Federal Reserve Does Not Lead, It Follows

by: Jim Mosquera
Summary

The Federal Reserve Bank sets the discount rate, which is a very narrow interpretation of short-term rates.

Treasury Bill and Eurodollar markets move ahead of Fed discount rate action.

Fed will be challenged to affect Federal Funds Rate with current excess reserves posture.

On December 17th the Federal Reserve raised the Discount Rate or the rate they charge member banks for overnight loans. Banks pledge government securities or eligible paper for these short-term loans. There were of course differing views on what the Fed should or shouldn't do. There were several schools of thought from professionals, academics and armchair quarterbacks.

One thought suggested the economy was too weak so even a 25 bp hike was too strenuous. Another suggested the Fed was well overdue in hiking rates because they created a casino investment environment destroying savers and forcing investors into a chase for yield. Yet another comment was that they needed to raise rates in order to lower them once the next recession arrived. Consider that rates were already near the zero bound and that a future, miniscule reduction would likely have no effect.

My intent in this portion of cyberspace is not to preach policy to the Wizards of the Eccles Building. Contrary to what many believe, the Fed is not a leader but a follower. The Fed follows the market and not the other way around. The market telegraphs Fed actions. Most recently I had a conversation with a private investor who asked what I thought the Fed was going to do. He was very fixated on their decision. My response to him wasn't quite Bobby McFerrin, "Don't worry be happy", but it was decidedly unemotional. I did tell him not to worry about the Fed and instead pay attention to the market. The response didn't make this investor happy, but at least I pointed him in the right direction.

A time series I like to watch that is a harbinger of future short-term interest rate activity is the 90-day Eurodollar rate. The Eurodollar is a U.S. Dollar (USD) deposit in a foreign bank. The rate suggests the market's future expectation about 90-day deposit rates in these banks. The following chart is a back adjusted futures time series of this 90-day rate using closing prices only. On November 30, 2015, the time series rolled over to the March 2016 contract. Data prior to November 30th is back adjusted for the purpose of creating a continuous March 2016 Eurodollar chart. This type of chart construction is important for technical futures traders though the market's overall direction will still be in evidence. In this chart, higher values represent lower interest rates and vice versa.

90-day Eurodollar Futures

On October 14th, this market made a high and continued falling through December 18th. That drop was the most significant in the last five years. If the Fed watchers wanted guidance based on this chart, the conclusion was that they would increase the discount rate. The chart won't tell you when the Fed will take action but it certainly telegraphs the direction of their action.

The next chart is a cash series for the 90-day Treasury bill rate. Higher chart values signify higher interest rates. Once again, note how rates took off around mid-October. This chart indicates that short-term interest rate trends are up, thus if the Fed intended on taking action on rates on December 17th, they would go higher.

As an aside, there is a relationship between the T-bill rate and the Eurodollar rate via the TED spread. The TED spread suggests credit risk. The higher the spread, the greater the short-term credit risk. The current spread is about 29 basis points, which is quite low. By comparison in September of 2008, the spread was 315 points, signifying elevated credit risk. During the stock market crash of 1987 the spread moved to 200 points while 90-day T-bill rates dropped 2% in a single month. In both instances, the flight to quality was in force as investors rushed for the relative safety of Treasury Bills.

The key point to remember with both the Eurodollar rate and the T-bill rate is that both interest rate markets revealed changes ahead of Fed action.

90-day Treasury Bill (Cash market)

The next chart provides readers a recent historical perspective on Fed discount rate actions versus the 30-day T-bill rate. The blue, jagged line represents T-bill rates and the black, stepped line is the Fed's discount rate. I included red arrows near approximate highs and lows of the T-bill market to reveal when this market begins its move.

30-day T-bill and Fed Discount Rate

I would like to call the reader's attention to the action relative to the red arrows.

  1. In March 2002 the T-bill began a downward trend that accelerated in November 2002. The Fed lowered rates in November 2002.
  2. T-bill rates increased from below 1% in January 2004 until March 2007 when they reached more than 5%. During that period, the Fed kept the discount rate at 0.75%. The Fed didn't move rates until December 2007 when they dramatically increased the discount rate to just below 5%. That rate increase lasted all of one month. In January of 2008, the Fed began a series of rate reductions that ended one year later. The market had already spoken in 2007 when T-bill rates fell dramatically. So the Fed was very late with its discount rate increase (it followed the market quite late), then after short-term interest rates were heading down quickly, the Fed pivoted to follow them down.
  3. In early 2009, T-bill rates headed up and traded in a small range before increasing more decisively in early 2010. Once again the Fed followed with a small discount rate increase in February of 2010.
  4. Since early 2010, rates on T-bills have been in a consistently low, narrowing trading range and likewise the discount rate is flat and low. In October of this year, T-bill rates increased and the Fed followed yet again on December 17th.

The Fed does not lead interest rate trends, it follows them. The Discount Rate provides a very narrow perspective on short-term interest rates. This is the only rate directly controlled by the Fed and yet it garners a disproportionate amount of attention. The Fed can certainly affect interest rates based on direct purchases of securities like they did with their various iterations of Quantitative Easing (QE) but that is not what the discount rate is all about.

Banks borrow at the Discount Rate when their reserves are lacking. That is not a problem for banks right now. At the beginning of the financial crisis there were some $60 billion in excess reserves at the Fed, or amounts above and beyond required reserves. Excess reserves now total $2.6 trillion (thank you QE).

Banks can also borrow from each other to meet reserve requirements at the Federal Funds Rate. But there is not much need for this type of borrowing with banks flush with excess reserves. In addition to the aforementioned, the Fed is increasing the interest rate paid on excess reserves from 0.25% to 0.5%. Interest rates on excess reserves is manna from heaven.

The Fed's intention is to affect the Federal Funds Rate though that will be difficult if banks don't need to borrow from each other. Their new policy tool will be to lend out up to $2 trillion of their own bond stash in the overnight repo market. It will lend this stash to banks, money market funds, and other institutions overnight and repurchase them the following day at a slightly higher price. Their hope is to stimulate the Federal Funds Rate.

The message to investors is to pay less attention to Discount Rate announcements and more to other short-term rates. The Fed is not bigger than the market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.