Tag Archives: fed funds rate

When the fed funds rate starts rising: how high? what does this do to stocks?

April 1, 2010 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action, Shaping a portfolio for 2010, Strategy Tags: , , , , , , , , , , , , 5 Comments

The economy is healing

We know the US economy has turned the corner.  At some point, activity will be strong enough that the Fed will begin to raise short-term interest rates from their intensive-care-unit level of today.  (Yes, the Fed has already begun to raise the discount rate, but this has been to force the major banks back into the commercial paper market instead of dealing solely with the government.)

what happens when the fed funds rate rises?

Even though the initial move may be months off, when is less important than how high the rate is likely to go and the effect the move will have on stocks and bonds.  It’s not too soon to begin thinking about any of this.

two parts to this post

–The first will be what financial theory, such as it is, says about what should happen.

–The second will be an examination of the historical record of fed funds rate increases over the past twenty-five years.

Theory

fed funds rate behavior

One of the Fed’s jobs is to help carry out our highest-level national economic objective:  maximum sustainable growth with low and stable inflation.  “low and stable” means nothing much higher than 2%.

This gives us our first benchmark.  Under normal conditions the fed funds rate, the price of overnight interbank deposits, will be slightly positive in real terms–about .5%-1.0% higher than the target inflation rate.

If the economy is running too hot, the Fed temporarily raises the rate, both to telegraph its concern and to raise the cost of borrowing, thus slowing the economy back down.  When the economy is down in the dumps, on the other hand, the Fed drops the rate below inflation to try to pep activity back up.

Today, the rate is at about .25%, meaning the economy has been in a train wreck and is barely breathing.

Where is normal, then?  Assuming inflation is under control, that is, 2% or less (and I think it is), the fed funds rate should be somewhere around 2.5%-3.0%.  That means that one the Fed starts upping the rate, it won’t stop until it has tacked on 200 basis points, and possibly as many as 250.

Long rates won’t rise by as much, since this isn’t bond investors’ first rodeo and thus to some degree have already priced in some of the short-term interest rise.  The extent of the yield curve flattening (meaning a smaller rise in long rates than in short) remains to be seen, but the ten- and thirty-year bond yields could easily rise by 100 bp.

the effect on stocks

Strictly speaking, there is no independent demand either for stocks or for bonds.  This is because, to a great extent, the two asset classes are substitutes for one another.  There is demand for the more  general class of long-lived investment securities, which includes both stocks and bonds.

Why is this distinction important?  If stocks and bonds are more or less substitutes, then anything that changes the price of bonds also tends to change, in the same direction, the price of stocks, and vice versa.

As interest rates go up, the price of bonds goes down.  So rising interest rates should exert downward pressure on stocks as well.

For government bonds, that’s the end of the story.  Not so for stocks, however.

The Fed only  raises interest rates when economic activity–and thus corporate profits–are expanding as well.  Rising profits tend to put upward pressure on stock prices, offsetting part or all of the negative force of rising interest rates.  One can at least imagine circumstances where interest rates are rising slowly enough, or profits are growing fast enough, that stock prices are either stable or have a rising bias.

bond-stock equilibrium

One can also look at what the equilibrium relationship between stocks and bonds should be.  This is usually done by comparing the interest yield on government bonds with the earnings yield on stocks.  The earnings yield is typically calculated as the annual earnings per share of an index like the S&P 500 divided by the price of the index.  It’s the inverse of the PE ratio.

If we assume that the 2010 earnings per share for the S&P 500 will be 85 and the index level is a bit below 1200, then the earnings yield is about 7.0%, which equates to a price earnings ratio of 1/.07, or 14.

Let’s say that as a result of the rise in fed funds to 2.75%, the ten-year bond yield increases to 5.0%.

The “right” proportion between a unit of yield in the bond market and in the stock market is a function of investor preferences and changes as they do.

If investors were indifferent to whether the earnings came from stocks or bonds (a big if, but more or less the relationship that has prevailed over the past twenty years), equilibrium would occur when the interest yield and the earnings yield were equal.   A 5% long bond would imply a 20 times price earnings ratio (a 5% earnings yield) on the stock market.

Whatever the exact right number for today’s world may be, one can observe that a unit of earnings is available today much more cheaply than has historically been the case in the stock market vs. the bond market.

To sum up:  increasing earnings give stocks some defensive power against rising fed funds and long-bond interest rates.  Also, relative to one another, stocks are priced much more cheaply than government bonds–again arguably giving them some protection against rising rates/lower bond prices.

History Continue reading →

The Volcker rule for banks

February 22, 2010 By in Banks, Current Market Thoughts, economics, Industry Analysis Tags: , , , , , , , , Leave a comment

Glass-Steagall

In the late Nineties, Congress repealed the Glass-Steagall Act (aka the Banking Act of 1933).  Glass-Steagall mandated that commercial banking and investment banking activities could not both be conducted in or by the same legal entity.  The Act was a reaction to abuses that led to the collapse of the stock market in the US during 1929 and beyond.

