How The Best Investors Obsess Over Interest Rates

To investors,

What the Fed gives, the Fed can take away. This has been the story for interest rates and asset prices for as long as fiat central banks have existed. Each new generation of investors have to learn this lesson the hard way and that is exactly what we have seen over the last 18 months.

The Fed’s suppression of interest rates to 0%, coupled with trillions of dollars in QE, led to one of the most epic asset price bull markets in history. You could blindfold yourself and randomly pick winners across stocks, bonds, real estate, commodities, and crypto. In fact, Barstool’s Dave Portnoy was even picking Scrabble letters out of a bag to pick winning stocks. Incredibly entertaining, but obviously peak insanity too.

But the Fed eventually ended the party. They waited until inflation hit approximately 8.5% before acting, but they moved with speed and a violence of action that has previously never been seen before with interest rate hikes. Within one year, the central bank jacked up interest rates from 0% to 5%, which created a cratering of assets that would make the biggest market bears smile with joy.

None of this is new though.

Warren Buffett famously said, “Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” If asset prices go up, every asset owner is getting wealthier. The incentive is for people to demand lower and lower interest rates from their central bank. Ludwig von Mises nailed it years ago by stating, “Public opinion always wants easy money, that is, low interest rates.”

Regardless of public opinion, professional investors know that interest rates are the name of the game. The old adage of “Don’t fight the Fed” has been popularized for a reason. Ray Dalio is famous for saying, “It all comes down to interest rates. As an investor, all you're doing is putting up a lump-sump payment for a future cash flow.” So when interest rates go up, there is pain in the economy.

Former President Bill Clinton once said, “You know what higher interest rates mean. To you it means a higher mortgage payment, a higher car payment, a higher credit card payment. To our economy, it means business people will not borrow as much money, invest as much money, create as many new jobs, create as much wealth, raise as many raises.” It is not every day that we can point to a politician as a macro expert, but he got that one right.

We can go back in time and see the best investors in the world calling out the issues that we are now facing. Back in 2004, real estate billionaire Sam Zell said “The single biggest issue that I'm very sensitive to is inflation. I'm very concerned that this extended period where the interest rates were quite low and stimulated a lot of activity could breed inflation and create a problem for us.” The problem that he foresaw did not necessarily happen to the severity he predicted then, but the same cause and effect is what landed us in the recent high-inflation, chaotic environment we have lived through over the last two years.

So this begs the question — where do we go from here?

Mark Zandi once said, “An overheating economy, characterized by accelerating inflation and rising interest rates, is another precondition for recession.” This basically describes what we have seen over the first quarter of 2023. It doesn’t guarantee that we will experience a recession, but it definitely increases the odds in my opinion.

Maybe we are just paying for our past sins. Maybe we are merely in the spin cycle of the economic washing machine. No one really knows. But I will leave you with two quotes that highlight one way of thinking about the long term economic cycles.

Michael Hudson said, “The underlying strategy of the Fed is to tell people, "Do you want your money to lose value in the bank, or do you want to put it in the stock market?" They're trying to push money into the stock market, into hedge funds, to temporarily bid up prices. Then, all of a sudden, the Fed can raise interest rates, let the stock market prices collapse and the people will lose even more in the stock market than they would have by the negative interest rates in the bank. So it's a pro-Wall Street financial engineering gimmick.”

David Stockman said, “I think everybody in this generation, and I'm the leading edge of the baby boom - I was born in 1946 - has benefitted from a 30-year explosion of debt, which created temporary but unsustainable economic prosperity and a financialization of the system through lower, and lower, and lower interest rates that has created massive rewards to speculation but not real investments so I benefitted from it. Almost everyone who has been in the market has benefitted but they didn't earn it.”

Interest rates are the name of the game. Will the Fed continue hiking or will they wave the white flag? No one knows for sure. Whoever guesses correctly in the coming months, both in terms of direction and magnitude, will have a competitive advantage when allocating capital.

Hope you all have a great day. I’ll talk to everyone tomorrow.

-Pomp

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