Fed move won't hurt stock rally

When Ben Bernanke laid out the Fed's exit strategy on Febru- ary 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 Febru- ary 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-sensi- tive two-year Treasury yield rose 5bpsto0.92%.

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 astheFed'smovepushedshorter- dated yields--those most sensi- tivetomonetarypolicy--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 couldflattenfurther.

The timing of the discount rate hike, between the January andMarchmeetingsof theFeder- al 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 normalisa- tionandmonetarypolicy .

Before August 2007, the dis- countratewassetat100bpsabove 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 begin- ning the process of moving it backtowardstheoriginalspread.

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 $2,000bnduringthecrisis.

It has already tested on a limit- ed 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 whichwouldmakeitmoreattrac- tiveforthemtostoremoneyatthe 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 de- positsevenmoreeffective.

According to the latest roadmap offered by Bernanke, the Fed plans to ramp up these two programmes in advance of any tightening in monetary poli- cy--which would be achieved through an increase in the inter- est 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 excessreserves.

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 dri- ving such recoveries, research shows that economic growth and profits were not particularly important.Instead,thestrongest 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 creditmarketsarecurrentlyfine- lypoised.Thespreadintheyields of investment-grade corporate bonds (according to Moody's) compared to Treasuries now ex- ceeds 4 percentage points. This is far below the panic level of 7 percentage points from the worst of thecrisis,butisnotighterthan itwassixmonthsago.

Let's look at the US unemployment scenario. The monthly un- employmentrateforJanuaryhas fallento9.7%--downfrom10%in December. The peak for the cur- rent cycle was 10.2% in October 2009. If we consider the pattern of unemployment, recessions and both the nominal and real (infla- tion-adjusted) price of the S&P Composite since 1948, unemploy- mentusuallyappearsasalagging indicator that moves inversely with equity prices. Now, we had increasing peaks in unemploy- ment 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 andpreviousbearmarkets.

Credit markets remain open for business. Most of the volatili- ty 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 hedg- ing exposure rather than selling.