Last Thursday the Fed raised its discount rate by 25 bps to 0.75%, as highlighted 8 days previously in Bernanke’s Exit Strategy speech on 10 Feb 2010.  As a result it now stands 50 bps above the upper limit of the current 0% – 0.25% range for the Fed Funds rate.  The Fed also took the opportunity to announce the return to the usual 1-day time limit for banks borrowing at the discount window (down from 30 days which was first put in place on 17 August 2007 - as the credit crunch first started to bite).  These actions indicate that the Fed is confident that the banks have now got their funding arrangements back into good order.

Despite the FT’s Lex column (20 Feb 2010) claiming that the discount rate is “almost irrelevant these days”, the Fed’s discount rate will become very important when the Fed eventually begins its next rate tightening cycle.  This is because the discount rate effectively represents the upper bound of the overnight interest rate during the period when the Fed is steadily raising rates.  The market doesn’t care about the lower boundary for overnight interest rates when rates are trending higher.

The Fed has also taken the precaution of giving itself the option of paying interest on money that US banks have placed on deposit at the 12 Federal Reserve Banks ($1.1 trillion is currently sitting on deposit).  In this way the Fed can force market interest rates higher should it prove difficult to get the Fed Funds rate moving in the desired direction (because of the $1.725 trillion which the Fed has thus far supplied to the markets via its Quantitative Easing efforts).

However any actual rise in US interest rates is still over the horizon and well out of sight.  The Fed has a so-called dual mandate to both contain inflation and promote employment (unlike the ECB which is only tasked with keeping inflation under control).  US unemployment is still very high at 9.7%  and, counter-intuitively, the unemployment rate may well rise further as a strengthening economy creates jobs.  Bernanke said in testimony this week that low interest rates “are supporting a nascent economic recovery”  and that “although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures”.  In plain English, the Fed is going to wait and let the economy grow and create lots of jobs before risking its first rate rise. 

The Fed is simply getting its ducks in a row by preparing the ground for an eventual rate raising cycle.  It has to raise the discount rate first in order to create some additional headroom above the Fed Funds rate which it can then rise into.  By raising the discount rate well in advance of any hike in the Fed Funds rate, the Fed can now sit back and watch the market’s reaction, paying particular attention to 3-month Dollar Libor (the rate at which banks borrow Dollars from each other for a period of 3 months), which has been trading around 26 bps for many weeks now.

The Fed would like banks to borrow from each other and ideally to obtain funds from depositors rather than directly from the Fed itself at the discount window.  Historically the discount rate has been kept 100 bps above the Fed Funds rate and we can expect the Fed to aim for this level in future months.

German Chancellor Angela Merkel has extracted the necessary promises from Greece that they will be good in future and properly respect the rules of the euro-zone’s Growth & Stability Pact (i.e. bring their budget deficit back down to less than 3% of GDP).  Whilst the bigger & stronger countries within the euro haven’t quite worked out all the details yet, Germany has sent a “clear political signal” to Greece and the wider financial markets that (with the independent IMF checking that Greece keeps to its promises) they will support Greece if it cannot borrow enough money at a reasonable rate from government bond investors.

This is a pivotal moment in the course of the euro-zone and its monetary union.  Germany is the key player and can make-or-break any smaller country which gets into trouble raising money from government bond investors.  Bringing in an independent outside entity, such as the IMF, to play policeman will allow countries to sell difficult tax-raising budgets to their voters.  Having given up the Drachma for the Euro, Greece no longer has a central bank which can print money to finance its deficit and/or devalue its currency (both of which are exactly what the UK has done over the last year or so).

An important precedent has thus been set and Germany has used this Greek crisis to get what it wants, namely the peripheral nations are going to have to play by the rules from now on or they will get hung out to dry. This is going to be tough on the economies of the peripheral countries and their growth is going to suffer as they shrink their budget deficits back down from 10%+ to below 3% of GDP over the next 3 to 5 years. 

However the message to players in the government bond markets is clear – the great convergence trade (which last took place in the run-up to the euro’s birth on 1st Jan 1999) is now back on.  Spreads over bunds have now tacked back onto a tightening trend and, whilst they will not converge all the way down to 20bps or so, it is going to be worthwhile buying the dips every time the yield spreads over bunds widen back out again.

The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.