How does the Federal funds rate translate to Treasury rates?

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martincmartin
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How does the Federal funds rate translate to Treasury rates?

Post by martincmartin »

There's lots of confusion in this forum around the fact that the Fed is expected to keep raising "interest rates"; yet by the Efficient Market Hypothesis, the interest rate on Treasuries, mortgages or anything else set by a free market should already reflect those expected raises.

So, what is the process whereby the Fed, raising its rate, causes other rates to change?

The Fed's rate is the rate it pays banks to keep their funds with the Fed overnight, correct? So if that rate is, say, 10%, the bank thinks "I can get 10% interest by loaning to the Fed, and its super liquid." So for the bank to loan to a company or individual instead, the company/individual would need to pay enough in interest to make it more attractive.

One wrinkle is that Fed's fund rate can change every month, and while we might have a good idea what it will be in a few months, we don't for a few years from now. So if the Fed's fund rate is 10% now, its not like a 30 year fixed mortgage has to be > 10% to entice the bank.

On the other side, we have non-bank investors who are buying Treasuries. They can't get the Federal funds rate, so that's not directly relevant. But ... maybe if Treasury rates are too low, banks sell their Treasuries to raise money to keep with the Fed, and this causes Treasury prices to fall/rates to rise?

And this interest that the Fed is paying, this is newly printed money, correct? In general, printing money should cause inflation, but maybe that's a long term effect? And the short term effect is to discourage banks from lending to companies/individuals, and this makes it harder for companies to operate, cutting into their profits and reducing GDP? Or something?

In summary: what's the mechanism whereby the Fed raising rates affects Treasury rates, inflation and GDP?
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bobcat2
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Re: How does the Federal funds rate translate to Treasury rates?

Post by bobcat2 »

martincmartin wrote: Sat Jul 02, 2022 8:18 amThe Fed's rate is the rate it pays banks to keep their funds with the Fed overnight, correct?
No, that is not correct. The discount rate is the rate the Fed pays charges when lending to member banks overnight. It is rarely used by the member banks, perhaps because they sense the Fed may look at them closely if they use the discount rate regularly. The federal funds rate is the rate Federal Reserve member banks pay each other for overnight loans between member banks. Unlike the discount rate, this is used heavily by the member banks. The Fed cannot set the funds rate like it can set the discount rate. However, the Fed can very accurately target the federal funds rate through open-market operations at the NY Fed trading desk.

BobK

PS - The Fed's changing the discount is mainly about signaling future Fed intentions and is often referred to as "banging the gong".


Edited for dumb typo or thinko on my part. :oops:
Last edited by bobcat2 on Sat Jul 02, 2022 10:44 am, edited 2 times in total.
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ljford7
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Re: How does the Federal funds rate translate to Treasury rates?

Post by ljford7 »

martincmartin wrote: Sat Jul 02, 2022 8:18 am In summary: what's the mechanism whereby the Fed raising rates affects Treasury rates
I have wondered the same thing.

Another thing I have wondered is that the Fed appears to be telegraphing rates getting to the 3% - 3.5% range. What happens if the Fed raises them to say 3.5% and the market says, no we think it should be 3%. Can the market trade at a discount the Fed? Has it happened before?
billyt
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Re: How does the Federal funds rate translate to Treasury rates?

Post by billyt »

Currently:
Federal Reserve Target: 1.75%
Federal Funds Rate: 1.56%
3 month Treasury: 1.64%
alex_686
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Re: How does the Federal funds rate translate to Treasury rates?

Post by alex_686 »

You have many things correct, many things wrong.

We kind of do know what the Fed Funds rate will be years in the future. The 10 year fixed-to-float Fed Funds swap market is very liquid.

It is true that the interest rates are determined by supply and demand. It is also true that these different tenors of bonds are tightly and causally linked.

Consider scenario A where a person buys a 1 year Treasury. Then consider scenario B where a person buys a 6 month treasury and then will roll that 6 month treasury into a new 6 month treasury. Question- what do we expect the 6 month treasury rate 6 months from now? And we do know that answer. The 2 different scenarios must have the same expected returns or there is a arbitrage trade that I can make to generate risk free profits.

