This is the second part in an ongoing series designed to guide you toward a basic understanding of Federal Reserve and ECB monetary policy as conducted in recent history, as well as what exactly constitutes and drives quantitative easing. Despite being on the forefront of the mainstream media since 2007 you will rarely run into anyone who has a thorough understanding of how all the pieces fit together. We are completing our basic introduction and then will explore a chronological recap of what has transpired in the past few years. If you missed part one then please make sure you read it first before continuing below.
MONEY SUPPLY AND THE MONEY MULTIPLIER
Recall our scenario from before, with two US commercial Banks, A and B. Reserve Requirements are 10%, and the balance sheet of Bank A that we ended up with is shown below:
As explained before, required reserves are simply 10% of deposits, and also recall the changes to Bank B’s balance sheet after it made a loan of 20bn USD to a firm:
Changes to its BS after making a loan are highlighted in red: most importantly, excess reserves decrease slightly, as deposits grow (Bank B credits Firm X’s deposit account with the loaned money, and the loan itself appears as an asset on the BS). Clearly this could not occur if Bank B held no excess reserves in the first place. You can think of the loan as being a case of Bank B “using up” only 2bn of its excess reserves to “create” 20bn of money in the real economy. This will become important later, as this is known as the (money) multiplier effect.
To understand this effect we need to define Money supply – simply the total quantity of monetary assets available in the economy. There are different measures of money supply, of which the important ones are:
- Starting from the most narrow measure, we have M0 which is simply all the notes and coins in circulation. This does NOT include cash stored at the Federal Reserve Banks (ie. the central bank in the US) and cash stored at commercial banks’ vaults, as it is effectively dead money.
- The monetary base (MB) = M0 + bank vault cash + banks’ reserve accounts. This is a broader measure, that includes notes and coins but more importantly it includes a measure of central bank money, ie required and excess reserves, which commercial banks hold at their reserve accounts with the Fed. In our example from Figure 2.1, the monetary base would equal M0 + 0 + (10+40) bn + (17+43) bn = M0 + 110bn USD.
- M1 = M0 + demand deposits, and simply measures the money in circulation by also including the most common form of “electronic money”, which is easily accessible deposits (“on demand”), that one can use to withdraw money at any time without restrictions or delays. A common example of this is a debit (card) account. Note that this measure does NOT include central bank money and vault cash! M1 therefore measures commercial bank money. For our example in Figure 2.1, M1 = M0 + (100bn) + (170bn) = M0 + 270bn USD [Assuming all deposits in our example are demand deposits].
- M2 = M1 + savings accounts + “time deposits” (money has to be locked in for a period for time to earn interest, and cannot be withdrawn – e.g. bonds, money-market deposit accounts for individuals etc). This is a broader measure of commercial bank money. In our example of Figure 2.1, M2 = M1 as we assume there are only demand deposits. [ There are other broader measures of money which I will not discuss here for simplicity ]
The multiplier effect, which we described for Bank B above, can be measured in general by the money multiplier (MM) , which is simply a statistic, that measures the ratio of “commercial bank” money to “central bank” money. Out of the 4 measures of money supply listed above, only the monetary base can qualify as central bank money. So we can choose either MM = M1/MB or MM = M2/MB to be the money multiplier. Let’s take money multiplier, ie MM = M2 / MB as a broader measure. Firstly, let’s measure the MM for our example in Figure 2.1, substituting in our calculations for M2 and MB above:
MM = M2/MB = M1/MB = (M0 + 270bn) / (M0 + 110bn). We do not know the notes/coins in circulation (M0), but given that in modern economy it is very small compared to electronic money (ie deposits), we can assume for our example to be negligible. Therefore as M0 à 0, mathematicians reading this will know that MM à 270bn / 110bn = 2.45.
DOESN’T THE BUILD OF EXCESS RESERVES, WHICH RESULTED FROM FED QE, PREVENT THE MULTIPLIER EFFECT???
