Data Update 4 for 2025: Interest Rates, Inflation and Central Banks!

It was an interesting year for interest rates in the United States, one in which we got more evidence on the limited power that central banks have to alter the trajectory of market interest rates. We started 2024 with the consensus wisdom that rates would drop during the year, driven by expectations of rate cuts from the Fed. The Fed did keep its end of the bargain, cutting the Fed Funds rate three times during the course of 2024, but the bond markets did not stick with the script, and market interest rates rose during the course of the year. In this post, I will begin by looking at movements in treasury rates, across maturities, during 2024, and the resultant shifts in yield curves. I will follow up by examining changes in corporate bond rates, across the default ratings spectrum, trying to get a measure of how the price of risk in bond markets changed during 2024.

Treasury Rates in 2024

    Coming into 2024, interest rates had taken a rollicking ride, surging in 2022, as inflation made its come back, before settling in 2023. At the start of 2024, the ten-year treasury rate stood at 3.88%, unchanged from its level a year prior, but the 3-month treasury bill rate had climbed to 5.40%. In the chart below, we look the movement of treasury rates (across maturities) during the course of 2024:

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During the course of 2024, long term treasury rates climbed in the first half of the year, and dropped in the third quarter, before reversing course and increasing in the fourth quarter, with the 10-year rate ending  the year at 4.58%, 0.70% higher than at the start of the year. The 3-month treasury barely budged in the first half of 2024, declined in the third quarter, and diverged from long term rates and continued its decline in the last quarter, to end the year at 4.37%, down 1.03% from the start of the year. I have highlighted the three Fed rate actions, all cuts to the Fed Funds rate, on the chart, and while I will come back to this later in this post, market rates rose after all three.

    The divergence between short term and long term rates played out in the yield curve, which started 2024, with a downward slope, but flattened out over the course of the year:

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Writing last year about the yield curve, which was then downward sloping, I argued that notwithstanding prognostications of doom,  it was a poor prediction of recessions. This year, my caution would be to not read too much, at least in terms of forecasted economic growth, into the flattening or even mildly upward sloping yield curve. 

    The increase in long term  treasury rates during the course of the year was bad news for treasury bond investors, and the increase in the 10-year treasury bond rate during the course of the year translated into an annual return of -1.64% for 2024:

With the inflation of 2.75% in 2024 factored in, the real return on the 10-year bond is -4.27%. With the 20-year and 30-year bonds, the losses become larger, as time value works its magic. It is one reason that I argue that any discussion of riskfree rates that does not mention a time horizon is devoid of a key element. Even assuming away default risk, a ten-year treasury is not risk free, with a one time horizon, and a 3-month treasury is definitely not riskfree, if you have a 10-year time horizon.

The Drivers of Interest Rates

    Over the last two decades, for better or worse, we (as investors, consumers and even economics) seem to have come to accept as a truism the notion that central banks set interest rates. Thus, the answer to questions about past interest rate movements (the low rates between 2008 and 2021, the spike in rates in 2022) as well as to where interest rates will go in the future has been to look to central banking smoke signals and guidance. In this section, I will argue that the interest rates ultimately are driven by macro fundamentals, and that the power of central banks comes from preferential access to data about these fundamentals, their capacity to alter those fundamentals (in good and bad ways) and the credibility that they have to stay the course.

Inflation, Real Growth and Intrinsic Riskfree Rates

    It is worth noting at the outset that interest rates on borrowing pre-date central banks (the Fed came into being in 1913, whereas bond markets trace their history back to the 1600s), and that lenders and borrowers set rates based upon fundamentals that relate specifically to what the former need to earn to cover  expected inflation and default risk, while earning a rate of return for deferring current consumption (a real interest rate). If you set the abstractions aside, and remove default risk from consideration (because the borrower is default-free), a riskfree interest rate in nominal terms can be viewed, in its simplified form, as the sum of the expected inflation rate and an expected real interest rate:

Nominal interest rate = Expected inflation + Expected real interest rate

This equation, titled the Fisher Equation, is often part of an introductory economics class, and is often quickly forgotten as you get introduced to more complex (and seemingly powerful) monetary economics lessons. That is a pity, since so much of misunderstanding of interest rates stems from forgetting this equation. I use this equation to derive what I call an "intrinsic riskfree rate", with two simplifying assumptions:

1. Expected inflation: I use the current year's inflation rate as a proxy for expected inflation. Clearly, this is simplistic, since you can have unusual events during a year that cause inflation in that year to spike. (In an alternate calculation, I use an average inflation rate over the last ten years as the expected inflation rate.)
2. Expected real interest rate: In the last two decades, we have been able to observe a real interest rate, at least in the US, using inflation-protected treasury bonds(TIPs). Since I am trying to estimate an intrinsic real interest rate, I use the growth rate in real GDP as my proxy for the real interest rate. That is clearly a stretch when it comes to year-to-year movements, but in the long term, the two should converge.

With those simplistic proxies in place, my intrinsic riskfree rate can be computed as follows:

Intrinsic riskfree rate = Inflation rate in period t + Real GDP growth rate in period t

In the chart below, I compare my estimates of the intrinsic riskfree rate to the observed ten-year treasury bond rate each year:

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While the match is not perfect, the link between the two is undeniable, and the intrinsic riskfree rate calculations yield results that help counter the stories about how it is the Fed that kept rates low between 2008 and 2021, and caused them to spike in 2022. 

• While it is true that the Fed became more active (in terms of bond buying, in their quantitative easing phase) in the bond market in the last decade, the low treasury rates between 2009 and 2020 were driven primarily by low inflation and anemic real growth. Put simply, with or without the Fed, rates would have been low during the period.
• In 2022, the rise in rates was almost entirely driven by rising inflation expectations, with the Fed racing to keep up with that market sentiment. In fact, since 2022, it is the market that seems to be leading the Fed, not the other way around.
  

