Why the Fed doesn’t control long-term interest rates
It’s the economy, stupid!
Recently I heard someone say, “but why are long-term rates so much lower? Doesn’t the Fed control interest rates?” A good question. If you’re not a connoisseur of interest rates you might assume that the Federal Reserve is the master of the entire yield curve*. While that may be mostly true at the short end, what the Fed cannot do is control the long end of the curve. Let’s have a look at how all this works.
*Yield curve refers to the interest rates over different maturities. I.e. 1 month, 1 year, 10 year, etc. These interest rates are plotted graphically for easy viewing, and you end up with a chart like this. I snapshotted the chart from this lovely website.
How bond yields work
When we talk about interest rates we’re talking about the yield on a United States Treasury for any given maturity. If short-term rates are high, that could mean the yield on a 1 year Treasury note is 5%. If long-term rates are lower, that might indicate that the yield on a 30 year Treasury bond is 3% (or whatever number, bond yields are changing rapidly right now).
Here’s a simple way to think about it. A bond’s yield is indicative of where the market thinks interest rates will be when that bond matures. For example,
- 1 month bill is trading at 3.8% because that’s where interest rates, as set by the Federal Reserve, will be in 1 month
- 6 month bill is trading for 4.8% because the market is expecting the Fed to raise interest rates to ~5% and keep them there for several months at least
- 2 year note is trading at 4.4% because the market expects that the Fed will have begun cutting rates by 2024
- 30 year bond is trading at 3.6% because it’s pricing in low interest rates and low inflation
Apart from the Fed’s short-term rate, interest rates also correspond to inflation and economic growth expectations. If the market thinks that inflation is going to be high, bonds will sell off and yields will rise. If inflation is expected to come down, there will be a bid for bonds and yields will drop.
The same dynamic applies to economic growth. If the market believes growth is going to be robust bonds are likely to sell off. That happens because investors would rather earn money investing in the real economy (equities), instead of clipping coupons on bonds. So we can say that three of the biggest factors that influence interest rates are,
- Where the Federal Reserve’s short-term rate is set
- Inflation expectations
- Growth expectations
What the Fed controls and how
The Federal Reserve has more control over short-term than long-term interest rates. The way I look at it is in terms of alternatives. The Fed sets interest rates by adjusting their overnight lending rate. This is known as the Federal Funds Rate, or FFR, and it’s the yield that institutions can earn by depositing their dollars and reserves at the Fed.
Investors always want the highest yield* so if FFR goes up, investors will sell their bills and deposit the money at the Fed. Thus the yield on the bills will rise to match or exceed the FFR.
*All things being equal, investors want to earn the highest yield. However, t-bills are high quality collateral and demand for bills may be so great that they actually earn a lower yield than FFR. That’s a topic for another day.
By setting a floor price on yields, short-term interest rates follow whatever rate the Fed sets. How about the long end? Long-term interest rates are less influenced by the Fed’s overnight borrowing rate. Long-term rates are based on,
- Long-term inflation expectations
- Long-term growth expectations
- Where the market expects interest rates to be in five, ten, fifteen years etc.
If you own a 20 year bond you’re going to be clipping the coupon for two decades, so long-term economic prospects play a bigger role in determining that bond’s yield, as opposed to whatever the Fed is doing with FFR. That’s how we’ve gotten into our current situation where the US 2 year is trading at 4.3% but the 10 year is down at 3.6%. The market is saying that interest rates/inflation might be higher in the short-term, but long-term both are going down.
Finale
I hope this article was helpful. I explained it as simply as I know how, but there are a lot of moving pieces in this monetary puzzle. We didn’t even get into inverted yield curves and why they predict recessions. Perhaps a topic for another article.
The key takeaway is that long-term interest rates primarily depend on the economic outlook, while short-term rates tend to follow the Fed Funds Rate.
