Japan, Fed Balance Sheet, and Liquidity Update
(February 18, 2011)
Dear Subscribers and Readers,
In light of last weekend's commentary (“Japan – An Enigma”), a subscriber asks: What if the Bank of Japan chooses to purchase JGBs in order to monetize future fiscal deficits? Wouldn't this help depress interest rates?
The outcome of such a maneuver is highly uncertain, but the monetization of fiscal deficits is tantamount to running the printing presses. In a graying economy with negative population growth—and dismal productivity growth—this is a recipe for disaster. For one, nominal interest rates are typically tied to longer-term inflationary expectations; and a mass monetization of Japanese debt would no doubt raise inflationary expectations. That is, the medicine may be worse than the disease. Secondly, Japanese citizens have an unlimited choice of investments all around the world. If even 5% of Japanese holders of JGBs diversified into other assets because of domestic inflationary expectations, then this could cause a spike in JGB yields as the amount of foreign holdings would need to essentially double. Because of these factors, I doubt the Bank of Japan would purchase any JGBs as a response to higher deficits or the lessened ability of Japanese citizens to hold Japanese government debt.
Now, I again want to apologize for the delay in our mid-week commentary. We were waiting for the latest Federal Reserve data as I want to review of the size of the Fed's balance sheet—that is, the amount of securities held (which include Treasuries, agency debt, and agency MBS) on the Fed's balance sheet. From late June to mid-November last year, the size of the Fed's balance sheet (the amount of securities outstanding) remained steady in the $2.04 to $2.07 trillion range. Since the implementation of the Fed's “QE2” easing policy in mid-November, securities outstanding on the Fed's balance sheet has rocketed higher by nearly $240 billion as of February 16, 2011—a record high. As shown on the following charts, the Fed had been purchasing more Treasuries as the agency debt and agency MBS on its balance sheet matured over the last six months:
Since mid-November, the Fed has purchased a net $16 billion of securities every week. While the amount of agency securities (which includes debt + MBS) outstanding has declined by $93 billion, this has been more than offset by $331 billion in Treasuries purchases over the same period. More important, the size of the Fed's balance sheet has rocketed higher by nearly $240 billion in the last three months—to a whopping $2.29 trillion. Wth the U.S. economic recovery taking hold and with U.S. leading economic indicators still strong, I believe the Federal Reserve should start thinking about ending its “QE2” policy. It is ironic that just over 6 months ago, the Fed prematurely ended its easing policy—and yet they now “have the foot on the gas pedal” despite an economic recovery taking hold. Moreover, with global food prices making record highs, the Fed should be mindful of inflation and end its QE2 policy over the next couple of months.
I now want to provide an update to a more direct measure of liquidity of the U.S. stock market—the amount of cash sitting on the sidelines (as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background) has declined very quickly since its peak at the end of February 2009. In fact, it has declined to another cyclical bull market low, as shown in the following chart:
Note that we have updated the numbers as of Thursday evening. As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has consistently declined since February 2009. The ratio temporarily bottomed at the end of April, with the ratio rising by 3.99% from the end of April to the end of August (from 32.57% to 36.56%). However, this ratio has declined to a new cyclical bull market low of 27.87% as of Thursday evening (and is now at its lowest level since the end of December 2007). More important, this ratio has declined too far, too fast, and is very low compared to its readings over the last three years. We continue to believe that the market is highly vulnerable to a 5% to 10% correction. Should the Dow Industrials rally to the 12,500 to 13,000 area, we will likely shift to a 50% short position in our DJIA Timing System.
Henry To, CFA, CAIA