Market Preview

      The futures sold off hard and fast after the close yesterday, when the Fed surprised with the raise in DISCOUNT rates. First, let's remember this is the Discount rate, not the Fed Fund Rate. It's a huge difference, the Discount Window is lender of last resort (for the last couple years it has been the ONLY lender).
                A little review, may help us understand what impact this may have. The Discount Window is traditionally the lender of last resort, in fact in the past banks never went to the Discount window and instead lent to each other. The Fed tries to discourage lending money by setting the Discount Rate slightly higher than the Fed Funds rate (which is the rate that banks use as a target to lend to each other). Going to the Discount Window was an open admission of credit problems (and possible failure). Back in 2007 when more and more banks were going the Discount Window because they were running out of money and couldn't find anyone else to borrow from, they tried (as they might) from reporting they were going to the Discount Window, they didn't want people to panic or believe the bank was having problem.
                When the credit crisis exploded, it was no longer a secret, everyone went to the Discount Window. It got (obviously) so bad the Fed made some radical changes, they extended the loans from over-night to 30 days, they allowed banks to post "junk" rated paper as collateral to borrow, they allowed non-members come to the Discount Window to borrow, and even investment banks (JPM, Goldman, and others) converted to banks and were able to get coveted access to the Discount Window. The lending ballooned from 100s of millions to 100s of billions.
                After the independent injections of capital (outside the Discount Window), via Tarp, 100s of billions in bailouts, AIG back-door 100% guarantees, the stress at the Discount Window began to subsided. There was finally enough capital in the system. The problem now was the massive amount of debt the Fed has taken on - TALF (buying a trillion in mortgage back securities), Treasury buying, special-lending facilities, and finally the Discount Window loans. They need to do something to slow down the lending and start unloading the debt they have accumulated.
                The raise in the Discount Rate (while such a slight difference) is one way to slow down the lending and also charge a little something to start paying down the debt. However, a change in the Discount Rate (which only directly affects those that have access to it, unlike the Fed Funds rate), created some fear yesterday that this meant rates were going up. I even heard, one very uninformed reporter ( regular news channel), that Bernanke is raising rates and how it will affect mortgages, etc. He didn't not qualify the difference between Discount Rates and Fed Fund Rates. This kind of poor reporting just spurs panic and uncertainty and I personally think the market over-reacted. Bernanke (and the Fed) thought so as well and has clearly stated that they have NO intentions to change their position from January (which clearly states that they are not planning on raising FED FUND rates).
                But there is some interesting issues about the timing. Yesterday the PPI came out hot and some were talking about the CPI increasing and inflation coming. Additionally there is also concern coming from abroad about the national debt/deficit as well as the Fed debt. With problems in the EU, PPI running hotter than expected, Fed under-pressure from Congress, and less stress on the Discount Window - it was time to act - at least show they are doing something to get their house in order (not much - but at least something).
                The market - certainly over reacted. The treasury yields volatility in the last 12 hours have seen some volatility as well - a panic out and back in - almost as crazy as the futures drop and then back up.
                I believe the raise in the Discount Window is a good sign, but only that - it will have very little impact on lending or paying down the debt. You could say it is window dressing as well - telling the foreign central banks (primarily China) to back off and that we have a handle on our monetary policy (even though the Fed said the raise in the Discount Window is NOT a change in monetary policy). Like tough talk, it is small action that can be pointed to - showing the Recovery is here, we are paying down the debt, etc. I certainly don't expect the Fed to act quickly or make radical changes and it is nice to see this change - but we certainly don't need to be over-reacting about it. Does make for some great volatility.

http://www.bloomberg.com/apps/news?pid=20601087&sid=amj4X4IWKCys&pos=2

.