Friday, February 19, 2010 – my comments are in italics • Fed Action - discount rate spooking markets (US$ strong, eqties

/TSYs weak), but was expected and doesn’t signal a shift in monetary policy. From JPMorgan’s B Kasman: “This move does not alter our view that the Fed's first policy rate hike will come in 1H11”; Fed officials made comments Thurs night in wake of the discount rate action and downplay the potential for near-term action on Fed Funds rate. The fact the discount rate hike didn’t come during an FOMC monetary policy decision meeting emphasizes the fact that this wasn’t a monetary move – see more commentary below

Federal Reserve Discount Rate minus Federal Funds Target Rate (The Spread)

• Bank profits - Fed Move May Signal End to Easy Bank Profits; curve could start to flatten out, crimping bank profits; Banks have been able to borrow money cheaply and put it to work in lucrative ways, whether using the money to make loans at higher rates or to trade in the markets. NYT • Greece - Greece says a complex debt deal with US investment bank GS that has come under scrutiny by the EU was legal and will be explained in a letter being sent by the finance minister to the European Union. Greece has until today to supply answers about how it used the transactions (NY Post). Also today, S&P lowered its credit ratings on all 'AAA' rated Greek securitization tranches to 'AA' on account of its view of increased Greek country risk and Moody's is Reviewing For Downgrade Aaa Ratings Of Most Greek Structured Finance – the ratings agencies…always ahead of the curve. • “Volcker Rules” - U.S. Senate Banking Committee members are considering a watered down version of the 'Volcker rule' unveiled last month; Committee members are leaning against a strict ban on banks' proprietary trading and are considering requiring regulators to strengthen supervision of banks that are involved in such activities – Reuters • Health Care - Obama is preparing to release a proposal to restart the health-care debate before a White House meeting next week; Obama will offer “one proposal” that takes “some of the best ideas” from House and Senate bills “and put them into a framework moving forward,”; A senior White House official said the plan will be posted by the morning of Feb. 22. Bloomberg

Fed Officials comment Thurs night – downplay near-term Fed Funds action • Fed’s Bullard - “The idea that’s in markets that there’s a high probability that we’ll raise rates later this year is overblown,” • Fed’s Lockhart - “I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent,” Lockhart said. “Rather, this action should be viewed as a normalization step.” Bloomberg • Fed’s Duke says the hike in the discount rate to 0.75 is "further normalization of the Federal Reserve's lending facilities" and nothing more
• Bill Gross’ comments on the discount rate - "I don't think it's the beginning, really, of a tightening from the standpoint of monetary policy." Reuters

Everybody just calm down, this isn’t tightening, it’s “normalization.” The Fed and pretty much the rest of the sell-side are saying that this doesn’t mean a thing. But if it doesn’t mean a thing, then why do it? And they certainly intended for it to mean something when the loosened it on the way down as subprime first hit and Bear Stearns imploded. Discount window borrowing is well off its peak, but still significant. Federal Reserve Discount Window Borrowing - currently at $87.7 billion

And even if the move is just symbolic, it’s still symbolic. The positive view of this is that it is a return to normalcy and, therefore, a good thing. It could mean that the baton is being passed and now economic strength will carry the market rather than liquidity. On balance, I am still positive, as I believe the strength of the recovery is being under estimated by the market. But we have to consider the question; what if this is still a liquidity driven market? As investors, we can’t afford to occupy the same spot on the curve as the ratings agencies.