[Part 1 of 2] Understanding Yield Curve Inversion and the Federal Fund Rate
Updated: Feb 5
To many retail investors/traders, the Federal Fund Rate (FFR) is the defacto "Interest Rate." The term "Interest Rate" has been loosely used interchangeably with the "Federal Fund Rate." If you are an average Joe investor, dollar cost averaging Unit Trusts, just looking for positive YoY capital appreciation, then this misconception is acceptable. As we grow as traders and portfolio managers, we must understand the underlying mechanism behind one of the most famous leading economic indicators. We must rise above the cesspool of retailers who treat Federal Fund Rate and Yield Curve as random lines indicator mixed in with their moving averages, Bollinger bands, and MACDs. Such disrespect shall not be tolerated!
Where's the yield curve?!
Bringing the Yield Curve into the party right now is a little premature, but it is inevitable. Like Leonardo DiCaprio and models below age 25, the fate of the FFR and the Yield curve is intertwined.
Let the lesson begin!
The Federal Fund Rate is an overnight rate. It is a rate that Federal Reserve Bank is willing to borrow or loan out reserves to/from other banks. Reserve and Cash are two different animals altogether, but that is a topic for another day. If a bank has an additional reserve, it can loan it to the Federal Reserve Bank for an overnight rate equal to the Federal Fund Rate. If a bank needs to top up its reserve, it can also borrow the reserve from Federal Reserve, paying an overnight interest equal to, you guessed it, the Federal Fund Rate.
Banks do this borrowing and lending of reserve overnight among themselves, too, using the Federal Fund Rate as a benchmark.
As an overnight rate, the Federal Fund Rate sits on the front end of the yield curve. The shortest time to maturity. Towards the back end, we have the longest time to maturity, the 30-Year Treasury.
By plotting an X/Y chart with the time to maturity on the X-axis and the Yield on the Y-axis, you will get the Yield Curve.
Jeng Jeng Jeng!!! Inverted liao
When the Fed increases the FFR, corporate entities are more willing to do business with the Federal Reserve Bank since it offers rates, be it borrowing or lending. This also means that the Federal Reserve put pressure on rates of the Treasuries Bonds and Corporate Rates. New Treasury Bonds issued must offer equal or better rates than the FFR. Private Banks will also be pressured into raising their rates to stay competitive.
Federal Reserve CANNOT force the market or the treasury to increase rates. It is the market that wants to increase its rate to stay competitive with the FFR. This also affects the Treasury yield. When Fed increases the FFR (overnight rate) to be higher than the 1 Month Treasury Yield, the new issuance of the 1Month Treasury needs to offer a better yield than the FFR; if not, there will be zero demand for the bond. Thus the yield on 1Month Treasury goes up due to supply and demand. As the 1 Month Treasury yield head is higher than the 2 Month Yield, the 2 Month Treasury will also need to offer a better rate. So on and so forth until the 30 Years Treasury, which effectively determines your Mortgage Rates.
The FFR is a leading indicator for longer maturity yields. This forms the Yield Curve, which is a living, breathing organism. With this understanding, you will expect longer maturity rates to be higher than short maturity rates. This is because holding longer means higher risk. Think of Treasuries as insurance. If you're insured for longer, your premium is higher.
What happens when the Yield Curve gets inverted? Inversion is when long-term maturity rates are LOWER than short-term maturity rates. In other words, the market is saying,
"Yes, Federal Reserve, we know you offer higher rates, but we don't want it! We are willing to lock in a lower rate on longer maturity!"
Imagine that a bank offers a 4.6% PA Rate for 3 Month Fixed Deposit (FD), but customers choose 3.5% PA for 10 Year FD instead. That is the current situation; 3 Months Yield is at 4.6%, but 10 Year yield is at 3.5%
Now, why would the market do that? Have they gone mad?
The market expects the short-term yield to collapse due to a possible recession. The market is looking at every single piece of data available. If the economic data are pointing toward a recession, then sooner or later, Federal Reserve must lower the FFR rates, which would then drive the short-term maturity yield lower. While this has not happened yet, the overwhelming evidence of a possible recession is so high that the market is willing to lock in a lower rate at longer maturities because they believe that soon the short-maturity yield will collapse.
Think of it this way. Yes, you can get a 4.6%PA rate for 3 Month Treasury now. What if the economy, during that 3 months, goes into recession? The 3 Months Treasure yield will now collapse to 1% while the 10 Year Yield to 1.5% (hypothetical). After the three months end, you got back your capital, but now you can no longer re-roll your capital to 4.5% PA for another 3 Months since the 3 Month rates are now much lower. Now, you could park your cash in the 10-Year Treasury, but its rate has also collapsed. The 10-Year Treasury is no longer being offered at 3.5 %PA due to overwhelming demand. You realized in horror that you could have gotten a better deal had you parked your cash in 10 Year Yield from the beginning.
When the curve inverts, the longer maturity yield becomes the leading indicator for short-term maturity. Now that is why Yield Curve is a living organism; it reacts, but it also predicts. It is a collective mass of market expectations and central bank policies.
So, what is the Inverted Yield Curve predicting? It is predicting that the Federal Reserve will cut rates in the near future due to recessionary risk. It is predicting a Fed Pivot. Isn't it ironic how the stock market is asking for a Fed Pivot? There's a saying, be careful what you wish for.
Now the golden question. If the yield curve is inverted, then we know there is an incoming recession, then why is the stock market rallying? Folks who ask this question need help to understand the mechanism of the Yield Curve and the cause of Inversion. The yield curve cannot be just another "indicator" on their list where they apply shortcut analysis of " Line up means I long, Line down means I short."
Firstly, investors and traders protecting themselves caused the curve inversion. This means fund managers and portfolio managers are hedging their portfolios already. Big funds DO NOT hedge their portfolio because they see the curve inversion. It is the action of big funds hedging by locking in long-term rates that CAUSED the inversion.
The stock market, on the other hand... is a beast that cannot be tamed.
Let's take a break now before this turn into a wall of text. Part 2 shall be out in a few days! To be continued!
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