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Friday February 19, 2010 - 14:09:55 GMT
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What the Market Has to Fear From Discount Rate Hike

While the Fed is rushing to the press to down play the policy significance of the “surprise” discount rate hike Thursday, the Fed fails to grasp the basic physics for the rally in risk assets, seemingly.  If one believes that the massive flood of liquidity the Fed put into the banking system to avert a financial system arrest did a number of things but one very much more than anything else…it lifted asset prices and pushed investors out the risk curve reaching for yield/profit.  And to be frank it pushed the banking system into the reach for yield and profit on a near zero cost of funding.  It follows that removing this wall of liquidity will inevitably lead to a decline in the prices of assets, commodities and currencies that rose with the floodtide of zero cost funds.  And to be fair with the Fed in the crisis removing the stigma of borrowing funds from the discount window, banks in the spring and summer were surely using the discount window for funding either directly or indirectly wagers on assets prices, bets on commodities and bets on FX.


While no one should doubt that raising the discount rate 25 bps to 0.75% in the scheme of things is pretty minor – only $14bln in the latest week ending Wednesday (down from crisis high at $110bln) out at the window in the latest data and banks are funding themselves, as has been the case since the summer, mainly in the money market.  But the d/r hike is another step in taking away liquidity and I for one think this means in time that the very prop for the rally in risk assets will be removed…prices will retreat.  And the fact that liquidity s being taken from the system most everywhere where it was aggressively applied, even in Japan, and especially in China (bank loans), then we can’t conclude anything other than the key support for risk is starting more clearly to erode.  Now if you like risk then you have to think, as surely the Fed Board does (it was their decision alone – it sets the d/r), you can only stay fully exposed to risk if you think the recovery is sustainable…the private sector will arise from the grave and walk the earth again not as zombies but as unfettered, profit-motive-driven economic agents. 


Everyone was surprised which itself is surprising in hindsight (I was surprised…even though I wrote last week that a discount rate hike is imminent after reading the Bernanke testimony last week).  Recall a few weeks back the FT and WSJ each had the prerequisite articles raising the likelihood of a near-term hike in the discount rate (Fed almost always holds deep background briefings with key print journalists ahead of a policy change or when they feel a need to shape expectations and prepare markets for news).  Then we had Bernanke’s Congressional testimony which was very explicit on the need to hike the d/r.  Then we had the FOMC minutes which also stressed officials saw a need to hike the discount rate.  My guess is the Fed is going to have to rethink how it signals its policy intentions ahead…or more likely markets have to pay attention more to what the Fed says ahead.  Surely that will be the case given the reaction since late Thursday to the news.  Indeed the whole circus that followed the move says much more about market complacency (risk) than it does about any failure by the Fed to get its message across.   


On the timing of the announcement, I can only speculate over why Thursday and not after the FOMC meeting or last week after the Bernanke testimony.  As former Fed Governor Kroszner said announcing a d/r hike after the FOMC meeting in late January would have been seen implicitly as a policy tightening rather than a technical adjustment in rates.  This still leaves open the question why Thursday PM?  Well it was after the close of the stock market to minimize volatility (funny how the Fed is more attuned to stock market volatility than bond or FX volatility).  And let’s not forget that the Fed said it was ready to do this and ready to do it now. 


Beyond the timing question is the motivation question.   Again I can only speculate that the Fed internally is deeply worried about its independence in light of the extent of support it has offered to the economy, securities prices, mortgage market and US Treasury market (just think about any government issuing debt and purchased by a central bank that adds zeros to its balance sheet to pay for them), and in light of the massive regulatory failure at the Fed on bank leverage, risk, collateral, capital and derivatives.  Getting back to normal on all the unconventional measures will in theory return the Fed to a conventional, independent, position.  Sadly for the Fed this process by its very nature will be drawn out in part because the recovery is likely to prove tepid, the scale of the support for the banking system is so enormous and the banking system remains impaired (PPIP has done nothing to move “bad” assets from the banks balance sheets).  Yes a rather innocuous sovereign default like Greece could pull the thread of the global banking system hard enough to reveal a deeply impaired banking system with waves of new bad loans and asset mark downs.  Yes we are not far from contagion ramping up to another run on the banking system.


Another motivation equally difficult to pin down may well be that the Fed is steaming over how banks have used its ZIRP to take leveraged bets on assets, commodities and FX and not in the process adding to its risk exposure through more traditional banking products like commercial and consumer lending.  My guess is the Fed feels used by the banks.   This is a case of banks gone wild  (Wells Fargo is the exception among the large ones and its performance reflects this…wonder what it gets for “doing the right things”) with risk and ignoring the key function the Fed hoped all its support measures would restore – credit creation by the banks.  Sure the Fed has to be happy that banks have earned record profits in 2H 2009 and can use some of it to boost capital and provide for future loan losses (though like the White House the Fed is surely not happy about early reports of record bonuses to senior bank execs).  But to do so without moderation and all the while ignoring the credit creation function so crucial to capitalism (growth) is insulting.  Volcker best expressed this in his testimony in Congress a few weeks back…and his point of view is not partisan nor ideological…his point of view is one of a central banker with full degrees of freedom because he is not at the Fed.


So if we believe that as the Fed (and most central banks) moves to normalize liquidity conditions and asset prices have to fall in the process short of an unforeseen rapid recovery in the private sector, then it is key to watch for what lies next in this “technical” normalization of monetary policy (exiting QE).    This is surely coming to a theater near you in the form of reverse and term repos that will take funds directly from the banks making the near infinite ZIRP curve play and reach for yield that much harder for the banks.  No doubt the Fed is miles from hiking the Fed funds rate and when it does it will be more focused on IOR (interest rate on excess reserves the banks hold at the Fed because the wall of liquidity the Fed put into the banking system makes managing a funds rate target nearly impossible)…I think Larry Meyer is right…this is a 2011 event.  Nonetheless, “normalizing” policy is bad for risk assets and commodities and good for the dollar.


David Gilmore




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