POMO Pump Update

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.

Cheers,