US equities recorded their first successive weekly gains since late December on Friday, February 19 as a discount rate hike by the Fed helped reinforce hopes that the economy was on the mend. The rise in the discount rate?the level at which commercial banks can tap the central bank for funds?reflected a partial normalisation in policy. Prior to the emergence of the financial crisis in 2007, the discount rate was set 100 bps above the target Fed funds rate, currently capped at 0.25%.
When Ben Bernanke laid out the Fed?s exit strategy on February 10, he took great pains to make it clear that the impending increase in the discount rate did not mark the first step in the tightening of monetary policy. The fragile state of the economic recovery still warranted a very loose monetary policy?and this was not expected to change any time soon, Bernanke indicated.
But after the Fed made its move on Thursday, February 18 ?increasing the discount rate from 0.5% to 0.75%?markets were initially spooked by fears that it suggested a swift end to the era of easy money ushered in by the financial crisis and that borrowing rates for consumers and businesses could soon rise too. The signal was that the Fed is leaning more towards tightening than people previously thought.
Yet, Wall Street was firm and the S&P 500 was firmer on February 19 with a weekly gain of 3%. That followed a rise of 0.9% in the prior week. Stocks in Europe and London also rose on Friday and recorded back-to-back weekly gains. The policy-sensitive two-year Treasury yield rose 5 bps to 0.92%.
The yield on the 10-year note fell back from a five-week high, dipping 2 bps to 3.79%. The yield spread between 2 and 10-year notes shrank from Thursday?s all-time high of 293 bps to 285 bps as the Fed?s move pushed shorter-dated yields?those most sensitive to monetary policy?sharply higher. A steep yield curve is traditionally seen as a positive feature for banks because it allows them to borrow over the short-term cheaply and lend for the long-term at much higher rates. US banking stocks may therefore come under pressure if investors believe that the curve could flatten further.
The timing of the discount rate hike, between the January and March meetings of the Federal Open Markets Committee, which sets interest rates, was also not coincidental, according to economists. It was designed to reinforce this separation of the discount rate spread normalisation and monetary policy.
Before August 2007, the discount rate was set at 100 bps above the Fed funds rate?the central bank?s primary instrument of monetary policy. When the Fed funds rate moved up or down, so did the discount rate, by the same amount. But as the credit crunch unfolded, the Fed decided to narrow that gap to 25 bps in order to make it easier for banks to access emergency central bank funds. Now officials are beginning the process of moving it back towards the original spread.
Meanwhile, the Fed has been making concrete plans for more dramatic steps in the future?at least several months from now?in which it will move to tighten monetary policy and reduce the size of its balance sheet, which grew from $800 bn to more than $2,000 bn during the crisis.
It has already tested on a limited basis ?reverse repo??a tool that will drain liquidity from the financial system by allowing the Fed to borrow from short-term lending markets in exchange for cash. Another instrument called a term deposit facility, a kind of certificate of deposit for banks which would make it more attractive for them to store money at the central bank rather than lend it out, will be tested in the spring. Some economists have pointed out that raising the discount rate spread could make the term deposits even more effective.
According to the latest roadmap offered by Bernanke, the Fed plans to ramp up these two programmes in advance of any tightening in monetary policy?which would be achieved through an increase in the interest rate on central bank reserves, which now stands at 0.25%. If the economic recovery accelerates more rapidly than expected, the Fed could also increase rates at same time as it drains its pool of excess reserves.
As for gauging whether this stock market rally has legs or has petered out, the answer may well be found in the credit market. Looking for the key factors driving such recoveries, research shows that economic growth and profits were not particularly important. Instead, the strongest link was with the credit spreads. Provided credit continued to get cheaper (as shown by the extra spread for corporate debt compared to government debt), then stock market rallies could continue. Once credit spreads widen, equities cannot make much headway.
This is intriguing because credit markets are currently finely poised. The spread in the yields of investment-grade corporate bonds (according to Moody?s) compared to Treasuries now exceeds 4 percentage points. This is far below the panic level of 7 percentage points from the worst of the crisis, but is no tighter than it was six months ago.
Let?s look at the US unemployment scenario. The monthly unemployment rate for January has fallen to 9.7%?down from 10% in December. The peak for the current cycle was 10.2% in October 2009. If we consider the pattern of unemployment, recessions and both the nominal and real (inflation-adjusted) price of the S&P Composite since 1948, unemployment usually appears as a lagging indicator that moves inversely with equity prices. Now, we had increasing peaks in unemployment in 1971, 1975 and 1982.
The inverse pattern becomes clearer when viewed against real (inflation-adjusted) S&P Composite, with its successively lower bear market bottoms. The mirror relationship seems to be repeating itself with the current and previous bear markets.
Credit markets remain open for business. Most of the volatility has been in credit-default swaps rather than in cash bonds, suggesting again that investors have suffered only a temporary loss of confidence and are hedging exposure rather than selling.
There has also been some good news emanating from the epicentre of the credit crisis?the US. The just released Fed survey of senior lending officers in the US suggests that the credit crunch that triggered the crisis is easing in its intensity.
The author is a Wharton Business School MBA and CEO, Global Money Investor