The Fed Follows Rates by Todd Sullivan, ValuePlays
It seems that every day for the past several years some prominent discussion has taken place in the media.
“When will the Fed raise rates?” “What will the market and economy do?”
Keeping in mind that nothing about human behavior in the past is guaranteed to repeat in the future, i.e. absolutely nothing is guaranteed!, looking back at Fed action regarding rate moves, one comes to the conclusion that it is not the Fed which controls rates. A historical look-back reveals that T-Bill rates rise and fall well before the Fed raises and lowers the Fed Funds rate.
This reveal bares repeating because it is so opposite to consensus:
A historical look-back reveals that T-Bill rates rise and fall well before the Fed raises or lowers the Fed Funds rate.
Look at the chart History of Fed Funds and T-Bill Rates Jan 1990 to Jan 2015 below. Fed Fund Rates are in Light BLUE. T-Bill Rates are in Dark Blue. The difference in rates, i.e. The Spread (Fed Funds Rate – T-Bill Rate = Spread) is in Gray. You should see clearly that in the broad context when rates begin to have a major rise, the spread (Fed Funds Rate – T-Bill Rate = Spread) declines. This occurs because the Fed is not the first mover. It is T-Bill rates, i.e. market rates, which rise first and after a few months the Fed raises the Fed Funds rate to keep pace. Similarly, when rates begin to have major declines, the spread rises as again it is T-Bill rates which fall first with the Fed eventually lowering Fed Funds rate to catch up.
My interpretation is very simple. The Fed historically follows market rates, it does not have a history of setting them.
My experience and observations lead me to the conclusion that T-Bill rates are market rates and are set by investors seeking to maximize Returns while minimizing Risk. T-Bills are often viewed by investors as the carrying the least risk to capital (T-Bills have the backing of the US government and have very short maturity dates, 3mos.) This makes them a safe haven for capital while investors are deciding on potential opportunities for returns elsewhere. Once investor psychology deems that better investment returns can be had elsewhere, they sell T-Bills and shift funds. This drives T-Bill rates higher. On the other hand, if investors believe that investment opportunities have too much Risk and too little Return, they liquidate holdings and buy T-Bills causing T-Bill rates to fall. The Federal Reserve being the ‘lender of last resort’ attempts to maintain Fed Funds rate slightly above T-Bill rates makes its rate adjustments only well after T-Bill rates made a major shift. Once the Fed sees the rates trending , it eventually adjusts rates to maintain its position of ‘lender of last resort, Fed Funds higher than T-Bill rates.
History shows that the Fed has more often been a follower not a leader. Even in 1994 when Chairman Greenspan talked ‘irrational exuberance’ and market participants thought he was preemptively raising rates in the middle of economic expansion he was following T-Bill rates. T-Bill rates fell in early 1995 and Greenspan followed by lowering the Fed Funds rate. The same behavior in the Spread can be seen the chart. The only independent Fed rate rise we have seen in the last 50yrs was by Chairman Volcker who raised rates in the early 1980s to squash the consumer inflation mentality that had become embedded in the economy as a result of government stimulation from The Great Society.
Historical study reveals the Fed follows. It does not lead. I believe Chairwoman Yellen in all likelihood will follow this pattern. The Fed from my observations never wants to be viewed as the agency which killed an economy. The Fed has never shown itself prescient about economic direction. They will only follow the market’s lead in my opinion just as they have historically.