Entering 2025, the gap between intrinsic and treasury rates has narrowed, as the market consensus settles in on expectations that inflation will stay about the Fed-targeted 2% and that economic activity will be boosted by tax cuts and a business-friendly administration.

The Fed Effect

    I am not suggesting that central banks don't matter or that they do not affect interest rates, because that would be an overreach, but the questions that I would like to address are about how much of an impact central banks have, and through what channels. To the first question of how much of an impact, I started by looking at the one rate that the Fed does control, the Fed Funds rate, an overnight interbank borrowing rate that nevertheless has resonance for the rest of the market. To get a measure of how the Fed Funds rate has evolved over time, take a look at what the rate has done between 1954 and 2024:

As you can see the Fed Funds was effectively zero for a long stretch in the last decade, but has clearly spiked in the last two years. If the Fed sets rates story is right, changes in these rates should cause market set rates to change in the aftermath, and in the graph below, I look at monthly movements in the Fed Funds rate and two treasury rates - the 3-month T.Bill rate and the 10-year T.Bond rate.

The good news for the "Fed did it" story is that the Fed rates and treasury rates clearly move in unison, but all this chart shows is that Fed Funds rate move with treasury rates contemporaneously, with no clear indication of whether market rates lead to Fed Funds rates changing, or vice versa. To look at whether the Fed funds leads the rest of the market, I look at the correlation between changes in the Fed Funds rate and changes in treasury rates in subsequent months. 

As you can see from this table, the effects of changes in the Fed Funds rate on short term treasuries is positive, and statistically significant, but the relationship between the Fed Funds rate and 10-year treasuries is only 0.08, and barely meets the statistical significance test. In summary, if there is a case to be made that Fed actions move rates, it is far stronger at the short end of the treasury spectrum than at the long end, and with substantial noise in predictive effects. Just as an add on, I reversed the process and looked to see if the change in treasury rates is a good predictor of change in the Fed Funds rate and obtained correlations that look very similar. 

In short, the evidence is just as strong for the hypothesis that market interest rates lead the Fed to act, as they are for "Fed as a leader" hypothesis.

    As to why the Fed's actions affect market interest rates, it has less to do with the level of the Fed Funds rate and more to do with the market reads into the Fed's actions. Ultimately, a central bank's effect on market interest rates stems from three factors:

1. Information: It is true that the Fed collects substantial data on consumer and business behavior that it can use to make more reasoned judgments about where inflation and real growth are headed than the rest of the market, and its actions often are viewed as a signal of that information. Thus, an unexpected increase in the Fed Funds rate may signal that the Fed sees higher inflation  than the market perceives at the moment, and a big drop in the Fed Funds rates may indicate that it sees the economy weakening at a time when the market may be unaware.
2. Central bank credibility: Implicit in the signaling argument is the belief that the central bank is serious in its intent to keep inflation in check, and that is has enough independence from the government to be able to act accordingly. A central bank that is viewed as a tool for the government will very quickly lose its capacity to affect interest rates, since the market will tend to assume other motives (than fighting inflation) for rate cuts or raises. In fact, a central bank that lowers rates, in the face of high and rising inflation, because it is the politically expedient thing to do may find that market interest move up in response, rather than down.
3. Interest rate level: If the primary mechanism for central banks signaling intent remains the Fed Funds rate (or its equivalent in other markets), with rate rises indicating that the economy/inflation is overheating and rate cuts suggesting the opposite, there is an inherent problem that central banks face, if interest rates fall towards zero. The signaling becomes one sided i.e., rates can be raised to put the economy in check, but there is not much room to cut rates. This, of course, is exactly what the Japanese central bank has faced for three decades, and European and US banks in the last decade, reducing their signal power.

The most credible central banks in history, from the Bundesbank in Deutsche Mark Germany to the Fed, after the Volcker years, earned their credibility by sticking with their choices, even in the face of economic disruption and political pushback. That said, in both these instances, central bankers chose to stay in the background, and let their actions speak for themselves. Since 2008, central bankers, perhaps egged on by investors and governments, have become more visible, more active and, in my view, more arrogant, and that, in a strange way, has made their actions less consequential. Put simply, the more the investing world revolves around FOMC meetings and the smoke signals that come out of them, the less these meetings matter to markets. 

Forecasting Rates

    I am wary of Fed watchers and interest rate savants, who claim to be able to sense movements in rates before they happen for two reasons. First, their track records are so awful that they make soothsayers and tarot card readers look good. Second, unlike a company's earnings or risk, where you can claim to have a differential advantage in estimating it, it is unclear to me what any expert, no matter how credentialed, can bring to the table that gives them an edge in forecasting interest rates. In my valuations, this skepticism about interest rate forecasting plays out in an assumption where I do not try to second guess the bond market and replace current treasury bond rates with fanciful estimates of normalized or forecasted rates. If you look back at my S&P 500 valuation in my second data post for this year, you will see that I left the treasury bond rate at 4.58% (its level at the start of 2025) unchanged through time.

     If you feel the urge to play interest forecaster, I do think that it is good practice to make sure that your views on the direction of interest rates are are consistent with the views of inflation and growth you are building into your cash flows. If you buy into my thesis that it is changes in expected inflation and real growth that causes rates to change in interest rates, any forecast of interest rates has be backed up by a story about changing inflation or real growth. Thus, if you forecast that the ten-year treasury rate will rise to 6% over the next two years, you have to follow through and explain whether rising inflation or higher real growth (or both) that is triggering this surge, since that diagnosis have different consequences for value. Higher interest rates driven by higher inflation will generally have neutral effects on value, for companies with pricing power, and negative effects for companies that do not. Higher interest rates precipitated by stronger real growth is more likely to be neutral for the market, since higher earnings (from the stronger economy) can offset the higher rates. The most empty forecasts of interest rates are the ones where the forecaster's only reason for predicting higher or lower rates is central banks, and I am afraid that the discussion of interest rates has become vacuous over the last two decades, as the delusion that the Fed sets interest rates becomes deeply engrained.