Above we can see the money supply for the US economy, and the changes that resulted since 2008: As Fed started QE, the monetary base grew, but so did excess reserves – but M2 expanded at a lower pace than before, thereby reducing the MM to ALL-TIME lows.
According to the multiplier effect, an increase in bank reserves, which resulted from QE, should have been “multiplied” into a much larger increase in M2, as banks should have expanded their deposit and lending activities. The expansion of deposits, in turn, should have raised required reserves until there are no excess reserves in the system. Why has this NOT happened in our Figure 2.3 above?
To answer this, consider the situation from a commercial bank’s perspective. Once it gains excess reserves via QE, it has two options:
- deposit them with the Fed, in which case it would earn the Interest that the Fed pays On Excess Reserves (IOER); Since there were virtually no excess reserves until 2008, the Fed only started considering setting IOER after the 2008 crisis, and after briefly playing around with it, it was set to 0.25% and has remained that ever since.
- attempt to lend its excess reserves to earn an interest, which is higher than IOER (0.25%).
So the bank will attempt to lend out its excess reserves at any positive interest rate, greater than IOER. This additional lending in turn decreases short-term interest rates (Why? Interest is the price of money, and if more money is supplied via lending then this price goes down). This lending also creates additional deposits in the banking system as in Figure 2.2 and thus leads to a small increase in required reserves. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself, with banks making more new loans and the short-term interest rate falling further.
This multiplier process continues until one of two things happens:
- there are no more excess reserves, i.e. the lending has expanded so much that all excess reserves turned into required . In this case, the money multiplier is fully operational.
- However, the process will stop before this happens if the short-term interest rate slips below what the bank can earn on its excess reserves with the Fed, i.e. IOER. At this point, there is no longer an incentive to lend and hence the multiplier process stops.
Above we add the Fed funds effective rate, currently 0.15%, (ie the actual short-term interbank lending rate), and the IOER, 0.25%, to our money supply picture from before.
Initially in 2008 the money multiplier shrunk as the credit squeeze kickstarted a massive contraction in lending (ie money supply fell), the Fed responded by aggressively cutting the Fed Funds target rate, which in turn anchored the effective rate lower. Once the FF effective rate fell below the interest Fed paid on reserves, the banks were no longer incentivised to lend and the multiplier process stopped, resulting in further collapse of the MM.
In the summer of 2012, the Fed considered cutting IOER to 0% or even negative to encourage lending but that never got much traction and another round of QE went ahead instead. I would argue on the basis of the diagram above that further rounds of QE will become increasingly less effective, and therefore cutting IOER is a much more effective next step in monetary policy.
Will excess reserves cause inflation?
The market consensus is that the large quantity of reserves will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover. I would concur, as once grows picks up (IF IT PICKS UP), demand for lending will increase sharply, and the presence of such a huge amount of excess reserves, will encourage banks to lend them out aggressively – this can create an exponential surge in lending over a very short period of time, thereby resulting in runaway inflation.
However, the Fed has the power to control this via two ways:
- Under a traditional framework, ie Fed’s Open Market Operations (OMOs), it can remove nearly all excess reserves from the banking system. It can do so by selling back Treasuries it acquired via QE: recall our review of Fed ‘s OMOs in the previous article – the primary dealers (ie banks), would have to drain their reserve accounts to put up cash in exchange for Fed’s bonds. As their reserves shrink, but clearly required reserves have stayed the same, their excess reserves therefore also diminish.
- By raising the Interest on Excess Reserves (IOER), the Fed can manage the build-up of excess reserves more directly. As IOER is raised, it discourages banks from lending at the market rate, and instead simply park their excess reserves at the Fed. Of course, the IOER would have to be consistently set higher than the market lending rate.
The big problem here, which officials refuse to discuss, is that runaway inflation would quickly lift the market bond yields. Why? Well, imagine you are lending someone money at 5% a year, when inflation is 10%. You would be stupid, since you are effectively locking in a -5% annualized real return. Instead you could simply buy an asset, whose price grows with inflation (ie real estate) and earn 10%. Therefore, government bond yields (ie the rates at which the US Treasury borrows from the market) must also track inflation.