This is routinely done in the swap market.
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grok87
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Re: How does the Federal funds rate translate to Treasury rates?

Post by grok87 »

billyt wrote: Sat Jul 02, 2022 8:53 am Currently:
Federal Reserve Target: 1.75%
Federal Funds Rate: 1.56%
3 month Treasury: 1.64%
target is 1.5-1.75
https://www.federalreserve.gov/newseven ... 0615a1.htm
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barnaby444
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Re: How does the Federal funds rate translate to Treasury rates?

Post by barnaby444 »

bobcat2 wrote: Sat Jul 02, 2022 8:36 am
martincmartin wrote: Sat Jul 02, 2022 8:18 amThe Fed's rate is the rate it pays banks to keep their funds with the Fed overnight, correct?
No, that is not correct. The discount rate is the rate the Fed pays banks to keep their funds with the Fed overnight.
This is also not correct. The discount rate is the rate the Fed charges to lend to banks overnight. However it's correct that:
The federal funds rate is the rate Federal Reserve member banks pay each other for overnight loans between member banks.
The Fed influences this rate by controlling the amount of liquidity (bank reserves) in the banking system through open market operations (swapping treasuries for bank reserves). Banks borrow from each other at this rate regularly to have enough cash to settle payments. If the FFR is higher (because the Fed sold treasuries in exchange for reserves, thereby reducing the supply of reserves in the system), Treasury rates also go higher both because (a) there are now more Treasuries in the market than investors want at their current yield, so their price goes down and yield goes up, and (b) for banks, short-term treasuries are a competing investment with overnight lending to other banks, and if they can get a higher rate by lending to other banks, they will have less demand for treasuries, thereby pushing their yields up.
billaster
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Re: How does the Federal funds rate translate to Treasury rates?

Post by billaster »

barnaby444 wrote: Sat Jul 02, 2022 9:15 am
bobcat2 wrote: Sat Jul 02, 2022 8:36 am
martincmartin wrote: Sat Jul 02, 2022 8:18 amThe Fed's rate is the rate it pays banks to keep their funds with the Fed overnight, correct?
No, that is not correct. The discount rate is the rate the Fed pays banks to keep their funds with the Fed overnight.
This is also not correct. The discount rate is the rate the Fed charges to lend to banks overnight. However it's correct that:
The federal funds rate is the rate Federal Reserve member banks pay each other for overnight loans between member banks.
The Fed influences this rate by controlling the amount of liquidity (bank reserves) in the banking system through open market operations (swapping treasuries for bank reserves). Banks borrow from each other at this rate regularly to have enough cash to settle payments. If the FFR is higher (because the Fed sold treasuries in exchange for reserves, thereby reducing the supply of reserves in the system), Treasury rates also go higher both because (a) there are now more Treasuries in the market than investors want at their current yield, so their price goes down and yield goes up, and (b) for banks, short-term treasuries are a competing investment with overnight lending to other banks, and if they can get a higher rate by lending to other banks, they will have less demand for treasuries, thereby pushing their yields up.
Well, we are getting closer to correct!

Barnaby is right. The discount rate is the rate that the Fed charges to lend to banks overnight. This rate is usually higher than the Federal Funds Rate so is rarely used except in financial crisis. A bank forced to borrow from the discount window has a stigma that indicates a bank is in trouble. Instead, the Fed encourages banks to borrow and lend to each other through the Federal Funds Rate.

The Federal Funds Rate is not a specific rate, but a target range set by the Federal Reserve Board. Right now the range is between 1.50% and 1.75%. The actual rate, called the Effective Federal Funds Rate is determined by the weighted median of the interest that banks charge each other for overnight lending. So the Fed sets the target but the actual rate is determined by banks lending to each other, but influenced by the Fed

As Barnaby said, the Fed used to manage this rate by buying and selling Treasuries to throttle bank reserves, but that is no longer the case. Because of quantitative easing, the banks now have so much reserves that this mechanism no longer has a direct effect on the Federal Funds Rate.

Now, instead, the Fed uses two other mechanisms to manage the Federal Funds Rate. The Fed pays Interest on Reserve Balances (IORB). So if the target is 1.50% to 1.75%, the Fed sets its interest on reserves at 1.65%. This sets a floor on lending between banks because they can get at least 1.65% by simply keeping their reserves on deposit rather than lending to other banks.