Corporate Bond Rates in 2024

    The corporate bond market gets less attention that the treasury bond market, partly because rates in that market are very much driven by what happens in the treasury market. Last year, as the treasury bond rate rose from 3.88% to 4.58%, it should come as no surprise that corporate bond rates rose as well, but there is information in the rate differences between the two markets. That rate difference, of course, is the default spread, and it will vary across different corporate bonds, based almost entirely on perceived default risk. 

Default spread = Corporate bond rate - Treasury bond rate on bond of equal maturity

Using bond ratings as measures of default risk, and computing the default spreads for each ratings class, I captured the journey of default spreads during 2024:

During 2024, default spreads decreased over the course of the year, for all ratings classes, albeit more for the lowest rated bonds. Using a different lexicon, the price of risk in the bond market decreased during the course of the year, and if you relate that back to my second data update, where I computed a price of risk for equity markets (the equity risk premium), you can see the parallels. In fact, in the graph below, I compare the price of risk in both the equity and bond markets across time:

In most years, equity risk premiums and bond default spreads move in the same direction, as was the case in 2024. That should come as little surprise, since the forces that cause investors to spike up premiums (fear) or bid them down (hope and greed) cut across both markets. In fact, lookin a the ratio of the equity risk premium to the default spread, you could argue that equity risk premiums are too high, relative to bond default spreads, and that you should see a narrowing of the difference, either with a lower equity premium (higher stock prices) or a higher default spread on bonds.

    The decline of fear in corporate bond markets can be captured on another dimension as well, which is in bond issuances, especially by companies that face high default risk. In the graph below, I look at corporate bond issuance in 2024, broken down into investment grade (BBB or higher) and high yield (less than BBB). 

Note that high yield issuances which spiked in 2020 and 2021, peak greed years, almost disappeared in 2022. They made a mild comeback in 2023 and that recovery continued in 2024. 

    Finally, as companies adjust to a new interest rate environment, where short terms rates are no longer close to zero and long term rates have moved up significantly from the lows they hit before 2022, there are two other big shifts that have occurred, and the table below captures those shifts:

First, you will note that after a long stretch, where the percent of bond that were callable declined, they have spiked again. That should come as no surprise, since the option, for a company, to call back a bond is most valuable, when you believe that there is a healthy chance that rates will go down in the future. When corporates could borrow money at 3%, long term, they clearly attached a lower likelihood to a rate decline, but as rates have risen, companies are rediscovering the value of having a  calculability option. Second, the percent of bond issuances with floating rate debt has also surged over the last three years, again indicating that when rates are low, companies were inclined to lock them in for the long term with fixed rate issuances, but at the higher rates of today,  they are more willing to let those rates float, hoping for lower rates in future years.

In Conclusion

    I spend much of my time in the equity market, valuing companies and assessing risk. I must confess that I find the bond market far less interesting, since so much of the focus is on the downside, and while I am glad that there are other people who care about that, I prefer to operate in a space where there there is more uncertainty. That said, though, I dabble in bond markets because what happens in those markets, unlike what happens in Las Vegas, does not stay in bond markets. The spillover effects into equity markets can be substantial, and in some cases, devastating. In my posts looking back at 2022, I noted how a record bad year for bond markets, as both treasury and corporate bonds took a beating for the ages, very quickly found its ways into stocks, dragging the market down. On that count, bond markets had a quiet year in 2024, but they may be overdue for a clean up.

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Data Updates for 2025

1. Data Update 1 for 2025: The Draw (and Danger) of Data!
2. Data Update 2 for 2025: The Party continued for US Equities
3. Data Update 3 for 2025: The times they are a'changin'!
4. Data Update 4 for 2025: Interest Rates, Inflation and Central Banks!
5. Data Update 5 for 2025: It's a small world, after all!
6. Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question!
7. Data Update 7 for 2025: The End Game in Business!
8. Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta!
9. Data Update 9 for 2025: Dividend Policy - Inertia and Me-tooism Rule!

Data Links

1. Intrinsic risk free rates and Nominal interest rates
2. Bond Default Spreads and Equity Risk Premiums

Fed up with Fed Talk? Fact-checking Central Banking Fairy Tales!

     The big story on Wednesday, September 18, was that the Federal Reserve’s open market committee finally got around to “cutting rates”, and doing so by more than expected. This action, much debated and discussed during all of 2024, was greeted as "big" news, and market prognosticators argued that it was a harbinger of market moves, both in interest rates and stock prices. The market seemed to initially be disappointed in the action, dropping after the Fed’s announcement on Wednesday, but it did climb on Thursday. Overall, though, and this is my view, this was about as anticlimactic as a climactic event gets, akin to watching an elephant in labor deliver a mouse.  As a long-time skeptic about the Fed’s (or any Central Bank’s) capacity to alter much in markets or the economy, I decided now would be as good a time as any to confront some widely held beliefs about central banking powers, and counter them with data. In particular, I want to start with the myth that central banks set interest rates, or at least the interest rates that you and I may face in our day-to-day lives, move on to the slightly lesser myth that the Fed's move lead market interest rates, then examine the signals that emanate supposedly from Fed actions, and finish off by evaluating how the Fed's actions affect stock prices.

The Fed as Rate Setter

      As I drove to the grocery story on Fed Cut Wednesday, I had the radio on, and in the news at the top of the hour, I was told that the Fed had just cut interest rates, and that consumers would soon see lower rates on their mortgages and businesses on their loans. That delusion is not restricted to newscasters, since it seems to be widely held among politicians, economists and even market watchers. The truth, though, is that the Fed sets only one interest rate, the Fed Funds rate, and that none of the rates that we face in our lives, either as consumers (on mortgages, credit cards or fixed deposits) or businesses (business loans and bonds),  are set by or even indexed to the Fed Funds Rate. 

