Fed Hikes! Discount Rate That Is

A: Okay okay, so I teased you a bit. But this is the first real sign that the era of exit strategy has officially begun. Sure you could have argued that it began earlier with the expiration of some emergency credit facilities, but this is a sure sign of what is to come. To me, this feels like a test of sorts by the fed to the markets as they raise the discount rate by 1/4 point; nothing really too hawkish in the grand scheme of things but a signal as to what may lie ahead of us. The stimulative/liquidity spigots are basically still on.

Via Bloomberg's "Fed Raises Discount Rate by Quarter-Point to 0.75%":

The Federal Reserve Board raised the discount rate charged to banks for direct loans by a quarter point to 0.75 percent and said the move will encourage financial institutions to rely more on money markets rather than the central bank for short-term liquidity needs.

“These changes are intended as a further normalization of the Federal Reserve’s lending facilities,” the central bank said today in a statement. “The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.”

The dollar jumped and Treasuries extended losses as the Fed took another step in a gradual retreat from its unprecedented actions to halt the deepest financial crisis since the Great Depression. The Fed has provided hundreds of billions of dollars in backstop credit to banks, bond dealers, commercial paper borrowers and troubled financial institutions such as American International Group Inc.

The U.S. currency rose to $1.3541 per euro at 4:40 p.m. from $1.3616 before the announcement, while the yield on two- year Treasuries increased to 0.93 percent from 0.87 percent.

The discount rate increase is effective on Feb. 19. The Board also said that effective March 18 “the typical maximum maturity for primary credit loans will be shortened to overnight.”

While not the biggest of moves, it will be interesting to see how this affects the banks recap efforts & the greenback because that will impact other markets after what we saw for much of 2009! Should the dollar start to rise as we start to tighten policy and withdraw stimulus right when Europe seems to be facing sovereign debt issues, it could make for very interesting moves in many asset classes. The dollar rose, gold dropped and equity futures sold off on the news. As for banks, it will discourage borrowing from the fed's discount window and raise the cost for those that need access to that source of liquidity. The play for much of 2009 was for banks not to lend and instead borrow at zero from the fed, buy safe Treasuries and park them while pocketing the spread.

Now I promise you that you will start to hear the other side to this tale! You will hear the arguments that this is a sure sign the US economy is on the road to recovery and the fed is starting its strategy to temper future inflation expectations. Anyone want to bet that these sorts of headlines start to come out tomorrow? This move is really nothing in the grand scheme of things and when I cautioned about unintended consequences as a result of stimulus withdrawal, I was referring to a heck of a lot more than a 1/4 hike in the discount rate!

However we could look back at today as the start of a new era of a slow and drawn out period of stimulus withdrawal in many formats; hiking discount rate, hiking fed funds rate, stopping debt monetization experiment, removal of credit facilities, raising capital requirements, regulatory reform, phasing out of consumer tax credits, raising interest paid on excess reserves, and ultimately the selling of assets to primary dealers via POMO to further drain excess reserves just to name a few of the moves that look to be ahead of us!