Interest rates = financial gravity

My grandfather was a great engine mechanic. He was less great at opening doors or windows when testing his engines. I'd try to learn about the gaskets and pistons from him, peering through the blue haze of exhaust, conscious that carbon monoxide was pooling around my knees. Eventually I'd make a break for it, running to open the garage doors, making a play for optionality so we could both repair things another day.

It didn't matter if the engine sputtered a little, or hummed in perfect form, if the oxygen had been chased from the room.

In investing, you have to put appropriate weight on the big, influential variables. One of those variables is interest rates. Warren Buffett recently used an excellent analogy when he described interest rates as "financial gravity." If interest rates, like gravity, are high, they pull the value of other assets down. If interest rates, like gravity, are low, other values float up (and away sometimes).

The risk-free rate defines the baseline for investing. If you are going to get paid X without taking risk, something that contains risk needs to return X+B for it to attract capital. The more risk, the larger B has to be.

Here is the daily update to the yield of various U.S. Treasuries bonds:

On Tuesday, November 13, 1990, the oldest known web page was constructed. On that same day, U.S. Treasury yields looked this this, matching columns with the graph above:

Relative to previous decades, you can see that today gravity has been removed from the financial system. Gravity, like oxygen, is not a small variable. Because of its, shall we say, gravitas, much of the financial system has inflated upward.

Much, but not all. Returns tied directly to this rate are not inflating. For example, banking deposits. On top of the low rates, American banks are swimming in money as the government floods the system. This has led to an explosion in banking deposits:

With cash deposits just below the value of the entire American GDP, banks have no incentive to pay more interest. This impacts a wide swath of Americans who use banks to save.

To invest well in today's world, you have to accept that a major variable operates differently than it did 30 years ago. That acceptance, that realization, will keep you out of the blue haze.

Dan Cunningham

1. Here is the web's oldest page, If you are curious.
2. Commercial bank deposit source: Federal Reserve Bank of St. Louis
3. Treasury daily yield curve rates

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