The Fed Follows Rates

0
The Fed Follows Rates

The Fed Follows Rates by Todd Sullivan, ValuePlays

“Davidson” submits:

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?”

[Exclusive] DG Value Underperforms In H1, Sees Growing Number Of Distressed Opportunities

Dov Gertzulin's DG Capital has had a rough start to the year. According to a copy of the firm's second-quarter investor update, which highlights the performance figures for its two main strategies, the flagship value strategy and the concentrated strategy, during the first half of 2022, both funds have underperformed their benchmarks this year. The Read More

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 r