Wall Street recovery prompts Fed tightening

The Federal Reserve has continued to target its liquidity withdrawal for the banking system as conditions improve for Wall Street and prominent hedge funds take huge positions in financial institutions.

The Fed announced on Thursday after the stock markets closed that it will raise the discount rate from 0.5 percent to 0.75 percent, effective on Friday. Starting March 18, the maximum maturity for primary credit loans will also be shortened.

The Rate Hike

The discount rate is the rate the Fed charges banks for direct loans. The discount window, from which banks borrow at the discount rate, is considered a lender of last result for banks. Banks typically utilize this credit only in emergency situations.

Before attempting to borrow from the Fed, banks first borrow from each other at the federal funds rate, which is traditionally 1 percent lower than the discount rate. The fed funds rate is the main driver of interest rates in the U.S. economy and affects Main Street significantly.

The moves that the Fed made were expected but I do not believe anyone was expecting them to move this quickly, says Scott Redler, the Chief Strategic Officer at T3Live.

I have a feeling that the Fed saw enough strength in the [financial] sector that it felt it could make this move sooner rather than later, says Redler.

Squeezing Wall Street

While the U.S. government continues to pump billions of dollars into Main Street after first bailing out big banks, the Fed has slowly withdrawn liquidity from Wall Street.

In its released statement on the discount rate hike, the Fed stated the modifications are not expected to lead to tighter financial conditions for households and businesses. Instead, it is the latest move in a series of liquidity withdrawals that are mostly targeted towards banks.

Even before the discount hike, Fed Chairman Ben Bernanke reminded the world in his February 10 congressional testimony that the use of many of the Federal Reserve's lending facilities has declined sharply, with some that were closed and others that were allowed to expire.

He also stated that the Fed was already shortening the maximum maturity of the discount window at the time.

Bernanke's testimony indicated that the Fed would keep the federal funds rate low for an extended period because of current economic conditions but would raise the discount rate before long.

Financial Market Recovery

The Fed made its latest monetary normalization move in light of continued improvement in financial market conditions. Some of the savviest market participants certainly agree with the Fed's assessment.

Reuters reported that hedge fund industry titans are increasing their bets in financial companies.

John Paulson, who made $15 billion in 2007 largely on bets against the housing market, bought over 200 million shares in Citigroup (NYSE:C) in the fourth quarter alone. His holdings in Citi and Bank of America (NYSE:BAC) account for 11 percent of his portfolio. He also increased his holdings in JPMorgan (NYSE:JPM).

Eddie Lampert, famous for orchestrating the $11 billion merger between Kmart and Sears, bought 1.5 million shares in Wells Fargo (NYSE:WFC), 453 thousand shares in Bank of America, and 12.5 million shares in Citigroup in the fourth quarter.

George Soros, the man who broke the Bank of England in 1992 with his bets against the pound sterling, bought 95 million shares in Citigroup.

While the S&P 500 gained about 1.25 percent in the last three months, shares of big banks have lagged, especially in light of several anti-bank proposals from U.S. President Barack Obama.

Some firms such as Goldman Sachs (NYSE:GS) posted stellar fourth quarter earnings. However, hedge fund favorite Citigroup still posted a loss for the quarter, even after excluding the negative impact of repaying the government's financial bailout investment through the TARP program.

Similarly, Bank of America reported a quarterly loss, even after excluding the impact of TARP repayments.

Both banks' shares have been severely depressed since the financial crisis as investors priced in the impact of the financial crisis and hedge funds bought their shares recently as quarterly losses narrowed.

On March 25, 2007, Bank of America was trading at $51.20 and Citigroup was trading at $55.12. On February 19, 2010, Bank of America closed at $15.85 and Citigroup closed at $3.43.