by David Moon
At its meeting next week, the Federal Reserve is expected to raise its target for the Fed Funds rate, the one interest rate it explicitly controls. If so, the move will be largely irrelevant to the real world, just as was last December’s increase.
Beginning in 2014, some Federal Reserve Board governors, including Chair Janet Yellen, repeatedly told investors to expect higher interest rates—sooner rather than later. The empty warnings lasted more than a year, eventually becoming a running gag on Wall Street. The Fed’s long-threatened rate hike in December 2015 was a failing attempt to maintain some sort of central bank credibility. Investors, lenders and borrowers yawned, continuing to push rates lower for the next seven months.
Market rates are now increasing without any Fed action, further exposing the Fed’s irrelevancy. Since July 8 the yield on the 10-year Treasury has soared from 1.37 percent to 2.40 percent. That’s a 75 percent increase in the federal government’s cash cost to borrow 10-year money.
The federal government borrows a lot of money.
Most interest rates are set by borrowers, lenders, bond issuers and investors. The Fed has no direct influence on Treasury rates, CDs, mortgages, credit cards or municipal bonds. It does, however, set a target rate for something called the Fed Funds, the rate banks charge each other for overnight loans. But with banks sitting on $2 trillion in excess reserves, the need for overnight lending among financial institutions has plummeted. A quarter or even half-point increase in the Fed Funds rate is meaningless; it is the macroeconomic equivalent of a 400 lb. man trying to lose weight by cutting his daily ice cream consumption from 20 to 19 cones.
The effect of higher market rates depends on several factors, including the speed of the increase, its magnitude and the absolute level of rates. A 75 percent increase in rates over five months is rapid, but an increase from 1.4 percent to 2.4 percent is much less impactful than would be an increase from 5 percent to 8.75 percent, explaining how stocks could increase in the face of rapid and significant rate increases this fall.
Investors in longer-term bonds are experiencing a rare occurrence since a long-term secular rate decline began in 1982: significant declines in bond values based on higher interest rates, not diminished credit quality.
The Vanguard Extended Duration Treasury Index fund owns long maturity bonds, but only those issued by the US government, supposedly the safest investment on earth. Since July 1, higher interests rates have decimated the value of that “safe” mutual fund by 19 percent. Investors who equated “buying bonds” with “being conservative” will likely be unpleasantly surprised when they get their December 31 401(k) statements.
But don’t blame the Fed.
David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN)