(Un)Interest Rates

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Jason’s Random Words

By now you already know about the Federal Reserve’s decision to lower the federal funds rate by 50 basis points this past week. This is, in my roughly 15 years of as an active investor and finance pro, the most-covered interest rate cut I can remember and I don’t think it’s even close.

My knee-jerk reaction has been, this is a lot of noise. And to some extent I think that’s the correct reaction. Sure, there are some professional traders out there who’ve been able to create some profit, but I don’t think there’s a ton of opportunity for most retail investors to do the same. Sure, the billions of dollars held in cash will earn less yield now. That’s material. But I don’t think it really matters to almost any of us individually.

As a starting point, the inverted yield curve offers a hint where market makers have been expecting rates to go for some time.

Yield curve explained

The way lending works is the longer you want to borrow money, the higher rate you have to pay. Why? If I’m lending money, I want to be compensated for taking on the extra risk of lending it longer. You can see this in the respective interest rates of U.S. Treasuries, with the 10-year historically paying a higher yield than, say, two-year Treasuries or 3-month T Bills.

But sometimes, the yield curve “inverts” and long-term rates end up lower than short-term rates.

Historically, this has usually been bad

More often than not, the U.S. has gone into a recession within a couple of years of the yield curve inverting. We saw it happen prior to the early 2000’s recession, the Global Financial Crisis, and the Coronavirus recession. That’s three-for-three this century.

It’s more correlation than causation, but the underlying factors behind the inversion are that the market expects interest rates will fall, but in the interim, short-term rates follow the federal funds rate, while longer-term rates, to badly use a sports metaphor, skate where the interest rate puck is expected to go.

And that’s where interest rates have been since roughly late 2022, with short-term rates skyrocketing, and longer-term rates rising, but just not nearly as quickly at short-term rates.

So here we are, and the Fed is cutting rates to support an economy that’s cooling off. The yield curve is inverted. We are three-for-three with recessions following inverted yield curves this century.

Sticking the landing?

Thing is, we don’t always see a recession after the yield curve inverts. We are already approaching two years since the inversion, and (probably) no recession yet. It seems that more and more consensus is growing around the idea that the Fed could stick the landing, to abuse another perfectly good sports metaphor. Back in the mid 1990s, the Greenspan-led Fed did just that, lowering rates before things got too bad, setting the economy up for a booming near-decade to follow.

By now, I’m sure you are desperately hoping for a point. I have some:

• Expect to quickly see your cash savings, money market, and short-term CD rates fall quickly. The gravy train of 5% yields on cash are probably over.

• That’s really about it.

I think wonks like me and financial media have made this seem like a bigger deal than it is. For the former it’s because we find it interesting, for the latter it’s because they need to give you a(nother) reason to keep tuning or logging in.

Let me put it another way. I don’t think this rate cut directly matters for most of us. Sure, there are plenty of people on the margins who will now buy a home or a car, and lower capital costs will boost lending for businesses looking to expand or refinance debt. And when you take all of those marginal borrowers and combine them, it’s a very big number that should drive economic activity.

If you’re a hammer…

To sum it up, this interest rate cut probably won’t matter to you individually at all. But it matters in the aggregate to all of us. Maybe a lot, depending on what happens with the economy.

We are always working with imperfect information, so we diversify to hedge against ignorance and how we each are wired and biased. This is where holding cash and bonds can offset the near-term uncertainty and risk inherent in owning stocks, while also helping us reduce the impact of our own worst profit-chasing or overly-conservative loss-avoiding tendencies.

Jason