Why Warren Buffett thinks interest rates exert a huge gravitational pull on asset values

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The Federal Reserve has sent a clear message this week, that rates will remain higher for longer. Warren Buffett is the only person who has said that tighter Fed monetary policy will have a major impact on all investments. In a 2012 Berkshire Hathaway interview, the CEO stated that interest rates affect the price of every asset like gravity does the earth’s function. “Everything is based on interest rates… It’s a huge pull, a huge gravitational force, and it affects my actions.” The world’s largest central bank, which has kept rates at or near zero for the majority of the last 15 years to combat stubbornly high inflation, launched its most aggressive campaign since the 1980s to raise borrowing costs. Fed funds rates are now at their highest level in 22 years, with a target range of 5.25%-5.5%. Buffett, also known as the “Oracle of Omaha,” is of the opinion that low interest rates make investments more valuable. A sharp increase in interest rates will reduce the value of future earnings. Buffett said that interest rates are the most important factor in valuing a company over time. According to the time value theory, stock prices should reflect the current value of future cash flow and profits of a business. Investors “discount future dollars” to the present by using a rate that is based on benchmark interest rates. Lower rates increase the value of future cash flow. The higher the rate, the lower the future money will be worth today. Buffett stated that short-term Treasurys were “the yardstick by which all other values are judged” at Berkshire’s 2021 annual meeting. If I could reduce the gravity’s pull of about 80%, then I would be at the Tokyo Olympics. This incredible shift in valuation has occurred for everything that creates money. The short-term rates on the Treasury curve have surpassed 5% for the first year since 2007. The benchmark yield on the 10-year Treasury is just below 4.5%. The appeal of risky assets could be affected by rising yields, as Treasury bills and Treasury notes with shorter maturities offer solid returns. Additionally, as borrowing costs rise, investment activity tends to slow. Berkshire, which had $147 billion in cash at the end June, made Buffett one of the best investors to benefit from higher rates. Berkshire’s massive cash pile was a concern when short-term interest rates were at zero. Now, rates are above 5%, and Berkshire is reaping substantial returns.