As everyone knows, interest rates matter, and, depending upon the sector of the financial industry, interest rates matter a lot. With the Federal Reserve recently adopting the “Evans Rule”, which effectively states that monetary policy will remain unchanged until inflation expectations rise above 2.5 percent and/or the unemployment rate drops below 6.5 percent, one might ask: what kind of an effect (the effect is felt through interest rate policy) could this have on the financial industry, and in particular, on the private equity industry.
The question is at least partially answered by empirically looking at how sensitive employment in private equity businesses, hedge fund firms, and investment banking firms is to the Federal Reserve’s effective federal funds rate and the long term Treasury interest rates. The results are as follows.
Starting first with the private equity industry, the results show a moderately statistically significant (weak at best) effect of the effective federal funds target rate on overall industry employment, with an estimated effect of 0.008441 and a confidence level of 75.2 percent.
What does the 0.008441 mean? It means that about 75 percent of the time, when the federal funds target rate increases by 100 basis points, we would expect private equity employment to increase by about 8 people. This is the increase that is independent of U.S. employment growth and the other factors included in the regression model.
Interestingly, there’s little to no confidence that the 10 year note has any effect on private equity industry employment, with an estimated confidence level of 25.7 percent.
| Private Equity | ||
| Estimated Effect on Private Equity Employment | Confidence Level | |
| Employment (U.S.) | 0.000017 | 23.3% |
| Capital Gains Tax Rate | -0.907100 | 95.0% |
| Ten year Treasury | 0.004433 | 25.7% |
| Effective Federal Funds Rate | 0.008441 | 75.2% |
| Private Equity[-1] | 1.109000 | 100.0% |
| Employment (U.S.)[-1] | 0.000190 | 93.4% |
| Employment (U.S.)[-2] | -0.000202 | 99.9% |
| Private Equity[-4] | -0.124300 | 100.0% |
| _AUTO[-12] | 0.488200 | 100.0% |
| _AUTO[-10] | -0.177700 | 99.8% |
| Notes | ||
| 1Numbers in brackets represent lags, i.e. a [-1] indicates a one month lag of the given variable | ||
| 2_AUTO[.] represents an autoregressive error of n lag; used for model fitting | ||
Moving on to the second industry, investment banking, the results of the employment regressions are reported below.
The correlation between investment banking industry employment and the effective federal funds rate is much stronger, with an estimated coefficient of 0.36 and a confidence level of 89.8 percent. So, the effect of the effective federal funds rate indicates that a 100 basis point increase in the effective federal funds rate is correlated with an increase in investment banking employment by 360 people.
Contrary to the private equity industry, the investment banking industry is also much more sensitive to the 10 year note yield, with an estimated coefficient of 0.904 and a confidence level of 99.9 percent. What this says is that a 100 basis point increase in the yield on the 10 year Treasury is correlated with a 904 person increase in investment banking industry employment (again, after controlling for the effect of the overall economy, which generally pushes industry employment up independent of the 10 year note).
| Investment Banking | ||
| Estimated Effect on Investment Banking Employment | Confidence Level | |
| Employment (U.S.) | 0.000319 | 99.6% |
| Capital Gains Tax Rate | -308.800000 | 99.8% |
| Ten year Treasury | 0.903600 | 99.9% |
| Effective Federal Funds Rate | 0.357300 | 89.8% |
| Investment Banking (U.S.)[-1] | 0.792900 | 100.0% |
| Investment Banking (U.S.)[-24] | 0.214700 | 100.0% |
| Notes | ||
| 1Numbers in brackets represent lags, i.e. a [-1] indicates a one month lag of the given variable | ||
The results for the third group, the hedge fund industry, are reported below.
Overall, the results indicate a 99.9 percent confidence that the effective federal funds rate impacts hedge fund industry employment, with an estimated effect of 0.021. The 0.021 means that a 100 basis point increase in the effective federal funds rate is correlated (again, controlling for other effects) with a 214 person increased in the industry.
The results on the 10 year Treasury are not as strong, with an estimated effect of -0.016 and a confidence level of 62.8 percent. The negative coefficient indicates that as the yield on the 10 year goes up, it puts downward pressure on hedge fund industry employment.
| Hedge Funds | ||
| Estimated Effect on Hedge Fund Employment | Confidence Level | |
| Employment (U.S.) | 0.0000035 | 98.4% |
| Capital Gains Tax Rate | -0.4090000 | 80.3% |
| Ten year Treasury | -0.0156900 | 62.8% |
| Effective Federal Funds Rate | 0.0213900 | 99.9% |
| Hedge Fund (U.S.)[-1] | 1.1900000 | 100.0% |
| Hedge Fund (U.S.)[-24] | -0.2107000 | 99.9% |
| _AUTO[-12] | -0.6436000 | 100.0% |
| _AUTO[-24] | -0.3904000 | 100.0% |
| _AUTO[- 2] | -0.1626000 | 99.7% |
| Notes | ||
| 1Numbers in brackets represent lags, i.e. a [-1] indicates a one month lag of the given variable | ||
| 2_AUTO[.] represents an autoregressive error of n lag; used for model fitting | ||
The summarized results are reporting in the following table.
| All Three Effects | |||
| Estimated Effect on Private Equity Employment | Estimated Effect on Investment Banking Employment | Estimated Effect on Hedge Fund Employment | |
| Employment (U.S.) | 0.0000170 | 0.0003190 | 0.0000035 |
| Capital Gains Tax Rate | -0.9071000 | -308.8000000 | -0.4090000 |
| Ten year Treasury | 0.0044330 | 0.9036000 | -0.0156900 |
| Effective Federal Funds Rate | 0.0084410 | 0.3573000 | 0.0213900 |
| PE Confidence Level | IB Confidence Level | HF Confidence Level | |
| Employment (U.S.) | 23.3% | 99.6% | 98.4% |
| Capital Gains Tax Rate | 95.0% | 99.8% | 80.3% |
| Ten year Treasury | 25.7% | 99.9% | 62.8% |
| Effective Federal Funds Rate | 75.2% | 89.8% | 99.9% |
As reported, the 10 year Treasury has the largest effect on the investment banking industry, which would, not surprisingly, explain why professionals in the industry tend to talk more about long term rates than do the other two.
On the effective federal funds target rate, the effect is also largest among the investment banking industry, with the hedge fund industry coming in second again.
Perhaps interestingly, of the three groups, the private equity industry is the least sensitive to interest rate movement.
Overall, the Federal Reserve’s new “Evans Rule” policy affects the financial industry by varying magnitudes, with the private equity industry probably least affected when compared to the investment banking industry and the hedge fund industry.
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