February 19, 2010

A token for the Fed's sugar daddies?

Widely publicized and with plenty of market reaction, the Fed raised the discount rate to 0.75% on Thursday, but insisted that this does not tighten policy. As Reuters reported on on Friday:

The president of the New York Fed, William Dudley, said the central bank's pledge to keep benchmark borrowing costs low for an extended period of time "is still very much in place."

Well speak for yourself Mr. Dudley and Mr. Bernanke, but the market sure did not take your words all that serious.  In currency markets, the reaction was immediate as we saw in an immediate increase in the US Dollar against all major currencies.

The Fed "surprise move", maybe not be so surprising after all. In previous FOMC meetings, the end of quantitative easing had been alluded to already. But let's look at the the Fed move from another angle.  Central Bankers almost always base monetary policy on "controlling" interest rates and money supply. Looking at a Central Bank from a business perspective however, the Central Bank is in this most enviable position in that it can essentially write their own ticket, i.e. tell its creditors what rate they are prepared to pay for incurring yet more debt.  What if government finances were so out of whack that it became increasingly difficult to service the debt at these ultra-low rates? Now the objective is no longer that of "control" but rather a question of creating incentives to find buyers for yet more debt.

As Dow Jones reported:
"Treasury prices slipped a bit more Thursday, with the 30-year Treasury down by nearly a point in price, after a disappointing 30-year Treasury auction, the government's final offering of the week."

Further, the Department of Treasury announced the major foreign holders of US Debt where a similar "soft surprise" occurred.  As of latest data from Dec-09, Japan outranked China once more as the number one holder of US Treasuries with total holdings of $768bn.  China, now second, was holding $755bn worth of US Treasuries having scaled back their US holdings by about $45bn since last summer.  Maybe it is just a coincidence that the Fed moved ahead with a rate hike. But we cannot helping considering the pressure that has been building up for the Fed to continue financing their debt.  The prospects of further US budget deficits are daunting and it is too early in the game to derive any conclusions for the timing on further rate increases.  However, this small teaser move in higher rates may just be the right token for the Fed's sugar daddies...


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