The chart above illustrates this relationship between 5yr and 10yr bond yields and CPI for the last 50 years.
So in an inflationary scenario above, the borrowing costs for the US Treasury would rise materially. If the Fed employs OMOs to combat inflation, it risks screwing with the Treasury even more, as its bond sales would also lift bond yields even further (yield is proportional to the inverse of the bond price). As the size US government debt is well publicised (including social security payments its over 500% of GDP), you can easily see that the costs of funding that debt will become unmanageable – tax receipts that the Treasury will earn from a growing economy will be nowhere near enough to pay its debt, but if it borrows more from the market it will have to commit to paying even higher interest rates in the future. This is a classic debt spiral that terminates in one of two ways:
- Formal default. That would be the last resort, as since the US government bond market is the most liquid asset market in the world, it would bring down the Financial system globally and this time no central bank alone will be able to patch it up.
- Pseudo-default. In this case, the Treasury would not default officially but it will effectively make the US consumer pay – by inflating away its debt. It will print an enormous quantity of USD, which will dilute the purchasing power of the consumer in real terms. This would be hugely negative for the US dollar – we are talking about a bear market of our lifetime. For historical reference, look up Weimar Germany.
This is the first part in an ongoing series designed to guide you toward a basic understanding of Federal Reserve and ECB monetary policy as conducted in recent history, as well as what exactly constitutes and drives quantitative easing. Despite being on the forefront of the mainstream media since 2007 you will rarely run into anyone who has a thorough understanding of how all the pieces fit together. We will start with a basic introduction and then explore a chronological recap of what has transpired in the past few years.
Fed Monetary Policy and Quantitative Easing
Before the 2008 crisis, conventional monetary policy in the US boiled down to the Federal Reserve (the Fed) controlling interest rates. The way it achieved that was by manipulating what’s known as the Fed funds rate:
Commercial banks (banks in the US that accept deposits and make loans) have daily funding requirements. Let’s assume Bank A faces a withdrawal of deposits today totaling $1bn. Deposits are a liability of the bank, so to make that payment to its customers it needs to borrow money. It could do that in the interbank market with another commercial bank, so it negotiates an overnight rate and deals at that rate.
The weighted average rate of all such transactions in the banking system every day is known as the Fed funds effective rate. That is essentially a proxy for an overnight interbank market rate. The Fed regularly meets via Federal Open Market Committee (FOMC) and sets what is known as the Fed funds target rate, which is the level of interest rates they consider appropriate for the economy based on macroeconomic factors and so on. Their job as part of conducting monetary policy is to ensure that the market rate (ie the Fed funds effective rate) accurately mimics the benchmark Fed funds target rate.
The Fed uses Open Market Operations (OMOs) to achieve this, by directly altering the supply of money in the economy. In simple terms, think of it as two worlds: the Fed and the Monetary System (ie banks, lending institutions, and then the real economy). The way money reaches the economy is via banks’ lending money to firms and businesses. All the money that is sitting at the Fed does not affect the economy in any way since it is not available for lending to businesses. BUT if the Fed chooses to inject money into the economy, the quantity of money that banks have available to lend increases.
Interest rate is the price of money. And similar to a stock, if supply of money increases – its ‘price’ (ie the interest rate) goes down. During Open Market Operations, the Fed buys and sells government bonds to banks as a way of regulating money supply. Suppose the Fed funds effective rate (ie the actual market rate) is trading higher than the Fed’s target (the Fed funds target rate). To lower the market rate, the Fed can attempt to increase the supply of money. To achieve this, it buys government bonds from banks, and in exchange it credits their reserve accounts. That way the money now enters the monetary system as banks can lend that money to the economy.
