It is essential for anyone that invests in financial markets to understand the Fed's monetary policy decisions and the rationale behind them. Understanding the FOMC policies and the direction of the Fed Funds target rate provide insights into financial market trends, including stocks, bonds, commodities, and currencies.
The Federal Reverse meets eight (8) times per year. It uses the Federal Open Market Committee (FOMC) to announce monetary policies. The Fed maintained the federal funds rate near zero as recently as the first quarter of 2022, buying billions of bonds to stimulate the economy.
The Fed finally raised its target range for the federal funds rate during the 3/17/22 FOMC from 0%-0.25% to 0.25%-0.50%. Since then, Chair Powell and the Fed have embarked upon eight (8) additional consecutive rate hikes to contain rising inflation. With the recent 3/2/23 rate hike of 0.25, the Federal Funds target rate has skyrocketed to 4.75%-5.00%.
The Fed's mandate is to promote maximum employment, financial stability, stable prices, and consistent long-term interest rates. Fed Funds rates can dramatically influence the interest rates banks charge. Actions from the Fed through raising and lowering the Fed Funds rate are critical to 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 the prime rate, credit cards, car loans, mortgages, and other lending rates. Fed indirectly controls the credit markets, impacting the short end of the curve.
The Fed 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, if the economy grows too quickly and inflation pressures rise, the Fed will need to increase interest rates to slow down spending and borrowing.
Only time will tell if Powell and the Fed's actions can engineer a soft landing. In the meantime, a historical review of the Effective Federal Funds Rate chart and the two-year US Treasury yield may offer insights into pivotal turns in US interest rates.
Since 1972, the monthly chart of the Effective Federal Funds Rate (4.65 - Apr 2023) suggests when the monthly RSI overbought/oversold indicator first enters oversold levels (below 30), it has resulted in the FedRate staying at oversold levels for 38 months to 49 months. Oversold readings occurred during Dec 1990-Feb 1994, Apr 2001-Aug 2004, Mar 2008-Apr 2012, and recently Mar 2020-Apr 2022.
The 3/17/22 Fed rate of 25 bps has triggered a sharp rise in the Effective Funds Rate, as RSI quickly jumped from oversold (RSI is less than 30) to overbought (RSI is greater than 70). It is the quickest and steepest jump in the past 50 years.
How long can the Effective Fed Funds Rate stay overbought before reversing?
The Effective Funds Rate is now very overbought (RSI is 94.90). There have been seven (7) previous occurrences of overbought conditions, including Apr 1973-Aug 1974 (16 months), May 1978-May 1980 (24 months), Jan 1989-Jun 1989 (5 months), Sept 1994-Nov 1994 (14 months), Mar 2000-Dec 2000 (9-months), Dec 2005-Aug 2007 (20-months), Dec 2015-Aug 2019 (44-months). The average duration for the Effective Funds Rate staying in overbought levels is 19 months.
It has been 13 months of overbought readings so far. The Effective Fed Funds Rate has broken out of structural resistance above the top of its 42-year downtrend channel (2.39) and Apr 2019 high (2.42). Also, the MACD and the PPO price momentum indicators have broken above pivotal resistances.
The next resistance for Effective Fed Funds Rate is 5.26 (2006/2007 highs) and above this to 6.05-6.54 (1995 and 2000 highs).
Since the previous seven (7) overbought conditions averaged 19 months, this would imply the Effective Fed Funds Rate will peak during the second half of 2023.
Will another 25-50 bps hike take the Effective Funds Rate to critical resistance near the 2006/2007 highs at 5.26%?
On the downside, pivotal support is 2.39-2.42, coinciding with the extension of the 1981 downtrend breakout and Apr 2010 high.
Will a decline below 2.39-2.42 signal reaffirm a peak in the Effective Fed Funds Rate and the start of the next downturn in interest rates?
Another study of the Effective Fed Funds Rate (3.08-Oct 2022) and the 2-year US Treasury yields (UST2Y - 4.51) show the short-end of the treasury rates tends to move well in advance of any Fed's rate hikes and cuts.
In May-2021, when the 2-year US Treasury yields broke out, it warned the FED was way behind the curve in its rate hikes. It signals the Fed's need to aggressively increase the pace of its hike rates to keep inflation from soaring.
After nine (9) rate hikes, the 2-year US Treasury yield has broken above its prior Oct 2018 peak of 2.88, trading to a recent high of 4.83 (Feb 2023).
Will the 2-year yields peak near 5.20% (Jun 2006 high)?
Is the Fed no longer behind the curve?
Does this imply the Fed is nearing the end of its tightening process?