Forget the Fed. Watch the markets if you want to understand the economy.
KEY TAKEAWAYS
The Fed Funds Rate affects banks, not households
Prime Rate tracks the Fed Funds Rate but mostly impacts credit products
Consumer loans like mortgages and autos follow Treasury yields, not Fed policy directly
Credit card APRs remain elevated regardless of Fed actions
Consumption is driven primarily by the wealth effect, not interest rates
MY HOT TAKES
The Fed’s obsession with tiny rate adjustments is misplaced as is your obsession with the Fed 😉
Monetary policy has limited influence on real consumer behavior
The bond market, not the Fed, is the truest signal of economic reality
Wealth and confidence drive spending more than credit conditions
The Fed is ultimately a spectator to market-driven consumption
You can quote me: “When portfolios rise, America spends — not when Powell cuts.”
The real deal. I spent an inordinately long time this morning staring at all of my bond yield screens. My long-time followers know that the bond market is always on the top of my mind as I got my start on Wall Street as a bond trader. When I was just a neophyte Wallstreeter, I quickly realized that–though bond traders had a gruff and sometimes unkempt outer appearance (not me, of course 😉)–their style of analysis was more deeply rooted in numbers than the story-wielding equity traders of the day. This suited my quant-based style perfectly. You can actually calculate a bond’s price! Sure, there were stories, but ultimately, bonds are priced based on the yield curve. Yes, the curve and spreads traded up and down, but their relationship to each other and ultimately, government issued economic numbers, could be captured in relatively solid statistical models.
Now, a lot has changed in the 35 years since I first started creating quant models on a 40-pound Zenith laptop running Lotus 123. For you younglings, Lotus was the go-to spreadsheet application of the day (also Visicalc) when Excel wasn’t yet conceived. Bond traders have become even more sophisticated, and they have gotten better at personal hygiene,🫧 and though I moved on many years ago, my respect for interest rates and bonds remains strong. The bond market is still THE best arbiter of economic conditions.
Now that we got that out of the way, in yesterday’s blogpost/newsletter, I urged you to look outside the box in this “flying blind” period where important economic releases are being cold-stored during the government shutdown. Yesterday, I looked at Fedspeak to try and tease out a trend. This morning, I am looking for some answers in bond yields.
When we are talking about yields, the first thing that comes to mind is the Fed. Of course, the Fed is responsible for setting interest rate policy. Its hands are firmly on levers of rates. It raises them to curtail runaway growth which causes inflation, and it lowers them to stimulate the economy when it may be gasping for air. The basis for that control is really on consumers. The theory behind it is this: lower rates make borrowing cheaper, and consumers will spend more money, and vice versa when borrowing is more expensive. The same holds true for business investment, but let’s focus on consumers for now, because their spending makes up ⅔ of GDP. When consumers are buying more, increased demand for goods and services pushes prices higher–inflation. The Fed raises rates making borrowing more expensive, causing demand to fall off and allowing prices to normalize, thus defeating high inflation. That’s the theory.
Now, I have been quite public about my opinion on this. I have brought it up multiple times on national TV, though few are willing to engage me on this. The Fed is obsessed with tweaking interest up or down by 25 basis points, seeking some sort of perfect world where inflation is in control and employment is strong. But does the Fed Funds Rate REALLY affect how much you consume?
Here is the chain. The Fed Funds Rate is the overnight lending rate charged between Federal Reserve System member banks. It has nothing to do with you or me. However, the Prime Lending Rate does… well, kind of. Let’s dig further. The Prime Lending rate is the interest rate that commercial banks charge their most creditworthy corporate customers, and it serves as the benchmark for everything from credit cards to small-business loans. It moves almost in lockstep with the Federal Funds Rate, typically about 3 percentage points higher, which means when the Fed hikes, your borrowing costs follow. Have a look at this chart, then keep reading.
