Focusing on policy rates misses the bigger picture.
Economists had a lot to eat this year, which was surprisingly positive given most developed countries avoided recession and economic growth was generally positive. Obviously, it will be the Fed’s turn soon, as analysts expect strong US data this summer to force economists to double their 2023 GDP growth forecasts from June’s 1.0% estimate — which a reversal from the March recession forecast. We could easily write an article poking fun at all those eggheads with balls on their faces, but we see something a little more fascinating at work. Indeed, some analysts are already eyeing the forthcoming update to gauge what it means for interest rates next year and whether the Fed will continue to forecast full percentage point cuts. We think all of this is quite out of place, especially for investors, as it puts the wrong factor at the forefront.
If Fed rates were a massive economic swing factor, we’d be obsessed. But in reality they are just one variable – and a small one at that. The interest rates that matter most to the real economy determine the cost of money to businesses and households, including interest rates on business loans, mortgage rates, car loan rates, and consumer rates. These do not result from the base rate, but from the yields on 10-year US government bonds. Conventional wisdom has it that Fed interest rate moves affect them, but the connection isn’t so clear cut. If so, the 10-year bond has not traded below the Fed funds level since November. In the nearly ten months since then, the Fed has continued to hike interest rates, while 10-year Treasury yields have experienced a strong but sideways trend.
In theory, the policy rate should affect the supply of credit, if not the cost. This is because banks borrow at short-term rates and lend at long-term rates, making the difference between the two their gross margin on new loans. A larger gap means more profits, making banks far more willing to lend than when spreads are narrow or even inverted. The easiest way to gauge this gap is usually the US Treasury yield curve, with Fed funds or 3-month yields on the short end and 10-year yields on the long end. However, this only works if the Fed funds and 3-month rates mimic banks’ actual cost of funding.
Traditionally they have. The main purpose of Fed funds is to regulate the cost of funding for banks, based on the logic that if banks have to pay a certain rate of interest to borrow from each other, the cost of borrowing from depositors will, of course reflect. This works in a world where banks have to compete for a limited pool of deposits, but that is no longer the case today. Most banks – especially the big ones – hold far more deposits than they need or want, and as a result keep savings and checking rates extremely low for us ordinary people. CD rates have risen, as have rates at some online-only banks or smaller banks, but the average nationwide rate on savings is a paltry 0.43%.[i] The Fed funds’ target range is now 5.25% to 5.5%.[ii] Given that credit growth is still a decent 4.8% year-on-year — which is above inflation, meaning credit is still growing in real terms — it doesn’t look to us like a higher policy rate is a big deal would have an impact on lending.[iii]
The last three paragraphs are a bit academic, so here’s an image to illustrate the same point in a different way. Figure 1 shows quarterly GDP growth alongside the monthly average effective policy rate since 1954. As you’ll see, we’ve had high interest rates, low interest rates, and zero interest rates. We’ve had rates rising fast, falling fast, and long periods of no action. Overall, economic growth rates have not changed significantly during the expansion. If anything, growth was slower in the zero interest rate 2010s than in the achingly high 1980s, to pick just a few examples.
Figure 1: GDP growth and Fed Funds interest rates are not very closely related
Source: St Louis Fed as of 09/06/2023. Average Monthly Effective Fed Funds Rate, July 1954 – August 2023 and Quarterly Annualized Real GDP Growth Rate, Q3 1954 – Q2 2023.
Given that the US economy has already proven it can grow in a variety of interest rate environments, we simply don’t think the Fed’s moves in 2024 will be critical to growth. Or for stocks that are primarily concerned with expected economic conditions – not just interest rates. Economic activity is typically the most important factor influencing corporate profits. So when the economy is growing or even accelerating, it’s hard for us to understand why the level of interest rates has such a crucial impact on stocks. That has never happened before. Why should it now?
That so many people seem to be looking at the world from the wrong angle and prioritize interest rates above all else seems a recipe for overlooking what really matters most to markets. That omission is likely to come as a pleasant surprise if the world doesn’t spin as expected – a pretty good summary of the last 11 months in our opinion.
As a general rule, things that everyone is looking at are already included in stock prices. The US Federal Reserve’s interest rate movements are currently the prime example of this, making it pretty pointless for investors to fixate on them. Share prices, which have survived several rounds of interest rate hikes since October last year, have long since moved on. Do yourself a favor and join them.
[i] Source: Federal Deposit Insurance Corporation as of 09/06/2023.
[ii] Source: Federal Reserve, as of 09/06/2023.
[iii] Source: Federal Reserve Bank of St. Louis as of 09/06/2023.
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