Where To Invest After The Fed's 50 Basis Point Rate Cut | Will Rates Go Back To Zero?

The Fed just cut rates this week by 50 basis points. Are rates headed back to zero percent? Hello member super savers and bond course fans. So the last time the Fed raised rates was at its July 2023 FOMC meeting. Fast forward 15 months later and we finally have our first rate cut. With that in mind here are the three topics that we'll be covering in today's video. One, which rate did the Fed cut and how? Two, how does this lower rate impact short and long-term treasuries? And three, are rates headed back to zero like in the last decade and what now? I did one of our famous diamond nested deep dives for this question and you won't want to miss out on what we dug up for you here, especially if this last question has been heavy on your mind in recent weeks. As usual here's our front of video disclaimer. For a detailed disclaimer please refer to the end of this video. Let's dive in now folks. Our diamond nest egg regulars often hear me say on this channel that the Fed controls short-term rates. So let's talk briefly about who exactly makes such decisions at the Fed or more precisely who sits on the Federal Open Market Committee or FOMC and how they actually control interest rates. So the FOMC consists of 12 voting members. The seven members of the Board of Governors of the Federal Reserve System including its current chairman Jerome Powell, the President of the Federal Reserve Bank of New York and four of the remaining 11 Reserve Bank Presidents who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of banks. One bank president from each group Boston, Philadelphia and Richmond, Cleveland and Chicago, Atlanta, St. Louis and Dallas and Minneapolis, Kansas City and San Francisco. At the time of this taping these are the 12 people who sit on the FOMC with voting rights. They're the ones who set the rates and in that sense decide the fate of our bonds and our economy overall. The FOMC sets rates at eight regularly scheduled FOMC meetings every year and the rate that the FOMC controls is known as the Federal Funds Rate or Fed Funds Rate for short. Let's say we have Bank A. Bank A lends its reserve balances essentially the free cash it has on hand at the end of the day to Bank B overnight on an uncollateralized basis. Bank B pays Bank A a set interest rate on that overnight loan. This interest rate is the Fed Funds Rate and this lending that takes place between the banks because it is for one night only this is often referred to as the overnight lending market. The Fed Funds Rate is normally set as a range. So as I mentioned earlier between July of last year and just earlier this week the Fed Funds Rate was unchanged at between five and a quarter percent and five and a half percent. It now stands 50 basis points lower at between four and three quarter percent and five percent which quite frankly was more than we had expected given that core inflation last month came in higher than projected and retail sales are still going strong. Now you might be wondering why is the Fed Funds Rate set as a range and not as a single number right? Well because in our free market economy the Fed can't actually tell the banks exactly what they can charge other banks for overnight deposits and lending. So the Fed Funds Rate is set as a range so the Fed can use its monetary tools to make the banks stay within that range without forcing them directly. Here is an overview of the Fed's three primary monetary tools. The first tool is the interest it pays on money that banks deposit with them. This will generally be on the lower end of the Fed Funds Rate range. Now this interest rate also covers reverse repo agreements but we'll save reverse repos for another day if there's enough interest as they can get fairly complex very quickly. For today let's just say the reverse repos are essentially another tool for banks to deposit their money with the Fed and earn some interest on it but please do drop a comment below if this is something that interests you. Moving on to the Fed's second monetary tool and that's the interest rate it charges on money that banks borrow from them. This is also known as the discount rate and will generally be on the higher end of the Fed Funds Rate range. These first two monetary tools the interest rate the Fed pays on deposits and the discount rate the Fed charges on borrowing means that banks which have the privilege of depositing with or borrowing from the Fed would only deposit with or borrow from another bank if that other bank offers them better rates than the Fed. So for example if the Fed now pays four and three quarter percent for bank deposits here and charges five percent for bank loans here this means that the inter-bank rate the rate that banks will charge one another will end up somewhere between four and three quarter percent and five percent for example at 4.875 percent as the banks split the difference. Moving on now to the Fed's third monetary tool and that's open market operations. This refers to the buying and selling of government securities meaning treasuries for fine-tuning. The Fed uses it to regulate the amount of cash in circulation in the economy. Think quantitative easing and quantitative tightening. Again this can be a somewhat technical topic so we won't dive deeper here today but do drop us a note if you want us to have a closer look. Now the Fed Funds Rate is truly very short term. As previously noted it's strictly designed for overnight lending between banks on an uncollateralized meaning unsecured basis. Having said that the Fed Funds Rate is the basis for many other rates in the financial markets. So with that in mind let's move on now to the next section of this video and understand how this all influences the rates that we in our diamond nested community get for bond investments or pay for the loans we take out. Short-term treasury rates generally track the Fed Funds Rate very closely as we can see from this chart. The blue line shows the effective Fed Funds Rate for the last 20 years and the red line shows the yield on a three-month t-bill. When the Fed Funds Rate goes up so does the yield on the three-month t-bill. When the Fed Funds Rate goes down so does the yield on the three-month t-bill. In fact they're almost the same line if you look fast enough. So you can expect to see any change in the Fed Funds Rate to be translated almost immediately into other short-term financial products as well including t-bills and CDs with shorter maturity dates. Now perhaps a bit surprisingly this is quite different when we look at long-term treasury rates. Again the blue line shows the effective Fed Funds Rate for the last 20 years but this time the red line shows the yield on the benchmark 10-year t-note and while the red line for the 10-year t-note tracks the Fed Funds Rate in a wider general sense it sometimes does seem