Should Credit Unions Fear The Fed?

If and when the Federal Reserve finally raises the overnight funds rate, the bond market will already be way ahead.

Barring some major international incident between now and Dec. 16, the Federal Reserve will most likely raise the federal funds rate on that date for the first time since June 2006. This will also represent the first rate change of any kind since December 2008, when the Fed cut the rate to 0.0-0.25%.

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Conventional wisdom says interest rates will rise once this happens. In fact, this is a big selling point mortgage lenders make in their ads to refinance and why real estate agents are urging clients to buy now.

As portfolio managers or mortgage lenders, should credit unions fear the Fed?

The short answer is a flat no. Never forget the Fed dictates only one market rate, and that rate is the overnight funds rate. The Fed can try to influence other rates, but it cannot control them. The bond market that collection of traders, investors, portfolio managers, and pure speculative fund managers is what sets all other rates.

At the beginning of the last tightening cycle in June 2004, the Fed, under the leadership of Alan Greenspan, raised the funds rate from 1.00% to 1.25%. This instigated the infamous measured pace tightening cycle. The last move of that cycle occurred in June of 2006 when Bernanke finished what Greenspan started by raising the funds rate to 5.25%.

With the Fed tightening by a whopping 425 basis points, did longer-term rates soar?

No. But let’s look at what did happen.

By the time Greenspan tightened in June 2004, the yield on the 10-year Treasury note was 4.75%. Less than a year earlier, the yield was 3.00%, but the bond market had rightly guessed the Fed was late to the party and pushed the 10-year to 4.75% while the Fed stood pat. Three months after the Fed finally tightened, the 10-year yield was down to 4.1%. From that point until the final tightening, the 10-year yield rarely moved higher than 4.75% and was 4.75% at the end of the cycle.

The bond market has often gone against the Fed, and the win-loss record is heavily in favor of the bond market.

By the time the Fed eased for the first time in September 2007, the 10-year yield was down to 4.35% versus the 5.25% funds rate. The bond market was way ahead of the Fed once again.

The bond market has often gone against the Fed, and the win-loss record is heavily in favor of the bond market. Most of those times have come when the the bond market rightly judged the Fed to have tightened too much, eased too much, or stayed too long with one policy.

There are times when a flight-to-quality trade or other unexpected disruption moves the bond market, but eventually it comes down to the economy and inflation. The Fed might see it one way, and the market might see it another way. The market will price rates where it sees fit and leave the overnight funds rate to the Fed.

So, what is likely this time around?

If it happens, a December rate increase by the Federal Reserve will be the most advertised rate increase ever. The bond market will care less. The market will have priced in that first rate increase and the Fed move will have no impact on longer-term rates whatsoever. If the yield on the 10-year Treasury note is 2.25% the day of the rate increase, it won’t be far from that the next day.

A rise in wages would be the first sign that bond traders might head for the exits.

What really matters is what comes next. Currently the bond market is priced for a one and done Fed tightening. Big global bond traders believe global economic weakness and the stronger dollar will limit future growth if not sink the economy. More importantly, the bond market is betting inflation will simply not be a factor for years to come. But that bond market psychology could change. Traders are not afraid to switch sides mid-game.

Core inflation has been very steady just below 2% for several years. As long as inflation continues to hold, bond rates will go up very little if at all. But any variation or sign that inflation could rise, and bond rates will rise.

Be especially attentive to wages. A rise in wages would be the first sign that bond traders might head for the exits. The bond market doesn’t have to see inflation; it just has to fear it. Currently, there is no fear of inflation and certainly no fear of the Fed. Should bond traders start to fear inflation, rates will rise and the longer the Fed waits to respond, the worse it could be.

Feel free to worry about the economy and think about the inflation/deflation argument, but don’t bother wondering what will happen when the Fed tightens. The markets will be way ahead.

Dwight Johnston is the chief economist of the California and Nevada Credit Union Leagues and president of Dwight Johnston Economics. He is the author of a popular commentary site and is a frequent speaker at credit union board planning sessions and industry conferences.

November 5, 2015

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