During Temporary OMOs, Fed reverses its actions on money supply, i.e. if it initially bought bonds from banks it will reverse that after a period of time by selling an equivalent amount, thereby creating only a temporary change in money supply. In 2009 as response to the credit crisis, the Fed announced a longer-dated programme which became the main part of their Permanent OMOs (POMOs), as they started outright purchases of longer-dated bonds without immediate intention to sell them back. This has been labelled as QE (quantitative easing).
How Does QE Work?
To illustrate, consider two US commercial banks, ie institutions that take deposits and make loans. We have Bank A, which has been started with $10bn equity capital, and has accepted $100bn of deposits. These are liabilities on its balance sheet (BS), since it effectively “owes” that money to shareholders and depositors respectively. For simplicity, consider Bank B which has exactly the same liabilities. Let’s assume for simplicity that they are the only two commercial banks in the system.
By law a bank is obliged to maintain a certain level of reserves with the central bank, which it should hold at its reserve account. This is what is known as reserve requirements and they cover the bank’s assets and liabilities but the most basic form is that banks in the US should hold 10% of their deposits as reserves. These show up as assets, since they represent cash owned by the bank.
So total reserves in the system are $20bn and they are all required reserves, i.e. there are no excess reserves. Banks also make loans, which are assets on their balance sheet (since they are owed money by borrowers) and lets assume that they hold some securities on their balance sheet too (securities = stocks/bonds etc). Suppose Bank B has access to a larger pool of lending opportunities, and to be able to make more loans it has borrowed $40bn from Bank A. The full balance sheet of both banks is displayed in Figure 1.1 with the interbank loan in orange (Bank B owes money so it is a liability on its BS, and an asset on Bank A’s BS):
Note the importance of the interbank lending system in normal times, money has flown towards its most productive use (i.e. Bank B borrowed to service the need of its customers). In our example from Figure 1.1., suppose the financial system enters a period of turmoil like in 2008, which disrupted the normal pattern of lending and led to a “freeze”, which could be due to uncertainty about banks’ ability to pay back and also their ability to borrow for their own funding needs. Now Bank A does not want to continue lending to Bank B. This places a severe disruption on Bank B: if it is unable to quickly raise new deposits or borrow elsewhere to obtain the $40bn it owes, it could be forced to decrease its loans by $40bn. That in turn would force a contraction in deposits, as borrowers scramble to pay back loans to Bank B resulting in a sharp contraction in economic activity.
To prevent this, the Fed steps in with QE and suppose it buys $40bn of Treasuries from Bank B. Recall that in the original example the banking system, which consists of A and B, held no excess reserves. The resulting balance sheets after $40bn Fed QE are shown below (changes in red):
Fed credited Bank B’s reserve account with $40bn, which Bank B used to pay back the loan to Bank A (hence Bank A’s reserve account now holds extra 40bn). Bank B got the money by selling $40bn of its bonds (securities). Note that the total reserves in the system are now $60bn, but only $20bn are required – hence there are now $40bn of excess reserves. The chart below shows the actual US banking system total reserves (yellow) and excess reserves (red) that have resulted from QE, similar to the example above:
Numerous market observers and commentators such as ZeroHedge have used this to conclude that Fed has injected “dead money” that is sitting on banks’ balance sheets and hence its policies have been ineffective. But as our example shows, the job of the Fed here was to prevent an interbank market freeze and it was highly effective in this regard – it prevented Bank B from having to reduce its lending by $40bn!
In fact, lets assume that Fed does $50bn more QE, but this time the cash is released into the real economy, ie firms are sellers of the bonds to the Fed. The Fed can only deal with primary dealers which are banks, so suppose Bank B stands in as the intermediary and sells the bonds to the Fed on behalf of its clients:
Resulting Bank B’s balance sheet is now shown in Figure 1.3 (changes in red from Figure 1.2). I have split total reserves into required and excess reserves for clarity: the Fed deals with Bank B, which is representing the firms, so it credits Bank B’s reserve account with 50bn. Bank B is selling bonds on behalf of its clients to the Fed in return, so there is no drain to Bank B’s own stockpile of securities. To channel the proceeds of this sale to its clients, Bank B must credit the deposit accounts of its clients – hence its deposits increase by $50bn from Fig 1.2. So both reserves and deposits go up, BUT required reserves are only 10% * 150bn = $15bn, hence Bank B now gains $45bn in excess reserves (it previously held none).
