I want to share a recent note from Morgan Stanley with you guys. The note discusses the rise in front end rates and what it means for the relative attractiveness of other assets. I think it’s largely to blame for the repricing of risks we’re seeing in markets right now. And it’s going to be a continuing factor in the year ahead.

The important concept to understand here is “risk premia” and the premia spread between different asset classes. Here’s a short primer I wrote on the idea a while back.

The gist of it is investors make allocation decisions on expected returns relative to expected risks. At the base of this, the anchor, is the cash rate. 3-month T-bills are generally thought as the “risk-free” rate you get for holding cash.

From cash, you move further out in duration (thus assuming more risk) into longer dated government bonds (still seen as risk-free, credit wise, but with duration and inflation risks). From treasuries you go to investment grade bonds, then high yield, then equities and so on…. This is just a broad generalization but you get the point.

As you move further away from cash you assume greater risk and therefore expect more of a return to compensate.

Pretty simple, right?

Okay, well the cash rate, the 3-month bills, mostly move off of the Fed Funds Rate. This is the rate set by the FOMC. But since it has 3 months duration and is a market settled rate, it will fluctuate around rate expectations and Treasury supply relative to the demand for short-term paper.

Since this is the anchor rate. The rate that ALL other asset classes and potential investments are measured against. It matters a lot about where it goes.

If investors could get, say, 3% risk-free interest for just holding cash and the expected return for equities is low, because of high valuations and it being later in the cycle, then that 3% risk free looks pretty dang good relative to stocks. So that might drive money to flow out of stocks and into short-dated T-bills.