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What Is The Federal Funds Rate And Why Does It Matter?

For the last year, the #1 talking point among economists has been the federal funds rate. So what is the federal funds rate?

In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions’ reserve requirements.

The “what” is the easy part and it makes sense, the hard part is to understand “why it matters” so much to the global economy. There are a lot of researchers who have spent decades trying to figure out all the effects of interest rates and how it would impact the global economy.

I will just show the tip of the iceberg, to give you a decent understanding so you can use the knowledge when you’re investing.

Part one, the flow of capital.

Money was the first thing to become globalized in this new economy. It means that someone in Sweden could invest in US based securities and someone in the US could invest in, say, China. Below is a simplified version of capital flows 10 years ago.

capital-flowsThis only shows part of the picture, there are trillions of dollars in international capital flows (cross-border investments) every year. Let’s see how this has changed the way we think about exchange rates.

Part two, arbitrage the risk-free money

Thanks to international capital flows, the foreign exchange market (Forex trading) has become big business. There are computers who makes millions of trades a day, with tiny profits called arbitrage. Arbitrage is basically a trade where you can see a return with virtually no risk.  Here is an example where you buy euros, sell them for pounds, and then buy dollars with pounds. The result is that you just got $25,406 richer….. if only trading was so easy.

Triangular-arbitrage This is a short-term opportunity, when more people do this trade the profit gets smaller and smaller until your profit is zero.

Part three, how the interest rate affects the exchange rate. (The good stuff)

The same arbitrage can be done with interest rates and exchange rate. In this example, you either put your money in a US treasury bill with a 3.4% return… Or you exchange your dollars to euros and put it in a german treasury bond with a 4.6% return. After a year, you sell both of them and you make $170k on the US treasury note and $341k on the german one.

Covered-interest-arbitrage

Imagine if this trade would have worked every time?! This is not the case, as soon as people see that you can get a higher return on the german treasury bonds, people will sell their dollars and buy euros to take advantage of this opportunity. However, as with any supply and demand, it will affect the exchange rate. The dollar will get weaker and can’t buy as many euros as before since no one want dollars and everyone wants euros. In the end, it doesn’t matter if you go the US route or the German route they will give you the same return.

In layman’s terms this means that if the interest rate (federal funds rate) goes up, the value of the dollar goes up.

So why does the federal funds rate matter?

As you now know, an increase in the federal funds rate leads to a stronger dollar.

This has some serious effects, not only that your vacation to Greece or your London shopping spree costs you less. It has some negative effects too…

In a global world, the workforce is now starting to compete against each other. One example of this is Ford ($F), who are moving their factory jobs from in Michigan and open new factories in Mexico. A strong reason for this is the exchange rate between the dollar and the Mexican Peso. The dollar has appreciated 50% during the last 3 years, which means that you can buy 50% more tequila for the same $20 bill but it also means that ford can now afford to hire 1.5 times more workers for the same dollars spent.

ford-workers

Governments all over the world are now fighting this exact problem. This is the reason China has cut its interest rate  this year. The example I gave before with the german and US treasury bills yielding high returns is a mere theory today, the more accurate numbers is 0.5% on a 1 year US treasury bill and the german 1-year treasury bill would actually cost you 0.61%. This is unprecedented times where you have to pay to lend out your hard earned money.

During the time that the Mexican peso lost 50% of its value to the dollar, the federal funds rate has only been hiked once and that was in December last year from 0 to 0.25%.

Just the pure expectation that the interest rate will be hiked has increased the value of the dollar by about 30% during the last two years and it is giving strong headwinds not only for employees but for companies with international profits. This is why the federal funds rate matters and why it affects your portfolio.

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