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The Fed Funds Rate and its Impact on Prevailing Interest Rates

By April 21, 2021 No Comments

We find there is a lot of confusion on interest rates. Your bank is still paying you next to nothing in interest in your savings account. But mortgage rates have steadily risen over the last 6 months. In the financial media you may read that the Fed plans to keep interest rates at zero for the next two years on the same website that says the market is worried about rising interest rates. So what’s going on here, are interest rates rising or are they falling? And which interest rates matter most?

The Federal Reserve sets the Fed funds rate

The boilerplate definition of the Fed funds rate is the overnight rate that large commercial banks (think JP Morgan and Bank of America, etc) charge each other for short-term lending and cash swaps. These banks are moving around tens of billions of dollars by the hour, and they often lend or borrow from each other for periods of just one or two days to shore up reserves and/or to meet certain capital requirements by the Federal Reserve.

The Federal funds rate is one of only two short-term rates that the Federal Open Market Committee (FOMC) can “manually set.” If we were to think of every interest rate on every financial product in the country as a house, the Fed funds rate would be the foundation. Trillions of dollars in credit card balances, auto loans, mortgages, savings & checking accounts, money market funds and more is derived in some way based on the prime rate, which is in turn derived from short-term interest rates such as LIBOR and the Fed funds rate.

For average consumers, the Fed funds rate is something they’ll never deal with (and a rate they’ll never be able to borrow at). But as a foundation of a large interest rate structure, the level that short-term lending rates (like the Fed funds rate) are set is a very important metric to financial markets. This can quickly delve into more complex topics, so let’s discuss the few key items to know about the Fed funds rate and its impact on our portfolios in the near future:

The FOMC can only set a target rate range.

The Federal Reserve cannot make commercial banks honor the Fed funds rate (although it’s rare for commercial banks to move the target higher or lower in their daily operations). What the Fed can do, and does through other mechanisms, is adjust the total money supply in order to nudge the effective Fed funds rate to their target if need be.

But the Fed funds rate is a just a target, not a mandate. The goal of the Fed in setting an ultra-low fed funds rate is to remove as much friction as possible to banks making loans and extending credit. When the economy receives a shock wave that depresses activity – like we saw during the pandemic – banks have a reflexive instinct to constrict lending. So the Fed removes the challenge of there being any cost to a bank that wants to lend more but may be short on near-term cash reserves.

The bond market has more power over prevailing interest rates than the Fed does.

If the bond market sells off Treasuries, key interest rates like the 10-year Treasury yield will rise. That then impacts key financial products like mortgages and credit card rates. Banks and other financial institutions have to make a profit on any loans they issue, from prime rate customers (those with high creditworthiness) on down. So as the bank’s own internal costs rise, these costs just get passed on to the consumer through higher charged rates.

One of the Fed’s most powerful weapons isn’t the Fed funds rate or the discount rate (for banks that borrow from the Fed directly) – it is simply their own rhetoric. Especially in the post-Greenspan era, investors have been calmed and soothed by a Fed commitment to easing. Just knowing that they’re in a mood to foster growth and not crimp it has been a welcome sign among investors.

So why would the bond market sell off and drive rates higher than what the Fed “wants”? Bond investors could sell Treasuries and/or corporate bonds because they see higher rates or better returns elsewhere (like in stocks), or because they see inflation coming. Inflation can be quite nasty for a bondholder, because those future coupon payments (which are a fixed dollar amount) carry less purchasing power in a world with higher inflation.

Patience Prevails – For Now

While interest rates are indeed climbing the past few months, we are still in a very low range, and there’s been no mass rush to the exit by bondholders yet. Keep in mind that the Fed funds rate was also set to zero in the depths of the Great Recession in 2009, where it remained for almost a decade – and helped propel strong returns for both stocks and bonds for several years. Also during this time, many bond investors who thought they could see the future were betting aggressively that the Fed would have to hike the Fed funds rate within a year or two. It ended up taking 7 years, proving how adept the Fed was at getting their way.

The Fed is going to use every tool at their disposal to keep financial conditions eased, and frictions reduced, for at least the next year. The bond market will be casting their votes on the matter too, but as the economy is expected to have a very strong 2021, patience and a long-term focus remains the proper tactical stance. As we noted in a previous piece, history bodes well for stocks during a time of rising interest rates, as it usually reflects faith in strong economic growth ahead.

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