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The Fed's Magic Tricks


As the Fed tries to pull a rabbit out of its hat, this is what to watch: the discount rate.

The only way to watch a magician perform is to watch what he doesn't want you to see. Don't look at his hands or his eyes but pay close attention to his surroundings. As the Fed tries to pull a rabbit out of its hat, I think this is what to watch: the discount rate.

In 2003 the Fed dramatically raised the discount rate from 0.75% to 2.25%. This shifted the relationship to Fed funds from 50 basis points below to 100 above. The Fed did this to "move the patient from critical care to stable". They may just move the patient back to critical care.

Libor rates are at their highest ever to government rates. This means banks can't or won't lend to each other. Instead of taking central bank liquidity through the repo market and lending it out to other banks (thus expanding liquidity through the multiplier effect), they have been sucking up all of it to their balance sheets in desperate need of capital. Banks need huge amounts of capital as they write down the value of their assets like loans. This is why you are seeing Citigroup (C) and UBS (UBS) borrow money at 11%, MBIA (MBI) diluting its stock, and Washington Mutual (WM) cutting its dividend and laying off a bunch of people: they are all desperate for cash.

The bottom line is the banking system is seized up. It's not working. The reason is simple: there is too much debt.

Once again the Fed's answer is really the only answer it can give: create more debt. The system itself can't create it because it can't handle anymore. By lowering the discount rate the Fed will force feed the only entities that want the debt... banks.

Maybe a lot of the rally in stocks and reversal of credit spreads have already discounted this. Maybe stocks will shoot up, especially bank stocks, as bulls herald the final final final final solution to the problem.

But the cake is baked. All this non-lending is having a heavy effect on the real economy , which is hooked on debt . At some point it will become obvious even to the bulls.

Shorting stocks is crazy due to the high volatility. Anything can happen. The only message is that risk is increasing and to be very conservative in one's own finances.
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Positions in C, WM, UBS, MBI
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