We Will Crush You

We Will Crush You:
Two weeks ago I posted a long overdue update on the Federal Reserve’s market fuel injection activities. My previous post had been in October of 2011 and I 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’ (well, let’s not go there). 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 of 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 an 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. In January I counted 17 days of ‘coupon purchases’ (excluding one TIPS which I usually disregard) – there was not one sale. The implicit result of which was a rise of 88 handles in the S&P 500 and 1,015 handles in the Dow Jones Industrial.  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 holds 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 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 had spent so far in buying them via OMTs.
So why do we worry about all this? Because when we compare the balance sheet of the Fed to that of the ECB it almost exactly tracks the gyrations of the EUR/USD. There’s a pretty good Wall Street Journal article on the topic which makes that very point. My apologies for not providing my own chart but I have had a problem extracting the proper ECB data – it’s a bit like drinking from a firehose. If you have any pertinent insights then feel free to shoot me an email – I would appreciate any pointers.

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 rally. And at the end of the day it really boils down to who is printing more at this point – and 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 continues we should expect to see higher prices for commodities as well as equities across the board.