Everything so far converges here, on the single most important idea Phase 7 hands to the rest of your investing life. The image to hold is the one Warren Buffett used and M7.02 quotes in full: interest rates do to asset prices what gravity does to an apple. Low rates mean a weak pull and prices that float; high rates mean a strong one and prices that fall. That metaphor turns out to be literally arithmetic, and it ties straight back to the DCF and terminal-value work of Phase 3.
Why does a higher interest rate lower asset prices?
Why a higher rate compresses every asset price. Every asset is worth the present value of the cash it will produce, discounted at a rate built on the risk-free rate, the government yield you just learned to read off the curve. In a DCF, Value = Σ CFₜ / (1 + r)ᵗ, and in CAPM the discount rate itself is r = risk-free rate + β × equity-risk-premium (M3.03), so the risk-free rate is an input to the value of literally every asset, because it is inside every discount rate. Raise the risk-free rate (the curve shifts up) and you raise every discount rate, which lowers the present value of every future cash flow, which lowers every asset price: stocks, bonds, real estate, private businesses, all of it, simultaneously. That is the "gravity": the risk-free rate is the universal downward pull on the whole price structure, and when the central bank raises it (M7.02), gravity strengthens and everything gets heavier — cheaper. This is why the policy rate is the gravity M7.02 promised, and why 2022 saw stocks and bonds fall together (the correlation that breaks the 60/40 portfolio): the common cause, a rising discount rate, was pulling on both.
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Why do growth stocks and long bonds fall hardest?
Why long-duration assets fall hardest: the terminal-value bridge. Gravity does not pull equally on everything. From the bond duration page, the further in the future an asset's cash flows sit, the more their present value falls when the rate rises. That is the asset's duration. Now apply this to equities, using the DCF you built in M3.04–M3.05. A company's value splits into two pieces: the present value of the explicit-forecast cash flows (the next several years) and the present value of the terminal value (everything beyond). For a mature, cash-generative business, a big share of value sits in near cash flows, so it is short-duration equity. For a high-growth business (a young software company, an unprofitable tech name), almost all the value sits in the terminal value, cash flows a decade or more out, so it is long-duration equity. And the terminal value is itself the most rate-sensitive object in finance, because of the formula you already know:
Terminal Value = FCF_(n+1) / (WACC − g)
Look at that denominator. As WACC rises, (WACC − g) widens, and the terminal value falls. Because the gap (WACC − g) is often small (a WACC of 8% and a terminal growth of 4% gives a denominator of just 4%), a small rise in the discount rate is a large proportional widening of the denominator and therefore a large fall in the terminal value. A growth company is mostly terminal value, and its terminal value is acutely rate-sensitive, so a rise in rates hits growth stocks twice as hard as it hits cash-cows. This is the exact mechanism behind the 2022 rout: when the Fed and the RBI hiked, the discount rate rose, the terminal values that made up most of the growth stocks' worth compressed violently, and the long-duration corner of the market (unprofitable tech, richly-valued software, long bonds) fell far more than the short-duration corner of cash-generative "value" businesses. Same gravity; wildly different sensitivity, governed entirely by where in time the cash sits.
Worked Example 4 makes this a computation you can do yourself: the same synthetic company valued at two discount rates, decomposed so you can see that the near cash flows barely move while the terminal value collapses, and that because the company is mostly terminal value, the whole thing falls almost as much as the terminal value does. Do that example until the arithmetic is automatic, because it is the quantitative heart of macro-aware investing: the discount rate is the gravity, the terminal value is the long-duration object it pulls on hardest, and the yield curve you learned to read in the first three-quarters of this module is where that gravity is set.
After that, an inflation print and a yield curve are no longer news. They are the two dials that set the discount rate on every valuation you will ever build, and you can read both.
Should you try to forecast interest rates?
One closing discipline, in the spirit of the phase's humility (M7.01) and the program's guardrails: knowing that rates are gravity does not mean you should try to forecast rates and trade on it. Macro, and rates especially, is very hard to predict; the bond market embarrasses the most confident forecasters routinely (the 2022–24 inversion is Exhibit A). The point of this module is not to make you a rates forecaster. It is to make you rate-aware: to understand why your valuations move when rates move, to build in a range of discount rates rather than a false-precision point (M3.05), to recognize when an asset's price is resting on an assumption of permanently low gravity, and to size and stress-test your positions for the possibility that gravity strengthens. Be robust to rates, not predictive about them — the Buffett/Munger synthesis with which Phase 7 will close.