and I now see this the other way around for the stock market, for example. It is assumed that "in the long term", which is > 10 years for the current BTFD investors, interest rates will again quickly tend towards zero. But there I am not so sure if this is the "new normal" and not higher interest rates as in the Buffet quote, as a pull down could trigger....
As I said in early 2022, real rates are likely to rise cyclically (and they have by now risen more than 1% since I wrote the post), but structurally, we are now in an environment of interest rates that are too high.
I like the quote because it is true, but what is not try in my opinion is the assumption that interest rates have a stable long-term equilibrium. Yes, rising interest rates are bad for asset prices, but no, interest rates are not going to permanently increase back to the levels we have seen in the 1980s and 1990s (let alone the 1970s). See also the link to an older post in my response to Andy below.
I'd like to see a physical solution to all our financial questions - with a relative theory of interest rates as gravity for assets - and a unified theory that explains interest rates themselves are subject to different forces. I'm looking forward to your post on that Joachim!
First of all, I am very doubtful of the physics envy in social science (especially economics). As a trained physicist, I have always said that the one thing that does not exist in complex dynamic stochastic systems (which is what the economy is) is an equilibrium or "laws" akin to the laws of gravity or mechanics. So, I think that is a pipe dream of economists that will never be realistic.
But if you want to know how I think about interest rates and other economic variables subject to different forces, I have described that in my book about seven mistakes every investor makes. I don't want to look greedy so, I may one day write a post about that methodology to explain it. But you'll have to wait.
I want to share with you these two graphs that show clearly what you mentioned about the long term outlook for interest rates. If you look at the first graph, you can notice that there is a kind of stationarity around a downward trend. This means that this time series always returns to the trend over time and any shocks or fluctuations are not permanent (assuming more rigorous statistical tests confirm this) unlike what would happen with a stochastic trend.
That said, I am very interested in the topic of how market drivers, market valuations and different actors in those same markets influence each other. I am conducting an in-depth research on this argument and I would like to share an extract of the introduction with you: "[...] The financial system, akin to DNA, is fundamentally a repository of information in the form of prices of the instruments that comprise it. This information serves as a catalyst for productive activity aimed at generating wealth.
Both systems (biological and financial) are characterized by randomness and necessity. In the realm of biology, randomness is exemplified by genetic mutations that encounter the necessity of environmental selection at the macro level. In the realm of finance, randomness is exemplified by economic and financial events that encounter the necessity of a system created by human agency with a pre-determined purpose. And both systems go through processes of continuous evolution and transformation. The evolution of the physical world, from the subatomic level to the most complex social phenomena, is characterized by cyclical patterns of growth and decay, creation and destruction. Similarly, the financial system is characterized by periods of expansion and contraction, boom and bust, and the continuous evolution and transformation of the system over time. These events can create opportunities for growth and development, but they can also lead to financial crises and economic recessions. In essence, the cyclic nature of these systems is a reflection of the continuous evolution and transformation of the sensible world itself, as it progresses through time.
The financial system is teleological in its individual components; the randomness that "impacts" the system is categorized, and the affected elements act accordingly. In this context, the information generated is constrained by the positions of individual actors, and as it emerges from their interactions, it remains strongly dependent on the initial settings (portfolio compositions) and the willingness (mechanical or conscious) of the parties to engage in transactions in the market itself; both of which determine the reaction to the randomness of financially significant events (that randomness is not just a matter of disorder versus order, but rather a reflection of a larger and more complex order that we have not fully understood or broken down into its essential components yet). [...]"
However, even if you relax your assumption that interest rates fluctuate around a long-term declining trend, there is one major problem with that approach: Ex ante, you do not know what the trend is. The steepness of your long-term decline in interest rates for example is not known and every time you try to estimate it, it changes. Over long time frames it can change significantly. This is why it is impossible to use the "law of gravity" analogy because it implicitly assumes that there is an unchanging "law" that acts as an attractor to real observed variables. And that is simply not the case in a complex dynamic stochastic system.
I think your approach to compare it with biological systems trying to adapt to real world situations is interesting and can be fruitful. Coming from a physics background, I usually like to approach the economy and financial markets from the viewpoint of complex dynamic systems theory simply because it is something I am more familiar with. But I think coming from a biological perspective can be equally fruitful.
Thank you very much for your response. A part of my analysis focuses on the positions of dealers, asset managers, and leveraged traders on the E-mini S&P 500, as captured week after week in the "Traders in Financial Futures" report. The concept I'm referring to ["the information generated is constrained by the positions of individual actors, and as it emerges from their interactions, it remains strongly dependent on the initial settings (portfolio compositions) and the willingness (mechanical or conscious) of the parties to engage in transactions in the market itself"] finds application in the weight ratios between the contracts held on the E-mini S&P 500 by the actors who have the most influence on the movement of the S&P 500, considering that "on the E-mini S&P 500, we have the downstream result of everything that happens upstream." It's difficult to explain in a few lines. Currently, I have written material for over 100 pages; when I manage to finish, I will be glad to share the conclusions in a clear manner for everyone.
"No law of gravity in finance"? What do you think of this Buffett quote "interest rates are to asset prices, sort of like gravity is to the apple"
and I now see this the other way around for the stock market, for example. It is assumed that "in the long term", which is > 10 years for the current BTFD investors, interest rates will again quickly tend towards zero. But there I am not so sure if this is the "new normal" and not higher interest rates as in the Buffet quote, as a pull down could trigger....
