The Federal Reserve Board on Thursday announced that in light of continued improvement in financial market conditions it had unanimously approved several modifications to the terms of its discount window lending programs.

Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC). At that meeting, the Committee left its target range for the federal funds rate at 0 to 1/4 percent and said it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The changes to the discount window facilities include Board approval of requests by the boards of directors of the 12 Federal Reserve Banks to increase the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent. This action is effective on February 19.

In addition, the Board announced that, effective on March 18, the typical maximum maturity for primary credit loans will be shortened to overnight. Primary credit is provided by Reserve Banks on a fully secured basis to depository institutions that are in generally sound condition as a backup source of funds. Finally, the Board announced that it had raised the minimum bid rate for the Term Auction Facility (TAF) by 1/4 percentage point to 1/2 percent. The final TAF auction will be on March 8, 2010.

Easing the terms of primary credit was one of the Federal Reserve's first responses to the financial crisis. On August 17, 2007, the Federal Reserve reduced the spread of the primary credit rate over the FOMC's target for the federal funds rate to 1/2 percentage point, from 1 percentage point, and lengthened the typical maximum maturity from overnight to 30 days. On December 12, 2007, the Federal Reserve created the TAF to further improve the access of depository institutions to term funding. On March 16, 2008, the Federal Reserve lowered the spread of the primary credit rate over the target federal funds rate to 1/4 percentage point and extended the maximum maturity of primary credit loans to 90 days.

Subsequently, in response to improving conditions in wholesale funding markets, on June 25, 2009, the Federal Reserve initiated a gradual reduction in TAF auction sizes. As announced on November 17, 2009, and implemented on January 14, 2010, the Federal Reserve began the process of normalizing the terms on primary credit by reducing the typical maximum maturity to 28 days.

The increase in the discount rate announced Thursday widens the spread between the primary credit rate and the top of the FOMC's 0 to 1/4 percent target range for the federal funds rate to 1/2 percentage point. The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve's primary credit facility only as a backup source of funds. The Federal Reserve will assess over time whether further increases in the spread are appropriate in view of experience with the 1/2 percentage point spread.


Sounds scary, right?  And for sure, more than a few of you will hear someone mention this tomorrow as some sort of "end of the world."  And for sure, more than a few of you will field a question from a client saying something about the "Fed Raising Rates," but feel free to point them here to calm nerves.  Actually, it's so small of a deal to us that we probably won't cover it much beyond this paragraph, so you'll probably be pointing them to some sort of forthcoming coverage on MND that will make the mostly innocuous and very EXPECTED nature of this move apparent.

Long story short, longs aren't any more short than they already were.  And by that, I mean that the longer duration bonds are, as yet, unaffected with the unchanged 10yr note being a prime example.

2yr notes are understandably reacting, but only have moved to .9277.  Not huge by any metric, and perhaps to soon to tell for sure, but possibly a knee-jerk that will iron itself out by tomorrow.


Again, and to conclude: this is an EXPECTED and NORMAL part of the the gradual draw-down of insanely high levels of reserves in the banking system.  The discount rate is germane to the reserve requirements, and by the time the money creation process has it's say, the effect on mortgage rates will be insignificant to very small.  I just wanted you to be armed for discussion tomorrow and as I said, I wouldn't be surprised if MND does something slightly more thorough to that end. 

In fact, AQ already has this in the comments of the last post:

"Don't confuse the Fed Funds Rate with the Discount Rate. The Fed Funds Rate is the interest rate banks charge each other for the overnight sale of immediately available funds. Banks are lending to banks here. The Discount Rate is used when banks borrow funds from the Federal Reserve. These are funds that are not currently in the banking system. What the Fed is doing by raising the discount rate is limiting the amount of NEW MONEY that could be put into the banking system. Because there are currently over $1 trillion excess reserves already in the banking system...this move is not really a big deal. More than anything it's psychological. A reminder of the Fed's gradual withdrawal...."

now we can move on...

As far as the actual closing levels, it's a bit hit and miss as to assigning significance to them.  The volume spike that accompanied the rate hike was so small that the late day weakness in bonds is almost not even worth mentioning.  The fact that futures promptly recovered to somewhere just above the lows of the day should be the bigger take away and for that reason, the 10yr futures chart wins today for being the best-behaved from a technical perspective. 

see?  it's really not that big of a deal...

But it exerted a small effect on the cash market nonetheless.  Thankfully though, still in line with weakest levels of the day, and even with a perfect display of that whole "orbiting around technical levels" concept I've been going on and on about. 

To clarify that a bit, observe the red line in the chart above.  3.80 is the technical level, and rather than assume it's some hard and fast ceiling, it seems to have served me better to thing of the technical level as a gravitational force that draws yields or prices in to orbit around it as we can plainly see at the end of today. 

This is usually most true for INTRADAY charts, and less often the case when we're looking at daily closing marks.  Whatever our understanding of how things shook out today, the important thing to know is as Dr. Evil says "The plan goes ahead as..... planned!" 

And the plan is truly evil as far as low-rate seekers will be concerned, as it's the plan AQ and I have been soap-boxing for a bit now on generally higher rates in 2010.  The move up today is all a part of that, both in terms of the move from the fed and more importantly the move in MBS.  And hopefully it's clear by now that the move in MBS and bonds is NOT due to the Fed (how could it have been if the Fed came in at the end of the day?), but rather to the confluence of fundamental data pushing rates in the direction of the next technical level at which they'd eventually come to rest.

There was a brief shot of tomorrow's data in the last post, and some lock/float considerations.  I'd weight my overnight bias to lock just slightly more than it might have already been due to the uncertainty of the nocturnal session's reaction to the fed data.  It's entirely possible we can rally tomorrow, but late day data with the word "Fed" in it always carries a bit of an uncertainty premium as to how the markets will react between now and rate sheets tomorrow.