The Economy and Bond Market
In a surprise move this week, the Federal Reserve raised the discount rate (the rate at which banks borrow from the Fed), indicating that we have begun a new phase of monetary policy. Fed Chairman Bernanke just last week suggested that this process was just around the corner, but many market participants were surprised at how quickly the Fed acted. While it still may be some time before the Fed raises other short-term interest rates, the process could be faster than many had predicted. The fed funds futures market reacted to this week’s developments as can be seen in the chart below. The futures curve shifted higher, especially during 2011.
Strengths
- January CPI rose a modest 0.2 percent and “core” prices actually fell slightly. Inflation remains contained for the time being, which allows the Fed plenty of room to maneuver.
- Industrial production rose a very strong 0.9 percent in January to reach the highest level in more than a year.
- Housing starts hit a six-month high, even with suboptimal weather in many parts of the country.
Weaknesses
- The increase in the discount rate signals the beginning of a tightening cycle.
- China sold $34 billion in Treasury securities in December, a sign of waning demand for U.S. debt.
- While consumer prices were well-behaved in January, producer prices were another story. January PPI rose 1.4 percent driven by higher energy prices.
Opportunities
- If financial markets are a good mechanism for discounting the future, the future appears relatively robust. The markets have been able to shake off bad news relatively easily this week, probably a good sign for the economic recovery.
Threats
- If one of the eurozone countries were to seriously threaten default, the whole euro currency system comes into question and threatens global financial stability.