Let’s further assume that Bank B directly increases lending by making a new loan of $20bn to a firm. Resulting balance sheet is shown in Figure 1.4: Bank B now has a new asset (the loan to the firm of 20bn) and an offsetting liability (it credits the firm’s deposit account at the bank by 20bn). Note that Bank B’s total reserves have not changed at all, and excess reserves have only narrowed slightly to ($60bn – 10%*170bn) = $43bn.
This is counter intuitive, as even though bank lending in the economy increased, total reserves and excess reserves still went up! Sure, the firm in our example can now withdraw that money from its deposit account and spend it, but since most of the money payments are nowadays electronic whatever they spend this money on (investment, research etc) will just end up at other firms’ accounts, which in turn would end up as another bank’s deposits.
This is the general principle: loans to banks and firms and direct purchases by the central bank all increase the TOTAL level of reserves in the banking system by the same amount. It doesn’t imply anything about the level of lending in the economy! Similarly, the level of excess reserves in the system does NOT imply that banks are not lending. In the example above bank lending went UP by nearly 10% ( = $20bn / Total loans [$150bn + $60bn] ) But Bank B’s excess reserves also went UP by $43bn.
As I’m typing this the SPX is a bit over 33 handles away from its all time high of 1576.09. Whereas just yesterday we were stuck near an inflection point which the bears could have exploited to their advantage the landscape has changed quite a bit since early this morning:
After the limbo comes the rocket. As of right now I don’t see any technical hurdles that would prevent us from continuing toward our P&F target of SPX 1615.
As a matter of fact today it triggered a triple top breakout – that’s just two days after a bear trap warning when the ES was stuck near that diagonal resistance line. The bears had a real good shot there to exploit this but once again didn’t have the balls to exploit momentary weakness. Not that I could blame them given the full roster of POMO auctions scheduled throughout March.
Crude is looking interesting tonight. That hourly candle tells me that it has a pressing appointment with its 100-hour SMA, which also matches the 100-day on the daily panel. Which would constitute a possible last kiss goodbye move – and that is a spot I would love to get positioned at.
However most of the action is happening over on the FX side today – please step into my lair:
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If you look at the tape of the last week we’re seeing fast moves in both directions. Unless you enjoyed the advance warnings courtesy of yours truly then odds have it you were at minimum rattled a few times or perhaps even lost some coin in the fog of all that emotional turmoil. I think we’ve done exceptionally well throughout those gyrations and for that we should be thankful.
Looking forward we are now approaching a make or break point on the equities side. The reason for that is that congestion periods mixed with high volatility in volatility (see wild swings on the VIX) are opportunities to force the completion of a trend. We had fast moves on both sides, as opposed to a fast drop followed by a slow crawl reversal higher. In that case I would be actively looking for a Retest Variation Sell at this point – Scott’s post earlier this morning did mention an alternative scenario and I agree with him that this trend is obviously slowing.
I am however not sure that we are done here just yet – there may be enough mojo left for a final leg higher. Although the volume profile doesn’t show us any meat above 1525 we have seen equities push through shallow volume patches without breaking out much of a sweat.
Which brings me to exhibit B: The NY Fed’s POMO schedule for March – which has us pumping another $45 Billion into the hands of preferred financial institutions over the course of the next month. You recall a similarly looking roster last month and we know how that turned out.
All that said and done – there may come the day when cheap Fed cash just won’t do the trick anymore, hence we look at mainly price to guide our way. Technically speaking the bulls are very vulnerable here. If we can’t make it over 1524.5 today or Monday at the latest gravity could easily start dragging things lower in a heartbeat. At minimum that 25-day SMA at 1508 needs to remain intact, so set your watches, comrades!
