Darshan's Blog

Darshan's Daily Ma rket Ponderings

Why did the Fed hike the emergency lending rate to 0.75%?

Friday February 19th, 2010

Well options expiry weeks you couldn't make them up if you tried. As I said max pain was near 1110 we got to 1108.9 and then sold off in the futures last night. What a pump it's been over the last two weeks simply obvious squeeze action with plenty of downside gaps left to attract a fall back down. Of course, we could still revisit the 1110 mark today during expiry. However, what caused the 'sudden' panic after the bell? Good question. What excuse did the Fed come out with this time to manipulate price?

Well it hiked the discount rate to 0.75% from 0.5%. Remember this is the rate for banks to borrow emergency funds from the Fed. Hiking it, is a policy tool to try to get banks to borrow from each other. Was this a shock? No it was clear from the FOMC minutes that it was due and Bernanke's speech last week. The shock for the market was the timing of it right at the end of a Thursday, a day before options expiry and four days before China begins trading again. You have to ask why? I'll explain more in a bit.

For now I am concerned by the chatter that this somehow implies monetary tightening for consumers. It does not this is a policy tools for banks, not for consumers. It's means saying Listen banks, you can borrow amongst each other we're trying to reduce our balance sheet and we'd rather you didn't rely on emergency loans . Fair enough, historically a rise in the discount rate has started off the rate cycle back up for the funds rate but this time it's different. The Fed cannot afford to hike the funds rate. It could cause chaos for a consumer driven economy.

In fact, the Atlanta Fed President, Dennis Lockhart made it very clear last night that rates would remain where they were until the employment markets recovered...and we know that's code for 'Goodness knows it could be ages . His exact words:

"I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent....Rather, this action should be viewed as a normalization step. It is important that markets not misinterpret the move .

Although the man is not a voting member, I doubt he would make such a statement without a consensus view at the Fed. His words clearly show that the Fed is pretty worried about the consumer economy but is willing to start reducing it's risk with the banks.

So we can put this aside for now. On to more important questions did someone already know of the hike before the announcement and why was it announced last night?

Well other than the huge sell order that went through just before the announcement, the action on the 10 year notes might indicate key players knew of the statement before hand. Nothing new there then! More importantly, why was this announced yesterday? I would hazard a guess that there are three reasons:

1) Options expiry today because it's too late to hedge, it means this entire squeeze is dealt with and anyone long calls is hurt (I guess anyone short calls just got saved!). Hey the Fed has to look after the banks you know wink wink. If this announcement had not come, then this squeeze might have been misinterpreted as real buying and things could have gotten carried away today. (They can be allowed to get carried away after opex of course)

2) It's a panic move as the long end curve was widening too much and they needed to do something. This was the move.

3) With PPI coming in stronger than expected and CPI due out today, the FED probably wanted to act ahead of time so that it looks like they are handling any inflationary pressures. However, like I said yesterday inflationary pressures don't seem real in the every day life of the ordinary Americans. In fact consumers are just not biting hard enough at the moment. If I was a cynic (I am), I would be in danger of guessing that the Fed are playing with the inflation figures to give them an excuse to reduce their balance sheet. Either way, the move yesterday before CPI today, is telling of how much they are relying on 'inflationary pressures' to unwind their liquidity pumps.

It's all laughable but at the same time sad really. They just don't have real control over anything, so expect more games like this over the next few months. We're back to the good old days of 2007, when the maxim 'Don't fight the Fed' was heard on a daily basis. Expect after hours surprises, Sunday night surprises, basically surprises anytime that can hurt the majority in the markets.

I guess the saying could now be 'Don't fight the Fed they've lost the plot'.

Interestingly while they reign things in, it seems their counterparts at the ECB are finding out about the hard life. The ECV marginal lending facility is getting hammered, as banks fight for liquidity in case anything kicks off in Italy, Spain or Portugal next. Next week will be very interesting. Without opex manipulation, the real market might just turn up again.

For today I would just be vary of extreme volatility and just wait it out until Monday. I personally, am still expecting downside action to correct the gaps before we head up again. However, also wary that we could hit near 1120 on the SPX and 10470 on the Dow before we come down...either way let's see how the end of the day goes. (In the long run, we collapse for the longer term down to new lows).

Happy trading and if you have any questions, don't hesitate to ask.

Darshan

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