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Dorn: Discount Rates in the Land of OZ

In the movie, the Wizard of Oz was a powerful being purported to have the knowledge to get Dorothy back to her home in Kansas with Auntie Em. The Wizard used a smoke and mirror routine to make his powers appear larger than they truly were. The Wizard at heart was no more than a tinkerer who didn’t know the outcome of his own experimentation.

Wizard of Oz: Pay no attention to that man behind the curtain.

When The Fed wishes to reduce interest rates they will increase the supply of money by buying government securities. When additional supply is added and everything else remains constant, price normally falls.

In this case the price that is referred to is the Federal Funds Rate.

Conversely, when The Fed wishes to increase the Fed Funds Rate, they will instruct the Open Market Committee to sell government securities thereby taking the money they earn on the proceeds of those sales out of circulation and reducing the money supply. When supply is taken away and everything else remains constant, price (or in this case interest rates) will normally rise.

Two years ago, Tony Cherniawskiand a colleague did a study to see what relationship, if any, that existed between the Federal Funds Rate and the 90-day treasury bill rate.

Here, in part, is what they found.

Their actual study went back to 1954, when the Fed Funds Rate was tracked.

They overlaid the Fed Funds Rate to the 3-month T-Bill Discount Rate and were surprised to conclude that the Fed does not make monetary policy, it follows the market. In falling interest rate markets, the Fed Funds Rate lagged higher, whereas in a rising interest rate environment, the Fed Funds Rate lagged with a lower margin over the 3-month T-Bill Discount Rate.

In essence, Tony Cherniawski and his colleague concluded that the Fed is one very large hedge fund. The “carry” is the 90-day T-Bill and the investments are the loans made to financial institutions. The Fed now faces two problems. First, T-Bill rates are extremely low and the spread is very thin. Second, Washington’s voracious appetite for more debt is resulting in record-breaking Treasury auctions, putting (rising) pressure on interest rates.

Federal Reserve Chairman Ben Bernanke said in a recent statement that the timing of the end of record-low interest rates would depend on economic conditions, but the Fed would be ready to move.

"The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments," Bernanke said in written testimony.

No, Ben. It will depend on the markets.

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Dr. Janice Dorn is the only Ph.D. (Brain Anatomist) and M.D. (Board-Certified Psychiatrist and Addiction Psychiatrist) in the world who actively trades, writes commentary on the financial markets and manages a subscription-based website. Dr. Dorn has been trading the gold futures markets full time since 1993. She has written over 1000 articles on trader and investor psychology, and mentored over 600 traders and investors.She writes on all aspects of trading psychology and provides a real-time trading service on her website: TheTradingDoctor.com.