Interest Rates Matter, but the Economy Is far Bigger

Economists have had to eat a lot of crow this year, what with most developed nations avoiding recession and economic growth generally surprising to the upside. Evidently, it will soon be the Fed’s turn, with analysts anticipating this summer’s run of strong US data will force staff economists to double their 2023 GDP growth projections from June’s 1.0% estimate—which was an about-face from March’s recession projection. We could easily write a piece poking fun at all these eggheads with egg on their face, but we see something a tad more fascinating at work. You see, some analysts are already picking apart this forthcoming update to assess what it means for interest rates next year and whether the Fed will still project a full percentage point’s worth of cuts. We find this all rather misplaced, particularly for investors, as it places importance on the wrong factor.

If Fed rates were some massive economic swing factor, we would get the obsession. But in reality, they are only one variable—and a small one at that. The interest rates that matter most to the real economy are those determining the cost of money for businesses and households, including business loan rates, mortgage rates, auto loan rates and consumer rates. These derive not from the fed-funds rate but from 10-year US Treasury yields. Conventional wisdom says Fed rate moves influence these, but the relationship isn’t so cut and dry. If it were, then the 10-year wouldn’t have been below fed-funds since November. In the nearly 10 months since then, the Fed has continued hiking rates while 10-year yields took a bouncy but sideways trip.

In theory, the fed-funds rate should affect credit supply, if not the cost. This is because banks borrow at short-term rates and lend at long-term rates, making the gap between the two their rough profit margin on new loans. A larger gap means more profits, which makes banks far more eager to lend than when spreads are slim or even inverted. The easiest way to assess this gap, normally, is with the US Treasury yield curve, with fed-funds or 3-month yields at the short end and 10-year yields at the long end. But this works only if fed-funds and 3-month rates mimic banks’ actual funding costs.

Traditionally, they did. Fed-funds’ primary purpose is to regulate banks’ funding costs, on the logic that if banks must pay a given rate to borrow from one another, the costs to borrow from depositors will naturally mirror that. This works in a world where banks must compete for a limited pool of deposits, but that isn’t the case today. Most banks—particularly large ones—have far more deposits than they need or want and, as a result, keep savings and checking rates painfully low for all of us normal people. CD rates are up, as are rates at some online-only or small banks, but the average national savings deposit rate is a measly 0.43%.^[i] Meanwhile, the fed-funds target range is up to 5.25% – 5.5%.^[ii] Given loan growth is still clocking in at a decent 4.8% y/y rate—which exceeds the inflation rate, meaning credit is still growing in real terms—it doesn’t look to us like a higher fed-funds rate is having much effect on lending.^[iii]

Those last three paragraphs are a bit academic, so here is a picture to make the same point in a different way. Exhibit 1 shows quarterly GDP growth alongside the monthly average effective fed-funds rate since 1954. As you will see, we have had high rates, low rates and zero rates. We have had fast-rising and fast-falling rates, as well as long stretches with no action. Through it all, economic growth rates during expansions haven’t changed much. If anything, growth was slower in the zero-rate 2010s than in the painfully high-rate 1980s, to cherry pick a couple examples.

Exhibit 1: GDP Growth and Fed-Funds Rates Don’t Have Much of a Relationship

Source: St. Louis Fed, as of 9/6/2023. Average monthly effective fed-funds rate, July 1954 – August 2023 and quarterly annualized real GDP growth rate, Q3 1954 – Q2 2023.

Considering the US economy has already proven it can grow through a variety of fed-funds rate environments, we just don’t buy the notion that the Fed’s 2024 moves are make-or-break for growth. Or for stocks, which care primarily about the expected economic conditions—not just interest rates. Economic activity is typically the major force swaying corporate earnings. So if the economy is growing or even accelerating, we struggle to see why the level of interest rates would be so darn determinate to stocks. It hasn’t been before. Why would it now?

That so many seem to view the world backwards—putting interest rates above all else in importance—looks like a recipe for missing what truly matters most for markets. That oversight likely sets up positive surprise when the world doesn’t hit the skids as they assumed—a pretty fair summary of the last 11 months, in our view.

As a general rule, things everyone looks at are already incorporated into stock prices. Fed rate moves are the textbook example of this right now, making it rather useless for investors to fixate on them. Stocks, which are up nicely through several rounds of rate hikes since last October, have long since moved on. Do yourself a favor and join them.