Effective Fed Funds Rate and 2-year Treasury Yields
The Federal Reverse meets eight times per year and uses its Federal Open Market Committee (FOMC) to announce monetary policies. Fed raised its target range for the federal funds rate in the Mar 2022 FOMC from 0%-0.25% to 0.25%-0.50%. Chair Powell and the Fed will now embark on a rate-hiking process to contain rising inflationary pressure.
The objective of the FOMC continues to be to promote maximum employment, stable prices, and consistent long-term interest rates. Fed Funds rates can dramatically influence the interest rates banks charge. Actions from the Fed when rising and lowering the Fed Funds rate are critical to the economic stability, economic recovery, inflation, cost of borrowing, and lending activities, among others.
The Fed controls the Fed Funds Rate, which directly influences the prevailing US interest rates such as prime rate, credit cards, car loans, mortgages, and other lending rates. Fed indirectly controls credit by controlling the short-end of the curve. It will lower interest rates to allow for cheaper rates for businesses to borrow money, invest, and hire employees to strengthen the economy when the economy slows. FED can also lower interest rates to entice consumers to spend more and borrow, leading to higher economic growth. On the other hand, when the economy grows too fast, and inflation skyrockets, the Fed will increase interest rates to slow down spending and borrowing.
Although it is difficult to know if the FED's actions will lead to a soft landing, a quick review of the Effective Federal Funds Rate chart and the two-year US Treasury yield may offer investors insights into pivotal turns in interest rates.
The following chart of the Effective Federal Funds Rate (0.20) from 1972 suggests when the monthly RSI overbought/oversold indicator first enters oversold levels (below 30), it has resulted in the Effective Federal Funds Rate staying at oversold levels for 38-months to 49-months. For instance, oversold readings occurred during Dec 1990-Feb 1994, Apr 2001-Aug 2004, Mar 2008-Apr 2012, and recently from Mar 2020-Mar 2022. The average duration of the four (4) previous oversold conditions is around 38-months. The current 2-year overbought condition sustained from Mar 2020 to Mar 2022 is the shortest in the past five (5) decades.
Although a higher-low pattern has developed at 0.5 (May 2020) and 0.6 (May 2021), there is crucial initial resistance at 0.15-0.20 (May 2010 and 2013/2014 highs). A breakout here signals a rise in the Effective Federal Funds Rate to 0.34 (the bottom of the long-term downtrend channel and the extension of a previous breakdown.
However, above 0.34 warns of a sustainable rally toward 2.42-2.54 (top of the downtrend channel and Apr 2019 high). Note the monthly PPO price momentum indicator is rebounding from extreme overbought levels, coinciding with the 2010 lows.
Another study of the Effective Fed Funds Rate (0.20) and the 2-year US Treasury yields (UST2Y - 2.28) shows the short-end of the treasury rates moving well in advance of any Fed's rate hikes and cuts. Since early last year (2021), the 2-year US Treasury yields have rallied 220 basis points, signaling the Fed needs to hike rates aggressively into the end of the year and 2023. The acceleration in the 2-year US Treasury yields nears a critical phase, corresponding to the previous Oct 2018 peak of 2.88. Effective Federal Funds Rate is far from its Apr 2019 peak of 2.42, suggesting the Fed is well behind in its rate hikes.
Investors need to closely track the 2-year interest rates near the Oct 2018 high (2.88). A breakout above resistance warns of short-term rates rising to 5.20, coinciding with the Jun 2006 top. Watch the Effective Fed Funds Rate as the Apr 2019 high is 2.42, suggesting another 225-basis point move by the FED.
If the Fed hikes future rates in increments of 50 basis points, this implies another four to five rate hikes. On the other hand, if the Fed raises rates by 25 basis points in subsequent FOMC meetings, another nine rate hikes are required by the end of the year and into 2023.