Focusing solely on the fed-funds rate overlooks the bigger picture. Economists have been proven wrong this year, as most developed nations have avoided recession and economic growth has been better than anticipated. It is now the Fed’s turn to revise their GDP growth projections for 2023, with analysts expecting a significant increase from their previous estimate. While some analysts are questioning how this update will affect interest rates and potential future rate cuts, we believe that this focus is misplaced for investors.
In reality, the interest rates that have the most impact on the real economy are those that determine the cost of money for businesses and households. These rates include business loan rates, mortgage rates, auto loan rates, and consumer rates. Contrary to popular belief, these rates are not solely influenced by the fed-funds rate, but rather by 10-year US Treasury yields. The relationship between Fed rate moves and these rates is not as clear-cut as it seems, as evidenced by the fact that the 10-year yield has been below the fed-funds rate since November. Despite the Fed continuing to hike rates, 10-year yields have remained relatively stable.
Theoretically, the fed-funds rate should impact the supply of credit, if not the cost. Banks borrow at short-term rates and lend at long-term rates, with the gap between the two representing their profit margin on new loans. A larger gap incentivizes banks to lend more, while a slim or inverted spread discourages lending. Traditionally, the US Treasury yield curve is used to assess this gap, with fed-funds or 3-month yields at the short end and 10-year yields at the long end. However, this only works if the fed-funds and 3-month rates align with banks’ actual funding costs.
In the past, they did align. The primary purpose of the fed-funds rate was to regulate banks’ funding costs, as the rate they pay to borrow from each other would reflect the costs of borrowing from depositors. However, the current banking landscape is different. Most banks, especially larger ones, have more deposits than they need and therefore keep savings and checking rates low for individuals. Despite the fed-funds target range being up to 5.25% – 5.5%, the average national savings deposit rate is only 0.43%. Given that loan growth is still positive, it is evident that a higher fed-funds rate has not had a significant impact on lending.
Looking at historical data, it is clear that GDP growth and fed-funds rates do not have a strong relationship. Exhibit 1 displays quarterly GDP growth alongside the monthly average effective fed-funds rate since 1954. Despite varying rates and rate changes, economic growth rates during expansions have remained relatively consistent. This challenges the notion that the Fed’s rate decisions in 2024 will dictate growth or have a significant impact on stocks.
Instead of fixating on interest rates, investors should focus on expected economic conditions, which have a greater influence on stock performance. Economic activity is the primary driver of corporate earnings, and as long as the economy is growing or accelerating, the level of interest rates should not be the determining factor for stocks. It is important to avoid the backwards view that places interest rates above all else in importance, as this could lead to overlooking what truly matters for the markets.
As a general rule, stock prices already incorporate widely observed factors. Currently, Fed rate moves fall under this category, rendering it useless for investors to obsess over them. Stocks have already adjusted and performed well through multiple rounds of rate hikes, proving that they have moved on from this concern. It would be wise for investors to do the same and focus on more impactful factors.