The Fed, the Noise and the Fury.

Federal_ReserveThe Federal Reserve has met and told the world that it is not raising rates this month but it intends to do so 2 more times this year. And if you really know what the Fed will do, you are ahead of the majority of the market. So what exactly does the Fed do and how does it impact the market? The Federal Reserve sets the overnight lending rate between banks. That rate has been set to zero percent from 2008 all the way though December of 2015 when it was raised by a quarter percent. Why does this matter? Some other rates are adjusted based on what the Federal Funds Rate is, such as prime. Prime rate is basically whatever the federal funds rate is plus three and a quarter percent. Currently it is at 3.5%, it is supposedly the rate which banks will give their best borrowers.

In reality, both rates have very little resemblance to the cost of funds of major players like banks, or even wealthy investors. For example, when the federal reserve raised its benchmark rate by a quarter percent in December of 2015, the yield on the 10 year treasury actually dropped by about a quarter to half a percent. Why did this happen? The 10 year treasury is seen as a safe haven asset and the yield was bought down by both US and foreign investors looking to place their capital in the asset that would preserve their value in a falling equity market. This resulted in consumer rates (such as mortgage rates) actually dropping when the Federal Reserve raised its benchmark rate. Before December their was a floor on the 10 year treasury of 2% after the rate hike there is now a ceiling of resistance at 2% which the 10 year treasury has traded below.

The Federal Reserve is creating a lot of noise and rattles its saber with talk about increasing the cost of borrowing so that the US economy doesn’t over heat. But, in reality, they are creating a perception of toughness. The Fed understands that its federal funds rate will only affect short term rates to some extent but has little effect on long-term rates. The Fed, like many central banks around the world, is burdened by the necessity to dictate fiscal policy because the US legislature has become polarized and somewhat dysfunctional. As such it realizes that the US economy is not as strong as it would like it to be and is tasked with attempting to normalize monetary policy while every other major central bank is easing. Essentially, the position is untenable. However, the farce must go on and Wall Street plays the game as well with a race to bonds whenever the rates actually increase creating downward pressure on the 10 year treasury note yields.

So what power does the Federal Reserve really have to do when it actually wants to raise long term rates? The Fed is sitting on over 4 trillion of treasuries. Currently 216 billion worth of treasuries are coming due this year (meaning the Fed will receive 216 billion dollars from the US treasury). So, what is the Fed doing with this money? They are going to turn around and re-invest it into treasuries. They are quietly continuing the policy of quantitative easing by re-investing their proceeds from their maturing US treasuries. In 2016, the Fed will be purchasing 1 of every 2 dollars of debt issued by the US government. The Fed is buying down the long-term interest rate while they raise the short term rate. Why would they do this? Because they want to appear hawkish but at the same time are afraid of the consequences. A strong movement in interest rates would deflate equities in an election year. So what will the Fed do when it actually wants to raise interest rates? It will stop rolling over its proceeds from maturing US treasuries and stop buying down the long term interest rate.

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