We’re talking long-term interest rates this week… in honor of America’s Independence Day, I suppose.
When we left off yesterday, we suggested that the Federal Reserve (the Fed) no longer has control over long-term interest rates – which are the rates that matter the most.
The reason being is that there are three key interest rate benchmarks that influence rates throughout the US economy. They are:
- The Federal Funds Rate (Fed Funds Rate)
- The Secured Overnight Financing Rate (SOFR)
- The 10-year Treasury Rate
We talked about the Fed Funds Rate yesterday.
As a reminder, when we talk about the Fed cutting or hiking rates, we’re talking about the Fed Funds Rate. But here’s the thing – it only influences short-term interest rates. To understand why, we have to understand the other benchmarks.
The Secured Overnight Financing Rate (SOFR) is the primary benchmark for trillions of dollars in corporate loans, adjustable-rate mortgages, floating-rate loans, interest rate swaps, futures contracts, options, derivatives, and other structured financial products. It reflects pure borrowing costs without bank credit risk.
SOFR is a critical benchmark for large corporate and institutional borrowing and hedging activity, and that extends into longer-term financing. Often this activity occurs when a company is undertaking larger-scale projects.
So SOFR is arguably more important than the Fed Funds Rate when it comes to spurring larger projects that could generate economic growth.
And here’s what’s critical about it – SOFR is based on actual transactions in the Treasury repo market. The rate is derived from actual market activity.
The Treasury repo market is similar to the Fed’s overnight window for banks, except it’s open to many other financial institutions like securities dealers, investment firms, asset managers, money market funds, mutual funds, hedge funds, pension funds, sovereign wealth funds, insurance companies, and other institutional investors.
When one of these institutions needs short-term funding, it can go into the repo market to essentially borrow money from another institution that’s willing to lend. The interest rate for that loan is determined by the two parties involved.
Just to be accurate, these aren’t standard loans.
In a repo transaction, the borrowing institution sells US Treasury securities to the lending institution and agrees to buy them back on a specified future date at a higher price. That price difference represents the interest on the loan.
Again, the key here is that these are market-based transactions in which self-interested parties determine the interest rate that they are willing to accept. The aggregation of all the daily transactions in the repo market is what establishes the SOFR rate.
The takeaway here is that SOFR cannot be “set”, nor is it tied to the Fed Funds Rate. SOFR is determined by market forces.
This is why Jerome Powell replacing the London Interbank Offered Rate (LIBOR) with SOFR was so revolutionary.
As we’ve discussed before, LIBOR was set by a consortium of 16 massive banks – 11 of them in the European Union. When LIBOR was the dominant benchmark, that banking consortium could and did manipulate it lower at will. We learned this when the “LIBOR scandal” broke in 2012.
This is why the world came to believe that the Fed completely controls interest rates throughout the economy. For the better part of the last two decades, it did.
If we remember, former Fed Chair Ben Bernanke initiated the era of globally coordinated monetary policy in 2008 in response to the financial crisis. Bernanke announced that the Fed would collaborate with other central banks with the stated goal of pushing interest rates to zero and keeping them there.
During that era, the LIBOR consortium could manipulate LIBOR lower whenever the Fed cut interest rates. That made it look like the Fed had the power to move all interest rates down at will… but it was really a coordinated effort to snuff out market forces.
And that brings us to the 10-Year Treasury…
The yield on the 10-year Treasury note is a critical benchmark as well. It is considered the global “risk-free” rate for longer-term investments.
The US Treasury sells 10-year Treasury notes to raise money to finance government spending. Investors pay a lump sum payment upfront to buy it, and then the US Treasury agrees to pay the investor coupon payments at a specified interest rate for ten years.
Obviously, the US Treasury wants to sell these securities at the lowest rate possible, while investors want to get the highest rate possible. They have to meet in the middle somewhere to get the deal done.