The Fed only pays interest on reserves keep on deposit by Federal Reserve member banks, which are about a third of all the big commercial banks in the U.S., about 3000 banks. For non-member banks, the Fed has a separate mechanism called the Overnight Reverse Repo Purchase facility (ON RRP) which works similarly to the IORB, but for non-member banks.

So the Fed sets the Federal Funds Rate which becomes a floor for all other borrowing from mortgages to auto loans to business loans.
Last edited by billaster on Sat Jul 02, 2022 11:12 am, edited 1 time in total.
coachd50
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Re: How does the Federal funds rate translate to Treasury rates?

Post by coachd50 »

bobcat2 wrote: Sat Jul 02, 2022 8:36 am
martincmartin wrote: Sat Jul 02, 2022 8:18 amThe Fed's rate is the rate it pays banks to keep their funds with the Fed overnight, correct?
No, that is not correct. The discount rate is the rate the Fed pays charges when lending to member banks overnight. It is rarely used by the member banks, perhaps because they sense the Fed may look at them closely if they use the discount rate regularly. The federal funds rate is the rate Federal Reserve member banks pay each other for overnight loans between member banks. Unlike the discount rate, this is used heavily by the member banks. The Fed cannot set the funds rate like it can set the discount rate. However, the Fed can very accurately target the federal funds rate through open-market operations at the NY Fed trading desk.

BobK

PS - The Fed's changing the discount is mainly about signaling future Fed intentions and is often referred to as "banging the gong".


Edited for dumb typo or thinko on my part. :oops:
It is SO refreshing to see someone accurately describe the Fed's actions here. I constantly hear people stating "The Fed set the Fed Funds rate at ..." and cringe.
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Re: How does the Federal funds rate translate to Treasury rates?

Post by coachd50 »

billaster wrote: Sat Jul 02, 2022 11:06 am
barnaby444 wrote: Sat Jul 02, 2022 9:15 am
bobcat2 wrote: Sat Jul 02, 2022 8:36 am
martincmartin wrote: Sat Jul 02, 2022 8:18 amThe Fed's rate is the rate it pays banks to keep their funds with the Fed overnight, correct?
No, that is not correct. The discount rate is the rate the Fed pays banks to keep their funds with the Fed overnight.
This is also not correct. The discount rate is the rate the Fed charges to lend to banks overnight. However it's correct that:
The federal funds rate is the rate Federal Reserve member banks pay each other for overnight loans between member banks.
The Fed influences this rate by controlling the amount of liquidity (bank reserves) in the banking system through open market operations (swapping treasuries for bank reserves). Banks borrow from each other at this rate regularly to have enough cash to settle payments. If the FFR is higher (because the Fed sold treasuries in exchange for reserves, thereby reducing the supply of reserves in the system), Treasury rates also go higher both because (a) there are now more Treasuries in the market than investors want at their current yield, so their price goes down and yield goes up, and (b) for banks, short-term treasuries are a competing investment with overnight lending to other banks, and if they can get a higher rate by lending to other banks, they will have less demand for treasuries, thereby pushing their yields up.
Well, we are getting closer to correct!

Barnaby is right. The discount rate is the rate that the Fed charges to lend to banks overnight. This rate is usually higher than the Federal Funds Rate so is rarely used except in financial crisis. A bank forced to borrow from the discount window has a stigma that indicates a bank is in trouble. Instead, the Fed encourages banks to borrow and lend to each other through the Federal Funds Rate.

The Federal Funds Rate is not a specific rate, but a target range set by the Federal Reserve Board. Right now the range is between 1.50% and 1.75%. The actual rate, called the Effective Federal Funds Rate is determined by the weighted median of the interest that banks charge each other for overnight lending. So the Fed sets the target but the actual rate is determined by banks lending to each other, but influenced by the Fed

As Barnaby said, the Fed used to manage this rate by buying and selling Treasuries to throttle bank reserves, but that is no longer that case. Because of quantitative easing, the banks now have so much reserves that this mechanism no longer has a direct effect on the Federal Funds Rate.

