Fed Rate Indicator Hints at Big Cuts, Looming Economic Challenges

Just when you might have thought every possible metric that might apply to the status of Fed interest rates has been a calculation to incomprehension, Barron’s found a new one — the difference between the effective federal fund rate and the yield of the Treasury two-year.

Ever since Federal Reserve chair Jerome Powell confirmed that “time has come for [monetary] policy to adjust,” markets have taken this reasonably as something as close to a guarantee the central bank can offer as a promise of rate cuts. But the effective federal funds rate (EFFR) — the average amount banks charge one another for overnight loans without collateral — won’t change until it the Federal Open Market Committee makes it.

That means, as of Monday, September 9, the EFFR was 5.33% while the 2-year yield was 3.68%. Subtract the former from the latter and the result is -136 basis points, the most negative figure since the -146 basis point difference in January 2008.

Barron’s noted that while this isn’t a guarantee of an imminent recession, “it does suggest that the shift in monetary policy could be as rapid and significant as the response to the 2008-2009 crisis.”

A GlobeSt.com analysis of the data at the Federal Reserve Bank of St. Louis’ FRED site brings up another point. Since 1976, every time the difference between the two rates dropped below approximately -100 basis points, a recession started between two and 12 months later.

Barron’s referred to the 2008 recession as a balance sheet recession. The term refers to a situation when there are high levels of public debt accompanied by low asset prices. The publication said that neither consumers nor individuals are heavily indebted.

“This doesn’t look like a balance sheet recession yet, but credit spreads are starting to widen while the yen strengthens; both are liquidity drains,”  Jeff deGraaf, founder and CEO of Renaissance Macro Research, said in a client note.

Perhaps that is true, but the suggestion falls away for a great deal of the CRE industry, where there is a lot of debt and declining valuations that in many cases can’t be refinanced or sold at their previous values. There has been downward pressure on rents and upward pressure on such expenses as insurance, taxes, and utilities. A recession in 2025 would only exasperate negative conditions.

An associated concern is, should there be a significant economic problem, could and would the Fed cut rates to the bone/?

RXR CEO Scott Rechler recently said there isn’t a level of cuts the Fed would offer to save commercial real estate. Instead, the interest rate story will be “higher is the new normal.”

And Powell admitted in July congressional testimony, “I think we probably won’t go back to that era between the global financial crisis and the pandemic, [when] rates were very low, and inflation was very low.”

Even if the change is 3% to 4% rather than 0% to 2%, that “still is going to require us to recalibrate values, recalibrate capital structures along the way,” Rechler said. There may not be a cavalry available in 2025 should things turn sharply downward.