On February 18, the U.S. Federal Reserve announced it would increase the discount rate by 25 basis points, to 0.75 percent. That has left market participants wondering if a hike in the Federal funds rate is coming next—and what the implications will be for the economy and the markets.
To understand the significance of the Fed move, it’s important to understand how commercial banks borrow funds for emergency financing and to meet short-term liquidity needs. They can borrow from the Federal Reserve, and the discount rate is the rate of interest the Fed charges. Banks can also borrow from each other, and this overnight inter-bank lending rate is known as the Fed funds rate. The Federal Reserve controls a target for both rates through open market operations. Currently, the Fed funds rate ranges from 0 to 0.25 percent.
The Fed’s discount rate is almost always higher than the Fed funds rate, because typically the Fed is viewed as a lender of last resort during highly distressed times, or times when liquidity is poor. Banks prefer to borrow and lend with each other whenever they can (using the Fed funds rate), so the discount rate doesn’t have an impact on banks under normal conditions.
While the discount rate doesn’t tighten credit, changes in the rate do send the market a signal. They can act as a harbinger of what may be ahead in terms of monetary policy and the economy. In the table below, we can see how discount rate changes have acted as a leading indicator. In 2007 as the markets were in decline, the Fed lowered the discount rate, and several months later, the Federal funds rate followed.
Discount Rate 2003 - 2010
After the discount rate was increased on February 18, market participants had quickly priced in a greater likelihood an increase in the Federal funds rate would follow. On Friday, February 19, the August Fed funds futures contract, traded at the CBOT, was pricing in a 50 percent chance the Fed funds rate would be increased at the August 10 Fed policy meeting, and the October contract was pricing in a 74 percent chance of an increase by the September 21 meeting. Those odds both have dropped since, because speculators seemed to come the conclusion (for now anyway) that the discount rate change wasn’t that big a deal, and that there are other factors acting as a possible threat to growth in the economy and inflation.
In the current environment, banks are not lending much in general. After the financial crisis of 2008 - 2009, they have been trying to get their house in order, and have excess reserves. The banks are already tightening their lending, so they are already in a sense doing some of the work for the Fed. We are also seeing credit lending down about 14 percent year-over-year. Even if there were an increase in the Fed funds rate, I don’t think it would slow the economy a great deal, although we’ll have to see what Fed Chairman Bernanke and other global policymakers have to say in coming weeks. In a speech on February 24, Bernanke said the U.S. economy is experiencing a “nascent” recovery that still requires low interest rates.
S&P 500
The S&P 500 reached a 15-month high on January 19, but has seen some consolidation since. I think we will see the S&P hit 1,000 before we’ll see 1,200. Looking at a weekly chart of the S&P 500, we see a strong trendline that was broken about a month and a half ago. The S&P came up to the 50-day moving average, but couldn’t move past it. I think the rally is losing steam, and we’ll see a significant pullback to perhaps below 1,000 within the next 2-3 months. Right now, with March futures trading under 1,100, the market looks like a better sell than a buy.
Tuesday, February 22 saw a sharp sell-off after the release of a reports showing consumer confidence was at its lowest level since August 2009. At the start of the year, we saw good growth being priced into equities, and I’m not sure now how much growth we will see. The slow growth of the American economy has yet to be priced in, so I expect equity prices to decline.
U.S. Dollar
An increase in the Fed funds rate would be bullish for the dollar, and I like the U.S. dollar’s prospects right now. Any time we get a distressing market event, people want to flock to the dollar. Say what you will about the U.S. economy, but the dollar remains the place people go for a safe-haven. The dollar is on a strong uptrend right now, although it may face some resistance.
You can watch the ICE U.S. Dollar Index contract as a barometer for dollar sentiment, as it represents the dollar’s standing against a basket of six global currencies. It’s also a great contract to trade. However, you have to remember that the euro has the heaviest weighing (about 60 percent) in the index. So it helps to have an outlook for the euro as well, and I think the euro’s outlook is poor. If you’ve been following the news, you know about the turmoil over a possible debt default in Greece. The Pigs (Portugal, Italy, Greece and Spain), have off-balance sheet debt and a host of issues we haven’t even gotten to the bottom of yet. We’ve never had a situation in the Eurozone where a country has defaulted on debt, nor the threat of a country (Greece) being kicked out for failing to adhere to Euro member requirements. I think ultimately Greece will be bailed out, but I don’t see much positive for the euro in the near future.
U.S. Dollar Index Futures
Crude Oil
Crude has been trading in a channel of about $70 – $80 or so a barrel for some time. Right now, crude oil looks to be on an uptrend, and there are speculators who feel that if the economy turns around, people will need crude. So they are buying now to get ahead of the trend. However, it’s difficult to have significant growth if energy prices are too high, so it’s a catch-22 situation. I want to see crude oil pull back, but I wouldn’t recommend shorting it right now. We have some geopolitical issues in Iran going on over its uranium enrichment projects, and if anything distressing were to happen, the price of crude would definitely react.
On the other hand, I don’t recommend buying crude oil either for fundamental reasons. While crude oil has been in an uptrend for the past couple weeks, oil inventory numbers have shown increases. Generally, when inventories rise, we have too much supply and it should not be bullish.
Crude Oil Inventories
Crude Oil Futures
Gold
Gold has been a great trade for investors over the past year. Right now, it seems to be at a point where the run is stalling. The market had peaked above $1,200 an ounce in late 2009, but can’t seem to retest the highs. The market bounced off of support at $1,100 numerous times in the past few days. If you are bullish in the short term, you might try purchasing around $1,100 for a quick move up, but I feel the U.S. dollar is going to move up, and gold, which is priced in dollars, will more likely move lower.
Drew Shaw is a Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at dshaw@lind-waldock.com.
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