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"Interest rate is like gravity on assets."


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I don't know about you guys, but I am shocked by the current move in interest rates.

 

While I understand that they should be moving up with decent job numbers and improving economic performance, or a healthy thing, what I find shocking is that they are moving up despite the Fed buying $40 billion a month non stop or pretty much the entire new supply. It wasn't the entire new supply just 6 months ago. Then you have insurance companies, pension funds and other institutions buying treasuries to meet future obligations no matter what the rate is day in and day out. So who is selling to create such upward pressure on rates? And where are they going?

 

You may say that I exaggerate, but for the 10 year yield to move above 2.2% in about a month from 1.6% is a big percentage move. If you look at this chart you can also see the 1 year trend which is clearly upward.

 

http://finance.yahoo.com/echarts?s=%5ETNX+Interactive#symbol=^tnx;range=1y;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

 

If you get such move with investors "thinking" that the Fed "could be" considering tapering, then where are the rates going to go when they just take their buying down by say a quarter? Who is going to recommend stocks based on their yields once the 10 year treasury reaches just 3%?

 

Cash is starting to look like an awesome proposition since you will be able to earn a growing yield waiting for the carnage to play itself.

 

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After reading this post, I stumbled upon this one almost immediately.

 

From the Buttonwood blog on The Economist:

Too tight or back to normal?

http://www.economist.com/blogs/buttonwood/2013/06/bond-market

 

AN INEVITABLE consequence of the falling inflation and rising bond yields referred to in a recent post is that real yields have risen, as the chart (from Patrick Legland at Socgen) shows. Real yields in the euro area are now on a par with those in Japan (the blue line). In this respect, financial repression is disappearing; the US and euro area are no longer inflating away their debt. One aim of Abenomics is surely to drive down real yields by allowing inflation to rise to 2% without a concomitant rise in nominal bond yields, which would make the financing of government debt look perilous.

http://media.economist.com/sites/default/files/imagecache/full-width/images/2013/06/blogs/buttonwood039s-notebook/20130615_woc774.png

 

One can see this as bad news - monetary policy is effectively being tightened at a time when the economy is weak - or as good news - real rates are returning to normal levels, indicating that the market believes economic conditions are recovering. The latter argument might hold for a while but the authorities won't want to see real rates rise much higher - either in the form of higher nominal bond yields or lower inflation. Deflation is still not that far away.

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I agree with the title, but I wonder as to its application.

 

I hear a lot of people talk about how the S&P 500 and/or various securities are only at their current valuations because of the extremely low interest rates.  Okay, that makes sense.  Interest rates really do act like gravity on the pricing of all assets.

 

However, I wonder if anyone has gone beyond the aphorism and gone to the application. Let's say that the 10-year rate over the last decade was about 5% -- has anyone gone and run the numbers on where assets should priced be now that rates are at significantly lower values?  Does the asset valuation of the market as a whole or individual securities actually reflect the extremely low interest rates via the discount rate for a DCF?

 

I ask this because many people say that "interest rates act like gravity" but there is no follow up on the "implied interest rate" in valuations today. If the implied interest rate is 3% and interest rates go to 2%, does that mean the price of assets will drop?  (In the short-term, probably, because it's a knee-jerk reaction.  In the long-term, maybe not?)

 

Just a thought experiment.

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I ask this because many people say that "interest rates act like gravity" but there is no follow up on the "implied interest rate" in valuations today. If the implied interest rate is 3% and interest rates go to 2%, does that mean the price of assets will drop?  (In the short-term, probably, because it's a knee-jerk reaction.  In the long-term, maybe not?)

 

Hi Merkhet. This is a good book about the interaction of rates, inflation and multiples.

 

http://www.amazon.com/Unexpected-Returns-Understanding-Secular-Market/dp/1879384620

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I ask this because many people say that "interest rates act like gravity" but there is no follow up on the "implied interest rate" in valuations today. If the implied interest rate is 3% and interest rates go to 2%, does that mean the price of assets will drop?  (In the short-term, probably, because it's a knee-jerk reaction.  In the long-term, maybe not?)

 

Hi Merkhet. This is a good book about the interaction of rates, inflation and multiples.

 

http://www.amazon.com/Unexpected-Returns-Understanding-Secular-Market/dp/1879384620

 

Thanks!

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While I understand that they should be moving up with decent job numbers and improving economic performance, or a healthy thing, what I find shocking is that they are moving up despite the Fed buying $40 billion a month non stop or pretty much the entire new supply. It wasn't the entire new supply just 6 months ago. Then you have insurance companies, pension funds and other institutions buying treasuries to meet future obligations no matter what the rate is day in and day out. So who is selling to create such upward pressure on rates? And where are they going?

 

You may say that I exaggerate, but for the 10 year yield to move above 2.2% in about a month from 1.6% is a big percentage move. If you look at this chart you can also see the 1 year trend which is clearly upward.

