Thursday, February 18, 2010

Fed Raises Discount Rate... More "Unwind" in the Future?

The Fed raised the Discount rate (not the Fed Funds rate) to 0.75% per Calculated Risk.

Just to be clear, this is the discount rate (this is the rate the Fed charges banks that borrow reserves) and not the Fed Funds rate. This move was being discussed for some time although the timing is a surprise.
Regardless, the bond market sold off in an expected, non-expected manner (nobody expected it today, but given the surprise hike shorter rates sold off more than longer rates in what would be an expected fashion).

Why expected?

Short rates are more directly impacted (on a relative basis) by expectations of Fed hikes, whereas longer rates are more directly impacted (on a relative basis) by future rates, (thus expectations of inflation). This removal of liquidity from the system may mean the Fed is more likely to hike Fed Funds sooner (I don't buy that aspect of it), while inflation concerns may be less justified with less liquidity in the system.

What to expect now?

Besides the obvious answer "the unexpected", remember that renormalization following the unwind? Expect that unwind to be back in play.

Source: Bloomberg

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