The Federal Open Market Committee (FOMC), the policy making arm of the Federal Reserve, cut the overnight lending target rate this past week. There had been much speculation about whether it would do so by either 25 basis points (0.25%) or 50. Personally, I had been pretty vocal about the potential need for a 50 bps reduction. However, I strongly suspected the FOMC would be bureaucratically cautious, and only do 25.
As you undoubtedly know by now, it decided to make a 50 bps cut. This took the upper range of the overnight rate down from 5.50% to 5.00%. Therefore, I was both right and wrong at the same time. However, in this instance, I don’t mind being wrong.
But what does this all mean?
Here’s what it does:
First, a lot of people don’t fully understand what it means when the “Fed cuts rates.” For all practical purposes, all this means it reduces the upper limit of the interest rate range where the Fed wants financial firms to lend to one another for one business day.
Put another way, lowering the rate cuts the cost of overnight cash in the banking system.
Here’s what it doesn’t do:
- It doesn’t directly cut mortgage rates.
- It doesn’t directly tamper with the yield to maturities of U.S. Treasury debt securities.
- It doesn’t restructure existing ‘fixed rate’ loans.
- It doesn’t control the interest rate spreads between corporate, municipal and Treasury securities.
- In fact, it doesn’t directly do a lot of things many people think it does.
The 5-year car note you took out at, say, 6.9% is still 6.9%. The fixed rate on your 15 or 30-year conventional mortgage hasn’t changed. The coupon on your bonds is still the coupon on your bonds, at least for the vast majority of them. The loan shark down on the corner couldn’t care less what the Fed did or does in the future.
If that is the case, why does anyone really care if the Fed cuts the overnight rate?
The reason is because a lot of debt is now “variable rate.” This means the interest rate fluctuates off a predetermined benchmark or index. Many, if not most, of these are indirectly tied to the Fed’s overnight rate.
For instance, the “prime lending rate,” (Prime) which is the benchmark rate banks charge clients with good credit, has been 300 bps above the overnight rate for literally decades. However, the Fed doesn’t directly change Prime; banks do. It is important to note, they don’t have to ‘reset’ their Prime because the FOMC changes the overnight rate, but they still do.
So, if you have a personal loan or revolving debt credit card which floats off “Prime,” your debt service went down a little this week. That’s right, by 0.50%. That’s better than a sharp stick in the eye, which just about everything is.
Here is the math.
Assume, you have a $10,000 balance on some revolving debt at Prime. This means prior to Wednesday, your annual interest rate was 8.50%. When you woke up on Thursday morning, the rate was 8.00%. This means your annual interest payment fell from $850 to, drum roll please, $800. That works out to be a savings of around $4.17/month.
This is just for Prime. There are other ‘floating rate’ indices banks use. However, the story will largely stay the same, at least directionally. Where the rubber meets the road, borrowers with $10,000 in revolving debt got a cost savings of $3-5/month thanks to the Federal Reserve.
If that sounds like something of a “nothing burger,” the first rate cut in an easing cycle normally is in the short-term. $4 in the first month? Big deal. What is that? Roughly the cost of one of those puny “double cheeseburgers” on the value menu at McDonald’s? You know, the one with 3.2 ounces of meat despite the impressive name?
Yeah, that is about it.
Therefore, I contend this first 50 bps cut won’t have a tremendous impact on consumer behavior for the first several months, if not longer.
The conventional wisdom is that it takes 9-15 months, or even longer, for the economy to feel the full impact of a change in the overnight rate. By that point, the FOMC will have likely made a few more cuts, and the whole thing will have a sort of snowball effect.
You can think of it sort of like this. Imagine a doctor tells a 500-lb. patient, of average height, they need to lose 250 lbs. over the next 15 months. With a couple of small changes to their diet, the patient starts to lose some weight. After 3-months of cutting out alcohol, added sugar and fried food, they are down 50 lbs. By anyone’s definition, that is a huge step in the right direction. Well done.
However, the patient is still a relatively morbidly obese 450-lbs. Simply put, they need to lose more. Because there has been some relief to their joints, they begin walking, gradually increasing the distance each day. After another 3-months, they have lost an additional 50 lbs., taking them to 400-lbs and now only 150 away from the goal. You guessed it, they have to do even more.
So, they add some weight training to their exercise regimen, and really start hitting the gym. Since muscle burns fat, the excess fat starts to really melt from their body. So much so, their physical stamina greatly increases and their entire appearance starts to change. Before you know it, another 75+ lbs. vanishes from their body.
With some additional tweaks to their diet, a few more steps each day and a some added plates to the barbell, they are able to reach their goal in the stated time.
Using this analogy to illustrate the point, this week, the FOMC took fried foods and soft drinks out of our diet. This is just the first step in our journey, and everyone knows the Fed is going to make more changes in order to help us reach our economic goals.
With this in mind, what is the old Chinese proverb? A journey of a thousand miles begins with a single step?
Of course, the markets have mostly liked the FOMC’s widely expected move thus far. It hasn’t been the wild, euphoric rally perhaps many people expected. Still, the markets are positive since the rate cut announcement, and positive is always better than the alternative.
In truth, I suspect the Fed’s actions this week, despite it being a 50 bp cut instead of 25, were sort of anti-climactic. You know, sort of like Christmas morning after all the presents are open. Do you remember that scene in “A Christmas Story,” when Ralphie’s dad asks “didn’t I get a tie this year?”
Again, yeah, that is about it.
In the end, the Fed gave us the first of what will prove to be many rate cuts in this easing cycle. Each one will build on the previous one until they create a sort of “financial snowball.” Instead of an interest savings of $4.17/month, it could be as high as $20 or more on that $10,000 loan.
Now, imagine if that loan balance was, say, $250,000, which isn’t too unusual when it comes to things like Home Equity Lines of Credit (HELOC). How does $521/month strike you IF the FOMC cuts the overnight rate by 250 bps?
That’s when it gets fun throughout the entire economy. Until then, well, I suppose you can say it will start sneaking up on us…but in a good way.
Have a great weekend.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this and every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as well as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.