    The place to start to dispel the “Fed sets rates” myth is with an understanding of the Fed Funds rate, an overnight intra-bank borrowing rate is one that most of us will never ever encounter in our lives. The Federal Open Market Committee (FOMC) has the power to change this rate, which it uses at irregular intervals, in response to economic, market and political developments. The table below lists the rate changes made by the Fed in this century:

Note that while most of these changes were made at regularly scheduled meetings, a few (eleven in the last three decades) were made at emergency meetings, called in response to market crises. As you can see from this table, the Federal Reserve goes through periods of Fed Funds rate activism, interspersed with periods of inactivity. Since the Fed Funds rate is specified as a range, there are periods where the effective Fed Funds rate may go up or down, albeit within small bounds. To gain perspective on how the Fed Funds rate has been changed over time, consider the following graph, where the effective fed funds rate is shown from 1954 to 2024:

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In addition to revealing how much the Fed Funds rate has varied over time, there are two periods that stand out. The first is the spike in the Fed Funds rate to more than 20% between 1979 and 1982, when Paul Volcker was Fed Chair, and represented his attempt to break the cycle of high inflation that had entrapped the US economy. The second was the drop in the Fed Funds rate to close to zero percent, first after the 2008 crisis and then again after the COVID shock in the first quarter of 2020. In fact, coming into 2022, the Fed had kept the Fed Funds rates at or near zero for most of the previous 14 years, making the surge in rates in 2022, in response to inflation, shock therapy for markets unused to a rate-raising Fed.

    While the Federal Open Market Committee controls the Fed Funds rate, there are a whole host of rates set by buyer and sellers in bond markets. These rates are dynamic and volatile, and you can see them play out in the movements of US treasury rates (with the 3-month and 10-year rates highlighted) and in corporate bond rates (with the Baa corporate bond rate shown).

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There is a final set of rates, set by institutions, and sometimes indexed to market-set rates, and these are the rates that consumers are most likely to confront in their day-to-day lives. They include mortgage rates, set by lenders, credit card rates, specified by the credit card issuers, and fixed deposit rates on safety deposits at banks.  They are not as dynamic as market-set rates, but they change more often than the Fed Funds rate.

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There are undoubtedly other interest rates you will encounter, as a consumer or a business, either in the course of borrowing money or investing it, but all of these rates will fall into one of three buckets - market-set interest rates, rates indexed to market-set rates and institutionally-set rates. None of these rates are set by the Federal Reserve, thus rendering the "Fed sets interest rates" as myth.

Response to comments: It is true that the prime rate remains one of the few that is tied to the Fed Funds rate, and that there is subset of business loans, whose rates are tied to the prime rate. That said, the portion of overall business debt that is tied to the prime rate has declined significantly over time, as variable rate loans have switched to treasury rates as indices, because they tend to be updated and dynamic. It is also true that central-bank set rates can affect a larger subset of rates in some countries, for one of two reasons. The first is that the country has poorly functioning or no bond markets, making market-set rates a non-starter. The second is if the government or central bank can force banks to lend at rates tied to the central bank rate. In both cases, though, the central banking power works only if it is restrained by reality, i.e., the central bank rate reflects the inflation and real growth in the economy. Thus, if inflation is 20%, a central bank that forces lenders to lend at 12% will accomplish one of two objectives - driving lending banks to calamity or drying up the market for business loans.

The Fed as Rate Leader

    Even if you accept that the Fed does not set the interest rates that we face as consumers and businesses, you may still believe that the Fed influences these rates with changes it makes to the Fed Funds rate. Thus, you are arguing that a rise (fall) in the Fed Funds rate can trigger subsequent rises (falls) in both market-set and institution-set rates. At least superficially, this hypothesis is backed up in the chart below, where I brings all the rates together into one figure:

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As you can see, the rates all seem to move in sync, though market-set rates move more than institution-set rates, which, in turn, are more volatile than the Fed Funds rate. The reason that this is a superficial test is because these rates all move contemporaneously, and there is nothing in this graph that supports the notion that it is the Fed that is leading the change. In fact, it is entirely possible, perhaps even plausible, that the Fed's actions on the Fed Funds rate are in response to changes in market rates, rather than the other way around.

    To test whether changes in the Fed Funds rate are a precursor for shifts in market interest rates, I ran a simple (perhaps even simplistic) test. I looked at the 249 quarters that compose the 1962- 2024 time period, breaking down each quarter into whether the effective Fed Funds rate increased, decreased or remained unchanged during the quarter. I followed up by looking at the change in the 3-month and 10-year US treasury rates in the following quarter:

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Looking at the key distributional metrics (the first quartile, the median, the third quartile), it seems undeniable that the "Fed as leader" hypothesis falls apart. In fact, in the quarters after the  Fed Funds rate increases, US treasury rates (short and long term) are more likely to decrease than increase, and the median change in rates is negative. In contrast, in the periods after the Fed Fund decreases, treasury rates are more likely to increase than decrease, and post small median increases. 

    Expanding this assessment to the interest rates that consumers face, and in particular mortgage rates at which they borrow and fixed deposit rates at which they can invest, the results are just as stark.

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In the quarter after the Fed Funds rate increase, mortgage rates and fixed deposit rates are more likely to fall than rise, with the median change in the 15-year mortgage rate being -0.13% and the median change in the fixed deposit rate at -0.05%. In the quarter after the Fed Funds rate decreases, the mortgage rate does drop, but by less than it did during the Fed rate raising quarters. In short, those of us expecting our mortgage rates to decline in the next few months, just because the Fed lowered rates on Wednesday, are being set up for disappointment. If you are wondering why I did not check to see what credit card interest rates do in response to Fed Funds rate changes, even a casual perusal of those rates suggests that they are unmoored from any market numbers.