Now, instead, the Fed uses two other mechanisms to manage the Federal Funds Rate. The Fed pays Interest on Reserve Balances (IORB). So if the target is 1.50% to 1.75%, the Fed sets its interest on reserves at 1.65%. This sets a floor on lending between banks because they can get at least 1.65% by simply keeping their reserves on deposit rather than lending to other banks.

The Fed only pays interest on reserves keep on deposit by Federal Reserve member banks, which are about a third of all the big commercial banks in the U.S., about 3000 banks. For non-member banks, the Fed has a separate mechanism called the Overnight Reverse Repo Purchase facility (ON RRP) which works similarly to the IORB, but for non-member banks.

So the Fed sets the Federal Funds Rate which becomes a floor for all other borrowing from mortgages to auto loans to business loans.
Again, it is refreshing to see someone accurately describe central bank operations! Thank you.
barnaby444
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Re: How does the Federal funds rate translate to Treasury rates?

Post by barnaby444 »

billaster wrote: Sat Jul 02, 2022 11:06 am
barnaby444 wrote: Sat Jul 02, 2022 9:15 am
bobcat2 wrote: Sat Jul 02, 2022 8:36 am
martincmartin wrote: Sat Jul 02, 2022 8:18 amThe Fed's rate is the rate it pays banks to keep their funds with the Fed overnight, correct?
No, that is not correct. The discount rate is the rate the Fed pays banks to keep their funds with the Fed overnight.
This is also not correct. The discount rate is the rate the Fed charges to lend to banks overnight. However it's correct that:
The federal funds rate is the rate Federal Reserve member banks pay each other for overnight loans between member banks.
The Fed influences this rate by controlling the amount of liquidity (bank reserves) in the banking system through open market operations (swapping treasuries for bank reserves). Banks borrow from each other at this rate regularly to have enough cash to settle payments. If the FFR is higher (because the Fed sold treasuries in exchange for reserves, thereby reducing the supply of reserves in the system), Treasury rates also go higher both because (a) there are now more Treasuries in the market than investors want at their current yield, so their price goes down and yield goes up, and (b) for banks, short-term treasuries are a competing investment with overnight lending to other banks, and if they can get a higher rate by lending to other banks, they will have less demand for treasuries, thereby pushing their yields up.
Well, we are getting closer to correct!

Barnaby is right. The discount rate is the rate that the Fed charges to lend to banks overnight. This rate is usually higher than the Federal Funds Rate so is rarely used except in financial crisis. A bank forced to borrow from the discount window has a stigma that indicates a bank is in trouble. Instead, the Fed encourages banks to borrow and lend to each other through the Federal Funds Rate.

The Federal Funds Rate is not a specific rate, but a target range set by the Federal Reserve Board. Right now the range is between 1.50% and 1.75%. The actual rate, called the Effective Federal Funds Rate is determined by the weighted median of the interest that banks charge each other for overnight lending. So the Fed sets the target but the actual rate is determined by banks lending to each other, but influenced by the Fed

As Barnaby said, the Fed used to manage this rate by buying and selling Treasuries to throttle bank reserves, but that is no longer the case. Because of quantitative easing, the banks now have so much reserves that this mechanism no longer has a direct effect on the Federal Funds Rate.

Now, instead, the Fed uses two other mechanisms to manage the Federal Funds Rate. The Fed pays Interest on Reserve Balances (IORB). So if the target is 1.50% to 1.75%, the Fed sets its interest on reserves at 1.65%. This sets a floor on lending between banks because they can get at least 1.65% by simply keeping their reserves on deposit rather than lending to other banks.

The Fed only pays interest on reserves keep on deposit by Federal Reserve member banks, which are about a third of all the big commercial banks in the U.S., about 3000 banks. For non-member banks, the Fed has a separate mechanism called the Overnight Reverse Repo Purchase facility (ON RRP) which works similarly to the IORB, but for non-member banks.

So the Fed sets the Federal Funds Rate which becomes a floor for all other borrowing from mortgages to auto loans to business loans.

