You Need To Know The Fed ISN’T Important. Here’s Why 1

July 26, 2021

You Need To Know The Fed ISN’T Important. Here’s Why 1

Asking the question almost feels sacrilegious, given how everyone is taught that the central bank sits in the middle of modern finance, and that nothing happens in markets without their sanction.

On top of this, the vast majority of financial folk believe what they were taught, which makes questioning the central bank-centric model a lot more difficult.

But, do central banks actually control interest rates?

Let us first consider this question from an empirical perspective, comparing US Treasury yields with the Federal Funds Target Rate (FFR).

If central banks really are omnipotent, then the Fed, being the most important one of them all, should have control over short term US rates. “Control” in this case meaning the Fed’s policy decisions regarding the FFR defines turning points in short term US rates.

After all, if the Fed really controls interest rates, then rates must do what the Fed says.

The FFR is compared against yields on the US 2 year Note, as this is the longest maturity over which the Fed’s policy rate is thought to directly influence.

Also, the FFR data in the chart combines the single rate that it was before December ‘08 with the lower bound of the target range that the Fed switched to after.

Looking at the above chart, it is quite clear that the Fed follows, rather than leads markets. In interest rate cycles going back to 1984, the Fed has always cut rates after 2y yields peaked.

While this delay was not too egregious, the last two cycles saw the Fed wait for longer periods of time before cutting rates. During the months leading up to the Great Financial Crisis, the Fed only cut rates in September 2007, about 15 months after 2 year yields peaked in June 2006.

There was a similar delay going into 2020’s recession, with the Fed cutting rates in September 2019, almost a year after 2 year yields peaked in October 2018.

Both scenarios will forever be remembered for the financial maelstroms that followed, with Wall Street’s implosion in 2008 and Covid induced lockdowns in 2020, but rate cuts prior to these events point toward recessionary conditions already being in place.

More importantly, the rate cuts coming about a year after 2 year yields made their highs point towards the US Treasury market pricing in recessionary conditions before the Fed.

Now, looking at rate hikes, we observe the same patterns.

Firstly, going back to 1984, the Fed has only ever raised rates after 2 year yields made their lows.

Secondly, just as with rate cuts, the Fed is taking longer to raise rates. However, it is important to note that this only applies to one rate hike cycle, in December 2015, which came about 52 months after the 2 year yield made its lows in August 2011.

If the Fed is always lagging the UST market, doesn’t that, by definition, make the market the leader, and the Fed the follower?