The Fed Raises the Discount Rate:
What It Means For You
by Dr. Mark Skousen, Contributing Editor
Tuesday, February 23, 2010: Issue #1202
Last Thursday, the Federal Reserve suddenly raised the Discount Rate (the interest rate charged to member banks when they borrow from the Fed) from 0.50% to 0.75%. All members of the 12 Federal Reserve banks supported the decision.
In its decision, the Fed cited “continued improvement in financial market conditions,” but warned Wall Street that the increase was “not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.”
Hogwash.
It might not seem like much, but it’s the first increase in two years. More importantly, though, it does signify a significant change in monetary policy.
The Fed Expects to Keep Interest Rates “Low”
The Fed said it expects to keep interest rates “low” for an “indefinite future,” but the sooner the bankers raise rates to the “natural” level, the better.
Why?
Because the Fed knows that keeping rates low for too long creates serious imbalances in the economy.
Exhibit A: The period from 2004-2007 when doing so blew up the real-estate bubble.
And part of the Fed’s grand plan has had an unintended result. One Fed official expressed unhappiness that banks were borrowing from the Fed at ultra-low levels, then reinvesting the money elsewhere at a higher rate of return, rather than lending money to businesses.
In fact, banks and financial institutions (including hedge funds) have taken advantage of the yield curve and used leveraged money to make double-digit returns on their cash.
Result? Several banks have reported huge profits in “net interest income” on their quarterly earnings reports…
Printing Money and Posting Great Returns
For example, Webster Financial Corp. (NYSE: WBS), owner of New England Webster Bank, announced that its net interest income more than doubled in 2009 – from $26 million to $64 million. Deposits also rose to $13.6 billion from $11.9 billion a year earlier. That resulted in the firm beating analysts’ earnings expectations by a substantial margin and the stock rose sharply.
But banks aren’t the only ones who’ve profited from the yield spread. Several leveraged REITs have cashed in, too.
Take Annaly Capital (NYSE: NLY) and Capstead Mortgage Co. (NYSE: CMO), for example. Having borrowed at rock-bottom interest rates and invested the money in mortgage securities guaranteed by Freddie Mac, Fannie Mae and Ginnie Mae, their dividend yields are 16.9% and 17.2%, respectively. It’s like printing money.
Following the Fed’s announcement last week, market rates have only risen slightly. Until rates move back up, financial stocks like Webster, Annaly Capital and Capstead Mortgage will probably do well. But if rates rise rapidly, you should sell them.
Here’s another way to play Fed policy and a dollar rebound…
Double Up on the Euro’s Negative
As interest rates have remained low over the long-term, we’ve seen the ramifications that the policy has had on the U.S. dollar.
But on the other hand, higher interest rates would cause the dollar to rally, thus resulting in price drops for commodities like oil and gold – both of which are quoted in dollars.
With the prospect of higher rates to come, combined with the serious financial problems in Europe’s PIIG nations that my colleague, Karim Rahemtulla discussed here recently, another good play is to short the euro.
Despite efforts to save Greece from bankruptcy, the euro is likely to decline against the U.S. dollar this year, as other European countries face difficulties brought on by excessive deficit spending.
During monetary stress, investors tend to move to the dollar and Treasuries for safety. So a good way to play it is to short the euro by purchasing the UltraShort Euro Proshares (NYSE: EUO). It’s a double-leveraged play, meaning that it aims to produce twice the inverse performance of the euro.
Good investing – AEIOU,
Mark Skousen
- The Fed Fund Rate Announcement & Interest Rate Decision
- The Fed Gets Zero for Zero
- My Confrontation With Ben Bernanke: The Question He Refused to Answer
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