Forecasting the Federal Funds Rate

Bundesbank Determines ECB Rate

In this article, we examine the relationship of the U.S. federal funds rate compared to the European Central Bank (ECB) rate. Short-term German yields, as illustrated below, led the decline in ECB rates. Beginning in early 2015, the ECB rate and German yields were in parity, but later that year, the Bundesbank asset purchases reduced the German yields of 3-month and 2-year bunds to as much as a negative 60 basis points. This resulted in a reduction of the ECB rate to a negative 30 basis points in 2015, then a negative 40 basis points in 2016.

In 2016 German short-term yields fell to record lows of -92 basis points. Important to note, however, is the 3-month cycle low of -90 basis points in 2016 and 2017, improved to -84 in 2018, and -72 in September 2019. This favorable trend occurred despite the 2-year bund yield falling to -90 basis points in September 2019.

Germany and other major European countries objected to the reduction in the ECB rate and the required asset purchases over the near term to keep the rate that negative. Since Germany had already established a cycle low in negative yields in September 2019, the actions of the ECB with a restart of asset purchases were not needed (see Chart I).

Chart I

Spreads Between U.S. and German Yields Price Fed Funds Rate

In an attempt to reduce the U.S. trade deficit, the administration adopted tariffs that would drive foreign governments to improve trade deals with the U.S. Germany’s and Japan’s economies slowed and, more importantly, China’s slowed dramatically. This shift in trade, along with other factors, created a decline in German manufacturing, causing the Bundesbank to create negative yields on bunds with purchases of bunds and other assets. Since the U.S. yields have historically followed bund yields, this manipulation has a direct effect on U.S. Treasuries.

The mandate of the Federal Reserve is to set a funds rate that will promote both maximum employment and stable prices for goods and services. The significant number and size of the increases in the fed funds rate in 2017 and 2018 attempted to accomplish the mandate, but in retrospect the rate increases to 2.5% proved too extreme. As the fed funds rate rose, the spread between U.S. and German short-term yields widened above the 10-year yield spread, causing inverted yield spreads, and indicating the rate increases were too aggressive for the world market.

The Federal Reserve was slow to react to the U.S. manufacturing slowdown and subsequent reductions in the fed funds rate were delayed to 2.25% in July and 2.0% in September. Yet, these reductions maintained the inverted spread of the federal funds rate less the ECB rate, and 3-month spreads relative to the 2, 5 and 10-year spreads (see Chart II).

Chart II

If structurally weak demand pushes foreign interest rates down, that can create deflationary pressure in the U.S. via a strong dollar unless the Federal Reserve also lowers rates.1 Another reduction in the fed funds rate to 1.75% would narrow the U.S.-to-German Central Bank rate and short-term yield spread to the level of the 10-year spread (see Chart II and Chart III). If economic weakness continued in the U.S. as well as the world, a further reduction in the federal funds rate to 1.50% or 1.25% is possible. On the other hand, a reversal in economic conditions with successful trade agreements is expected to reverse the German 10-Year yield to a positive 60 basis points with a 1.7% spread, indicating a U.S. 10-Year yield of 2.3% in 2020. Given this success, a federal funds rate of 1.75% seems reasonable for 2020.

Chart III

Recent Events

U.S. manufacturing activity fell to a 10-year low in September. One of the primary causes is Germany cutting back dramatically on imports from the U.S. since March 2019. As the largest foreign buyer of US manufactured products, this decline in US exports reduced the manufacturing PMI.

The U.S. manufacturing PMI fell in September to 47.8 from 49.1 in August, primarily due to soft global trade. The yield on the U.S. 10-year T-Note fell slightly to 1.54%, above its cycle low of 1.47%. The German PMI for manufacturing, which accounts for about a fifth of the German economy, fell to 41.7 in September from 43.5 the previous month. The German 10-year bund yield held steady at -58 basis points, above its cycle low of -70 basis points (see Chart IV).

On October 3, the U.S. set to impose tariffs on imports from the EU, with 10% levies on aircraft and 25% on duties and other products including Irish and Scotch whiskies, cheese and hand tools. Amid these implementations, German yields remained stable.

The U.S. economy added 161,000 jobs on average per month in 2019, and unemployment reached record lows in September, yet manufacturing sector employment declined. The predominant issues to blame for the manufacturing slump are the strong U.S. dollar putting U.S. manufacturing at a disadvantage, and the decline in exports to Germany.

Due to the secular improvement of German 3-month yields in 2018 and 2019, 2-year yields in 2019 mirroring lows from 2016, and the reversal in both U.S. and German 10-year yields, IDC Financial Publishing believes U.S. and German yields have hit cycle lows. Higher yields will be dependent upon future successful trade deals with Japan, China and Europe.

Chart IV

1. Wall Street Journal “For a Change, It’s the World that is Pulling Down the U.S. Economy”

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John E Rickmeier, CFA, President, jer@idcfp.com

Robin Rickmeier, Marketing Director