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How the cost of capital shapes market structure and determines which assets can grow...
If the base liquidity mentioned in the previous article is responsible for the amount of money in the system, then the cost of money determines its price. Together, these two factors form a complete picture of financial conditions. And if liquidity creates the opportunity for risk, then the cost of money determines how justified that risk is.
In the global financial system, the cost of money is not an abstract concept. It is measured through interest rates, bond yields, and, most importantly, through real rates — that is, inflation-adjusted rates. These indicators determine how much capital costs and how it is allocated among assets.
The key benchmark for the entire system is the yields on US government bonds, primarily 10-year bonds. They act as a base discount rate, from which the valuation of almost all financial instruments is derived. When yields are low, future cash flows are valued more expensively, supporting high asset valuations. When yields rise, the discount increases, and asset prices begin to correct.
Government bonds as the base price of capital
Bond yields determine the "risk-free rate" in the economy. This is the alternative for an investor. If an investor can obtain a stable return without risk, they become less inclined to invest in risky assets. This creates a direct link between the level of rates and the demand for risk.
When yields are low, capital is forced to seek alternatives. This leads to growth in equities, credit markets, and other risky instruments. When yields rise, some capital returns to bonds, putting pressure on other assets.
Real rates as a key factor in capital allocation
Nominal rates do not give a complete picture. Real rates, which account for inflation, are critically important. They determine the true cost of preserving and multiplying capital.
When real rates are low or negative, money effectively loses purchasing power in risk-free instruments. This encourages investors to seek alternatives, including gold, stocks, and other assets. When real rates rise, these alternatives lose attractiveness, as an investor can achieve a positive real return without increased risk.
This is why changes in real rates are often accompanied by significant movements in non-income-generating assets, particularly gold.
Interest rate differentials as a driver of global flows
In addition to the absolute level of rates, the difference in rates between countries is crucial. It determines the direction of capital movement in the global system.
When rates in one economy are significantly higher than in another, capital begins to flow to where returns are greater. This creates currency flows and forms the basis for strategies such as the yen carry trade. Investors borrow in currencies with a low cost of money and invest in currencies with high yields.
Thus, the cost of money not only determines asset valuation but also shapes global financial flows.
Cost of money and leverage in the system
Another critical aspect is the impact of the cost of money on leverage. Cheap money encourages leverage, as the cost of financing is low and risk seems controlled. In such conditions, investors and funds actively use borrowed capital to increase positions.
When the cost of money rises, leverage becomes more expensive and less attractive. This leads to a gradual reduction of positions, which can put pressure on markets even without changes in asset fundamentals.
It is through this mechanism that rate hikes are often accompanied by widespread deleveraging in the financial system.
Non-linear effect of interest rate changes
It is important to understand that the impact of the cost of money is not linear. The market can ignore a gradual increase in rates for a long time, especially if liquidity remains sufficient. But there is a certain level after which asset revaluation begins.
These turning points are usually related not only to the level of rates but also to a change in expectations. When the market begins to believe that rates will remain high for longer, a rapid change in investor behavior occurs.
Such moments often become transition points from a risk-on to a risk-off regime.
Ultimately, the cost of money is the second fundamental element after liquidity. If liquidity is responsible for whether there is money in the system, then the cost of money determines how that money is used.
Together, these two factors create the environment in which all financial markets exist. They determine whether risk is supported or whether the system is transitioning into a phase of reduction. In this sense, the cost of money is no less important than liquidity, as it determines whether risk is economically viable under current conditions.