The Fed has been talking about its “exit strategy” for quite some time. Few believed he would pull the trigger on anything soon. Yet, Bernanke, unexpectedly raised the discount rate headed into options expiration.

Please consider the Federal Reserve Discount Rate Announcement released after the market close on February 18, 2010.

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 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. 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. ….

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.

Unsustainable Course

That move comes on the heels of St. Louis Fed President Hoenig saying policy was on an unsustainable course as noted in “Three Paths Forward” – Kansas City Fed on Current U.S. Fiscal Imbalance, Hyperinflation, Printing.

From Hoenig …

No Short Cuts

Finally, there are no short-cuts. We currently must adjust from a misallocation of resources. There is no way to avoid some short-term pain in fixing the fundamentals in our economy. It is inconvenient for the election cycle, and it is undeniably terrible to have at least 10 percent of the labor force out of work. But short cuts now mean people out of work again in only a few years because we again try and avoid difficult adjustments. Outlining a credible course for managing our debt for the future will accelerate the restoration of confidence in our economy and contribute importantly to sustainable capital investment and job growth.

Conclusion

As I mentioned in the beginning, the fiscal projections for the United States are so stunning that, one way or another, reform will occur. Fiscal policy is on an unsustainable course. The U.S. government must make adjustments in its spending and tax programs. It is that simple. If pre-emptive corrective action is not taken regarding the fiscal outlook, then the United States risks precipitating its own next crisis. …

The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.

Treasuries Decline After Announcement

Bloomberg reports Treasuries Decline After Federal Reserve Raises Discount Rate

Treasuries declined after the Federal Reserve raised the discount rate charged to banks for direct loans for the first time in more than three years to encourage financial institutions to rely less on the central bank for short-term borrowing.

“This is all about how to start draining excess reserve and implementing a tighter policy,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. “It’s not overtly hawkish, but not an indication of perpetual dovishness or accommodation. This is a necessary step before they could do the rest of the sequence of events.”

The rate increase is another step in the Fed’s gradual retreat from its unprecedented actions to halt the deepest financial crisis since the Great Depression. The central bank has provided hundreds of billions of dollars in backstop credit to banks, bond dealers, commercial paper borrowers and troubled financial institutions such as American International Group Inc.

Fed Chairman Ben S. Bernanke and policy makers “have reiterated in every way that this does not signal a change in policy,” said Aaron Kohli, an interest-rate strategist at primary dealer Royal Bank of Scotland Group Plc in Stamford, Connecticut. “This is a normalization of policy. They worked hard to remove the stigma from the discount window, and now they are normalizing the rate.”

Change In Policy?

All the news articles on this hike are reiterating this is not a change in policy. Say what you want, but this appears to be a change in policy from doing nothing to tightening. At the very minimum this is likely to change perceptions about the resolve of the Fed’s willingness to take its exit strategy seriously.

Krugman will no doubt be pulling his hair out, but Hoenig is correct: the present course is not sustainable.

The shocking thing to me is the announcement coming on Thursday before options expiration. This repeats the pattern (except in reverse), of Fed moves to cut the discount rate and the Fed Funds rate several time during options expiration week.

This is an important step, the first step always is. Yet it is only the first step. So, let’s not get too excited until there is some follow through.

Slow Steps Expected

Bernanake is likely to go slowly, certainly with hikes.

Moreover, it will be relatively painless for Bernanke to start draining excess reserves. The reason is excess reserves do not play a role in bank lending as noted in Fictional Reserve Lending And The Myth Of Excess Reserves.

The only reason excess reserves are a problem is they interfere with the Fed’s ability to tighten.

Because the Fed will drain those excess reserves before it tightens, Bernanke can slow his exit strategy implementation as much as he wants. In this regard, the market is likely to overreact, pricing in rate hikes by Bernanke that will come later rather than sooner.

What Does It Mean?

If Bernanke follows through with additional tightening measures, it’s a signal that the Fed either believes the economy is strengthening or the Fed simply does not care. The latter seems to be the position of Hoenig.

Either way, this is very bullish for the dollar. I have the dollar index at 81.18 right now, a new high for the move. Note that the Euro cracked 1.35 to the downside, a new low for its move.

My target of 82.50 for the US dollar index set when the index was at 75 looks more than doable right now. The dollar index can get a lot higher than that. If the Fed starts hiking before the EU, we could see the Euro collapse to 1.15 or lower, with the dollar index challenging 90 once again.

In response to the Fed’s move, Gold and silver are taking a big hit, yet one must respect the relative strength in gold vs. silver or other commodities. Gold is close to all time highs while silver, copper, and especially energy are nowhere close.

In the commodity sector, I still expect gold to outperform.

Important Takeaway

The most important takeaway from this is a potential change in the market’s perception of what the Fed is likely to do, and when it may do it, in light of Bernanke’s surprise move in options expiration week.

In an equity market as overbought and overloved as this one is, Bernanke’s move heightens market risk. Ironically, the same holds true even if there is no follow through from the Fed. The reason being, lack of follow through will be an indication of deteriorating economic fundamentals.

I think Bernanke has seriously misjudged the strength of this recovery. The only alternative is the “we need to do this regardless” mentality of Hoenig has won out. Either way, risk is high and rising. There is little to like about equities in this environment.

Mike “Mish” Shedlock
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