How Does The Fed Rate Cut Affect Me?

A common question I receive is ‘what interest rate does the Federal Reserve Bank (“Fed”) control’ and ‘how does it affect me?’ Since I’ve received the question a few times, here’s a memo!

The Fed controls the very shortest maturity rate called the Federal Funds rate. It is the interest rate that banks charge each other to lend overnight. 

Banks have something called Reserve Balances, or an amount that the Federal Reserve requires them to maintain in their banks on a daily basis. This is to ensure that they can meet redemptions by customers.

If they are below that reserve balance, they can borrow from other banks who have a surplus in order to meet their daily requirement. The surplus bank lending to the deficit bank loans the capital at the Federal Funds rate.

This interest rate is set by the Federal Open Market Committee (“FOMC”) which is a subset of governors and other officials at the Federal Reserve. They meet every seven weeks but can adjust the rate outside of those meetings in rare circumstances.

Why Does The Federal Reserve Change This Rate?

The FOMC typically changes the rate to fulfill their dual mandate, which is to keep prices stable with inflation at a target of 2.0%, and to maintain full employment in the economy. 

In a recent memo, I stated that you can think of the Federal Funds rate as a “brake” on the economy. The higher you place the rate, the harder they are pumping the brakes on the economy.

Why would they want to pump on the brakes?

The number one reason would be to prevent the economy from overheating and spurring inflation. This is what the Fed was doing in the last year- pressing hard on the brakes to reduce the rate of inflation.

And it worked!  Inflation is down from over +9% in June 2022 to +2.5% last month.

Likewise, when the economy is in recession or stalling out, they reduce the rate to stimulate economic activity. 

How Does The Rate Change Affect Me?

Since Fed Funds is the benchmark rate, borrowing costs for all types of loans and credit should decrease. The most common are on credit cards, home equity lines, and some student loans, which tend to be ‘floating rate’ meaning that they change with some short-term rate benchmark.

Household debt today is primarily fixed coupon meaning the payment rate doesn’t change as interest rates change. Americans were smart and locked in the ultra-low rates we saw shortly after Covid. 

However, most of our clients would be better classified as savers. They have very little debt (if any) and the debt they do have is the fixed variety mentioned above.

The drop in rates is more likely negatively affecting them via lower yields on their savings. For example, the 10-year US treasury bond yielded just over 5% a year ago. Today the yield is down to 3.75%. That’s a 25% haircut to your income.

That can be seen across many differing types of financial products including money market funds, certificates of deposit (“CDs”), and high yield savings accounts at banks.

The most common question or thing I see is about the 30-year mortgage. Technically speaking, Fed Funds has no relationship with the 30-year mortgage rate. That said, there is a loose relationship between longer-dated treasury bonds and mortgage rates so a reduction in the Fed Funds may put a small amount of downward pressure on mortgages. 

In general, 30-year mortgage rates are typically 2% to 2.5% above the 10-year rate. Today, they are a bit more than that because investors are not as willing to purchase secondary mortgages as investments given the prospect of homeowners refinancing them quickly.

Over the last year, we’ve seen several trillion dollars flow into money markets as they finally earned you a decent amount of yield. The Schwab money market rate is now 4.76%, after peaking at 5.37% about 10 months ago. 

As the Fed cuts rates further money market and CD yields will decline much lower. If the market is correct about the number of rate cuts through the end of next year, money market rates could be as low as 3.0% or below by January 2026. 

We think money will start to flow out of money markets sometime next year and into longer-dated bonds.  This is why we’ve been purchasing bonds with fixed coupons with maturities as long as 30 years ahead of this occurrence. Investors will soon be jumping over each other wanting those bonds to lock in the much higher yields then what will be available by then in money market funds.

If you have a significant amount of money in money markets or high yield savings accounts and are not going to need the money over the next 9-15 months, consider having that money invested in longer dated bonds. 

As always, we appreciate the trust you place in us. 

Sincerely,

Mark J Asaro, CFA