At this point we are sitting a bit in limbo as this does not feel just like a honeypot period – if that doesn’t mean anything to you then check out my post on market weather. We do have pretty clear inflection points here, so let’s use them. Right now the onus is on the bulls to push things just a little bit further – if they are unable to do so the grizzlies may seize the moment. And if that happens POMO cash may not be sufficient to save the day as things could drop like a rock in a matter of just a few days. Starting Monday watch the VIX for divergences – I’m also going to make sure to check my VXV:VIX and VIX:VXO ratios.
Crude now officially a sell as it dropped through its 100-day SMA. As you can see it will also complete this week well below its weekly NLSL. That is medium term bearish and you may start wondering why gas prices at the pump keep going up and up and up… (answer – you are being ripped off as usual – reduce your driving and see the market respond).
Platinum update – our last kiss goodbye trade is really picking up steam now. What you may not be aware of is the weekly panel which also had triggered a sell signal at the same time. As of right now the weekly target roughly matches that of our daily panel.
USD/CHF – if you took that long entry a week ago then it’s time to scale out. It’s been a great ride but that daily BB will now start putting up some resistance.
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Enjoy your weekend everyone!
A few weeks ago I resumed my regular updates on the Federal Reserve’s POMO activity. With good reason as in early January of this year the Fed decided to cease Operation Twist and once again pursue regular unsterilized POMO auctions. No more concurrent draining of the pool – now it’s back to regular pumping of their balance sheet as seen during QE1 and QE2. If you need a quick primer on the topic then look no further than my previous post.
As predicted by the Fed’s POMO schedule which I posted earlier this month – we’ve had plenty of activity throughout February and apparently it has fueled a relentless ramp on the equities side. Last week’s correction was long overdue but after just two days of red candles we are already two steps into a VIX buy signal.
Here’s an update on the FED/ECB balance sheet activity. Clearly the Fed is back on a printing binge while the ECB has continued to reduce its own – this is due to MRO and LTRO loan repayments by EMU periphery banks.
As you can see on paper the ECB balance sheet has continued to drop but Draghi is continuing to pursue the Euro version of sterilized injections via the Outright Monetary Transaction program, which is done via concurrently offering one-week deposits to the banking system. So it may be too early to congratulate Mr. Draghi [via soberlook.com]:
it is important to note that the ECB has simply swapped a portion of its on-balance sheet exposure for an unlimited off-balance sheet commitment via the Outright Monetary Transactions program … Just because off-balance sheet exposure is not visible doesn’t make it any less real. As a reminder of how off-balance sheet exposures can quickly appear on balance sheets, just take a look at the start of the financial crisis in 2007. Large U.S. and European financial institutions had significant off-balance sheet exposures by providing backstop guarantees to their commercial paper vehicles prior to the financial crisis. When that commercial paper could no longer be rolled, banks, particularly Citi, RBS, and Wachovia, were forced to take assets – mostly mortgage securities – onto their balance sheets.
The recent drop in the FXE vs. the Dollar finally took its toll and perhaps was one of the reason why gravity finally managed to drag equities down a few notches. However when comparing the drop on the EUR/USD with the SPX it’s clear that the correction on the latter has been rather mild thus far. It’s possible that we’ll see continuation to the downside before it’s all said and done but apparently the Fed’s POMO activity continues to produce quite a bit of headwind for the bears.
Although I would want nothing more than to see a strengthening of the Dollar the easy stretch of the run is now over. My long term chart has it crossing its 100-month SMA and that is certainly very positive. However expect things to get more bumpy as it’s pushing toward the 84 mark – which now lines up with its long term nemesis, a diagonal resistance line that has been in place since 2005.
The Fed will do its best to suppress the Dollar as well with the BOJ encourage a weak Yen much to the chagrin of the ECB. Already now there are calls in Europe to ease some of its austerity measures. France for example has been the most disciplined in meeting its economic growth target, which however has resulted in a negative divergence in growth compared with that of its Euro counterparts.
