Tuesday, December 11, 2007

Fed Funds Rate Down to 3% in 2008?

According to Larry Kudlow writing in his most recent column:

"The Fed also must undo the inverted Treasury yield curve whereby the 4.5% Fed Funds rate remains well above the 4% 10-year Treasury rate. This situation has prevailed for 18 months (see shaded area in chart above); unless it's fixed immediately, it represents an illiquidity threat that increases the odds of recession. A 3-month Treasury bill around 3% is pointing the way for the fed funds rate."

Over the last half century, the Fed Funds rate has been below the 10-year Treasury yield by an average of 0.87%. Assuming that the 10-year Treasury rate remains at about 4%, that would mean that the Fed Funds target rate would have to get down to somewhere between 3% and 3.25% to restore the historical relationship between the two benchmark interest rates (see chart above). In that case, a 50 basis point rate cut in the target Fed Funds rate today to 4% would be a good start, and additional rate cuts next year could be expected.

Interestingly, the Fed Funds futures contracts for December 2008 are predicting a Fed Funds rate of about 3.4% a year from now.


At 12/12/2007 6:28 PM, Anonymous Anonymous said...

a.k.a.... arbitrage opportunity?

At 12/13/2007 11:07 AM, Anonymous Anonymous said...

The Fed does not control the slope of the yield curve. While current and future Fed action does control ST rates, the market determines the long end of the yield curve, this fact was on display during the last Fed tightening campaign when LT rates barely moved despite the fact that the Fed Funds rate increased by 425BP. The Fed must make interest rate decisions based on its economic outlook, not on recent fluctuations on LT treasury debt.

Also, Fed policy has a limited effect on the LIBOR rate. This has been highlighted by the fact that the 100BP in recent Fed Funds easing has not been mirrored in LIBOR rate movement.

At 12/13/2007 1:02 PM, Anonymous Anonymous said...

understood. the yield curve is a representation of the future treasury rates. however: if the fed rate is the basis for short-term (interbank) borrowing and for longer-term consumer rates, then can banking seize an arbitrage by "borrowing" long term (i.e., selling long-term investments at the treasury rate) and lending at the higher, short term rate?

or am i just being stoopid and naive?


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