Banks, You're On Your Own

The Fed threw the markets a curve ball this afternoon by raising the Discount rate 50 basis points to 0.75%. The financial media is all a-buzz with stories discussing how the Fed is going to tighten sooner and more rapidly than expected. Let's put things into perspective.

Raising the discount rate affects no one and nothing except for banks needing funding from the Fed window. If anything this was a shot across the bows of the banks. The statement the Fed is trying to get across is that banks have been given enough help. It is now time for banks to fly under their own power. This will have little or no effect on the strongest banks. Banks which still have impaired balance sheets and which could have difficulty getting interbank financing at the Fed Funds or LIBOR rate should take the move as an incentive to fix whatever remains broken.


The knee-jerk reaction in the corporate bond market could be to broadly widen credit spreads on all bank and finance bonds. If that happens to bonds issued by J.P. Morgan, Goldman Sachs, Morgan Stanley US Bancorp, PNC, etc. should be viewed as a buying opportunity. Even BAC should be a good buy. Beware the regionals and banks which remain government owned.

Upon the Fed's announcement the dollar rallied and the long end of the treasury curve sold off. The reason for the dollar rally was the speculation that by investing in dollars one will be able to ride short-term rates higher. Another reason is that if this is the start of a greater trend for higher borrowing costs for banks, they will be forced to lend and the economy will expand. This is also why long-term treasuries sold off. I think the markets are being a bit too optimistic.

Banks will not lend if they cannot securities the loans. That means that loans have to be of a very high quality and /or be agency eligible. If bank borrowing costs rise, credit will not flow any easier as it is more cost-effective not to borrow and lend than to write bad loans.

This could also be a warning sign that the newly confirmed Ben Bernanke is more Paul Volcker and less Arthur Burns. Today we had a somewhat higher PPI report. That doesn't matter that much to CPI unless businesses can pass along price increases. That is not the case at this time.Many pundits believed that Mr. Bernanke would not take any action to raise any rates as long as employment struggled. Today's jobless claims data was disappointing. So why did the Fed shock the markets at all? Because raising rates could help employment.

Stay with me here folks and let me explain. Picture yourself as a business owner or chief executive. Your costs for materials has just risen, but your sales have not. Consumers are not back in the game and may not be back for a long time (if ever) so you cannot raise prices for your goods or services. How are you going to make ends meet? You are going to pare workers. However, what if rates rose, the dollar strengthened and, due to a stronger dollar, the prices you pay stabilize or fall. Now you do not need to cut your workforce further.

Look for growth to remain modest as the dollar strengthens. A stronger dollar hurts U.S. exports (there goes manufacturing), but is helps every other area of the U.S. economy. It also attracts foreign investment into the U.S. keeping long-term rates under control.

I think long-term rates will rise some more, but low to mid 4.00% is all we get out of the 10-year treasury this time around. Fed Funds and LIBOR probably to go beyond a 4.00% handles. Owners of LIBOR floaters may get a point or two more out of their preferreds, but the time to sell is fast approaching.

Have a great weekend and buy large bank bonds on any dips.