Fed Funds Rate Holds Steady at 3.64 Percent Amid Neutral Policy Regime

The current rate of 3.64% is classified as a neutral level within the current economic cycle. This regime is characterized as a Pause/Hold, following a period of active policy easing. Over the last two years, the Fed has implemented six rate cuts, resulting in a net decrease of 175 basis points. Despite these cuts, the rate remains in the 43rd percentile of historical data since 1954. The 52-week range for the Fed Funds rate spans from a low of 3.64% to a high of 4.33%. This suggests that the market is currently operating at the bottom of its recent annual range, providing a stable floor for borrowing costs.

Credit spreads over the Fed Funds rate provide insight into market expectations and risk appetite. The 10-year Treasury currently yields 4.34%, representing a spread of 70 basis points over the Fed Funds rate. Shorter-term spreads are much tighter, with the 3-month Treasury yielding only 5 basis points above the effective rate. The 10Y-2Y spread is positive at 0.53%, indicating a normally sloped yield curve which is generally healthy for the economy. Corporate spreads show more significant premiums, with AAA corporates at 1.88% and BAA corporates at 2.42% over Fed Funds. Interestingly, the BAA spread has widened by 30 basis points over the last month, suggesting some increasing caution in the credit markets.

Historically, the current 3.64% rate is below the long-term median of 4.32%. This places the current environment in the 43rd percentile of all observations since 1954. Looking at historical parallels where the rate was within 25 basis points of 3.64%, we find ten similar periods, including late 2022 and early 2008. Data from these parallel periods suggests a favorable outlook for equities, with the S&P 500 showing a median 12-month return of 7.4%. Positive returns for the S&P 500 occurred in 80% of these historical instances. However, the outlook for financials and long-term Treasuries is less optimistic based on these parallels, with both sectors showing median returns of 0.0% over a 6-month horizon.

Rate-sensitive sectors are showing varied responses to the current neutral rate environment. Growth stocks like NVDA and MSFT have shown strong momentum, with NVDA up 16.6% and MSFT up 14.4% over the last month. Banks have had a mixed performance; while GS is up 10.1% in a month, WFC has seen a slight decline of 1.0%. REITs like Realty Income and American Tower have posted gains of over 5% in the last month, benefiting from the rate stabilization. Utilities have also seen modest gains, with NextEra Energy rising 4.6% as the pause cycle reduces pressure on dividend-paying stocks. The 1-day performance for many of these stocks was slightly negative, despite the broader S&P 500 gain of 0.80%, suggesting daily volatility remains present.

The broader market outlook remains cautiously optimistic as the S&P 500 recently gained 0.80% with the VIX at 18.7. The stability of the Fed Funds rate at 3.64% provides a predictable backdrop for corporate earnings and valuation models. Sector rotation appears to be favoring growth and technology, as evidenced by the significant monthly gains in NVDA and MSFT. The positive 10Y-2Y spread of 0.53% supports a constructive view on the economic expansion continuing. Investors should note that while equities have historically performed well in this rate percentile, fixed income returns have been stagnant. The 10-year Treasury yield at 4.34% offers a decent yield but faces headwinds if the neutral regime persists without further cuts.