For this reason, the 10-year Treasury rate is seen as a gauge of economic growth and inflation expectations in the United States. If investors expect low growth and/or high inflation in the US, they require higher interest rates to mitigate their risk.
That makes the 10-year Treasury a benchmark for corporate bond rates, municipal bond rates, and mortgage rates. Specifically, the 30-year fixed mortgage rate in the US closely tracks the 10-year Treasury rate.
So the 10-year Treasury rate is also arguably more important than the Fed Funds Rate. Long-term borrowing costs track the 10-year rate, not the Fed Funds Rate.
During the era of global central bank coordination, the 10-year Treasury rate fell alongside the other primary benchmarks. But again, that was due to manipulation.
Remember Bernanke’s quantitative easing (QE) programs that his predecessor, Janet Yellen, continued? They printed trillions of dollars from nothing to buy the 10-year and other long-dated Treasuries specifically to manipulate rates lower.
Powell put a stop to that. He engaged in quantitative tightening (QT) to allow interest rates to normalize. This chart tells that story:
This is a chart showing the total dollar amount of assets held on the Fed’s balance sheet. When we see the line going up, that’s the Fed printing money to buy US Treasuries. It also bought mortgage-backed securities in the wake of the 2008 crisis.
The act of printing money to buy Treasuries pushed long-term interest rates down. We can see clearly that this was going on for most of the time period from 2008 to 2022.
But the line’s been going down since 2022. That means the Fed ended QE. That is to say, it stopped buying Treasuries on net… which allowed interest rates to normalize.
The reality is that the 10-year Treasury rate is largely determined by self-interested market actors in the absence of QE. If the rate is too low compared to economic and inflation expectations, real investors aren’t going to buy the securities… so the US Treasury has to offer attractive rates given the state of the market.
To be fair, global central banks can attempt to manipulate rates by buying or selling Treasuries in large quantities at the same time. But they can’t print dollars to do so. They must use their dollar reserves – which means their impact is limited and short-lived.
It all comes down to this…
We’re back to an age where longer-term interest rates are largely set by market forces once again. The Fed can still set short-term rates, but it cannot control long-term rates now that SOFR is in place and QE has ended.
And that’s not theoretical – we’ve already seen it.
Powell cut the Fed Funds Rate by one percent in the fourth quarter of last year… but long-term rates didn’t go down. To the contrary, they went up. The 10-year Treasury rate steadily moved one percent higher after the Fed’s cuts.
The same thing happened when Trump’s Big Beautiful Bill was announced and the CBO projected that it would increase the deficit dramatically—long-term rates went up in response. Specifically, the 10-year Treasury moved about half a percent higher.
My point is – we’re no longer in a world where the Fed controls interest rates. Thanks to SOFR and the absence of QE, long-term rates are now largely set by the market.
Friends, the financial media and many analysts haven’t realized this yet. Instead, they still see the world and make assessments through the lens of the previous era, where all interest rates went down when the Fed cut the Fed Funds Rate.
But that era is over. And that means any analysis stuck in the old framework will be faulty.
Coming full circle, fixating on the Fed is now largely a distraction.
How the US Treasury manages the current debt wall and whether the Trump administration can get the federal budget under control are far more important in my view.
More to come…
-Joe Withrow
P.S. In honor of America’s Independence Day tomorrow, I wanted to put a fantastic program on your radar. It’s called Liberty Classroom, and it’s produced by my friend Tom Woods.
I spent 12 years going through the government-funded educational system and another 5 years at a public University. I was led to believe that those 17 years would teach me everything I needed to know about various topics, including American history and economics. I was sadly mistaken.
Tom Woods’ Liberty Classroom is the world-class education that I never got. It’s chalk-full of exciting courses that provide a true understanding of history and economics according to America’s founding principles.
If you haven’t seen this program yet, it’s the perfect gift for Independence Day. If you’re interested, you can get more information on it right here: Tom Woods Liberty Classroom Course Listing