Rate Hike Skewers Options Friday and Starts its Exit Strategy

Remarkable that the Fed would hike the night before options expiration, giving no chance to unwind positions. Karl Denninger notes they have done this before: in Aug 2007 just as the market was topping at all time highs. Did anyone notice that 2 million SPY shares were dumped right in front of the announcement?  

No surprise, futures have erased the whole day's gain in the after market. Right now the March S&P is down to 1095, below where it started this morning. Here is what we should now expect in stocks:

While the Fed made sure to say that this does not signal tightening, and it shouldn't affect commercial rates, it is and it will. The FX market knows what it means: the Dollar reversed a small slide and got above DX81, and the Dollar Carry Trade may be over. Higher US rates means stronger US Dollar. 

The discount rate hike itself is not a big deal - it is largely symbolic, since the intrabank borrowing action is elsewhere - but it is the start of the tightening process. Next we should see the Fed offer higher interest rates on reserves held in the Fed using term deposits: higher rates but locked up for a term. Think of them like Fed CDs. This is meant to keep the $1T of bank reserves in the Fed and not out in the wild, where they could be lent at up to 10x multiples and spike inflation. This as all part of their exit strategy. The actual Fed Fund hike that starts the tightening rise of rates should follow. 

The historical context is fascinating. Back in 1931, the Fed faced a brewing banking crisis out of Europe, with sovereign debt defaults starting with Austria and eventually ending with England getting off gold. The Fed had dropped rates after the crash as vigorously and quickly as Bernanke, but then began raising the discount rate too quickly as a reaction, as shown in this chart (courtesy Jesse's Cafe Americain):

Are we about to repeat, with Greece taking the place of Austria? The Greek debt is roughly the size of Lehman! It may be that the sovereign debt spreads "blowing out" over the past few months, starting with Dubai, is a consequence of the ending of QE and the beginning of tightening, meaning this specific hike isn't the catalyst; the whole reflation attempt and inevitable tightening is. This time we are tightening ahead of the sovereign debt problems, but consequences may be similar to 1931.

One scenario for investors to consider is that the Fed slows the tightening as the Euro crisis waxes, maybe slowing rate hikes into 2011 (which Goldman predicts). The Fed may also have to continue QE longer than they wanted. The other place to watch is the Treasury auctions. We had a nearly failed auction a few days ago. The Fed may find itself between a rock (the need to sell Treasuries) and a hard place (the desire to protect the European banks from the PIIGS). 

Comments

[Steven_737]

Thanks Duncan;

I would appreciate more information with respect to the first chart; i.e.
1) who compiled it
2) what it is based on

cheers.

[yelnick]

Steven, the first chart comes from this link: http://pragcap.com/fed-raises-discount-rate-futures-tank

The source is Morgan Stanley:  http://pragcap.com/morgan-stanley-stocks-are-set-to-decline-in-2010 

[Steven_737]

Thank you Duncan.

http://steven737.typepad.com/blog/2010/02/spx-wave-2-count.html

http://steven737.typepad.com/blog/2010/02/ndx-wave-2-count-february-18-2010.html

The Elliott wave counts on the futures make much more sense, especially regarding the ending diagonal.

cheers.