Last week the Federal Reserve met and decided to leave rates unchanged. So what does that mean to you?
Well, if you are a bank or financial institution it is relatively simple to understand – the interest rate you pay to borrow money for less than 24 hours, just stayed the same! For you and me and the rest of us, the impacts aren’t quite as simple.
When the Federal Reserve Bank (a private financial institution) sets interest rates, they are really setting only one rate. This rate is called the Fed Funds Rate, or the Overnight Lending Rate. This is the interest rate that banks charge to each other for overnight loans.
Why do banks borrow money for less than 24 hours?
The “Fractional Reserve Banking System” (google it) says that banks must have cash on-hand at the close of each business day equaling at least 10% of the amount they have taken in, in deposits. When your bank doesn’t have the required cash it needs it borrows from another bank that is over the limit to meet the requirements just for the night. The loan is repaid in the morning, with interest.
These increases in the overnight rates are designed to be passed on to the customers of the bank in the form of higher rates things like your mortgage loan – but if you look closely you will see that this isn’t always the case.
In fact, the past several times that the Federal Reserve raised the overnight lending rate, the interest rate that is most widely quoted in the market (the 10-year Treasury Rate) actually went down. And it went down meaningfully. Mortgage rates followed suit.
The 10 year Treasury Rate is the interest rate the United States Government pays to borrow money for 10 years. It is currently around 2.26%.
Federal Reserve Rate Increases
December 17, 2015 - 10-year Treasury Rate went down from 2.23%, to 1.36% by July 2016.
December 16, 2016 - 10-year Treasury Rate went down from 2.57%, to 2.31% by mid-February 2017.
March 16, 2017 - 10-year Treasury Rate went down from 2.52%, to 2.13% as of June 14th.
June 16, 2017 - 10-year Treasury Rate initially went up a bit, but then went down from 2.16%, to 2.06% by early September.
Lately, the Fed’s tools have not worked as intended. Last week, they changed gears and instead of increasing the overnight lending rate, the economists at the Fed decided to stop reinvesting the money that they receive in interest and principal from their investments.
This is a complicated topic if you don’t already understand how the Federal reserve “bailed out” the big banks during the financial crisis. You probably remember hearing that markets were “frozen” and so on. People had begun to hoard what cash they had and the Fed decided that they needed to “put more cash into the system”.
Essentially, the Federal Reserve printed up a bunch of money and gave it to several irresponsible companies that were already unable to repay their investors.
Later, the Fed turned around and printed even more money to purchase the very bonds that the companies were having difficulties paying on.
At a basic level the Federal Reserve Bank overpaid for a bunch of worthless junk. Since then, any interest they have earned or principal they have received has been reinvested in even more junk. In 2008, the Fed owned 875B worth of mostly high-quality “stuff”.
Fast forward to 2017, the Fed now owns 4.3 Trillion of junk. They now think that the time has come to take all that cash they printed up, out of the market. For all intents and purposes, when you hear “take cash out of the market” you can imagine that any cash received by the Fed (interest and principal payments), is essentially lit on fire.
This takes money out of the system and is designed to increase interest rates across the board.
This is the biggest financial experiment ever conducted.
What could possibly go wrong?
Shane Fleury, RICP | Chief Investment Officer
September 25th, 2017