Dear friends – I hope the summer months are treating you well.
It’s been quite a while since I’ve last written to you. We have been busy working on a range of updates and upgrades for The Phoenician League behind the scenes. We are also in the early stages of planning a multi-day event that I think will be both fun and insightful. More information on that to come…
It’s been unusually hot up here in the mountains of Virginia. It’s rare that the temperature moves above the low 80s during the summers here… but it’s been pushing into the 90s the last few weeks.
For some relief, the kids and I ventured to a little-known swimming hole on the banks of the great Cowpasture River this past weekend. Here it is:
Crystal clear waters, a clear blue sky, and a quiet gravel beach… what more could one ask for?
The Cowpasture River originates in Virginia’s rugged northern highlands and winds its way south for 84 miles through the western part of the state. Then it merges with the Jackson river at Iron Gate to form the James – which meanders east across the state until it empties into the Chesapeake Bay past the original colony of Jamestown.
The natives called the river the “Walatoola”, which means “winding waters”. But then the Brits settled the area in the 1720s and dubbed it the “Cowpasture River”. They must have been a creative lot. Regardless, it’s hard to beat a morning by the river out here on the Virginia frontier.
Getting back to the world of finance…
A lot’s being made in the financial world right now about President Trump berating Federal Reserve (Fed) Chairman Jerome Powell and pressuring him to cut interest rates. The financial media jumped onto this to drum up a story around it – should Powell cut rates or not… and is he stupid like Trump says?
This drama is a complete distraction in my mind.
With where we are today, it really doesn’t matter much if Powell cuts rates. As I’ve mentioned before, his job is largely done.
We have talked about the significance of Powell replacing LIBOR with SOFR on numerous occasions before… but mostly from a geopolitical bent. Today, let’s assess the situation purely from a financial standpoint.
There are several 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
The Fed Funds Rate is the rate at which US banks lend reserve balances to each other overnight. Here’s how it works at a high level…
At the close of business on any given day, some banks find themselves short on their reserve requirements while others have a surplus. Those banks with a deficit must borrow reserves from banks with a surplus. The Fed Funds Rate is the interest rate they pay on those loans.
When we talk about the Fed hiking or cutting rates, we’re talking about the Fed Funds Rate. That’s the only interest rate benchmark within the Fed’s control.
The Fed Funds Rate directly influences other short-term rates throughout the economy. They are:
- Short-term Treasury securities (up to 2 years duration)
- Prime rate (used for many short-term business and consumer loans)
- Money market rates
- Savings account rates
- Certificate of Deposit (CD) rates
If we look at this list, short-term Treasury rates are probably the most important. The higher those rates are, the higher the US government’s debt service cost will be on new short-term debt issued.
As for the prime rate – it does impact short-term borrowing costs for businesses and consumers. So a lower Fed Funds Rate may encourage people to borrow more money to spend on short-term projects… but I don’t see that as the key to sustained economic growth.
Typically short-term borrowing sprees are what create the boom/bust business cycle. And if we look at consumer debt levels today – it doesn’t seem like access to high-interest credit is much of a problem.
Then the last two items on this list are related to money markets, bank savings accounts, and CDs. In the old days, these were immensely important savings vehicles for Americans. But are they today? I sincerely doubt it.
So I look at this list, and I just don’t think these items are what’s important right now.
Cutting the Fed Funds Rate here would help reduce debt service costs on the $7 trillion worth of debt that the US Treasury needs to roll over between now and New Year’s Eve. And given the debt pile, just a few basis points would make a big nominal difference if the Treasury has to sell a lot of short-term debt.
However, they would prefer to sell long-term debt if possible. And the reality is that none of it matters if they can’t get the budget under control. But that’s a topic for another day…
The key takeaway is that the Fed no longer has control over the longer-term interest rates that matter the most. We’ll look at why that is tomorrow.
-Joe Withrow