This chart shows the Fed Funds Rate (blue line) and the observed Prime Lending Rate going back to 2010. You can see how they move in tandem with each other. I showed you this, because you need to understand how Fed policy is tied to your budget. Banks set the Prime rate, not the Fed, but you can see how one affects the other.
Now, as I mentioned before, all other consumer lending and even some business lending is–should be–based on that Prime Rate. What is the first thing that comes to mind when you are thinking about consumer borrowing? Mortgages? Ok, but they are based on 10-year treasury yields. Auto loans? Ok, but they are also mostly tied to treasury yields, but shorter maturities like 3 years. Now, as you have probably learned by now, those yields are mostly in the hands of bond traders–the folks I was so lovingly referring to before. Fed policy influences them–3-year more than 10-year–but only indirectly.
Beyond those 2 big-ticket items, what comes next? Well, credit cards, personal loans, and HELOCs. Credit cards are a big one. Americans love credit cards! It would therefore make sense that consumers would be highly sensitive to credit card APRs. AHA, the connection. The Fed can control consumption through credit cards, right? Have a look at this chart, then keep reading. Be patient, we are almost there.
You can see from this chart of credit card APRs that first, they are super-high–over 20%, and second that they haven’t fallen much since the Fed started cutting interest rates. But still, you can see, if you look at the Prime Rate chart above 🙃, that the path of credit card rates kind of approximates Prime. Ok, so now we have established how the Fed can affect what you spend, indirectly. Fed Funds -> Prime Rate -> Credit APRs.
Check out this next chart and follow me to the close. 😀
This is a chart of Personal Consumption (white line) going back to 2005. I intentionally showed you a longer time series so that you can appreciate just how steep and mostly uninterrupted its growth has been over the past 2 or so decades. Wow! Obviously, COVID affected it, but only briefly. Please note 2 things on this chart. First, it has grown from $11 trillion to $16.6 trillion, up by some 48%! Second, it was completely unaffected by the Fed’s aggressive hiking regime in 2022 and 2023. Think about that. Consumption, what you and I spend on goods and services, the category which makes up ⅔ of US GDP is almost completely unaffected by the Fed Funds rate!
So, what does affect consumption? Well, before I offer you a clue, I want to point out that I have been very general. There is, as you might expect, variation in spending habits between different income classes. Lower income classes, for example, may be more sensitive to interest rate movement than high income classes. But for now, let’s keep it basic.
I was going to show you a chart of the S&P 500 over the same period, but I figured that you have seen enough, and you know that the S&P has grown by around 400% through the period on the chart above. I submit to you: the wealth effect. The wealth effect is simple–when people feel richer because their homes or portfolios rise in value, they tend to spend more, even if their paychecks haven’t changed. It’s not about income or credit card rates, it’s about confidence and perceived wealth. Roughly two-thirds of Americans own homes and over 60% own stocks, so when asset prices climb, consumption follows. In a consumption-driven economy, that feedback loop between wealth and spending is what keeps the engine running–or stalls it when markets fall. Your bottom line here folks? The Fed can impact all of this only in extremes–it can cause a recession which would impact your wealth. But, based on what we just went through, do you think that a 25 basis-point rate cut will have a material effect on your spending?
The Fed is, sadly, a spectator, just like you and me. Granted, it has better seats, but the main attraction is still the equity markets. I am still staring at my bond yield screens–equity markets open in a few short hours.
YESTERDAY’S MARKETS
Stocks traded higher with the S&P 500 and Nasdaq hitting fresh highs as the government’s long weekend became longer yet with no end in sight. Hopes of Fed Funds rates and a strong showing in the upcoming earnings season is keeping the bulls bullish. Gold continues to gleam, finding salvation in chaos and strong demand from foreign central banks.
NEXT UP
Consumer credit (August) may have slipped to $14.00 billion from $16.00 billion.
Fed speakers today include Bostic, Bowman, Miran, and Kashkari.