I will address the question of the long-term outlook of interest rates in a couple of weeks' time in my "Against Cassandras" series. So stay tuned.
But when it comes to interest rates, please be aware that there is a strong likelihood that interest rates trend structurally lower for centuries. See for example here: https://klementoninvesting.substack.com/p/the-long-run-is-lying-to-you-or-is
As I said in early 2022, real rates are likely to rise cyclically (and they have by now risen more than 1% since I wrote the post), but structurally, we are now in an environment of interest rates that are too high.
I like the quote because it is true, but what is not try in my opinion is the assumption that interest rates have a stable long-term equilibrium. Yes, rising interest rates are bad for asset prices, but no, interest rates are not going to permanently increase back to the levels we have seen in the 1980s and 1990s (let alone the 1970s). See also the link to an older post in my response to Andy below.
I'd like to see a physical solution to all our financial questions - with a relative theory of interest rates as gravity for assets - and a unified theory that explains interest rates themselves are subject to different forces. I'm looking forward to your post on that Joachim!
First of all, I am very doubtful of the physics envy in social science (especially economics). As a trained physicist, I have always said that the one thing that does not exist in complex dynamic stochastic systems (which is what the economy is) is an equilibrium or "laws" akin to the laws of gravity or mechanics. So, I think that is a pipe dream of economists that will never be realistic.
But if you want to know how I think about interest rates and other economic variables subject to different forces, I have described that in my book about seven mistakes every investor makes. I don't want to look greedy so, I may one day write a post about that methodology to explain it. But you'll have to wait.
As a non physicist I realise now how hazardous it is to mention physics I the comment section
Not to worry :-D
https://www.visualcapitalist.com/700-year-decline-of-interest-rates/
https://www.visualcapitalist.com/the-history-of-interest-rates-over-670-years/
I want to share with you these two graphs that show clearly what you mentioned about the long term outlook for interest rates. If you look at the first graph, you can notice that there is a kind of stationarity around a downward trend. This means that this time series always returns to the trend over time and any shocks or fluctuations are not permanent (assuming more rigorous statistical tests confirm this) unlike what would happen with a stochastic trend.
That said, I am very interested in the topic of how market drivers, market valuations and different actors in those same markets influence each other. I am conducting an in-depth research on this argument and I would like to share an extract of the introduction with you: "[...] The financial system, akin to DNA, is fundamentally a repository of information in the form of prices of the instruments that comprise it. This information serves as a catalyst for productive activity aimed at generating wealth.
Both systems (biological and financial) are characterized by randomness and necessity. In the realm of biology, randomness is exemplified by genetic mutations that encounter the necessity of environmental selection at the macro level. In the realm of finance, randomness is exemplified by economic and financial events that encounter the necessity of a system created by human agency with a pre-determined purpose. And both systems go through processes of continuous evolution and transformation. The evolution of the physical world, from the subatomic level to the most complex social phenomena, is characterized by cyclical patterns of growth and decay, creation and destruction. Similarly, the financial system is characterized by periods of expansion and contraction, boom and bust, and the continuous evolution and transformation of the system over time. These events can create opportunities for growth and development, but they can also lead to financial crises and economic recessions. In essence, the cyclic nature of these systems is a reflection of the continuous evolution and transformation of the sensible world itself, as it progresses through time.
The financial system is teleological in its individual components; the randomness that "impacts" the system is categorized, and the affected elements act accordingly. In this context, the information generated is constrained by the positions of individual actors, and as it emerges from their interactions, it remains strongly dependent on the initial settings (portfolio compositions) and the willingness (mechanical or conscious) of the parties to engage in transactions in the market itself; both of which determine the reaction to the randomness of financially significant events (that randomness is not just a matter of disorder versus order, but rather a reflection of a larger and more complex order that we have not fully understood or broken down into its essential components yet). [...]"
I have written about that in this blog post: https://klementoninvesting.substack.com/p/the-long-run-is-lying-to-you-or-is
However, even if you relax your assumption that interest rates fluctuate around a long-term declining trend, there is one major problem with that approach: Ex ante, you do not know what the trend is. The steepness of your long-term decline in interest rates for example is not known and every time you try to estimate it, it changes. Over long time frames it can change significantly. This is why it is impossible to use the "law of gravity" analogy because it implicitly assumes that there is an unchanging "law" that acts as an attractor to real observed variables. And that is simply not the case in a complex dynamic stochastic system.
I think your approach to compare it with biological systems trying to adapt to real world situations is interesting and can be fruitful. Coming from a physics background, I usually like to approach the economy and financial markets from the viewpoint of complex dynamic systems theory simply because it is something I am more familiar with. But I think coming from a biological perspective can be equally fruitful.
Thank you very much for your response. A part of my analysis focuses on the positions of dealers, asset managers, and leveraged traders on the E-mini S&P 500, as captured week after week in the "Traders in Financial Futures" report. The concept I'm referring to ["the information generated is constrained by the positions of individual actors, and as it emerges from their interactions, it remains strongly dependent on the initial settings (portfolio compositions) and the willingness (mechanical or conscious) of the parties to engage in transactions in the market itself"] finds application in the weight ratios between the contracts held on the E-mini S&P 500 by the actors who have the most influence on the movement of the S&P 500, considering that "on the E-mini S&P 500, we have the downstream result of everything that happens upstream." It's difficult to explain in a few lines. Currently, I have written material for over 100 pages; when I manage to finish, I will be glad to share the conclusions in a clear manner for everyone.
Thank you for providing this high-quality space.