Definitions: Discount rate is the “penalty rate” for banks needing emergency funds from the Federal Reserve (normally around 1% higher than the Fed Funds Rate). Fed Funds Rate is the interest rate at which banks lend their balances (known as federal funds) held at the Federal Reserve to other banks, usually overnight. The Discount Rate is set by the Fed Board of Governors, and the Fed Funds Rate is set by the Federal Open Market Committee (FOMC).
Last week the Fed’s Board of Governors raised the Discount Rate from 0.5% to 0.75% inter-meeting. The surprise was not the amount, but the timing. Two weeks ago, Bernanke’s prepared text to Congress stated the intent to raise the Discount Rate soon (defined normally as “in the future”, and market didn’t really appreciate that would be in 7 days). The Fed also reduced the length on discount window borrows to the normal overnight term (since the Fall of 2008 the term had been extended to 28 days). Currently, only $14.9 billion of window borrowing is outstanding, compared with over $1 trillion of cash held in Federal Reserve funds. The Dow Jones rallied 233 points with the first discount rate decrease (Aug 2007), and markets declined with the discount rate increase. The effect on the economy, bank lending and non-bank company profitability has nothing to do with the discount rate over the long-term. It took increasing the Fed’s balance sheet to almost $2 trillion to arrest the downward spiral in the economy and markets (current financial crisis was a credit crisis, not a liquidity crisis, so reducing Fed Funds Rate and Discount Rate had a negligible effect on arresting the downward spiral).
For months, the Fed has written and talked extensively about exiting from the various strategies used to stabilize the financial markets. The raising of the discount rate means the exiting has started, even if done gradually. Markets of any kind really dislike uncertainty. The inter-meeting change created uncertainty about the market pricing of all financial assets. Interest rates, foreign exchange rates, and implied volatility of all assets have now been priced into the market. This is reflected in an uncertainty premium. The dollar has strengthened and solidified it’s strong trend relative to the Euro, Pound and commodity exporting countries.
Bottom Line: 1) Uncertainty is now firmly entrenched into the markets, 2) Investors need to be very clear on the timeline of their investments – short-term, intermediate and long-term – and the acceptable level of uncertainty on those investments, and 3) Looking at over 200 years of financial and economic history, this is a normal process.
Always Asking, Never Assuming™
Christopher Holtby