The last time this lending metric was this tight was 2008 and the market fell 31% over the coming six months. I'm going to explain a somewhat complex reading we are getting in the lending market that has led to massive downturns in the market in the past. The spread between the discount rate and the feds fund rate is extremely tight right now. Which implies that banks don't want to lend to each other right now. To explain what this means you first have to know what the discount rate is.
- The discount rate is the rate at which the US government lends to Banks. Which is set by Powell and the fed.
- The fed funds rate is the rate at which banks lend to each other (this is also set by the FED). The federal reserve always sets the discount rate above the fed funds rate to help incentivize banks to lend amongst themselves instead of relying on the fed for funding.
Therefore when the spread between the fed funds rate and discount rate tightens its a sign that banks don't want to lend to each other and would rather get funding from the FED implying weak appetite for risk throughout the banking sector. The only real comparable tightening of these two metrics was back in May of 2008 which led to stocks falling 31% over the coming six months. When you consider what's going on in the banking sector and how poorly capitalized some banks are which I covered in past videos 15I think it's logical to assume this tightening within the lending market could be very economically restrictive. When you dig into the numbers the results seem quite supportive that this tightening of economic conditions has negative impacts on stocks. The discount window on average is roughly 25% higher than the fed funds which makes the current spread of 3.6% somewhat alarming. On average stocks drop when this spread is below the 25% average, and vice versa which gives validity in using this lending metric as a predictor of stock moves. When the discount rate is less than 10% higher than the fed funds rate the average return doubles to the downside.
Look I know these numbers are not huge but we are seeing these two rates tighten with underlying issues throughout the banking sector, which is what I believe we have now its a deadly combination as 2008 showed us. But no indicator or metric doesn't have exceptions to the rule. As you can see in 2020 the spread for one day was 0% but then it jumped 34% literally the next day. The tightening is only significant if these conditions are sustained. As you can see in 2008 we had steady declines in this spread between fed funds and the discount rate for the most part. The same is true for our current situation in 2023,since May of 2022 this spread has consistently tightened. This all coincides with the banking sector being poorly capitalized outside of the bigger banks. In summary the federal funds rate & discount window is telling you something very clearly, economic conditions are tightening. Given inflation is triple the federal reserve's goal of 2% the Fed may be forced to continue to pile on rate hikes which would continue to tighten economic activity. This isn't 2008 or 2020 the fed cant print its way out of the problem. Stay safe everyone, if you think I'm missing something let me know in the comments.
Data Link (Source FED) : https://docs.google.com/spreadsheets/d/10kCJsCYsC00uIESD5WyxRmXXJxaRHrQX3O2Zmevm_1Y/edit?usp=sharing
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