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Writer's picturePeter Lee

Is the Fed still behind the curve?

The Federal Reverse meets eight times and uses its Federal Open Market Committee (FOMC) to announce monetary policies. Chair Powell and the Fed have been hawkish as it has raised its target range for the Federal Funds Rate six times starting in the Mar 2022 FOMC at 0%-0.25% to a current target range of 3.75%-4.00% (as of Nov 2, 2022). The FOMC meeting date and the rate change in bps are as follows: 3/17/22 (+25 bps), 5/5/22 (+50 bps), 6/16/22 (+75 bps), 7/27/22 (+75 bps), 9/21/22 (+75 bps), 11/2/22 (+75 bps).


Chair Powell and the Fed have embarked on a rate-hiking process to contain rising inflationary pressure. The objective of the FOMC continues 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 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 credit by controlling the short end of the curve. It will lower interest rates to allow for cheaper interest rates for businesses to borrow money, invest, and hire employees to strengthen the economy whenever 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 or hard 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 the directional trends of

US interest rates.


The enclosed monthly chart of the Effective Federal Funds Rate (3.08-Oct 2022) from 1972 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.


In the past 25 months, the FedRate has skyrocketed from oversold (RSI less than 30) to overbought (RSI above 70). It is the quickest and steepest jump in the past 50 years, as evidenced by the four (4) consecutive rate hikes of 75 bps in FedRate.


The question is - how long can the Effective Fed Funds Rate stay overbought?


The FedRate has been overbought (RSI above 70) for the past five (5) months, starting in May 2022. History shows mixed results regarding how long the FedRate can sustain overbought readings before mean reverting.


Sometimes the FedRate can stay in overbought conditions for couple-to-several years (i.e., May 1978-May 1980, Dec 2005-Aug 2007, and Dec 2015-Aug 2019). Other times, the FedRate remains in overbought conditions for only several months to 1-year plus (i.e., Apr 1973-Aug 1974, Jan 1989-Jun 1989, Sept 1994-Nov 1995, and Mar 2000-Dec 2000).


The monthly price chart of the FedRate and several technical indicators suggest an inflection point has developed as the FedRate challenges the top of the 42-year downtrend channel and the Dec 1992 low (2.54-2.92). Also, the MACD and the PPO price momentum indicators encounter pivotal resistances. A confirmed FedRate breakout would confirm the FedRate extending its rally to retest 5.26 (2006/2007 highs) and above this to 6.05-6.54 (1995 and 2000 highs). On the other hand, a reversal below 2.54-2.92 signals a potential top that sends the FedRate to 0.33 (bottom of the 40-plus year downtrend channel).


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 tend to move well in advance of any Fed's rate hikes and cuts. Since early last year (2021), the 2-year US Treasury yields have warned that the FED is behind the curve in its rate hikes and suggests the Fed must aggressively increase the pace of its hike rates into the end of 2022.


However, if we fast forward, the 2-year US Treasury yield has surpassed its previous Oct 2018 peak of 2.88.


Is the Fed still behind the curve?


Does the recent 2-year US Treasury yield breakout above 2.88 imply a retest of the Jun 2006 high (5.20)?


Does this also suggest the Fed Funds Rate may need to retest 5.26, coinciding with the Feb 2007 high?


Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com

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