What Will The Fed Do Next?
In the depths of the Great Recession, the Federal Reserve implemented an aggressively accommodative policy to reinvigorate capital markets and the overall economy, dropping the Fed funds rates to zero starting in December 2008. By lowering and raising the Fed funds rate (the rate at which banks can lend money to each other typically on an overnight basis), the Fed influences the supply of available funds. By raising rates, borrowing becomes more expensive and, inversely, lowering rates makes borrow cheaper, meaning borrowers have a greater access to capital that can subsequently flow into the economy.
To some degree, the move to lower rates has had its desired effect: Equity markets have climbed substantially over the last decade, hitting all-time highs on a seemingly regular basis. And yet given somewhat disappointing global growth over the same timeline, the Fed has remained unwilling to bring rates back in line with historical norms, having only raised rates slightly since the recession and most recently cutting rates again amid signals of a slowing global economy. Investors continue to closely watch the Fed while positioning portfolios and trying to determine whether we are in fact heading toward the first recession in more than a decade.
The Fed’s Influence
When investors hear that the Fed is cutting rates, some expect that rates will subsequently affect other rates, like savings account rates, bond yields, mortgages rates, etc. And yet the relationship between these rates and the Fed funds target is not always so clear-cut. While the Fed can directly influence short-term interest rates (see chart below), they have few tools to directly affect long-term interest rates. Therefore, longer-dated rates don’t always move in conjunction with the Fed funds rate.
On the other hand, long term rates, such as mortgage rates and longer-dated treasury rates, are historically not as sensitive to changes in the Fed funds rate. Although overall longer-term rates have declined with the fed funds rate overall, longer-term rates have deviated substantially from the Fed funds rate (see chart below).
There are several reasons for this discrepancy in Fed policy rates and prevailing long-term rates. Certain factors such as creditworthiness and inflation expectations impact longer-term rates more than they do short term rates. As those factors change relative to the Fed funds rate, we would expect a deviation in longer-term rates. Additionally, there is some discourse as to whether the Fed funds rate is meant to broadly dictate interest rates or whether the rate is merely a way to “nudge” markets in a direction.
The New Norm
While technically the Fed doesn’t directly set the target for long-term interest rates, markets interpret the target as an indication of the Fed’s view of the economy, often resulting in longer-term rates moving not in lockstep, but in the general direction of short-term rates. Additionally, correlation does not equal causation; the Fed sets rate policy based on other market measures like inflation and GDP growth, which together impact bond yields. Therefore, the market does not purely react to Fed policy but considers other economic factors as well.
After years of maintaining low rates to spur economic growth, the Fed decided to begin raising rates again in December 2015 to move toward normalized rates amid a strengthening economy. Low interest rates incentivize market participants to invest money versus saving at low interest rates, thereby shifting capital to areas of the economy that need support. Unfortunately, persistently low rates also raise the risk of asset bubbles and the overvaluation of equity markets. When rates rise and investors feel incentivized to invest in safer, lower-yielding investments, these overvalued assets could decline sharply.
The Fed therefore carefully messages policy change to the market, particularly when it began raising rates. From December 2015 through September 2018, the Fed successfully raised rates gradually without shocking markets (see chart below).
Around the end of September 2018, market sentiment changed as investors began to fear further rate increases, especially in the face of slowing global growth and the trade war with China. The Fed’s decision to raise rates in December 2018 further caused a sharp stock market sell-off. From the Fed’s perspective, a healthy labor market and overall economy supported the decision, and yet investors clearly felt otherwise.
Just as rates began to return to more normal levels, economic headwinds and investor sentiment reversed, forcing the Fed to reconsider its rate policy and to subsequently lower longer-dated interest rates again as economic conditions worsened.
Investors often highlight how low investment yields affect wealth projections and the ability to cover future expenses. To alleviate the effect, investors can diversify fixed-income allocations with the use of tactical bond managers to exploit market mechanics and to gain exposure to varied maturities and strategies.
Meanwhile, the Fed will continue to make interest rate decisions based on not only economic factors, but the strength of capital markets, messaging every move with a delicate hand to appease investors who have grown accustomed to such significant accommodation over such a long timeline.
In the meantime, we continue to monitor economic developments and Fed messaging, always within the context of maintaining a diversified portfolio to alleviate exposure to low yields and to improve outcomes for retired clients despite low rates.
1 The Fed Funds Rate’s Impact on Other Interest Rates. Federal Reserve Bank of St. Louis – https://www.stlouisfed.org/on-the-economy/2017/october/increases-fed-funds-rate-impact-other-interest-rates
2 A Perspective on Nominal Interest Rates Fernando Martin – https://research.stlouisfed.org/publications/economic-synopses/2016/12/16/a-perspective-on-nominal-interest-rates/