Fed Meeting September 17/18 2019: What To Expect And Trade Ideas

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Includes: C, DIA, FAZ, JPM, MS, QQQ, SPY, WFC
by: Alan Longbon
Summary

Many expect the Fed to lower rates at the next meeting.

This article runs the scenario on how lower rates impact investment markets and the macro economy.

Interestingly from a macro point of view lower rates shrink the economy overall!

Best of all Main Street gets a break from bank interest debt drag.

The Federal Reserve lowered the target range for the federal funds rate to 2-2.25 percent during its July meeting. The first rate cut since the financial crisis, as inflation remains subdued amid heightened concerns about the economic outlook and self-created trade tensions.

The start of a global trend in downwardly moving interest rates looks to be in progress.

This article provides an impact assessment of the FOMC September 17/18 2019 meeting and a possible reduction in the Federal Funds Rate to 2% from 2.25%

The chart below shows the current FFR situation.

USA FFR A movement of the FFR has four broad impacts:

  1. Bank lending costs on required reserves.
  2. The interest burden on private debt.
  3. The Interest on newly issued Treasury deposits.
  4. Interest paid on excess reserves, also known as the support rate.

These four impacts will are looked at in turn.

The table below shows the impact of rates on bank reserves advanced by the Fed, via the discount window, when a bank makes a loan.

Fed discount rate on required reserves

(Source: Author calculations based on Trading Economics GDP measure)

The interbank rate is shown in the chart below and shows that at present commercial banks can get their funds in the interbank market at a lower rate than the FFR. There are excess reserves in the system since the GFC. Banks would not have much use for the discount window at the Fed and to pay the FFR on borrowed required reserves. The only reason would be unless other banks were not willing to lend to it for some reason.

US dollar Libor

Every 0.25% rate movement changes the cost of loan funds by $10 billion. The private banks then pass on this rate change to the customer if they can.

The next aspect is the interest burden on private debt.

The following table shows the impact of the FFR on the stock of private debt in absolute terms and as a percentage of GDP.

USA private debt to GDP

The chart shows that with each 0.25% FFR change, $105 billion, or 0.57% of GDP, is transferred from the household and business sector to the finance sector in a macro intersectoral income transfer or vice versa.

At present, just over 5% of GDP goes to banks as interest on loans. Debt drag on the real economy.

A lowering of the FFR will give businesses and households in the real economy a big break and cause a flow of $105B to go back to the real economy and out of the banking sector.

Treasury deposits are the next area of impact from a change in the FFR.

The following table shows the generalized impact of the rate rise on the stock of Treasuries.

USA treasuries and FFR

(Source: Author calculations based on Trading Economics Government Debt measure)

The table above shows that with each 0.25% rate change, a flow of $55 billion occurs either into or out of the economy.

An FFR decrease means that the economy receives $55B less each year by way of interest payments from the Federal Government to bondholders. Overall this is a net loss of income to the economy given that the Federal Government is a net payer of interest.

The fourth and last impact of a change in the FFR is the mutual adjustment of interest on excess reserves and interest on reserves.

Fed interest on excess reserves

Each time the FFR rises or falls, the IOER set to just underneath it. Most likely, a decrease in FFR will lead to a fall in the support rate to 1.85%. Such a change will remove approximately a further $3.45 billion of money from the economy. The total paid per annum is $25.95 billion.

The recent changes to the IOER are summarized in the table below.

Interest on excess reserves USA

This loss of income decreases the bank's capital base, which, in turn, means it must reduce its lending to remain within the limits of its capital ratio. Private sector credit would likely remain flatlined, as illustrated in the chart below.

USA private sector credit

Loans to Private Sector in the United States increased to 2356.33 USD Billion in July from 2346.38 USD Billion in June of 2019.

There are winners and losers from changes in the FFR and IOER, and these can be assessed in terms of key actors in the credit markets.

Banks: On the one hand, banks pay less for their borrowed reserves from the Fed when they make a loan. This rise is good news for those that hold a lot of fixed-rate loans, as their margin is eased. On the other hand, those banks that have a lot of Adjusting Rate Mortgage (ARM) loans will not enjoy an automatic rate rise when the trigger rate is hit.

At present with the yield curve contracting around the FFR/IOER and short term rates being higher than longer-term rates, banks are not keen to lend long if this means earning no interest income or even worse making a loss.

Banks slowly devour a larger and larger share of GDP with each rate rise for no additional effort and no actual production of a good or service. A lower rate reverses this process.

Bank stocks can be expected to fall due to the reduced income from:

  1. Decreased loan interest from households and businesses on the existing loan book of over 197% of GDP. Even with lower rates, it is unlikely that the loan book will grow given how high the stock of debt already is. It is though lower than the GFC peak of 212.9% of GDP.
  2. Interest on treasuries bought in exchange for excess reserves by the Federal Reserve goes down.
  3. Interest paid on excess reserves by the Federal Reserve bank goes down.

One could look at shorting the big banks (JPM) (MS) (C) (WFC) (FAZ)

Borrowers: They suffer when rates rise and benefit when they fall. Borrowers in the household and business sector get slowly squeezed with each rate rise. More and more income is devoted to debt service, and the appetite for more debt reduced. Aggregate demand falls, and unemployment and recession follow. Rate decreases reverse this unhappy process and breathe more life into Main Street, and that is what is happening now.

Macroeconomy: Gains income overall when rates rise and loses it when rates go lower due mainly to the size of the stock of treasuries. The following table shows the impact on the macro money supply at an FFR of 2%

Macro impact of FFR change forecast

(Source: Author's calculations based on FRED statistics and Trading Economics dot com statistics)

Contrast this with the present situation at 2.25% shown in the following chart.

Present macro FFR rate change table

(Source: Author's calculations based on FRED statistics and Trading Economics dot com statistics)

The net change to the money supply is minus -$48B (plus the drop in private credit creation) and deflationary overall and shrinks the economy.

The boost to Main Street by way of a reduction of the cost of credit, a key business input, may cause the economy to do better and for the general stock market to rise as a result. (SPY) (DIA) (QQQ)

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.