Why the Fed Funds Rate Matters

CEO Confidence & M&A Market Growth

When the Federal Reserve came out aggressively and cut the Fed Funds Rate by 50 basis points (bps), it left me scratching my head a bit. One side of my brain said, “Great—finally. Maybe this will be the catalyst the merger and acquisition (M&A) market needs to break out of its doldrums.” But given the twists and turns the market has taken since COVID-19, a more cynical voice came over me, “That’s not good. That’s a crisis-response level cut. What do they know that they are not saying?”

So which raw reaction won? Maybe they both did to different degrees. The optimist in me, which is biased because I run an investment bank, was the dominant voice but there is still a skittish element of the unknown. I also took comfort in the Federal Reserve’s suggestion that there may be “hundreds of basis points” to go. At 4.9% after the cut, that would mean we would be back in striking range of 2.0% to 2.5% hopefully at some point in the not so far, far away.

We cannot assess the unknown, so I started to think about direct correlations between the Fed Funds Rate and our world of M&A—which I shared in my discussions with Yahoo Finance and Schwab Network. Our Market Intelligence team, led by Max Morrissey in this case, helped me get outside the box with the thinking. Inside the box is all the standard stuff—higher interest rates lead to more expensive cost of capital, which in turn puts pressures on business valuations, which leads to lower M&A volume. We all get that. It’s easy to quantify, and it has been.

I started to ask our Market Intelligence team questions to test other inter-relationships. An interesting question was asked, “Is there any relation between the Fed Funds Rate and CEO confidence, and if so, how does that track to growth in the M&A market?” Not surprising, they came back with some compelling analyses worth sharing. If for no other reason, the perspective is unconventional. It’s one which I have neither explored nor seen before. But that’s just me.

I’m not an economist, nor am I a statistician. I recognize that there is a plethora of other variables that come into play beyond what the team looked at. I’m also sharing this framework as a matter of intellectual curiosity—I am not debating lead or lag measures, nor do I have variation coefficients to share. This is simply an exercise in “things that make you go—hmmm.” And tying this back to the opening optimism, I like the perspective because it supports our pending rebound thesis.

Take a peek at the exhibits that follow, and consider the possibility of these key takeaways:

• M&A volumes and growth are supported by periods with high CEO confidence levels.
• CEO confidence levels appear to spike and remain relatively high when the Fed Funds Rate is in the range of, or below 2%.

• Middle market M&A volume growth is between 1.5-2.0x greater during quarters where the Fed Funds Rate is less than or equal to 2%.

• When the Fed Funds Rate is at or below 2%, quarterly middle market deal volumes are 21% higher.

This all makes intuitive sense, but there is a “chicken and the egg” question, and as noted above, a host of other variables to consider. However, what I found interesting was the addition of CEO confidence levels into market statistics. What I would expect to see in the quarters ahead—assuming nothing new comes into focus in the meantime—is climbing CEO confidence levels. I believe the middle market has been missing that for some time, and that takes supply (of deals) out of the market.

Considering I have the time to run this exercise and share some thoughts, it’s a sign that investment bankers are begging for triangulation of positive dynamics to lead the way to the next bull market run. The lack of visibility we have all been working under is frankly just plain boring. We have been living in a world of conflicting data and confusing—or no—answers. We are on the offensive because everything is pointing in the right direction. Trends matter. If not now, when?

To discuss the impacts of the Federal Reserve’s interest rate cut on M&A, provide an update on your business, or learn about Capstone's wide range of advisory services, please contact us.