Don’t Discount the Impact of the Discount Rate Increase

Don’t discount the impact of the discount rate increase. The longest journey from the removal of extraordinary stimulus starts with the first step and that step has now been taken.

As the US stock market closed, the Federal Reserve raised the discount rate charged to banks for direct loans to 0.75 percent from 0.50 percent. The Fed wants to wean banks away from taking loans from them and push their lender back into the real world when they have to borrow money for their short term liquidly needs. Oh sure, the Fed is trying to say not read too much into this and that these changes are only intended as a further normalization of the Federal Reserve’s lending facilities but come on. Who are they trying to kid? Let’s face it, the normalization of the Fed's lending facilities is a big change and perhaps a red stick pin in the chart of the history of the greatest financial crisis since the Great Depression.

Or sure the Fed says that these so called 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, yet at the same time in the Fed Minutes the Fed said that the outlook for the economy was brighter and this would be the most likely next move towards getting us back to normal. You remember normal, now don’t you?

Of course the Fed had other inspirations like losing control of the long end of the yield curve where the spread between the long and short end of the curve widened further than the Snake River canyon. Long end yields hit the highest level since last summer. And on top of that, we are seeing hot inflation data as evidenced in the Producer Price Index that rose by a much hotter than expected 1.4%. The truth is that no matter what the Fed is telling us it is clear that the market and the economic data is starting to force the Fed hands. If the long end of the yield curve does not come in after this move, it is more likely that the Fed will have to start on its next move.

Now the Fed agreed that the first move would be a an increase in the discount rate which has happened but now do we go to systems repos or do we go to just go to all out rate increases? Do we drain that excess cash the Fed has gone in to overtime printing? Or do we shock the traders out of the long end with end of the curve with a quarter point downer increase in the Fed Funds rate? Or maybe does the Fed Just change the language try to fake out the so called “bond vigilantes” into believing that the Fed is ready to move. Does the Fed drop the range on the Fed Funds rate or do we as Kansas City Fed President Thomas M. Hoenig suggested change the language to because as the Fed minutes said, “he believed it was no longer advisable to indicate that economic and financial conditions were likely to "warrant exceptionally low levels of the federal funds rate for an extended period." In recent months, economic and financial conditions improved steadily and Mr. Hoenig was concerned that, under these improving conditions, maintaining short term interest rates near zero for an extended period of time would lay the groundwork for future financial imbalances and risk an increase in inflation expectations.

Mr. Hoenig believed that it would be more appropriate for the Committee to express an expectation that the federal funds rate would be low for some time, rather than exceptionally low for an extended period. Such a change in communication would provide the Committee flexibility to begin raising rates modestly. He further believed that moving to a modestly higher federal funds rate soon would lower the risks of longer-run imbalances and an increase in long-run inflation expectations, while continuing to provide needed support to the economic recovery.

In other word the increase in rates could help inspire an economic recovery. An increase in rates may be a signal to home buyers and businesses that the days of easy money are coming to an end. That it may be time to start making some commitments before we start talking about the good old days when you could get a mortgage for 4.93%.

For oil bears the timing of this move could not have come at a better time. The oil market was strong yesterday for a lot of reasons. Some of them technical as oil had an air bubble after it close above 7550 which should have given us a run towards $80 which happened, but there were a lot of things that drove us to that point. Obviously the oil inventories were a key factor but there was also strength in the dollar. The dollar versus the euro and the euro versus the Swiss played a massive role in some of the crazy moves that we saw but also the fact that the UN’s International Atomic Energy Agency finally woke up to the fact that Iran was working towards getting a nuclear war head. Wow! We are all shocked! Are we not?

Then next thing we find out was that there was gambling at Rick’s. But even before that stunning announcement the dollar and oil swung on reports of a central bank intervention by the Swiss National bank. Bloomberg News reported after a big rise in the Euro, reversing its losses against the dollar, there was speculation the Swiss National Bank sold the Swiss franc in an effort to cap the currency’s gains. Bloomberg said at that point that the dollar earlier rose toward a nine-month high against the common currency amid speculation the Federal Reserve will be one of the first major central banks to remove stimulus measures.

They were right on that speculation as it does indeed appear the US will lead the world out of the economic crisis. Well that’s only right because we did lead the world into it. Of course they were all willing participants in the easy money and mortgage yourself to the hilt false prosperity game. Oh sure, there are those who would argue that China is leading the world out of the global meltdown it but from my view point China’s expanding bubble is the next great threat to the global economy. The lack of concern by many over the way China’s economy has exploded and the crazy out of control lending by Chinese banks means that many have not learned from history. Sure there can be massive profits made riding the China bubble and it has been one incredible ride but you don’t want to be there when the bubble ends.

Now remember this is coming from one of the early China bulls as I was bullish on China long before being bullish on China was cool. Like 10 years ago. (Oh, my gosh, has it really been 10 years? It seems like yesterday). Obviously it is hard to predict when it will end but we are getting closer and if we have learned anything we know that China needs to be even more aggressive in trying to slow things down or we could see the next global economic shock faster than many complacent bubble intoxicated China bulls might think.

Oil bulls liked what they saw in the weekly oil inventory that was much more bullish on distillates than the API would have you believe. The EIA reported that distillate fuel inventories fell by 2.9 million barrels in the latest week that was more in line with the bulls more fidget dream forecast. Of course do not remind them that supplies are still 6.1 percent above year ago levels as that might make them a bit cranky. The EIA said that crude was up 3.1 million barrels which should have been bears if it were not foe the distillate drawdown. Gasoline increased by 1.7 million barrels which was bullish as well as many felt that with all the snow should have seen a larger increase.

Refinery runs improved to 79.8% if you want to call that an improvement. And demand, based off total products supplied over the last four week period, has averaged 19.0 million barrels per day, up by 0.2 percent compared to the similar period last year. Over the last four weeks, motor gasoline demand has averaged 8.6 million barrels per day, down by 1.3 percent from the same period last year. Distillate fuel demand has averaged 3.7 million barrels per day over the last four weeks, down by 7.4 percent from the same period last year. Jet fuel demand is 1.4 percent higher over the last four weeks compared to the same four week period last year.

Oil did hit a 5 week high but failed to take out 80. With the Fed move and with expiration of the March futures on Monday, it is unlikely that they will. As I said yesterday, the recent move does nothing to change our long term bearish outlook and this could present an opportunity. Unless oil closes above $85 we are headed to the $40 handle in my humble opinion. We expect a test of this area and short term traders and day traders can take advantage of the wider swing moves within the range. We have seen oil fall from the eighties to the sixty handle and have swung wildly in the seventies.

You can contact guest blogger Phil Flynn at pflynn@pfgbst.com



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