There is a belief among some people that interest rates will not increase significantly until the Fed (Federal Reserve) raises the federal funds target rate from its current 0-0.25% level, which does not figure to occur until about the second half of 2015. This is definitely a misconception.
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The federal funds rate is just one particular lending rate, and it is a very short-term rate. The federal funds rate is the interest rate at which depository institutions (e.g., banks) lend excess Fed reserve balances to each other overnight. Required (non-excess) Fed reserve balances are funds that depository institutions must hold in reserve at the Fed. Currently, the reserve requirement is 0% for $0 to $12.4 million of specified deposit liabilities (e.g., savings accounts), 3% for more than $12.4 to $79.5 million of specified deposit liabilities, and 10% for more than $79.5 million of specified deposit liabilities.
If necessary, the Fed buys or sells government securities to make the actual federal funds rate the same as or very near the federal funds target rate. Very short-term securities are bought or sold because the Fed is influencing a very short-term (i.e., an overnight) rate. For this and other reasons, a change to the federal funds rate has a knock-on effect upon other very short-term interest rates. It also has a knock-on effect upon other-term interest rates, but to a much lesser degree.
Eurodollar LIBOR (London Interbank Offered Rate) interest rates are short-term rates for international interbank U.S. dollar loans. LIBOR rates are not directly related to the U.S. federal funds rate. They are important because many U.S. loan interest rates are based upon them. The federal funds target rate has been 0-0.25% since 12/16/08, at which time it was lowered by 0.75-1.00%. After this occurrence, the 1-month Eurodollar LIBOR rate bottomed at 0.328% on 1/15/09; and the 12-month Eurodollar LIBOR rate bottomed at 1.737% on 1/14/09. The following chart shows peaks and troughs in Eurodollar LIBOR rates from this time forward.
|Date||1-Month LIBOR||Date||12-Month LIBOR||Notes|
|3/10/09-3/11/09||0.564%||3/11/09||2.297%||Near stock markets trough. (Moment of greatest U.S. financial crisis fear.)|
|3/7/13||0.202%||3/7/13||0.737%||Most recent data.|
The U.S. financial crisis elevated Eurodollar LIBOR rates for a while; but you can see that Eurodollar LIBOR rates changed a lot independent of this, and that the changes were more pronounced for the longer-term LIBOR rates. You can also see that Eurodollar LIBOR rates are currently at low levels.
The following is a chart showing peaks and troughs for 5-year, 10-year, and 30-year Treasury interest rates since the federal funds target rate was lowered to 0-0.25%. Notice the large changes in rates. Also, notice that these interest rates began rising, versus falling, soon after the federal funds target rate was lowered to near 0%. Also, notice that these interest rates are currently relatively low.
|Date||5-Year Treasuries||Date||10-Year Treasuries||Date||30-Year Treasuries|
Longer-term interest rates can be similar to or very different from very short-term rates like the federal funds rate. Longer-term rates somewhat anticipate what the interest rate environment will be like in the future, in addition to accounting for what the interest rate environment is like today. For instance, the current 30-year Treasury bond rate is somewhat anticipating what interest rates will be like in each year to 3/7/43 because some of these bonds are being bought to be held to maturity.
Currently, the Fed is buying $45 billion of long-term Treasuries per month and $40 billion of RMBSs (residential mortgage-backed securities) per month. Also, the Fed is reinvesting all RMBS principal payments received in RMBSs. As of 3/6/13, the Fed was holding over $1 trillion of RMBSs. Also, the Fed is reinvesting all matured federal agency debt in RMBSs. As of 3/6/13, the Fed had about $22 billion of federal agency debt maturing in one year or less. When the Fed stops doing any or all of these things, it will lessen the demand for long-term Treasuries and RMBSs and, via a knock-on effect, other longer-term debt. This will influence longer-term interest rates to rise.
For the sake of simplicity, let us assume that the $85 billion per month of Treasuries/RMBSs buying continues for another six months and the two reinvestment programs continue for another 12 months. The QE-related (quantitative-easing-related) aspects of the Fed’s balance sheet seem as if they will, then, look something like the following going forward.
|Federal Agency Debt||$73.59||$51.41||$33.78||$4.39||$2.35|
|Maturities / Retained Principal Payments||$0.00||$126.72||$202.57||$338.74|
(1) The 9/6/15 and 3/6/18 Maturities figures are estimated, but the totals of the two figures for each debt type are exact.
(2) The 9/6/15, 3/6/18, and 3/6/23 Maturities / Retained Principal Payments figures are estimated.
(3) Assumes no U.S. Treasuries, federal agency debt securities, or RMBSs are sold.
Notice that, in this scenario, the Fed’s balance sheet begins shrinking after 3/6/14, about 1.5 years before the federal funds target rate figures to be raised. Once the Fed’s balance sheet begins shrinking, a monetary tightening effect takes place. Normally, returned principal is reinvested or otherwise spent. In this case, the Fed will not reinvest or otherwise spend, but instead remove (non-physical) currency from circulation.
It is important to emphasize that the above scenario assumes, as already noted, that “no U.S. Treasuries, federal agency debt securities, or RMBSs are sold”. Fed Chairman Ben Bernanke said that the Fed may sell the securities bought via QE after the federal funds target rate is raised, but the Fed may just wait for some or all of the securities that have not already matured to mature. If some or all of these securities are sold, the Fed’s balance sheet will shrink more quickly than shown in the scenario above after about 9/6/15, when the federal funds target rate figures to be raised. If some or all of these securities are sold, it will influence interest rates to rise. If none of these securities are sold, it may be because interest rates have already increased a lot.
More specifically, the FOMC (Federal Open Market Committee) decides when to revise the federal funds target rate. The committee said that they anticipate keeping the federal funds target rate unchanged until the unemployment rate drops to 6.5%, as long as projected inflation one to two years ahead remains at or beneath 2.5% and “longer-term inflation expectations continue to be well anchored”. The consensus projection of the 19 members and potential members of the committee has unemployment dropping to 6.5% in about the third quarter of 2015, without projected inflation becoming a concern. The committee is not obligated to raise the federal funds target rate immediately after the 6.5% unemployment rate is reached, but the projections of the 19 committee members and potential committee members indicate they will.
Stock prices tend to change in anticipation of what will happen, versus on what is happening. Even though they change on current events, the most important question is: “What does this mean about 3-6 months from now?” Interest rates and fixed-income securities prices are similar in this respect. Smart investors will not wait for QE to be lessened or end, the Fed’s balance sheet to begin shrinking, or the federal funds target rate to be raised. They will anticipate these things. You should anticipate these things too.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.