Discount Rate Jitters
Research for Online Investors

by John Dalt

2/19/10

The Fed increased the bank ‘discount rate’ to 0.75% after the market closed Thursday.  This caught traders by surprise, although many Fed watchers said it should not have.  Stocks took a dive in the aftermarket.  Precious metals and commodities took the hardest hit.  Any increase in interest rates would strengthen the dollar, which makes these products comparatively cheaper in U.S. Dollars.

On reflection, investors understood this did not signal higher consumer or business borrowing rates.  The ‘discount rate’ is charged to banks that go to the Fed to borrow funds. The term was also shortened to one day from twenty-eight days.  The discount rate is used by banks facing liquidity problems and need access on an emergency basis.

The change did not affect the ‘federal funds rate,’ this rate is used for borrowing between banks and is pegged at 0% to 0.25%.  The discount rate traditionally is one-percent higher than the federal funds rate. Discount rates were lowered during the credit crisis to pump liquidity into the market, and help individual banks.

Fed Chairman Ben Bernanke said last week that the Fed would raise the ‘discount rate’, but the language in the FOMC minutes did not indicate the timing.  The market paid more attention to the wording of holding rates low “for an extended period.”

This move by the fed signals danger in the dollar trade, as the Fed will move rates higher as the economy improves. The core inflation rate rose at 1.6% in January after a 1.8% rise in December year-over-year. January’s numbers were greeted as good news as the numbers stripped of energy and food prices actually showed inflation fell by 0.1%  This was the first monthly drop in 27 years.

Pacific Investment Management, Co. is the world’s biggest bond firm.  According to Reuters, Bill Gross, Pacific’s co-investment officer said, “Pimco has been shifting some of its assets from Treasuries to German bunds, and other perhaps more solvent or potentially solvent sovereign credits."You should read that again.  Pimco is changing their mix of bonds away from U.S. Treasuries to “other more solvent…sovereign credits.”  You can read Reuter’s article “ Fed seeks to Calm Markets after Discount Rate Rise.”

Last week’s auction of 30-year treasury bonds showed a lack of appetite for long-term bonds paying 4.7% interest.  It didn’t fail, but the lack of depth of buyers for our longest term debt is ominous.  Fixed-term securities buyers are factoring in the increased chance of inflation as the U.S. must print more money to cover the deficits.

Seventy-nine percent of S&P 500 companies have reported for Q4 2009, today's chart provides some long-term perspective to the current earnings by focusing on 12-month, as reported S&P 500 earnings. Earnings declined over 92% from the peak in Q3 2007 to Q1 2009 low -- the largest decline since 1936. Since the Q1 2009 low, S&P 500 earnings have surged (up over 600%) and currently come in at a level that has only been exceeded during the latter years of the dot-com and credit bubbles.

The market is climbing to new highs, scarry.  But it has held there for extended periods.

Editors Note: I checked in with subscriber C.H. who is a captain in Afghanistan. He reports all is going well, and still expects to end his tour in 43 days, April 4th by my count. He has irregular access to a computer, but enjoys our info when he can. We wish him a safe return home to his family.

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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