to have its own life and momentum and this is what we mean when we say that the Fed influences rates on the short end of the yield curve. For shorter maturities but much less so on the long end of the yield curve for longer maturities where supply, demand, liquidity, default rates and other market forces are at play as well. For example when the yield curve started inverting in 2022 because the market was anticipating an oncoming recession which has yet to materialize at the time of this taping by the way or here and here when the market was front running the Fed before the actual rate cut decision at the recent FOMC meeting. Now rates on medium and longer dated bonds have come down a fair bit recently which is almost to be expected given that so many market participants have been eagerly waiting for this Fed rate cut moment since 2023 already because while rate cuts may not be good for and fixed income investors looking to buy bonds now basically meaning while they are not good for many of the bond fans in our diamond nested community rate cuts are good for existing bond holders who are seeing the prices of their previously purchased higher coupon paying bonds go up remember the old law of bonds rates down prices up rate cuts are also good for borrowers whether that's someone who's taking out a mortgage to buy a new home or a company who wants to issue new debt to fund capital projects or refinance old debt that was previously issued at higher rates but if I look at the flurry of recent municipal and corporate bond offerings including this Goldman Sachs four and a half percent 10-year non-callable one from just a it almost seems to me that some of these bond issuers may be thinking that this recent decline in longer term rates may be short-lived at least for them and in their segment of the market drop a comment below what do you think was this a blip or will rates really go back to zero like in the 2010s and what now which is a great segue into the next section of this video so my personal expectation is that rates are not headed back to zero I know some of you in our community still have nightmares about the practically non-existent rates from the 2010s but what you should know is that the zero interest rate environment from the last decade was the exception not the historical norm as you can see from this chart we took this from all the way back in July 1954 up until present day 1954 was as far back as the data went on fred and the only two notable periods of zero interest rates over that seven decade period were in the 2010s and post-covid remember that deep dive that I touched upon at the beginning of this video well here it comes when we take these data points together we can get to the average fed funds rate over the years so if we look at the past seven decades starting from august of 1954 until august of this year the average fed funds rate over that period was 4.61 percent here's what that average looks like if we start from august 1964 1974 all the way up to 2014 and yes it seems that the average rates have generally been going down over the past seven decades reaching a historical low of only 1.64 percent for the last 20 years and 1.61 percent for the last 10 years as you can see here however these last two decades also include the years with the now infamous zero percent interest rate but if we consider these two notable periods of zero interest rates as historical exceptions that may not be repeated in the near future and take them out of our analysis then the average fed funds rate over these periods goes up quite a bit to 3.36 percent and 3.01 percent respectively now what the past several years has taught us is that anything can happen and I don't have a crystal ball either but barring a significant recession or major pandemic level catastrophe and based on our analysis here a return to the zero interest world of the past decade looks not very likely to us at the moment especially given the recent higher than expected core inflation and retail spending numbers plus the fundamental driver of higher long-term rates has not gone away our national debt which just keeps on ticking up and up at a historically never before seen speed and regardless of which candidate wins the november election there seems to be no real plan to slow down spending that said I do believe that there will be ongoing uncertainty and volatility in the bond market as traders and other participants continue to play guessing games with the fed and make bets on each new piece of economic data that comes out nearly every week so in my mind if you're in the camp that's happy with your short-term t-bills and money market funds despite knowing that those rates will come down like I am basically then there's no need to do much I like some of the diamond nest egg regulars who joined us early on have essentially been riding short-term rates up since 2022 when the fed started hiking rates and personally I'll be riding them down as well until I find something better and many thanks to all of you who've emailed us about the potentially something better opportunities we will be covering those in the coming months as we often say at diamond nest egg though everyone's financial journey is different and if you fall for example into the camp who's retired about to retire or just wants to lock in some still attractive rates on longer dated bonds then here are some things for you to consider one if you're very risk averse either start or continue your dollar cost averaging strategy into longer term treasuries you may also want to look at annuities and cds as alternatives two if you're less risk averse consider longer term non-callable agency municipal or investment grade corporate bonds as part of an overall diversified portfolio and three stay realistic about what rates are achievable in today's environment you can't avoid the iron law of financial markets higher risk higher return so while many in our community will be missing their five percent plus rates on risk-free short term t bills and you can count me into that camp as well these may just not be available anymore in the coming months and you may need to accept a bit more risk if you want a bit more return now if you want to really get up to speed on bond investing and building out your bond portfolio before rates could potentially go down further then check out this video here on our 2024 bond courses or come join our next live member q a this sunday september 22nd at 5 p.m eastern time 2 p.m pacific time to continue the rate cut and fixed income discussions further i've also linked all the details on our bond courses and youtube super super saver membership below this video for your convenience all right members super savers and bond course fans i hope you enjoy this video and learn something new and see you again very soon with more brand new wealth building content for your financial journey