Equilibrium returns is one of the foundations of conventional macro theory. Without equilibrium between returns, most of the concepts and ideas of mainstream theory are invalid.
Most of the mathematics of this is done by analyzing cash flows. Financial analysts love talking about cash flows because it is something relatively concrete compared to asset valuation. Using cash flows and time preference, one can compare two different securities in a mathematically concrete way.
The big problem with analyzing cash flows, is that you then must ask "cash flows of what"? So there is a relative pricing problem inherent in even this most straightforward analysis.
All of this theory is relatively straightforward, although like anything, it may take a bit of work to learn the math and theory. For this reason, we will go over briefly how present values are computed.
At some point, I will probably write a more complete primer on the basics of interest rates, the things every financially literate and mathematically proficient person knows, which has relatively little controversy. Where there is controversy, is when to apply equilibrium reasoning, not how to compute present value from cash flow.
To compute present value, often you will assume zero risk, or another common practice, is simply adjust the cash flow to reflect expected values. This approach can be misleading for making decisions, but the mathematics is correct, so long as you understand the drawbacks of expected values.
Notably, expected values don't consider any diminishing marginal utility for money itself, or rather more importantly, the very high relative value of not dying, by starving to death. So a more complete analysis will look at the full probability event distribution, and not merely a probabilistically weighted average.
So to compare two different cash flows, you simply sum each lump of cash received adjusted for its "present value", ie the amount of money you would need to invest today to match that at the going interest rate.
So if the rate is 2.8% APY, $1000 received 3 years from now will have a present value of 1.028^3 * x = 1000. So x = $920.49
Why returns never fully equilibriate
The obvious reason returns never fully equilibriate is that risks are never fully known. But I think there is another factor that many neglect to fully account for, and that is overall asset size. This goes back to the "fastest growing" fallacy. It is relatively easy to be the fastest growing at something, because the smaller you are, the more headroom you have, and growth is measured geometrically or exponentially.
So to find the equilibrium return given a collection of assets, you simply take the value of all assets at the beginning of a period, and compare that to the value of all assets at the end of a period. The fraction of Final Value / Initial Value, gives you the cumulative growth.
If you can't see, this is basic "ex post facto" reasoning. So any relatively large asset, will impact the equilibrium of returns over that time period.
This size issue is especially important with fiat currencies and debt, because they represent such a large class of financial assets.
So if that particular financial class goes down in value, returns will be negative.
Why Support Levels Matter
The important issue here is support levels, because support levels can make or break an asset, and using equilibrium returns probably isn't a good way to identify supports.
If an asset's intrinsic returns go down, there will be an apparent negative return much more than that, based on these present value/time preference calculations. So let's say the going rate is 5%, but an asset's rate of return drops to 4%. We will assume that the market as a whole has time preference 5 years out. To adjust to the new rate of return according to time preference calculations, what was a 1% decrease in returns, becomes about a 5% price decrease, for the lost return over each of those 5 years. So the price of the asset immediately drops 5%.
Well, if it is not clear the reason for this price drop, if you extrapolate and assume this 5% drop in price will continue, each year, then all of a sudden the asset has an overall -1% return. Ideally people would be able to distinguish this price drop as markets reacting to a long term present value change, versus an ongoing trend in fundamentals, but such is not always possible. So at some point, the only thing that can keep the asset from self imploding, is some kind of support level, where someone steps up and buys the asset.
Fiat bonds are confusing, precisely because you must worry about both the performance of the unit of account, and the nominal returns. But in this case, unlike most debt contracts, the nominal yields of bonds can in turn affect the performance of the unit of account. If you measure the value of fiat bonds as a market cap, then rate hikes sort of force that market cap upward, by tricking markets into thinking they are guaranteed higher returns. While this may be somewhat true based on the increased interest expenses, there is definitely a limit where you can no longer funnel tax revenues into interest expense and expect this to improve your financial position. In other words, nominal yields matter, not just real yields.
And this is why mainstream doesn't get MMT, or at least what I attribute this lack of understanding to. They don't have a clear concept of how fiat bond interest feeds back into inflation itself, because they don't look at the value of fiat bonds as a market cap. It's really easy to understand though.
Fiat bonds are more like stock options than debt
Equity traders understand how dividends aren't the only thing driving share price, and dumping more payments into dividends is balance sheet neutral. Paying out a dividend just takes money on the balance sheet, and gives it to share holders. It is not magic. Similarly, deciding to increase one's interest expense by hiking rates, can make fiat bonds a more attractive asset, but only if the larger concern is immediate spending. But importantly, compared to dividends, which keep the market cap small, electing for a higher nominal bond yield generally increases the national debt. So it is a negative tradeoff.
There are lots of reasons for changes in market caps rather than just the dividend offered, which in a sense, is what legacy interest controls essentially reduce the value of fiat currencies to. Pay a higher bond yield, more money flows into bonds, meaning the amount of liquid money shrinks, and is therefore worth more. It is possible for this effect to work, but pretty much any time you push it too far, it's going to backfire, much like selling debt to pay a higher dividend on stocks.
The comparison may not be perfect, but that's what it is. Find the natural currency/debt support levels, and interest hikes can be avoided.
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