If the Dollar is running into resistance and the EUR/USD is bouncing back (and the EUR/JPY continues higher) I would not be surprised to see more calls here in Europe for more QE measures as economic growth may be stifled in the face of monetary pressure from the U.S. and Japan.
In the context of that contracting triangle formation on the DX we may be facing some rather exciting times on the FX front. A break out above DX 84 would certainly result in a major short squeeze – similarly a drop below 78 (near the 25-month SMA and the lower diagonal) could result into a massive sell off. The Dollar has now coiled up over 8 years and I’m eager to see a resolution – perhaps later this year and one way or the other.
Bottom Line: Forget about equities – it’s all about the Dollar (and the EUR) at this point. No matter what they try to tell you – earnings don’t drive markets anymore – the Fed and the ECB do via their respective monetary interventions. Once again, don’t pay attention to what they say (e.g. the last FOMC report was simply a fishing expedition) – pay attention to what they do. I’ll make sure to keep you posted every step of the way.
Two weeks ago I posted a long overdue update on the Federal Reserve’s market fuel injection activities. My previous post on the topic had been in October of 2011 and today I would like to address the reason for keeping silent on the subject for over a year.
A few months earlier that year the Fed announced ‘Operation Twist’, a program which would be conducted throughout late 2011 and all through 2012 to further ‘help stimulate the economy’. The term ‘Operation Twist’ isn’t new, it was first used back in 1961 (in a reference to the Chubby Checker song) when the Fed employed a similar policy. In essence it refers the Fed’s initiative of buying longer-term Treasuries and simultaneously selling some of the shorter-dated issues it already holds in order to bring down long-term interest rates.
Another popular term you may have heard in this context is ‘sterilization’. In theory the practice of buying the long end and selling the short end allows the Fed to drive down interest rates without further increase in the monetary base – thus they are calling it ‘sterilized injections’.
Operation Twist has been instituted in two parts. The first ran from September 2011 through June of 2012, and involved the redeployment of $400 billion in Fed assets. The second ran from July 2012 through December 2012 and redeployed a total of $267 billion. The Fed’s reasoning for initiating the second phase of Operation Twist was response to continued sluggish growth in the U.S. economy.
Now last December the Fed stated that it would end the program and replace it with a ‘stronger version’ of its existing policy of quantitative easing – which seeks to lower long-term rates by making open-market purchases of longer-dated U.S. Treasuries and mortgage-backed securities. And that brings us back to our POMO auctions.
If you look at our POMO chart above then you can clearly see the tail end of QE1 as well as the bell curve of injections representing QE2 – all that was done via good old fashioned ’unsterilized’ injections, thus resulting in a measurable increase in the U.S. monetary base. The St.Louis Fed is kind enough to maintain a chart of just that:
As you can see the Fed went from roughly $800 Million to about $2.8 Trillion between 2008 and 2011. Since then this chart has been pushing sideways, suggesting any injections were done via Operation Twist. If you look closely however you can see a sudden and steep rise over the past few weeks, and the same is visible on my POMO chart above. Apparently there has been yet another policy change and the Fed is now back to full scale unsterilized market injections via POMO auctions. And those means more slosh in the system which in turn provides more speculative fuel for asset purchases. Thus keeping a close eye on the Fed’s POMO activities has once again become relevant to our trading activities.
To dumb all of this down let me simply state that being short equities during active periods of POMO purchase activity is a losing endeavor. If you are looking for evidence – in January I counted 17 days of ‘coupon purchases’ (excluding one TIPS which I usually disregard) – there was not one single sale. The implicit (and perhaps intended) effect of which was a rise of 88 handles in the S&P 500, a 1,015 handle rally in the Dow Jones Industrial, and an all time high in the risk-on Russell 2000. Fortunately we here at Evil Speculator were prudent enough to not step in front of this speeding bus.
