ROE Determines the Fed Funds Rate

by: Julian Van Erlach

Let us dispense with the nonsense about the Fed having any control over the real economy by “setting” the Fed Funds rate – the market sets it; the Fed must follow…and what market-set short term rates are broadcasting is catastrophic profits to follow…and much more stock market pain coming…

It is widely believed that the Fed sets the Fed Funds (FF) rate according to policy goals; thus strongly influencing the yield curve and stimulating or slowing real economic activity. With current growth risks, the financial community sees the FF rate as one of the major remaining policy tools to mitigate the risk of extensive growth contraction. The Fed is often criticized, now being no exception, for acting too soon or late, for holding the rate too low or high. This concept may be backwards. There is strong evidence that the Fed follows market conditions and that the yield curve and level of short-term rates is determined by near term expected corporate return on equity (ROE).

Corporations may not wish to pay more for short-term borrowing than they expect to return to their shareholders. They could pay more for short-term debt, thus narrowing the spread to long-term bonds and flattening the yield curve, during unusually high expected near term ROE periods; up to a limit (beyond the scope here).

It is well known that the FF rate is highly correlated with the 3-month T-Bill yield (graph 1: Quarterly FF Rate vs. T-Bill Yield 1970-9/12/08): 

But does one determine the other or are they both a function of some other; over-arching macro economic factor?

Overlaying near-term actual and expected ROE compared to long run ROE results in graph 2.

ROE is calculated using SP500 trailing EPS indexed against the market value of non-financial corporate net worth obtained from Fed Funds Flows adjusted for share growth. Using forward or expected EPS obtains a very similar result. Since SP500 book value is difficult to accurately capture due to unconsolidated, foreign and other subsidiaries and factors, the Fed Funds Flow measure of net worth is used as a book value proxy, and SP500 EPS were used as a profit proxy indexed and compared as a ratio to each other; arriving at a “synthetic” ROE.

It would be difficult to argue that new FF action can affect past ROE or near-term expected ROE; thus, the chain of causation is most likely that ROE drives short term market rates and requires the Fed to follow; not lead.  This market mechanism is a result of still other factors affecting profits and is self-adjusting based on those conditions.

The ROE should also be related to credit risk perceptions and thus to the spread of risky corporate bonds over equivalent term to maturity Treasuries. Graph 3 shows just this expected relationship.

The risk spread is the ratio of Moody’s Baa 10-year corporate bond yield to the 10-year Treasury divided by the average period spread for simplicity. The coincidental, not leading, inverse relationship to ROE is apparent.

It is natural to ask how yield inversion arises and fits into this picture. While this mechanism does predict and account for yield inversion; this is beyond the scope of this article.

The Fed is not to be blamed nor credited with astute policy with regard to the FF rate. Some implications of the current 3-month T-Bill yield seem to be that the Fed will soon have to cut the FF rate to below 1% and that profits have much further to plunge. Until the short end of the yield curve rises materially and the curve itself begins to flatten; rising profits are likely to prove illusive. Since risk spreads track ROE, holders of risky bonds seem headed for massive losses. The coincident relationships among ROE, the yield curve and risk spread imply that markets have no significant ability to anticipate changes in credit risk. Short term rates appear to have lagged a huge ROE recovery after 2001 and may be viewed as being kept low too long. Conversely, the current ROE and 3-month yields (not shown) seem ready to force one or more additional FF rate cuts; which have notably lagged ROE. 

The yield curve and levels appear to be indicating a massive plunge in expected near-term inflation, profits and EPS; in addition to any negative risk premium that may be embedded in the short-term rate.

The material contained herein is patent-pending.

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