With second quarter earnings set to start today, there is surprisingly little excitement. Why? Because market participants, like well-trained Pavlov dogs, have finally understood what we meant in January of 2010 [10], when we said that the "the only relevant pieces of financial information are contained in the Fed's H.4.1 and H.3 statements", i.e., the Fed's flow of reserves. The only difference since then is that the Fed's script has been sent out around the world, and now every central bank in the developed (and developing [11]) world is doing just what Bernanke first started on March 18, 2009 with the massive expansion of the Fed's balance sheet, which (for the time being has) marked the S&P bottom. In fact, as more and more people focus solely on reserve and credit formation (most of them wrongly, [12]but you can't get everything), liquidity conduits, the flow vs stock debate [13](where even career economists are grasping that it is all about the flow), the conclusion is that, ironically, we have all now become 'Austrians [14]'. Which means that the sole driver of risk in the past 3 years has been nothing but continued pumping of liquidity into markets by central banks: aka the Global Central Bank Put. How does this look visually? The below summary charts showing global balance sheet expansions should blow everyone's minds.
Historically:
[15]
And in absolute terms:
[16]
Some parting thoughts from JPM:
- Central bank balance sheets are back in the limelight as the Bank of England restarts its asset purchase programme and the SNB is engaged in de facto unlimited FX intervention, selling Swiss francs equivalent to more than 10% of GDP per month.
- Once avant garde, balance sheet expansion is now very much established as a conventional tool of monetary policy. This chart pack compares the relative size and growth in central bank balance sheets and monetary bases and reviews the empirical relationship between QE and exchange rates.
- No central bank has expanded its balance sheet or the monetary base as comprehensively as the SNB – its assets have grown by 54% of GDP since 2008 compared to 17.6% from the BoE (with another 3% announced this Thursday), 17.2% from the ECB, 13.1% from the Fed and a comparatively stingy 7.2% from the BoJ. The central bank with the healthiest economy has thus delivered the most aggressive expansion, that with the highest inflation the second most aggressive, while the central bank with greatest structural deflation has delivered least easing – an odd ranking to say the least.
- Balance sheet expansion has been confined to Europe in the past six months, headed by the SNB, then the BoE and the ECB. The Fed and the BoJ have sat on their hands. This divergence remains a fundamentally positive force for the dollar and yen against European currencies.
- Bilateral exchange rates remains relatively well correlated with the relative size of central bank balance e sheets. The correlation between EUR/USD and the difference between the Fed and the ECB's assets base is -75% over 2 years and -90% over the past year. The empirical evidence supports a monetarist interpretation of what central banks are doing - balance sheet expansion creates inflation risks, which adversely affects exchange rates.
- The one exception to this was EUR/CHF but even here the franc is now responding to the SNB’s untrammeled money creation. The question is – will the SNB flinch at the inflation risk that its currency peg inevitably necessitates? We are sceptical of its appetite to create inflation and will keep a close eye on the extent to which continued its ongoing FX intervention is unsterilized or not (FX intervention in May was de facto half sterilised, in that money base creation was only one half the amount of FX intervention).
- The BoE continues to be the most assertive monetiser of domestic debt. The latest £50bn expansion will take its total debt purchases financed by the creation of base money to 25% of GDP. The ECB could yet deliver a third LTRO, but until it does this relatively faster pace of BoE expansion should at least put a floor under EUR/GBP, if not justify a modest appreciation. Relative balance sheets explain 55% of the performance of EUR/GBP over the past year.