    You may still be skeptical about my argument that the Fed is more follower than leader, when it comes to interest rates. After all, you may say, how else can you explain why interest rates remained low for the last decades, other than the Fed? The answer is recognizing that market-set rates ultimately are composed of two elements: an expected inflation rate and an expected real interest rate, reflecting real economic growth. In the graph below, which I have used multiple times in prior posts, I compute an intrinsic risk free rate by just adding inflation rate and real GDP growth each year:

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Interest rates were low in the last decade primarily because inflation stayed low (the lowest inflation decade in a century) and real growth was anemic. Interest rates rose in 2022, because inflation made a come back, and the Fed scrambled to catch up to markets, and most interesting, interest are down this year, because inflation is down and real growth has dropped. As you can see, in September 2024, the intrinsic riskfree rate is still higher than the 10-year treasury bond rate, suggesting that there will be no precipitous drop in interest rates in the coming months.

Response to comments: Some readers are suggesting a plausible, albeit convoluted, rationale for this result that preserves the Fed Delusion. In a version of 4D chess, they argue that investors in bond markets are largely in the business of forecasting what the Fed will do and that market rates move ahead of Fed actions. Besides being extraordinarily unhealthy for bond investing, if this is in fact what it is happening, there are four problems with this reasoning, First, bond markets pre-date central banks setting rates, and they seemed to do a reasonably good job before the Fed Funds rate was around. In fact, I started in investing in the 1980s, when the Fed went into hibernation on the Fed Funds rate, and trust me when I say the bond market did not miss a beat. Second, if the entire point of bond investing is forecasting what the Fed will do, how would you explain the rise in treasury bill and bond rates in the first half of 2024 (just to give one instance), when all the talk was about the Fed cutting rates, not raising them? Third, if bond markets exist to bet on Fed movements, when the Fed moves unexpectedly (by raising or lowering rates more than expected), there should be an immediate adjustment in the bond market? Thus, last week, when the consensus was that a 25 basis point cut was more likely than a 50 basis point one, there should be have a significant drop in treasury rates in the days after, and there was not. 

The Fed as Signalman

    If you are willing to accept that the Fed does not set rates, and that it does not lead the market on interest rates, you may still argue that Fed rate changes convey information to markets, leading them to reprice bonds and stocks. That argument is built on the fact that the Fed has access to data about the economy that the rest of us don't have, and that its actions tell you implicitly what it is seeing in that data. 

    It is undeniable that the Federal Reserve, with its twelve regional districts acting as outposts, collects information about the economy that become an input into its decision making. Thus, the argument that Fed actions send signals to the markets has basis, but signaling arguments come with a caveat, which is that the signals can be tough to gauge. In particular, there are two major macroeconomic dimensions on which the Fed collects data, with the first being real economic growth (how robust it is, and whether there are changes happening) and inflation (how high it is and whether it too is changing). The Fed's major signaling device remains the changes in the Fed Funds rate, and it is worth pondering what the signal the Fed is sending when it raises or lowers the Fed Funds rate. On the inflation front, an increase or decrease in the Fed Funds rate can be viewed as a signal that the Fed sees inflationary pressures picking up, with an increase, or declining, with a decrease. On the economic growth front, an increase or decrease in the Fed Funds rate, can be viewed as a signal that the Fed sees the economy growing too fast, with an increase, or slowing down too much, with a decrease. These signals get amplified with the size of the cut, with larger cuts representing bigger signals.

    Viewed through this mix, you can see that there are two contrary reads of the Fed Funds rate cut of 50 basis points on Wednesdays. If you are an optimist, you could take the action to mean that the Fed is finally convinced that inflation has been vanquished, and that lower inflation is here to stay. If you are a pessimist, the fact that it was a fifty basis point decrease, rather than the expected twenty five basis points, can be construed as a sign that the Fed is seeing more worrying signs of an economic slowdown than have shown up in the public data on employment and growth. There is of course the cynical third perspective, which is that the Fed rate cut has little to do with inflation and real growth, and more to do with an election that is less than fifty days away. In sum, signaling stories are alluring, and you will hear them in the coming days, from all sides of the spectrum (optimists, pessimists and cynics), but the truth lies in  the middle, where this rate cut is good news, bad news and no news at the same time, albeit to different groups.

Response to comments: Fed rate change signals, as I mentioned, are tough to read. If you have strong priors on the Fed having power to drive markets, you can always the benefit of hindsight to bend the signal to match your priors. 

The Fed as Equity Market Whisperer

    It is entirely possible that you are with me so far, in my arguments that the Fed's capacity to influence the interest rates that matter is limited, but you may still hold on to the belief that the Fed's actions have consequences for stock returns. In fact, Wall Street has its share of investing mantras, including "Don't fight the Fed", where the implicit argument is that the direction of the stock market can be altered by Fed actions. 

    There is some basis for this argument, and especially during market crises, where timely actions by the Fed may alter market mood and momentum. During the COVID crisis, I complimented the Fed for playing its cards right, especially so towards the end of March 2020, when markets were melting down, and argued that one reason that market came back as quickly as they did was because of the Fed. That said, it was not so much the 100 basis point drop in the Fed Funds rate that turned the tide, but the accompanying message that the Federal Reserve would become a backstop for lenders to companies that were rocked by the COVID shutdown, and were teetering on the edge. While the Fed did not have to commit much in capital to back up this pledge, that decision seemed to provide enough reassurance to lenders and prevent a host of bankruptcies at the time.

    If you remove the Fed's role in crisis, and focus on the effects of just its actions on the Fed Funds rate, the effect of the Fed on equity market becomes murkier. I extended the analysis that I did with interest rates to stocks, and looked at the change in the S&P 500 in the quarter after Fed Funds rates were increased, decreased or left unchanged:

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The S&P 500 did slightly better in quarters after the Fed Funds rate decreased than when the rate increased, but reserved its best performance for quarters after those where there was no change in the Fed Funds rate. At the risk of disagreeing with much of conventional wisdom, is it possible that the less activity there is on the part of the Fed, the better stocks do? I think so, and stock markets will be better served with fewer interviews and speeches from members of the FOMC and less political grandstanding (from senators, congresspeople and presidential candidates) on what the Federal Reserve should or should not do.

Response to comments: Here again, the 4D chess argument comes out, where equity markets are so clever and forward-looking, they already incorporate what the Fed will do. Without realizing it, you are making my case that when discussing equity markets and where they will go in the future, we should spend less time talking about what the Fed will do, might do or has not done, since if your premise about markets as forecasting machines is right, it is already in prices.

The Fed as Chanticleer

    If the Fed does not set rates, is not a interest rate driver, sends out murky signals about the economy and has little effect on how stocks move, you are probably wondering why we have central banks in the first place. To answer, I am going to digress, and repeat an ancient story about Chanticleer, a rooster that was anointed the ruler of the farmyard that he lived in, because the other barnyard animals believed that it was his crowing every morning that caused the sun to rise, and that without him, they would be destined for a lifetime of darkness. That belief came from the undeniable fact that every morning, Chanticleer's crowing coincided with sun rise and daylight. The story now takes a dark turn, when one day, Chanticleer sleeps in and the sun rises anyway, revealing his absence of power, and he loses his place at the top of the barnyard hierarchy. 

    The Fed (and every other central bank) in my view is like Chanticleer, with investors endowing it with powers to set interest rates and drive stock prices, since the Fed's actions and market movements seem synchronized. As with Chanticleer, the truth is that the Fed is acting in response to changes in markets rather than driving those actions, and it is thus more follower than leader. That said, there is the very real possibility that the Fed may start to believe its own hype, and that hubristic central bankers may decide that they set rates and drive stock markets, rather than the other way around. That would be disastrous, since the power of the Fed comes from the perception that it has power, and an over reach can lay bare the truth. 

Response to comments: My comments about the Fed being Chanticleer have been misread by some to imply that central banks do not matter, and Turkey (the country, not the Thanksgiving bird) seems to constantly come up constantly as an example of why central banks matter. Again, you are making my case for me. There is nothing more dangerous to an economy than a central bank that thinks it has the power to override fundamentals and impose its preferred interest rates in the economy. The Turkish central bank, perhaps driven by politics, seems to think that the solution to high interest rates (which are being driven by inflation) is to lower the rates that it controls. Not surprisingly, those actions increase expected inflation, and drive rates higher.... (see definition of insanity..)

Conclusion

    I know that this post cuts against the grain, since the notion that the Fed has superpowers has only become stronger over the last two decades. Pushed to explain why interest rates were at historic lows for much of the last decade, the response you often heard was "the Fed did it". Active investors, when asked why active investing had its worst decade in history, losing out to index funds and to passive investors, pointed fingers at the Fed. Market timers, who had built their reputations around using metrics like the Shiller PE, defended their failure to call market moves in the last fifteen years, by pointing to the Fed. Economists who argued that inverted yield curves were a surefire predictor of recessions blamed the Fed for the absence of a recession, after years of two years plus of the phenomena. 

    I believe that it is time for us to put the Fed delusion to rest. It has distracted us from talking about things that truly matter, which include growing government debt, inflation, growth and how globalization may be feeding into risk, and allowed us to believe that central bankers have the power to rescue us from whatever mistakes we may be making. I am a realist, though, and I am afraid that the Fed Delusion has destroyed enough investing brain cells, that those who holding on to the delusion cannot let go. I am already hearing talk among this group about what the FOMC may or may not do at its next meeting (and the meeting after that), and what this may mean for markets, restarting the Fed Watch. The insanity of it all! 

YouTube Video

Data

1. Fed Funds Rates, Treasury Rates and Other Market Interest rates - Historical
2. Intrinsic treasury bond rates

Interest Rates, Earning Growth and Equity Value: Investment Implications

The first quarter of 2021 has been, for the most part, a good time for equity markets, but there have been surprises. The first has been the steep rise in treasury rates in the last twelve weeks, as investors reassess expected economic growth over the rest of the year and worry about inflation. The second has been a shift within equity markets, a "rotation" in Wall Street terms, as the winners from last year underperformed the losers in the first quarter, raising questions about whether this shift is a long term one or just a short term adjustment. The answers are not academic, since they cut to the heart of how stockholders will do over the rest of the year, and whether value investors will finally be able to mount a comeback.

The Interest Rates Story 

To me the biggest story of markets in 2021 has been the rise of interest rates, especially at the long end of the maturity spectrum. To understand the story and put it in context, I will go back more than a decade to the 2008 crisis, and note how in its aftermath, US treasury rates dropped and stayed low for the next decade. 

Coming in 2020, the ten-year T.Bond rate at 1.92% was already close to historic lows. The arrival of the COVID in February 2020, and the ensuing market meltdown, causing treasury rates to plummet across the spectrum, with three-month T.bill rates dropping from 1.5% to close to zero, and the ten-year T.Bond rate declining to close to 0.70%. Those rates stayed low through the rest of 2020, even as equity markets recovered and corporate bond spreads fell back to pre-crisis levels. Coming into 2021, the ten-year T.Bond rate was at 0.93%, and I noted the contradiction in investor assessments for the rest of the year, with the consensus gathered around a strong economic comeback (with earnings growth following), but with rates continuing to stay low. In the first quarter of 2021, we continued to see evidence of economic growth, bolstered by a stimulus package of $1.9 trillion, but it does seem like the treasury bond market is starting to wake up to that recognition as well, as rates have risen strongly:

These rising rates have led to some hand wringing about why the Fed is not doing more to keep rates down, mostly from people who seem to have an almost mystical faith in the Fed's capacity to keep rates wherever it wants them to be. I would argue that the Fed has tried everything it can to keep rates from rising, and the very fact that rates have risen, in spite of this effort, is an indication of the limited power it has to set any of the rates that we care about in investing. To those who use the low interest rates of the last decade as proof of the Fed's power, I would counter with a graph that I have used many times before to illustrate the fundamental drivers of interest rates (and the Fed is not on that list):

The reason interest rates have been low for the last decade is because inflation has been low and real growth has been anemic. With its bond buying programs and its "keep rates low" talk, the Fed has had influence, but only at the margin. 

As for rates for the rest of the year, you may draw comfort from the Fed's assurances that it will keep rate low, but I don't. Put bluntly, the only rate that the Fed directly sets is the Fed Funds rate, and while it may send signals to the market with its words and actions, it faces two limits. 

• The first is that the Fed Funds rate is currently close to zero, limiting the Fed's capacity to signal with lower rates. 
• The second and more powerful factor is that the reason that a central bank is able to signal to markets, only if it has credibility, since the signal is more about what the Fed sees, using data that only it might have, about inflation and real growth in the future. Every time a Federal Reserve chair or any of the FOMC members make utterances that undercut that credibility, the Fed risks losing even the limited signaling power it continues to have. I believe that the most effective central bankers speak very little, and when they do, don't say much.

In particular, the Fed's own assessments of real growth of 6.5% for 2021 and inflation of 2.2% for the year are at war with its concurrent promise to keep rates low; after all, adding those numbers up yields a intrinsic risk free rate of 8.7%. While I understand that much of the real growth in 2021 is a bounce back from 2020, even using a 2-3% real growth yields risk free rates that are much, much higher than today's numbers. 

The Stocks Story

As treasury rates have risen in 2021, equity markets have been surprisingly resilient, with stocks up  during the first three months. However, as with last year, the gains have been uneven with some  groups of stocks doing better than others, with an interesting twist; the winners of last year seem to be lagging this year, and the losers are doing much better. While some of this reversal is to be expected in any market, there are questions about whether it has anything to do with rising rates, as well as whether there may be light at the end of the tunnel for some investor groups who were left out of the market run-up in the last decade.  For much of the last year, I tracked the S&P 500 and the NASDAQ, the first standing in for large cap stocks and the broader market, and the latter proxying for technology and growth stocks, with some very large market companies included in the mix. Continuing that practice, I look at the two indices in 2021:

Both indices are up for the year, but they have diverged in their paths. In January, the NASDAQ continued its 2020 success, and the S&P 500 lagged, losing value. In February and March, the tide shifted, and the S&P 500 outperformed the NASDAQ. Looking at the market capitalization of all stocks listed in the United States, and breaking down the market action in 2021, by sector, here is what I see:

The two sectors where there is the biggest divergence between post-crisis performance in 2020 and market returns in 2021 are energy, which has gone from one of the worse performing sectors to the very best and technology, which has made a journey in the other direction. Using price to book ratios as a rough proxy for value versus growth, I looked at returns in the post-crisis period in 2020 and in 2021, to derive the following table:

It is much too early to be drawing strong conclusions, but at least so far in 2021, low price to book stocks, which lagged the market in 2020, are doing much better than higher price to book stocks. 

Interest Rates and Value

As interest rates have risen, the discussion in markets has turned ito the effects that these rates will have on stock prices. While the facile answer is that higher rates will cause stock prices to fall, I will argue in this section that not only is the answer more nuanced, and depends, in large part, on why rates are rising in the first place.

Value Framework

As with any discussion about value and the variables that affect it, I find it useful to go back to basics. If you accept the proposition that the value of a business is a function of its expected cash flows (with both the benefits and costs of growth embedded in them) and the risk in these cash flows, we are in agreement on what drives value, even if we disagree about the specifics on how to measure risk and incorporate it into value:

This equation looks abstract, but it has all of the components of a business in it, as you can see in this richer version of the equation:

In this richer version, the effect of rising rates can be captured in the components that drive value. The direct effect is obviously through the base rate, i.e. the riskfree rate, on which the discount rate is built, and it is the effect that most analysts latch on to. If you stopped with that effect, rising rates always lead to lower values for equities, since holding all else constant, and raising what you require as a rate of return will translate into lower value today. That misses the indirect effects, and these indirect effects emerge from looking at why rates rose in the first place. Fundamentally, interest rates can rise because investors expectations of inflation go up, or because real economic growth increases, and these macroeconomic fundamentals can affect the other drivers of value:

	Higher real growth	Higher inflation
Riskfree Rate	Riskfree rate will rise.	Riskfree rate will rise.
Risk premiums	No effect or even a decrease.	Risk premia may rise as inflation increases, because higher inflation is almost always more volatile than low inflation.
Revenue Growth	Increases with economic growth, and more so economy-dependent companies	Increases, as inflation provides a backdraft adding to existing real growth.
Operating Margins	Increases, as increased consumer spending/demand allows for price increases	For companies with the power to pass through inflation to their customers, stable margins, but for companies without that pricing power, margins decrease.
Investment Efficiency	Improves, as the same investment delivers more revenues/profits.	No effect, in real terms, but in nominal terms, companies can look more efficient.
Value Effect	More likely to be positive. Investors will demand higher rates of return (negative), but higher earnings and cash flows can more than offset effect.	More likely to be negative. Investors will demand higher rates of return (negative), and while revenue growth will increase, lower margins will lead to lagging earnings.