This makes sense when the target rate is near zero (as it had been up until recently) but if the Fed wanted to raise rates significantly (as it is doing now), would they not, in addition to raising the IORB, also use open market operations to decrease the supply of reserves? I’m genuinely asking, as I don’t know what they’re doing now. But to me, permanently leaving abundant excess reserves in the system regardless of the target FFR seems odd.
billaster
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Re: How does the Federal funds rate translate to Treasury rates?

Post by billaster »

barnaby444 wrote: Sat Jul 02, 2022 11:35 am This makes sense when the target rate is near zero (as it had been up until recently) but if the Fed wanted to raise rates significantly (as it is doing now), would they not, in addition to raising the IORB, also use open market operations to decrease the supply of reserves? I’m genuinely asking, as I don’t know what they’re doing now. But to me, permanently leaving abundant excess reserves in the system regardless of the target FFR seems odd.
The answer is obvious when you see the context. Below is a chart up to 2007 showing required reserves in red and deposited reserves in blue. As you can see, the Fed was able to throttle deposited reserves very close to the required limit by buying and selling Treasuries. They could control interest rates just by increasing and decreasing deposited reserves slightly.

Image



Okay, now lets expand the same graph out to the present. Below you can see that quantitative easing has vastly increased the amount of reserves on deposit. Compare the scales on the top and bottom charts. The top chart goes up to $70 billion and the bottom chart goes up to $5,000 billion.

Below on the left up to 2007 you see the red and blue line are almost on top of each other. That is just a zoomed out view of the graph above scaled way up. But now the deposited reserves are way, way above required reserves so that the Fed can't throttle reserves anymore. And in fact, in 2020 the Fed threw in the towel and entirely eliminated reserve requirements because there isn't any point anymore. That's on the right where the red reserve requirements line goes to zero

Image

So that is why the Fed no longer uses open market operations to control the Federal Funds Rate. It doesn't work anymore. It instead uses the newer mechanisms of IORB and ON RRP. It's going to take many years for the Fed to reduce deposited reserves back down to previous levels at its current rate of 60 billion a month.
barnaby444
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Re: How does the Federal funds rate translate to Treasury rates?

Post by barnaby444 »

billaster wrote: Sat Jul 02, 2022 12:42 pm
barnaby444 wrote: Sat Jul 02, 2022 11:35 am This makes sense when the target rate is near zero (as it had been up until recently) but if the Fed wanted to raise rates significantly (as it is doing now), would they not, in addition to raising the IORB, also use open market operations to decrease the supply of reserves? I’m genuinely asking, as I don’t know what they’re doing now. But to me, permanently leaving abundant excess reserves in the system regardless of the target FFR seems odd.
The answer is obvious when you see the context. Below is a chart up to 2007 showing required reserves in red and deposited reserves in blue. As you can see, the Fed was able to throttle deposited reserves very close to the required limit by buying and selling Treasuries. They could control interest rates just by increasing and decreasing deposited reserves slightly.

Image



Okay, now lets expand the same graph out to the present. Below you can see that quantitative easing has vastly increased the amount of reserves on deposit. Compare the scales on the top and bottom charts. The top chart goes up to $70 billion and the bottom chart goes up to $5,000 billion.

Below on the left up to 2007 you see the red and blue line are almost on top of each other. That is just a zoomed out view of the graph above scaled way up. But now the deposited reserves are way, way above required reserves so that the Fed can't throttle reserves anymore. And in fact, in 2020 the Fed threw in the towel and entirely eliminated reserve requirements because there isn't any point anymore. That's on the right where the red reserve requirements line goes to zero

Image

So that is why the Fed no longer uses open market operations to control the Federal Funds Rate. It doesn't work anymore. It instead uses the newer mechanisms of IORB and ON RRP. It's going to take many years for the Fed to reduce deposited reserves back down to previous levels at its current rate of 60 billion a month.
Thanks. Also curious what your take is on OP’s original question (how does FFR influence treasury rates?). I took a crack at it but in light of your more updated description of the FFR control mechanism, maybe you have a different description here too?
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Re: How does the Federal funds rate translate to Treasury rates?

