A letter I received today:

Dear Vic,

I'm doing some back of the envelope. Real 10y rates went from 1.7% at year end to 0.9% now. Do you have any idea what a move in real 10y rates like that does to the discounted value of cash flows, i.e. the fair valuation of stocks? incredible?

This is not the Fed Model, which is clearly wrong because it uses nominal rates, and compares apples to oranges — Cliff Asness is definitely right on that — but looking at changes in the discounted cash flow valuation using changes in real rates is simply correct.

What say you?

I responded that I don't believe anything is wrong with the the Fed Model, and that the real rate according to the TIPS has not gone down as much as he says. But I agree with the conclusion anyway.

George Zachar remarks:

The declining relative weight of Treasuries in the debt universe, along with their well-known pricing distortions, make them a poor benchmark for such studies these days.

Five year interest rate swaps for current work, or, say, Baa 5 year corporate yields for historical studies, make more sense.


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