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.

The first hint of higher interest rates in the States arrived after this week’s FOMC meeting.  Thomas Hoenig (President of the Kansas City Fed) emerged as the first interest rate hawk on the FOMC and voted against an unchanged monetary policy.  Hoenig “believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Fed funds rate for an extended period was no longer warranted”.  In plain English Hoenig wants the Fed to signal to the markets that it is going to begin hiking interest rates at some stage in the not too distant future.

At the moment Hoenig is the only dissenter on the FOMC.  It will pay to keep a close eye on whether his view gathers support at future FOMC meetings.

The market’s reaction thus far to Wednesday’s announcement has been most evident in the US Dollar.  Its rally, which began after the 4 Dec 2009 Employment Report, has continued and the Dollar Index (DX) has now broken above its 200-dma.  The 50- and 200-week moving averages are the next resistance levels to be surmounted and they lie just above the current 79.59 level of the DX.  Hoenig hankering after US rate hikes will only serve to help the Dollar to extend its recent rally.  Commodities (as measured by the CRB index) have reacted badly, the US stockmarkets have remained under pressure (but they started falling two weeks ago) but the all-important US Treasury bond market has traded sideways despite Hoenig hinting at higher rates sooner rather than later.

However it is difficult to believe that the Fed is going to implement the first rate hike until the US economic recovery has gained significant traction which results in a very visible fall in the unemployment rate from its current 10%.  There is so much spare capacity in the States that the Fed can afford to let growth continue to build momentum without worrying about higher inflation resulting anytime soon.  Any premature rate hikes would be a serious policy error which would impact the economy & stockmarkets severely.

A more likely explanation for Hoenig’s action in voting against the others is that it allows the Fed to test the market’s reaction to a proposed change in the current policy stance of “low rates for yonks”.  If markets react badly over the next few weeks (particularly if the US bond market tanks) then we can expect all the other FOMC members to very publicly bang the drum that interest rates are not going up anytime soon.  The FOMC knows full well that it will eventually have to tell the markets that rates are not going to stay at “exceptionally low levels for an extended period” and this is a low risk way for it to prepare the markets for an eventual change in monetary policy.

I still think that the first US rate rise is out of view and over the horizon (and more likely to take place in 2011 than 2010) but will be paying close attention to future FOMC statements for clues as to when policy is likely to change.

The Fed and the BoE are going to allow themselves to fall behind the curve as they seek to hold rates low whilst an economic recovery gains traction and begins to absorb some of the spare capacity which has been created by the recent recession (i.e. unemployment falls and manufacturers’ capacity utilisation rises).

We saw the first inklings of how this will play out in practise after last Friday’s US employment report.  A stronger than expected 4th December 2009 report (which showed the unemployment rate falling by 2/10ths and non-farm payrolls essentially unchanged at -11,000, together with the prior two months revised to show 159,000 fewer jobs lost) caused the market to price in a rate hike by the Fed in Q2 2010 and the Dollar rallied on expectations of US rates rising.  However the Fed will probably keep rates on hold for far longer than the market currently thinks and we are going to see repeated attempts by the market to price in a series of rates hikes which will fail to materialise on time as the Fed stays firmly & willingly behind the curve.

So the US and UK yield curves are likely to steepen further as the Fed and BoE deliberately keep rates on hold whilst an economic recovery builds strength and they will want to see their respective unemployment rates much, much lower before they dare to begin hiking rates.  The press may ascribe 10-year Gilts selling off (higher yields) to worries about Labour’s complete unwillingness to sketch out a plan to bring the budget deficit back under control but actually the gilts market doesn’t care about Labour’s economic plans because the view at the moment is that the Conservatives are going to win next May’s general election and it will be their budget plans for 2010-15 which will matter. 

The more likely explanation for higher 10-year yields is that government bonds always sell off when the market scents economic recovery and last Friday’s US employment report hinted towards a sustainable trend of lower unemployment and consequently stronger GDP ahead. This is also why the strong correlation between a weaker Dollar & stronger stockmarkets (which has been maintained since stockmarkets bottomed in March 2009 all the way up until last Friday) now appears to have broken down. Markets are now sensing growing GDP which implies corporates will grow their top line sales (hence higher profits, so the stockmarket rally continues) and growing GDP also implies US Dollar strength after the weakness we have seen in the last 9 months. 

So two central banks have led the way and raised interest rates (Australia and Norway), starting their journey on the long way back to interest-rate normality.  But it does not necessarily follow that just because two commodity-linked countries have started to hike rates, the Fed, BoE and the ECB are about to follow suit anytime soon. Speculation that the Fed and BoE are contemplating rate hikes is way too premature – the order of events will surely be for Quantitative Easing spending to be halted first and only then will the central bankers turn to taking back some of the rate cuts they have implemented since the summer of 2007.

The US has recently reported GDP turning positive in the third quarter of this year but the US economy is still far too weak for the Fed to risk halting QE anytime soon, let alone even think about raising interest rates from their current floor of 0.25%. One positive quarter of GDP is just the start of a potential recovery  (which could easily fizzle out again next year) and the Fed made it clear in their Fomc statement earlier this week that rates are staying put “for an extended period” and the Fed won’t even finish spending its current $1.75 trillion QE money until the end of March 2010. As was announced today, US unemployment is still rising and has now reached 10.2%.

Similarly the Bank of England this week increased by £25 bln its QE target to £200 bln, to be fully spent by the end of January 2010.  The BoE will most likely decide to print even more money if GDP does not return to growth in Q4 (after the surprise of the UK posting another quarter of recession in Q3).  As the BoE will not raise rates ahead of next year’s General Election, theoretically the ECB is in line to be the first of the major Western central banks to implement a rate hike as they never embarked upon QE in the first place.  However the jury is out on whether the ECB will raise rates with Spanish unemployment of almost 20% and with Ireland looking set to go to the IMF to seek a loan.

Inflationary pressures will not be seen in the UK until a lot more of the £200 bln QE money finds its way off deposit at the BoE (where £151 bln currently sits) and out into the wider economy where it can begin to chase the price of goods & services higher.  Therefore the BoE will only come under pressure to raise rates in the near term if the Pound Sterling collapses.

So the sight of central banks raising rates looks to be spotted for the time being only in the economies of the world which export commodities.  China will probably be the first Asian central bank to increase rates because the Yuan is closely tied to the US Dollar and other Asian countries do not want to raise rates and cause their currencies to appreciate against the Dollar or the Yuan.