Wednesday, November 30, 2011

A Discount Rate cut? It just doesn’t matter

The rate on the Fed Liquidity Swap has been changed today to the OIS rate + 50 down from (OIS +100).
The Fed: The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.
The liquidity swap represents the Fed providing dollar funds to the ECB and other central banks while taking euros or other currency as collateral. The all-in rate should be around 60 bp. If the US chartered banks want to borrow from the Fed, they have to pay 75 bp – the so-called Discount Rate. Some have speculated that it makes no sense for the Fed to offer lower rates to foreigners than it would to the US banks and therefore the Fed intends to lower the Discount Rate.
MarketWatch: “It is now cheaper for foreign banks to borrow dollars from their local banks than it is for U.S. banks to borrow dollars from the Fed, so we could see a 25 basis point cut in the discount window in the coming days to level the playing field,” said Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets.
First of all that is unlikely because the Fed clearly stated at the last meeting that they want to raise not lower the discount rate:
FOMC Oct 3d Minutes: As another step toward restoring a pre-crisis discount rate structure, some directors supported increasing the primary credit rate by 25 basis points (to 1 percent) at this time. Such an action would result in a 75-basis-point spread between the primary credit rate and the upper end of the Federal Open Market Committee's target range for the federal funds rate. These directors favored a move toward normalization of the primary credit rate in light of current and anticipated economic conditions.
Second of all US banks are NOT borrowing from the Fed these days – they have no reason to. In fact they are lending via excess reserves.  The rate that is important is the “Fed Funds Effective Rate”, the rate at which banks lend dollars to each other overnight. And that’s sitting around 8-9 basis points.

 Fed Funds Effective (FEDL01 Bloomberg)

The need for dollars directly from the Fed comes from the European banks (via the ECB) because US banks and US money markets are limiting their lending to them. Thus lowering the Discount Rate simply won’t make any difference.
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