Cause and Effect

This is a quick follow-on from an older post. That post discussed the issue of low interest rates and their impact on justified valuation multiples. I wrote:

A popular contrarian narrative in the markets is that central bankers have artificially suppressed interest rates, and that absent their interventions the “natural” rate of interest would be higher (implying a higher discount rate and thus lower sustainable valuation multiples). The key risk to this thesis is that low rates are not some exogenous happening imposed on the market by a bunch of cognac swilling technocrats, but rather a consequence of secular shifts in the global supply and demand for funds. Specifically, that these days there is a whole boatload of money out there that needs to be invested to fund future liabilities and too few attractive investment opportunities to absorb it all.

If low rates are actually a function of the supply and demand for funds, it doesn’t ultimately matter what central bankers intend do with monetary policy. Market forces will keep rates low and elevated valuations will remain justified.

A friend questioned what I was driving at here, and whether it would be possible to falsify this thesis. For the record, I have no idea whether I’m right or wrong. I’m just trying to envision different possibilities.

That said, I am pretty sure the answer lies in the shape of the yield curve.

As many, many, many commentators have already observed, the Treasury yield curve hasn’t made a parallel shift upward as the Fed raised short-term rates. The short end of the curve has come up pretty significantly but the long end has basically held steady. This is important because central banks tend to have less influence over long-term rates than short-term rates.

chart
Source: Bondsupermart.com

As the Fed continues to shrink its balance sheet, what we would hope to see is the yield curve making a nice, steady, parallel shift upward. What we do not want to see is the 30-year Treasury yield stuck at 3%. The 30-year Treasury yield stuck at 3%, in the absence of Fed intervention, would support the theory that there are structural factors holding down future expected returns. Namely: an excess supply of financial capital relative to opportunities.

My previous posts on this subject have dealt with the risks of naively extrapolating very low interest rates forever. You can attack the issue from different angles but each case more or less boils down to overpaying for risky cash flows.

What I have not done is explored strategies for taking advantage of such an environment. As with the risks, you can attack the issue from a number of different angles. But again, they share a common thread. Here each strategy more or less boils down to taking on duration.

I want to examine this further in a future post, but here is a little teaser…

Duration is most commonly used to analyze interest rate risk in the fixed income world. But the concept can also be applied to other asset classes. Long duration equities are things like venture capital and development stage biotech companies, where cash flows are but a twinkle in your eye when you invest. Long duration equities usually can’t sustain themselves without repeated infusions of investor cash. They thrive when capital is cheap. They die when capital gets expensive.

If you knew capital was going to be remain cheap forever, you would probably want to make long duration equities a significant portion of your portfolio. You could get comfortable investing in really big ideas that would take a long time to be profitable. I am talking about massive, capital intensive projects with the potential to change the world (think SpaceX).

And here’s where I might start getting a little loopy…

…because what if an excess of financial capital is a precondition for tackling the really big projects that will advance us as a species?

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