By Dr. George Calhoun
Hanlon Investment Management Advisory Board Member
Executive Director of the Hanlon Financial Systems Center
The Federal Funds Rate (FFR) – the interest rate that everyone obsesses over – is a strange creature. It is not what it may seem, nor what many people assume it to be.
- To begin with, it is not an actual interest rate attached to any real loan or financial instrument – the FFR is only a target, a suggestion from the Federal Reserve, which no one is legally required to accept or follow.
- This target/suggestion refers only to the rate that applies to loans between banks within the Federal Reserve system.
- It applies only to overnight loans, the shortest of short-term transactions.
- These loans are not motivated by normal economic purposes for offering or obtaining credit, but are typically driven by the need to comply with the regulatory requirements (reserve requirements) imposed on the banks by the Federal Reserve.
The FFR thus technically aims at influencing the pricing for a very narrow category of loans which, if they do take place, involve transfers of funds that remain entirely within the closed system of reserve accounts deep inside the Fed itself, for reasons that are regulatory rather than economic. The FFR does not apply to any real loans to businesses or consumers. This shuffling of reserves is not capital allocation, but regulatory accommodation.
Yet the FFR is also intended, and advertised, as a policy tool to influence real interest rates throughout the economy, including the longer-term rates that actually impact the public directly (e.g., mortgage rates). This is what gives it the aura of importance that rivets the attention of the financial markets. And it can seem as though it is effective. Over the last 5 years, the yields on 10-year Treasury bonds have moved up and down in lockstep with Federal Reserve interest rate targets. The correlation is 92%. The same is true for rates on 30-year fixed-rate mortgages, which showed a correlation of 94% with the FFR.
This might suggest that the Federal Reserve does indeed wield a powerful and precise instrument for influencing important long term rates – the foundational myth upon which much of the Fed’s credibility rests. In a previous column, the shallowness of this myth was examined. The Fed’s ability to influence the real economy has been oversold. The Fed’s power is a matter of faith – as long as we believe in it, the illusion will retain its potency.
Until recently that faith has held up. The stock market has shown considerable sensitivity to Fed announcements, creating a strong clustering of stock returns around the days when the Federal Open Market Committee meets. The markets outperform on and around FOMC-days.
Effect of FOMC Meetings on Stock Market Returns Chart by author
This is extraordinary. There are only eight regularly scheduled FOMC meetings a year. If those eight days are removed, the gains of the S&P 500 on the other 347 days of the year are much lower.
S&P 500 With and Without FOMC Days Chart by author
[Note that this effect only appeared in the Greenspan years, where – arguably — an important shift in Fed communications policies emerged, aimed more explicitly at influencing the financial markets. Of course, this was never part of the Fed’s mandate, and there are many who view this innovative new mission with skepticism.]
Is this healthy? Is it sustainable? And what happens if at some point the faith…wavers?
There are signs this could be happening. And at the moment, a shadow of doubt may be emerging, exposed paradoxically by the recent long-awaited cut in the FFR target.
The Sept 16 Rate Cut – Why Didn’t It Work?
On September 16, Jerome Powell announced a 50 basis point reduction in the Fed Funds target rate, as described in a previous column. It was the first cut in more than four years. It was seen as an “emphatic” trend reversal, signaling a shift to monetary easing that would cause interest rates to begin to drop across the board. The Fed’s purpose was clear: to provide a stimulant to a softening economy, to bring down the cost of borrowing, not just for banks shuffling reserves back and forth, but for businesses and consumers in the real world.
However, this time the markets didn’t follow the Fed’s “suggestion.” Real interest rates in the real economy rose, rapidly and substantially. The yields on the 10-year Treasury bond rose above the significant 4% mark, reaching 4.08% on October 10 – up 47 basis points in less than a month.
10-Year Treasury Bond Yields Chart by author
Meanwhile, interest rates on 30-year fixed-rate mortgages were up 78 basis points. The national average is as high as it was one year ago.
30-Year Mortgage Rates Chart by author
The Policy/Market Gap
Consider the disconnect here. The Federal Reserve dropped its target rate by 50 bps, and yet market-based benchmark rates increased by the same amount. The “spread” between the policy rate and the market rate over this three-week period widened by a full percentage point or more.
Policy Rates vs Market Rates Chart by author
This is the opposite of a stimulus. Extended across the $25 trillion U.S. economy, and the $46 trillion bond market, that one percent widening of the spread amounts to a significant tightening of credit conditions.
There is a lesson in this. The Fed’s power to move the credit market is not automatic, as many people assume. Yes, in time the market rates will probably begin to track downward. But the truth may have poked through the illusion here. Is the likely convergence a matter of causation, or just correlation? The Federal Reserve and the financial markets may both reach a similar conclusion, but that does not validate the efficacy of the Fed’s policy moves. For the moment, what is on display is the independence of the markets in declining to immediately accept and fall in line with the new easing regime.
This is not that unusual. Over the last year (Oct 2023-Oct 2024) the correlation of the Treasury bond yields with the FFR was just 34% (much less than the 5-year averages). Since the FFR was fixed at 5.25% over that period, this means that the Treasury yields were bouncing around quite a bit, reflecting the market’s changing views on the probability and importance of various future events (recessions, soft landings, Fed policy changes) – rather than chaining themselves to the Fed target.
And in the year before that (Oct 2022-Oct 2023), as the Fed was cranking up the target rate, correlations between the FFR and both the 10-year Treasury yield and the 30-year mortgage rates were lower still, around 20%, indicating a very weak relationship.
A full percentage point of “adverse” reaction from the financial markets against the Fed’s suggestion is, well, at least a little bit shocking. This is one more chink in the Fed’s armor, even if the rates do eventually converge. It is starting to seem like the Fed’s chief asset — its credibility – may be at risk. Even the sober citizens who edit the Washington Post are worried. “The Federal Reserve’s greatest resource is its credibility. People have to believe…” And if belief falters, “the central bank won’t survive.” True, the Post’s concern here was focused on questions about personal transactions by Fed officials, but the modes of impairment that can threaten the public’s faith in the institution are multifarious. Public confidence in the Federal Reserve today is at or near an all-time low, and these small signals of the market’s apparent disdain for the Fed’s intentions should not be discounted.
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About the Author:
Dr. George Calhoun, a graduate of the University of Pennsylvania, received his Doctorate Degree from the Wharton School of Business. He has served in multiple capacities in the Financial Sector and in the Wireless Communication Industry. He has authored multiple articles on subjects of interest to him and several books. His most recent book “Price & Value: A Guide to Equity Market Valuation Metrics” is available through the Publisher Springer/Aspress. Dr. Calhoun currently serves as the Executive Director of the Hanlon Financial Systems Research Center at the Stevens Institute of Technology and is an Advisory Board Member of Hanlon Investment Management.