 

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There was a similar large move upward during tax season in 2012. Rates came back down afterwards.  Rates will likely remain low if history is any guide. I only see them rising in the near term if Bernanke admits he was a total failure and his policies flawed from the start which I think is unlikely.  Even then rates could remain low. Some points to make:

 

) Market rates are set at the margin. The Fed may be buying 90% of  government issued bonds but the price will be set by the remaining 10% and what they are willing to pay.

 

) 90% of new issuance is still a small part of total government debt/mbs markets.

 

) interest rates have to remain low for the government to finance itself.  Its curious that Fed buying has roughly matched deficit spending. Does Bernanke want to be remembered as the man who bankrupted the U.S.? Probably not. The deficit is doen due to forced capital gains last year in fear of higher taxes. It'll likely be back up next year along with increases in Fed buying.

 

Just my two cents

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[...] has anyone gone and run the numbers on where assets should priced be now[...]

 

If you guaranteed people that the long term rate would be 1.7 percent, or ten-year rate, or— you know, and short term rates would be practically nothing— you know, stocks should be, you know, selling at least double where they are now.
(emphasis supplied)

 

Warren Buffett, CNBC interview on May 6, 2013

 

Transcript is here (quoted section is on page 10 of 70).

 

Best,

Ragu

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Thanks ragu.  I supposed that makes my point for me.

 

If "the market" is "pricing in" a higher interest rate than what currently existed, then perhaps the interest rates going up shouldn't be a huge drag on the market.  After all, the market has "forgotten," in a sense, that they priced in something higher than what currently exists.

 

If we move the interest rate up and the market levels still, at some indeterminate point between where we are now w/ rates and, say, 10% on the 10-year Treasury, we would have the market at "fair value."  Of course, markets being what they are, the market is likely to overshoot on the downside as rates move up.

 

So, then my question is -- is it smarter to guess that interest rates are going to go up than it is to say that the market is going to go down?  Or are they essentially the flip side of the same coin?  And perhaps prognosticating on one is no different than predicting the other?  (i.e. - folly in both cases)

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Thanks ragu.  I supposed that makes my point for me.

 

If "the market" is "pricing in" a higher interest rate than what currently existed, then perhaps the interest rates going up shouldn't be a huge drag on the market.  After all, the market has "forgotten," in a sense, that they priced in something higher than what currently exists.

 

If we move the interest rate up and the market levels still, at some indeterminate point between where we are now w/ rates and, say, 10% on the 10-year Treasury, we would have the market at "fair value."  Of course, markets being what they are, the market is likely to overshoot on the downside as rates move up.

 

So, then my question is -- is it smarter to guess that interest rates are going to go up than it is to say that the market is going to go down?  Or are they essentially the flip side of the same coin?  And perhaps prognosticating on one is no different than predicting the other?  (i.e. - folly in both cases)

 

It does make your point for you -- and it is a well articulated and well thought out point.

 

I might add that, since interest rates "can" spike, it makes sense that Buffett and Munger use a floor discount rate of 7% no matter how low rates go (others have quoted 6% -- I recall from old transcripts 7% but it seems close enough not to matter). 

 

But, if one was certain that risk free rates would stay low for a long time, then it makes sense to pay up -- to pay waaaaaay up -- for a basket of stocks with decent to good ROE's. 

 

However, in order to maintain a balance between opportunity costs (of low risk free rates for a long time -- see Japan) and the possibility that rates spike during your holding period of an asset with a cash flow (stocks, apartment building, etc. as opposed to gold or other collectibles), I can see why Buffett and Munger use a floor discount rate as a margin of safety.

 

Nevertheless, in support of your point, multiples are not so high right now that they're not already pricing in substantially higher risk free rates (whether or not, as you point out, stocks "drop" in response to an increase in rates).  That is, if, like Buffett, you have the option to commit your capital to an asset whose cash flows you can control, it does seem to make sense to pay even 20x earnings for a high ROE company (with just a modicum of reinvestment opportunity at a high ROE) even if risk free rates on 20 year treasuries were, say, 4.5% right now.  Moreover, as Buffett has noted over and over (indirectly but clearly), he's willing to pay a high multiple for a high ROE company (at least 20x for a company with an ROE over 20%...not a utility) even if 20 year treasuries were yielding 6 or 7%.

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I ask this because many people say that "interest rates act like gravity" but there is no follow up on the "implied interest rate" in valuations today. If the implied interest rate is 3% and interest rates go to 2%, does that mean the price of assets will drop?  (In the short-term, probably, because it's a knee-jerk reaction.  In the long-term, maybe not?)

 

Hi Merkhet. This is a good book about the interaction of rates, inflation and multiples.

 

http://www.amazon.com/Unexpected-Returns-Understanding-Secular-Market/dp/1879384620

 

His website is also great. If you read all the white papers here you would get 90% of the book. http://www.crestmontresearch.com/.  The guy use to teach classes at SMU, but don't know if that is still true.  Might be worth seeing if there isanystuff floating around from his teaching days

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