Why the Fed funds rate influences investment decisions

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Investment decisions

When deciding about investing in short-duration versus long-duration investments, investors often look at current and future expectations for the Fed funds rate.

In its simplest form, duration is the time taken, in years, by a bond’s internal cash flows to recover its cost. Bonds with low duration bear less interest rate risk, as their cost is recovered faster so the price of the bond is less susceptible to interest rate changes. The higher the duration, the more the bond’s price will react to interest rate changes. So this is a measure of the sensitivity of a bond’s price to changes in interest rates.

The Federal funds rate

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The Federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. It’s one of the most influential rates in the U.S. economy. The Fed funds rate is decided by the Federal Open Market Committee (or FOMC), the primary monetary-policymaking body in the U.S.

Simply put, the higher the Fed funds rate, the higher the cost of credit available in the economy. It acts like a base rate for determining all other interest rates in the economy. The main concern of an investor is interest rates. So the market interest rate, largely determined by the Fed funds rate, also determines investors’ decisions with respect to choice of investment.

Quantitative easing and the zero lower bound Fed funds rate

The mass bond-buying program by the U.S. Federal Reserve to induce liquidity in the financial markets, also referred to as “quantitative easing” (or QE), leads to a reduction in the Fed funds rate, as there’s greater availability of credit in the market. The current QE cycle started on September 13, 2012, has led to a decrease in the Fed funds rate to a zero lower bound (or ZLB) level, evident in the chart above. The ZLB is a situation where the short-term nominal interest rate is zero, or near zero.

Tapering and the Fed funds rate

Considering a pick-up in economic activity and growth, the Fed decided to taper its $85 billion a month QE program by $10 billion each time, starting January 2014. The Fed has, since then, tapered its QE program thrice. The current bond buying stands at $55 billion a month.

Though changes in the Fed funds rate directly affect the performance of ETFs tracking short-term Treasury securities like the iShares Barclays 1-3 Year Treasury Bond Fund (SHY), the change cascades along the Treasury yield curve and eventually affects longer-term Treasury-tracking ETFs like the iShares Barclays 20 Year Treasury Bond Fund (TLT) even more due to their higher duration.

However, with interest rates having been low for a while and the market expecting a rise after the first quarter next year, investors sometimes prefer ETFs that are designed to play rising interest rates, such as the SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN), which tracks the floating rate debt of companies like Goldman Sachs (GS) and JP Morgan Chase & Co. (JPM).

To learn more about how the Fed funds rate has moved in the last six months, read on to the next part of this series.

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