Total Fiscal and Monetary Stimulus Since 2008

As many are hopeful that we are finally leaving the financial crisis behind, sometime in the not too distant future the government is going to have to start unwinding the major stimulus that it has provided to the economy through fiscal deficits and monetary expansion since the crisis began.

Below is a cumulative tally of how much stimulus has come from the Fed and Treasury over the last four years.  The total is now about $7T ($5T worth of deficits plus another $2T worth of monetary expansion).  Amazingly, to the extent that one believes that the crisis was primarily housing market related, the $7T total represents ~70% of all the mortgage debt outstanding in 2008.

Cumulative deficit plus change in size of Fed balance sheet since 9/2008

Monetary Base Ticks Slightly Higher

The monetary base ticked higher by a non-negligible amount for the first time since QE3 started last week.  The Fed has agreed to purchase more than $150B worth of securities since September but up until now the monetary base has remained relatively flat due to the time it takes for mortgage trades to clear and shifts in other balance sheet items which absorbed some of the growth.  

Interestingly the debt ceiling is a driver of this week's growth as one of the "cookie jars" that is keeping the government running is Treasury's deposit account at the Fed.  When Treasury draws this account down to fund itself the money it spends finds its way into the calculation of the base.

It seems like this should be a turning point for the base, but admittedly it's been difficult to predict the way that the dynamics have played off of each other to keep the Base flat.  Tune in next week for an update on whether paint has dried further.

QE3 Just Starting to Hit Fed Balance Sheet

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.

The Fed has agreed to purchase ~$100B worth of mortgages since September, but holdings have only increased by $40B due to the lag in time of settlement for MBS trades.  The fact that the balance sheet has mostly been unchanged suggests that we may not yet have seen the effects of QE3 in securities markets.

Monetary Base Since QE3

The monetary base is an indicator which I always pay close attention to because it has been highly correlated with the price of oil and gold since 2009.  Since QE3 was announced I have been paying even closer attention to the measure than usual, but it hasn't yet moved as one would expect it to.  Over the last several weeks the monetary base has fallen as the Fed has purchased more MBS for reasons that  I don't totally understand (likely some technicality and timing of the way assets are accounted for in the Fed's H.4.1 release).  I would expect this to reverse in the coming weeks, but until it does, it may help to explain why oil has been weak since QE3 as well.

What Would September Look Like Without Draghi and Bernanke?

As September is coming to a close, the S&P 500 looks set to post another monthly gain.  However, most of that gain came completely on two trading days: September 6th and 13th when Mario Draghi and Ben Bernanke each announced infinite monetary action.  Without those two days the S&P 500 would be 52 points lower and the chart would look like it does below.

Of course, it's not really possible to strip away two trading days or the effect of what that news did to prices.  However, the hypothetical chart below does highlight that there have been more down days than up days in September.

Comparison of Japan and US Monetary Base

Before the Fed eased last week, I wrote that the ECB's actions could force the Fed to ease in order to maintain the value of the dollar relative to the euro.  Today, the BOJ's decision to purchase another 10T Yen worth of assets confirms that global central banks are in a prisoner's dilemma race to the currency bottom.

Below is a chart of the relative size of the Japanese monetary base compared to the US base.  The Japanese monetary base is about 50x larger than the US base (measured in nominal local currency units), but for most of the last 2 decades it has been more like 100x the size.  The chart implies that as the US monetary base grows compared to the Japanese, the Yen could strengthen further, which is a problem for a Japanese economy that relies on exports.  Unfortunately for Japanese exporters, the Fed has announced an easing program which is likely to be larger than the BOJ's.

The Fed Can't Extend Twist Because it's Running Out of Short Term Bonds to Sell

Along with announcing more QE today, the Fed reiterated that Operation Twist will continue through the end of the year.  Interestingly, the Fed might not be able to extend twist beyond year end even if it wanted to.  That's because the Fed has almost completely exhausted its portfolio of short term treasuries, and at the current pace it probably wont have many short term Treasuries on its balance sheet at year end.

Below is a chart of the maturity profile of Treasuries on the Fed's balance sheet.  In total, the Fed owns $1.6T worth of Treasuries, and only $490B of that is paper with less than 5 years of maturity.  Only $3B of that has a maturity of less than 1 year.

At the current pace of $45B per month, the Fed will sell 30% of its remaining 1-5 year holdings by year end and be left with about $350B of 3-5 year maturities (assuming the 1-5 year portfolio is roughly equally weighted by maturity and they sell the nearest maturities first).  From there, it would be about 8 months until the Fed has sold all maturities 5 years and in.

The end of operation twist could have a couple of major implications for rates markets in 2013.

1) Twist is empirically the only monetary program so far that has actually flattened the curve while pushing equity prices higher.

2) Since the new QE is only focused on mortgages, the Treasury market could be missing a major buyer in 2013.

Could this, along with the very real inflation implications of printing money in an economy with tightening capacity utilization finally be the straw that breaks the rates market's back?

Forecast of Monetary Base to 2015 Based on Today's Fed Action

Pretty much as expected, the Fed announced that it will be conducting outright QE at the pace of $40B per month without any clear end date.  Based on this pace of purchases, below is a forecast of what the monetary base could look like out to 2015 assuming that the Fed prints at today's pace for as long as it intends to keep rates exceptionally low.

If this pace were maintained until then, the monetary base would increase by about 5x between 2008-2016, which would be a CAGR of 22%.  The current pace of $40B per month represents an annualized growth of about 18% from current levels.  Given gold and oil's correlation with the growth of the monetary base, $2700 gold and $170 brent crude prices might not be out of the question if the Fed maintains QE for that long.

Correlation of Rates and S&P 500

Operation twist has had the opposite effect on rates that outright QE has had, but equities have rallied during twist just like they did during QE1/2.  This has lead to a divergence between equities and interest rates over the past year.  Previously equities and rates had been relatively correlated: when equities moved higher so did interest rates.  Recently though, the daily correlation has broken down and over the past year has actually turned slightly negative.

Will there be more QE?

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.

Recently following two sizeable LTROs the ECB balance sheet has grown significantly to eclipse the Fed balance sheet (in nominal fiat/local currency terms).  The balance sheet would likely expand even further on new outright purchases.  This implies that there could be further downside for the Euro, unless Bernanke acts to counteract.

The ECB's newfound willingness to expand its balance sheet introduces an interesting game theory aspect to US monetary policy that wasn't as prominent in 2009/10.  If Bernanke wants a weak dollar relative to other global currencies, he may be forced to act further.  Otherwise we could be looking at a much stronger dollar along with the anti-correlated equity prices that come with that.

Of course, who cares if the numerical value of the S&P falls if the dollars that measure its value are worth more?  Depending on his actions, Bernanke might.