In case you are wondering what February may hold for us – here’s the Fed’s POMO schedule for this month. And once again we’re seeing bumper to bumper POMO purchases on the roster and not one single sale. The Fed’s message to the bears: Don’t screw with us – we will frilling crush you.
Now that is not the end of the story – there is another factor we need to consider and it’s the actions of the ECB on my side of the Atlantic. Draghi has been cooking his own stew of sterilized injections by swapping a portion of the ECB’s on-balance sheet exposure for an unlimited off-balance sheet commitment via the Outright Monetary Transactions program. He’s doing this by concurrently offering one-week deposits to the banking system. Banks bid competitively for the deposits, thus permitting the ECB to withdraw from circulation an amount of money equivalent to what it has spent via OMTs.
Fed Versus ECB
So why do we worry about all this? Because when we produce a ratio of the balance sheet of the Fed against that of the ECB it almost exactly tracks the gyrations of the EUR/USD (chart donated by John – I’m currently compiling my own):
There’s a pretty enlightening Wall Street Journal article on the topic which makes that very point. Particularly interesting are the rather distinct ratio divergences vs. the EUR/USD which should make for some nice contrarian trade opportunities.
If you are an equities trader (and if you are reading this I assume you qualify) then it is important for you to embrace the fact that you are implicitly trading the EUR/USD. The chart above makes this rather clear – the moment the Dollar rises against the Euro equities suffer – when it falls equities are on the rise. And it’s not just all about the Federal Reserve’s actions – at the end of the day it really boils down to which side is printing more. At the moment the Fed is once again expanding its balance sheet while the ECB has been reducing it. That means a (relatively) stronger Euro, a weaker Dollar, and thus a continued rise in equities.
The current P&F target on the FXE is 139.5 – and given both the Fed’s and ECB’s activities I have little doubt that we will fulfill that price objective and perhaps more. And as long as the Dollar’s fall continues we should expect to see higher prices for commodities as well as equities across the board. And most likely higher prices as well at the pump and at the cash register.
Happy MLK Day! As my long term charts have not produced anything salient I spent the day crunching some updated numbers I extracted from the New York Fed’s Open Market Operations page. The last time we talked about POMO auctions was in late October 2011 – more than a year ago! Since then the Fed’s repo activities have been relatively muted but seem to be picking up steam again in recent weeks:
It’s a big one so you may want to click on the chart to catch more context. Shown here is the 20-day rolling total of Permanent Open Market Operations (POMO), total par accepted, and in Billions. This gives us a more directional plot as there’s a focus on recent activities. Clearly visible are the QE1 spike in 2009 and the QE2 spike in 201 as the Fed was conducting purchases of treasury and agency debt, thus injecting money into banks in exchange of (less than stellar) debt instruments.
As you can see during the past year the rolling total has been swinging around the zero mark, which is due to a shift toward Operation Twist, an effort to affect the treasury yield curve via the purchase of longer term debt and selling short term paper. In theory both actions are supposed to offset each other but as they are done on different days it obviously had an effect on how stock prices were responding to additional liquidity. Throughout 2012 we saw deeper corrections but obviously the trend continues upwards which indicates that the Fed is using additional measures to inject liquidity into the banking system.
Here’s the running total – truth to be told I had to tweak the numbers as my data was only going back a few years. I do recall that the Fed reached the $1 Trillion mark in late December of 2010, so I was extrapolating based on that. Again we peaked around August 2011 and it’s been sideways since. However, most noteworthy is the little pick up lately, which correlates nicely with the recent run up in equities. Coincidence? I think not
I literally spent all day formatting the imported data, adding missing days, removing weekends, adding up double auctions, etc. Suffice to say I’m not a big with Excel but I somehow managed – Google is your friend. I promise to keep a close eye on this one again moving forward, in particular if I see more pertinent activities. By the way – this little tidbit posted on January 15th raised my eyebrows, but as the old saying goes: Don’t listen to what they say – pay attention to what they do.