After QE3’s announcement in mid September there was some concern that the effect of QE on the market had eroded because the S&P 500 proceeded to sell off by 5%. It could be true that QE is losing its efficacy, but it’s worth noting that true balance sheet expansion didn’t really start until mid November because of the mechanics of MBS purchases. It therefore may or may not be coincidental that MBS started to show up on the Fed’s balance sheet around the same time that the S&P 500 found a bottom.
Over the last several years, many analysts have argued that QE isn’t inflationary because the money that the Fed has printed has been locked up in reserve balances. I don’t personally share this view, but it’s worth noting that recently reserve balances have been contracting and currency in circulation has been growing as banks have chosen to convert reserves to currency. Currency in circulation is now growing at nearly a 10% annual rate.
Although QE3 was announced almost 2.5 months ago, the mortgages that the Fed has been purchasing have only just started to hit the Fed’s balance sheet over the last couple of weeks. The monetary base has continued to hold flat, but mortgage holdings have ticked ever so slightly higher.
Given that Mario Draghi announced unlimited asset purchases last week, equity markets have been rallying along side the Euro; however, if Draghi ends up exercising his buying power and Bernanke doesn’t announce more QE tomorrow, the Euro rally may be short lived. Since 2009 (as theory would predict) the value of EUR/USD has been closely linked with the relative size of each central bank’s balance sheet. The more that the Fed prints, the more the EUR gains against the dollar. The more the ECB prints, the more the EUR falls against the dollar.
One indicator that we pay close attention to is the monetary base, the sum of currency and reserve balances at the Fed. Over the last two weeks the base has grown by $43B, about 1.5%. The base is important to us because of the relationship that it has had with commodity prices over the last several years. If the relationship holds, it might suggest that commodity prices like oil and gold will trend sideways rather than down.
As far as Fed Balance sheet trends go, it’s also worth noting that reserve balances continue to fall. The “reserve balances” line is a perennially misunderstood line-item, which is often used as evidence that excess liquidity is just being stored at the Fed rather than entering the economy. In actually the high level of excess reserves is just a symptom of QE because in the aggregate all of the reserves in the system must return to the Fed even if different banks hold them. At any rate, these reserves are now starting to be converted more rapidly into hard currency, which should render the argument over excess reserves moot.
Fed Liabilities Portion of Balance Sheet: