The Fed has lowered its short-term interest rate three times so far this year. What was the effect of these decisions on the yield curve? How does it affect the economy and consumers?
In this paper, I am looking at the immediate reaction by the U.S. Treasury market to the Fed’s decision to cut interest rates. The Fed controls and decides the level of the federal funds rate. Federal funds rate is a very short-term interest rate that banks charge each other for overnight lending. In theory, the Fed controls very short-term interest rate. But in reality, the Fed has a strong indirect influence on the long-term rates and the entire yield curve.
The Fed has lowered its federal funds rate three times so far this year: on July 31st, September 18th, and October 30th, 2019. Each time, the decision was to cut rates by 0.25%. In theory, the decision to cut federal funds rate should have had a minimal impact on the long-term rates. In reality, treasury bonds across the yield curve had significant impact. I have analyzed this impact on the entire yield curve two days after the Fed’s decision to cut federal funds rate.
On July 31st, 2019 the Fed cut its federal funds rate from 2.50% to 2.25%. In just two days, long-term rates declined significantly. 5 Year Treasury bond yield was down 8.7%; 10 Year Treasury bond yield was down 7.8%; and 30 Year Treasury bond yield was down 5.4% (see Table 1 and Chart 1).
On September 18th, 2019 the Fed cut its federal funds rate from 2.25% to 2.0%. The yield curve reaction was milder at this time. However, long-term rates still declined moderately. 5 Year Treasury bond yield was unchanged; but 10 Year Treasury bond yield was down 1.1%; and 30 Year Treasury bond yield was down 2.2% (see Table 1 and Chart 2).
On October 30th, 2019 the Fed did its third cut in federal funds rate from 2.0% to 1.75%. In just two days, long-term yields declined significantly. 5 Year Treasury yield was down 9%; 10 Year Treasury yield was down 8.2%; and 30 Year Treasury bond yield was down 6.9% (see Table 1 and Chart 3).
The decision by the Fed to cut its short-term federal funds rate has caused long-term rates to decline. The reason for the decline in long-term rates is in economic expectations. Investors become more worry about the health of the economy. By lowering federal funds rate, the Fed signals about potential risks to economic growth and low inflationary expectations. Investors rush towards safety and buy long-term bonds causing the yield on long-term bonds to decline. The increased demand for bonds causes bond prices to increase and yields to decline.
The effect of lower interest rates is very positive for consumers and the economy. Homeowners can benefit from lower interest rates and increase their disposable income almost immediately. For example, homeowners can refinance their mortgage at lower interest rate. Homeowner will have lower monthly mortgage payments and extra money to spend. Homeowners can then use this extra savings to increase consumption which will benefit overall economy. Consumption is about 70% of the US Gross Domestic Product – broad measure of the US economy.
Companies can also benefit from lower interest rates. Companies can issue new debt at lower interest rate and retire more expensive debt early. This will bring the cost of borrowing lower. Lower cost of debt will improve profitability. New projects will become more feasible to pursue. Companies will increase business spending and investments because of lower interest rates.
Lower cost of debt will also benefit the stock market. Companies will look more profitable and their stock prices will be worth more due to lower cost of debt. Lower interest rate will bring down the weighted average cost of capital (WACC). With lower WACC, the equity valuations will be higher. Analysts will assign higher stock price valuations to companies. The stock market will be valued at a higher level causing the stock prices to increase.
To summarize, as the Fed lowers its short-term interest rate, it has the effect on the entire yield curve; the economy and the stock market. By the decision to cut federal funds rate, the Fed signals increased risk of economic slowdown and lower inflation. Investors rush to safety and buy long-term treasury bonds. The entire yield curve shifts down. Lower interest rates help homeowners to refinance their mortgages and provide extra disposable income. Companies can issue new debt at lower interest rate and bring the cost of capital down. Lower, weighted cost of capital will increase equity valuations. More profitable and higher valued companies will see their stock prices increase. The immediate reaction to the Fed’s decision to lower interest rates are higher stock markets and higher GDP.
U.S. Department of the Treasury data accessed on October 31, 2019
The analysis of the yield curve is based on limited and short-term data, future reality may be different from historical results. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor and accountant before making an investment decision.
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