Put simply, the effect of rising rates on stock prices will depend in large part on the precipitating factors. 

• If rising rates are primarily driven by expectations of higher real growth, the effect is more likely to be positive, as higher growth and margins offset the effect of investors demanding higher rates of return on their investments. 
• If rising rates are primarily driven by inflation, the effects are far more likely to be negative, since you have more negative side effects, with risk premiums rising and margins coming under pressure, especially for companies without pricing power. 

To see how changes in interest rates play out in equity markets, I started with a simple, perhaps even simplistic adjustment, where I look at quarterly stock returns and T.Bond rates at the start of each quarter, to examine the linkage.

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While the chart itself has too much noise to draw conclusions, the correlations that I have calculated provide more information. The negative correlation between stock returns and rate changes in the prior quarter (-.12 with the treasury bond rate) provide backing for the conventional wisdom that rising rates are more likely to be accompanied by lower stock returns. However, if you break down the reason for rising rates into higher inflation and higher real growth increases, stocks are negatively affected by the former (correlation of -0.078) and positively affected by the latter (correlation of .087). It is also worth noting that none of the correlations are significant enough to represent money making opportunities, since there seems to be much more driving stock returns than just interest rates, inflation and real growth. 

I also updated my valuation (from January 2021) of the S&P to reflect current rates and earnings numbers, and played out the effect of changing rates on the intrinsic PE ratio for the index:

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In making these computations, I looked at three scenarios, a neutral scenario, where changes in the T.Bond rate are matched by changes in the expected long term earnings growth rate, a benign scenario, where expected long term earnings growth runs ahead of the change in the T.Bond rate by 0.5%, in the long term, and a malignant scenario, where earnings growth lags changes in the T.Bond rate by 0.5%, in the long term. Note that in the best case scenario, at least with my range of outcomes, where rates drop back to 1.00%, but long term earnings growth runs ahead of riskfree rates by 0.5%, the intrinsic value for the index is 3919, just above current levels. In the worst case scenario, where rates rise to 3% or higher, and growth lags by 0.5%, the index is over valued significantly. Connecting to my earlier discussion of how inflation and real growth play out differently in earnings growth, I would expect a real-growth driven increase in rates to yield values closer to my benign ones, where an inflation-driven increase in rates will be far more damaging for stocks.

Rates and the Corporate Life Cycle

There is a surprisingly complicated relationship between interest rates and stock prices, with higher interest rates sometimes coexisting with higher stock prices and sometimes with lower. As rates rise, though, the effects on value will vary across companies, with some companies being hurt more and others being hurt less, or even helped. To understand why, I will draw on one of my favorite structures, the corporate life cycle, where I argue that most companies go through a process of birth, growth, aging and ultimate decline and death. To see the connection with interest rates, note that there are two dimensions on which companies vary across the life cycle:

1. Cashflows: Young companies are more likely to have negative than positive cash flows in the early years, as their business models are in flux, economies of scale have not kicked in yet, and substantial reinvestment is needed to deliver the promised growth. As they mature, the cash flows will turn positive, as margins improve and reinvestment needs drop off. 
   
   
   
2. Source of value: Drawing on another construct , the financial balance sheet, the value of a company can be broken down into the value it derives from investments it has already made (assets in place) and the value of investments it is expected to make in the future (growth assets). Young companies derive the bulk of their value from growth assets, whereas more mature firms get their value from assets in place. 
   
   
   

Connecting to the earlier discussion on interest rates and value, you can see why increases in interest rates can have divergent effects on companies at different stages in the life cycle. When interest rates rise, the value of future growth decreases, relative to the value of assets in place, for all companies, but the effect is far greater for young companies than mature companies. This will be true even if growth  rates match increases in interest rates, but it will get worse if growth does not keep up with rate increases. 

To illustrate this, I will use two firms, similar in asset quality (return on equity = 15%) and risk (cost of equity is 5% above the risk free rate), but different in growth prospects; the mature firm will grow 1% higher than the riskfree rate and the growth firm will grow 10% a year higher than the risk free rate, for the next 10 years. After year 10, both firms will be mature, growing at the risk free rate. As I increase the risk free rate, note that the costs of equity and growth rates will go up for both firms, and that their reinvestment needs will change accordingly. The effects of changing the T.Bond rate in this simplistic example are illustrated below:

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Both companies see a decline in PE ratios, as interest rates rise, but the high growth firm sees a bigger drop. This is captured in the growth premium (computed by comparing the PE ratio for the growth firm to the PE ratio for a mature firm). You can check out the effects of introducing malign and benign growth effects into this example, with the former exacerbating the differential effect and the latter reducing it.

The Rest of 2021

I hope that this discussion of the relationship between interest rates and value provides some insight into both why the equity market has been able to maintain its upward trend in the face of rising rates, as well as explain the divergences across growth and mature companies. The primary story driving interest rates, for much of 2021, has been one of economic resurgence, and it does not surprise me that the positives have outweighed the negatives, so far. At the same time, there is concern that inflation might be lurking under the surface, and on days when these worries surface, the market is much more susceptible to melting down. My guess is that this dance will continue for the foreseeable future, but as more real data comes out on both real growth and inflation, one or the other point of view will get vindication. Unlike some in the market, who believe that the Fed has the power to squelch inflation, if it does come back, I am old enough to remember both how stealthy inflation is, as well as how difficult it is for central banks to reassert dominance over inflation, once it emerges as a threat.

YouTube Video

Data links

1. Treasury Rates; 1928 to 2020
2. Intrinsic versus Actual T.Bond Rate: 1954-2020
3. Stock Returns, Interest Rates, Inflation and Real Growth: 1960-2020

Spreadsheets

1. S&P 500 valuation spreadsheet- March 23, 2021
2. PE calculator for mature and growth companies