from 1987 to 1996 interest rates were positive. Owning bonds during that time would have resulted in a real appreciation of capital. Since 1996 real interest rates are once again negative: a holder of bonds since 1996 would have lost capital in real terms.

Now comes the important part: Not only are interest rates negative in real terms at the moment, but the gap between inflation and interest rates is the largest it has ever been. Inflation is running at over 17% on a year-over-year basis and short-term interest rates are at 1.6%. Investors who own short-term bonds thinking they are “safe” are actually guaranteed to lose more than 15% of their capital on an annual basis.