Post by billaster »

barnaby444 wrote: Sat Jul 02, 2022 12:56 pm Thanks. Also curious what your take is on OP’s original question (how does FFR influence treasury rates?). I took a crack at it but in light of your more updated description of the FFR control mechanism, maybe you have a different description here too?
Here's a chart showing Federal Funds Rate in blue, 1-year Treasury yield in red and 10-year Treasury yield in green. As you can see, the 1-year Treasury very closely tracks the Federal Funds Rate. Longer term bond yields don't track as closely. The longer term bond yields are the market's estimate of how the 1-year year yield will vary over the next 10 years or so.

On the far right you can see that the 1-year yield is running significantly above the Federal Funds Rate at this time. That suggests that the market is anticipating a rapidly increasing Federal Funds Rate.

Image
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Re: How does the Federal funds rate translate to Treasury rates?

Post by Oicuryy »

There is no direct connection between the federal funds rate and Treasury rates. Here are three ways the Fed influences interest rates in the economy

The Fed's overnight reverse repurchase program lets primary dealers and money market mutual funds lend to the Fed at a fixed interest rate set by the Fed. Primary dealers can act for their own accounts or for their clients. Money market funds act for their shareholders. The Fed sets this interest rate slightly above the bottom of its target range for the federal funds rate. This tends to set a floor for overnight market interest rates.
https://www.newyorkfed.org/markets/dome ... agreements

The Fed's standing repo facility lets primary dealers borrow at a fixed interest rate set by the Fed. The Fed sets this rate at the top of its range for the federal funds rate. This tends to set a ceiling on overnight market interest rates.

Banks reflexively set their prime lending rate at three percentage points above the top of the Fed's target range for the federal funds rate. This tends to affect the interest rates banks charge for loans to the extent those rates are tied to the prime rate.
https://fred.stlouisfed.org/graph/?g=RhDN

Treasury is just another borrower that has to live with the influence the Fed has on market interest rates.

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Re: How does the Federal funds rate translate to Treasury rates?

Post by nisiprius »

At some level, if you want to borrow money for ten years, one way of doing that is to borrowing it overnight 3,650 times. If you were absolutely sure you knew what the overnight rate would be for the next 3,650 days, that would put a floor under the ten-year rate--because if the ten-year rate were going to be less, then everybody would just take the "one-day-at-a-time" route. In order to get people to buy ten-year bonds, the Treasury has to pay more than people think they can get by just rolling over shorter-term bonds.

So it seems likely that there is some relationship between "the anticipated/expected/predicted overnight rate over the next ten years" and "the ten-year rate."

On the other hand, there can possibly be any simple translation because from 2004 to 2007, the Fed Funds rate rose more than 4%, but the 10-year rate rose less than 1%.

So the Treasury Y-year rate is a market-based value, based on market judgment of many factors, of which the today's Fed Fund rate is only one... and the expected future time course of the Fed Funds rate over the next Y years is another.
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martincmartin
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Re: How does the Federal funds rate translate to Treasury rates?

Post by martincmartin »

Thanks nisprius.
nisiprius wrote: Sat Jul 02, 2022 1:45 pm At some level, if you want to borrow money for ten years, one way of doing that is to borrowing it overnight 3,650 times.
But I, as a retail investor, can't borrow from the Fed. So I would buy a Treasury, even if the rate were lower than the one-day-at-a-time option, since that option isn't open to me.

Similarity for companies, I think. Walmart can't borrow overnight from the Fed, can it?
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Re: How does the Federal funds rate translate to Treasury rates?

Post by rockstar »

It has nothing to do with treasury rates. However, QE and QT both impact treasury rates.

Now, for a nice proxy to the Fed Funds, I think, the 3 month t-bill is in the same ballpark.

Finally, if the Fed Funds rate goes to 4%, then it's likely that you'll see longer duration treasury rates much higher as I would expect the 3 month t-bill to end up at roughly 4%. You could have some inversion, but I can't see it being more than a point.

These are my guesses.

We're likely already in a recession with the Fed ready to raise rates again. Now, this is feeling like Greenspan. The treasury market is likely to become more volatile in the short term as it's really difficult to figure out what's going on.
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Re: How does the Federal funds rate translate to Treasury rates?

Post by billyt »

As recently as September 2019, the 10 year rate was 50 basis points less than the 3-month. Unusual, but does happen during Fed tightening cycles.
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