Fed Asset Purchases Vs. Bond Yields

//research.stlouisfed.org/fred2/graph/graph-landing.php?g=GIm

How counter intuitive it may seem, when the Federal Reserve tapers (reduces asset purchases of bonds and mortgages), the bonds actually go up instead of down. This article explains it clearly. So you can predict what bond yields will do by listening to the asset purchase plans of the Federal Reserve. Then profit on it.

The obvious reason is that reduction of QE is good for the dollar (and good for bonds), while QE is bad for the dollar because it generates inflation concerns (hence bad for bonds).

So QE will send bond yields higher because of inflation concerns, while reducing QE will send bond yields lower.

The second reason is that all of the money printing goes into capital goods like stocks. When QE ends, stocks will drop and that money goes back into bonds.

Conclusion: Expanding Fed balance sheet sends bond yields higher and vice versa.

Gold Price Disconnected from Central Bank Balance Sheets

With this correlation between central bank balance sheets Vs. gold in our minds, we can confidently say that gold will have to move to $2000/ounce in a hurry to balance out all the money printing in this world.

Central Banks Vs. Gold Price

To help you monitor the balance sheet expansion, you can check this chart daily. Look how Japan is almost winning the race from Europe.

Central Bank Balance Sheets: U.S., Eurozone, Japan

This page is created to monitor the balance sheet of the U.S., Eurozone, Japan and the United Kingdom.

There is a strong correlation between the price of gold and the expansion of the total sum of all central bank balance sheets in the world.

ECB = blue

U.S. Federal Reserve = red

Bank of Japan = green

Bank of England = orange

(The Chinese balance sheet is not included in this graph as it is not available on FRED)

Potemkin Rally

The Potemkin Villages were Russian constructions, created to deceive others into thinking something is better than it really is.

The Potemkin Rally describes how the Federal Reserve is manipulating the market in order to create a deception of a rising stock market. It looks like the economy is improving, but it’s actually just a mirage.

As long as the following chart (stocks divided by Fed Balance Sheet) stays flat, the stock market rally is really engineered by the Federal Reserve. If the Federal Reserve takes the punch bowl away, everything collapses.

I read about a very unusual correlation at Zerohedge. Apparently, there is a similarity between the employment to population ratio (red graph) and the Potemkin Rally (blue graph). (The Potemkin Rally graph measures the ratio between the stock market and the Fed’s Balance Sheet.)

There are implications if this correlation is true. It means that when the U.S. government prints money (otherwise known as QE), the blue graph goes down (in a scenario where the stock market flattens out). If the blue graph goes down, the red graph goes down too, which means the unemployment rate goes up.

This means we are venturing into a paradox. It means that we get to a stage where money printing makes the unemployment rate go up instead of down. Janet Yellen’s QE won’t help employment.

But the alternative is equally bad. Not to print money could make the stock market crash, which will also result in a declining blue chart. So we are now stuck between a rock and a hard place.

U.S. Federal Reserve Balance Sheet Vs. Dow Jones

This page is created to monitor the U.S. Federal Reserve Balance Sheet’s assets Vs. Dow Jones.

Whenever the Federal Reserve expands its balance sheet (blue chart), the Dow Jones will rise with it (red chart). 

Conversely, when the Federal Reserve Balance sheet stays flat, the Dow Jones is likely to drop.

Fed has started QE3

It seems that the Federal Reserve has finally jump-started the QE3 program.

Mortgage backed securities went up from $852 billion to $893 billion in the month of November 2012. That’s a $40 billion increase, precisely right on schedule according to its press release in September 2012, where it stated to buy $40 billion in MBS’s each month.

Chart 1: Federal Reserve Balance Sheet

Chart 2: S&P 500

If we put together Chart 1 and Chart 2, we can find a significant correlation.

Chart 3: Federal Reserve Balance Sheet Vs. S&P

The same can be said on gold prices Vs. Federal Reserve balance sheet (Chart 4).

Chart 4: Gold Vs. Fed Balance Sheet

You know what this means, start to buy equities and gold as the correlation between stocks/gold and the federal reserve balance sheet is a fact.

Short Bonds Now!

As the fiscal cliff is nearing with the end of the year 2012 in sight and total public debt skyrocketing to the debt limit of $16.4 trillion, investors need to seriously start worrying about the U.S. bond market.

Technically, the bond yields on the 10 year treasury notes are bottoming out. We could see bond yields rising and bond prices collapsing. Just recently Jim Rogers disclosed that he is short U.S. bonds. Aside from the rising debt and the fiscal cliff we should note first that 30 year fixed mortgage rates have hit a new high of 3.5% and are on average at 3.4%. As bond yields follow the mortgage rates closely I expect bond yields to go up too.

Chart 1: 10 year U.S. bond yield

Further evidence of a coming bear market in U.S. bonds can be found on the open interest front. Historically, when commercials are net short the bonds, bond prices will show weakness going further. This can be seen on Chart 1 versus Chart 2. When the bond yields go down on Chart 1, the net open interest will tend to go to the short side (red curve goes downwards on Chart 2). At the same time, when bond yields go up, the net open interest will go to the long side or upwards. The only time this correlation didn’t add up was during the economic crisis of 2008 where bond yields were artificially suppressed. 

To see what more evidence I have, go here.

A Detailed Federal Reserve Balance Sheet

Just by having heated (and uncomfortable) discussions with seekingalpha commenters I learn new things. This is what you get when you write financial articles without any financial background.

But there are positive things coming from discussions.
Today I found a very nice interactive chart to follow the Federal Reserve’s balance sheet (Chart 1).
You can play with the interactive chart here:
http://clevelandfed.org/research/data/credit_easing/index.cfm

Chart 1: Detailed Federal Reserve Balance Sheet

And what’s very interesting is that the federal reserve has massively increased their treasury holdings. It’s no wonder that bond yields are going down in the market. It won’t be long when the federal reserve’s balance sheet consists only of treasuries and mortgage backed securities, which are the most risky assets in the world.

Composition of Fed Balance Sheet Indicates Low Interest Rates For Eternity

I have been talking a lot about the federal reserve balance sheet. But what is it composed of? And how did it evolve higher?

Chart 1 gives the composition. You can see that QE1 and QE2 were mainly bond purchases (light brown area). QE3 should be another round of bond purchases and should expand the light brown area again.

Second, the spike in 2008 was mainly lending to financial institutions at the time of the banking collapse. This lending has been paid off in 2010.

But the most interesting part is the mortgage backed securities area in brown. In that period, congress passed the Emergency Economic Stabilization Act of 2008, which authorized the Treasury to purchase mortgage-backed securities. As a consequence, the brown area increased in size at the same time when lending to financials decreased. That means that the federal reserve has bought approximately $US 1 trillion of mortgage backed securities in an attempt to support the housing market. It didn’t do much to the housing market. New home sales and housing starts were flat, but the housing market index improved a bit though.

I will point out the importance of convexity to make my case of lower interest rates in the foreseeable future.

Chart 1: Federal Reserve Balance Sheet

To read the analysis go here.