The Fed funds rate is the rate at which banks borrow Fed funds overnight. It’s currently at 0%–0.25%. It’s been at this level since the end of 2008. This is the longest period in history with a near-zero interest rate environment.
The quantitative easing policy was adopted by the Federal Reserve at the end of 2008 to boost economic growth. It involved massive securities purchases from member banks to increase the money supply. It also included a drastic reduction in interest rates.
Lower interest rates are expected to stimulate economic growth. Cheaper loans help businesses expand. Similarly, more money to spend is available in people’s hands, which results in increased demand.
LIBOR rates are affected by the Fed funds rate. Generally, LIBOR rates follow the Fed funds rate closely. Since most bank loans and adjustable-rate mortgages are based on LIBOR rates, changes in these rates impact the amount borrowers pay on their loans.
Interest rate environment impacts banks’ profitability
Prevailing rates also have an indirect impact on a bank’s profitability. The rates impact loan demand, default rates on loans, and activity in capital markets. Similarly, increased capital market activities translate into higher fee-based income for banks for services such as underwriting, mergers and acquisitions, advisory, and more.
You may invest in banks, including Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), and JP Morgan (JPM), through ETFs that focus on the financial sector, such as the Financial Select Sector SPDR ETF (XLF) and the iShares U.S. Financials ETF (IYF).
A sustained low-rate environment might impact banks negatively. You’ll see in the next part of this series how that can happen.