Gramm-Leach-Bliley

The bill that repealed Glass-Steagall was the Gramm-Leach-Bliley Act of 1999.  Although formulated by Republicans and passed along party lines in the Senate, the bill received bipartisan support in the House and was signed by Bill Clinton, a Democratic president.  The ostensible purpose of Gramm-Leach-Bliley was to allow American banks to expand activities to compete better with the big foreign “universal” banks, primarily in Europe.  But by once again permitting commercial banks to also do investment banking activities inside one entity, GLB opened the floodgates to the unfettered proprietary trading that has yielded such disastrous results over the past several years.

The ensuing problem

Part of the problem with the American commercial bank/investment bank conglomerates that were spawned by GLB was that the investment bankers and traders working at these entities turned out to be, by and large, either incompetent or dishonest.  In addition they were supervised by commercial bank executives cut from the same cloth, who seem to have had no clue about what the investment bankers they supervised were doing.

In the simplest terms, GLB allowed the investment banks in the combined entities to use the stronger credit rating of the commercial bank parent to lower their borrowing costs.  This financing advantage would in theory lead to “extra” profits in the investment bank and increased financial strength in the parent.

What happened instead was that the investment bankers in these conglomerates “bought” business by accepting lower anticipated returns on the high-risk deals they took part in.  The could do this only because their own cost of funds was so low.  When these marginal deals started to turn sour (it turned out the returns were overestimated in the first place), they ended up not only hurting the investment banks but also destroying the credit ratings of the commercial bank parents.

What is the Volcker rule? Continue reading →

The Fed just raised the discount rate–what does it mean?

February 19, 2010 By in Current Market Thoughts, discount rate; Fed Funds rate, economics, Recent Market Action, Vocabulary Tags: , , , , , , , , Leave a comment

The discount rate is going up to .75%

After the close of stock market trading yesterday, the Federal Reserve announced that it was going to raise the discount rate from .5% (annual rate) to .75%, effective today.  It will also limit the maturity of “discount window” loans to overnight, effective March 18th.  Previous policy allowed loans of up to 90 days.

What does this mean?

Some background

the Fed Funds rate

Federal banking laws require that each bank keep deposits, called reserves, with the central bank equal to a specified proportion of the loans it makes.  The proportion varies with the kind of loan.

Banks don’t always have the exact amount of money they need to have on deposit with the Fed.  Some have more than they need, some less.  Under normal circumstances they borrow and lend with each other in the market for overnight bank deposits, called the Federal Funds market.

The Fed uses this market as its principal tool for setting money policy.  It announces its desired level for the fed funds rate.  The Fed also trades in this market as necessary to keep the rate at the designated level.  The current fed funds policy, which is to keep that rate under .25%/year, remains unchanged by the rise in the discount rate.

the discount rate

The Fed has another tool for controlling short-term rates, the rate for borrowing funds directly from the Fed rather than from other banks.  This rate, which was a prominent Fed tool a generation ago but is no longer particularly relevant, it called the discount rate. Banks who use this rate are said to be going to the Fed’s “discount window.”

Under normal circumstances, the discount rate is higher than the fed funds rate.  Just before the financial crisis, the discount rate was 1% more.  Banks have no absolute right to borrow from the discount window, but must ask the Fed for permission to do so.  Discount window borrowing normally carries a stigma with it, since it implies that the bank in question has either hugely messed up its planning of reserve deposits, or that other banks are unwilling to lend to it.  Serial discount window borrowers may face Fed disciplinary action.

The situation up until today

With the onset of the financial crisis in 2007, interbank lending, even overnight lending, started to dry up.  At the height of the crisis, no one would buy bank commercial paper.  No one would lend in the fed funds market.  Therefore, banks couldn’t raise money to make loans to customers.  Even worse, banks that were borrowing to have money to meet minimum reserve requirements on outstanding loans were faced with the prospect of having to call in loans to satisfy the reserve rules with the cash they had on hand.

The Fed dealt with this mess by becoming an active lender to any and all member banks at the discount window, by lowering the premium over the fed funds rate, in stages, from 1% to .25% and ultimately extending the maturity of discount window loans from overnight to 90 days.

At the height of the financial crisis discount borrowing was extremely important, reaching well over $100 billion.  Today it has shrunk to less than $15 billion.

Why the changes?

Two reasons:

–the short-term lending market has pretty much returned to normal.  The only reason for a bank to borrow from the discount window today is that the rate is better than a weak bank could get in the open market.  By ending this subsidy, the Fed is sending a message to these institutions to get their houses in order.

–it’s a signal to the financial markets that the Fed intends to act responsibly and return money policy to normal when conditions are right.  Remember, in its announcement, the Fed stressed that for now the Fed Funds rate, the key policy rate, will remain unchanged.  The Fed has already withdrawn a couple of its support programs, but an increase in the discount rate is a much more visible step.  So it has much greater psychological value.

Market reaction

So far, reaction has been muted but slightly negative for stocks and positive for the dollar.  Treasury bonds are up, but that’s because of favorable inflation data announced this morning.

The rise in the discount rate will have no practical effect on world economies.  As a statement, I think it should be read as a mild positive, that the US economy is healthy enough that it no longer needs this support (which wasn’t doing that much any longer, anyway).  I think stock markets should be up on the news.