Tomorrow is a big day, with the FOMC announcement and the Fed revealing what it wants you to think about what it thinks it’s going to think it wants you to think. Or something like that. This Fed “tranparency” thing has been covered to death in the mainstream media. I think it’s another utter waste of time. I want to know what the Fed is doing, not what it wants you to think, and that’s what I report on every week in my reports to subscribers. It’s hard enough to know what the Fed is actually doing, but if you can get a handle on that (and, not to mention, the ECB), then you’ll have a leg up on the crowd, most of whom don’t have a clue. 

With that in mind, here’s what I wrote on Saturday in the executive summary of the Fed update in the Wall Street Examiner Professional Edition (Liquidity Is Bullish Is All).
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Those who don’t know me well have sometimes accused me of being a permabear. Those of you who do know me via these [Wall Street Examiner Professional Edition] reports know that I always strive to be just like Faux News, “fair and balanced.” I think this week’s report exemplifies that high ideal. It’s as bullish as I’ve ever been, and yes maybe I should be faded when I start “pounding the table” like this. But I’m only pounding on what the indicators are showing. There’s certainly no personal bias in this direction. My bias is only to follow the indicators, regardless of what mayhem or foolishness they may be pointing toward.

I don’t like this, but it is what it is. The world financial system is an over manipulated piece of excrement. But sometimes manipulation works; sometimes it has unintended consequences that benefit one party over another; and sometimes the US gets the roses while the rest of the world sinks into the sludge that most of the pundits and government manipulators are worried about. This is one of those times, and herein is its story.

Take this story and do with it as you wish. If you think that it’s wrong, I’d love to hear from you as to why. The easiest way to do that is to leave a comment in the comment section of the Wall Street Examiner posting associated with this report.

Liquidity flows in the US branch of the system have been turning more bullish in recent weeks. Several indicators that had been neutral or bearish have turned bullish, joining deposit flows into the US banking system (apparently from EU) which have been the lead bullish sled dog for a while. In this liquidity based model of the market, there is no way the markets can decline as long as this continues. It forces us to assume that the bias will remain to the upside. Meanwhile, the Fed continues to quietly tap the brakes, without explanation or comment, while the money supply explodes. The Fed is transparent only when attempting to jawbone the market higher. Anything that might run counter to that, it shuts up tight as a clam.

The media has been rife with speculation that the Fed is on the brink of another massive quantitative easing. Given the rapid growth of the money supply, the recently strong stock market performance, and the surging Federal withholding taxes, and improvement in other economic indicators, it’s hard to see justification for the Fed to make such a move. The Fed is well aware that additional QE would be likely to set commodities off on another tear that would be self defeating for the economy.

I’d have to guess that the pundits looking for another QE at this week’s meetings are wrong, but it doesn’t matter. The markets follow the money. My guess is that any initial market disappointment in the face of “no new QE” would quickly be shrugged off. If I’m wrong and the Fed announces or hints at additional QE, I’d watch the commodities and hitch a ride if I liked moon shot roller coasters.

In the meantime, the liquidity indicators are strengthening. Bank deposit net inflows continue. Fed pumping of cash to Primary Dealers remains in a bullish trend, and will continue to as long as the MBS replacement program remains in effect, which will be until mid summer unless the Fed makes a course change before that. Those flows will slow drastically if Treasury rates rise, but due to the delayed settlements of the Fed’s MBS purchases, the impact of that reduction won’t be felt until April or May at the earliest. Meanwhile Treasury supply looks likely to be lighter than expected (See Treasury update -http://wallstreetexaminer.com/money/treasury011912.pdf

Foreign central bank purchases of Treasuries and Agencies turned bullish last week. Their trend has improved from a bearish to a neutral influence. The trend of reserve and other deposit levels at the Fed have been stable, and are thus a neutral market influence. Banks bought Treasuries last week and the trend of that indicator has turned unequivocally bullish. Bank non Treasury trading accounts were little changed last week, but that trend is also bullish.

The composite liquidity indicator upticked last week, slightly breaking the November peak in the process. The indicator now has a slight uptrend since last summer. The performance of stocks and bonds has been consistent with that. Recent behavior of the components and typical cyclical patterns suggest that some degree of strengthening is likely to continue in the weeks ahead. That should be bullish for stocks, especially if Treasury market inflows begin to wane, as last week’s signals suggest they may.

Finally, for whatever reason, stock prices have tracked the Fed’s actions, and Treasury prices have more closely tracked the ECB’s moves in recent years. That stands to reason as investors in European debt have sent cash pouring into the US, particularly via purchases of Treasuries, whenever the ECB has provided the funding to do so. But it is notable that US stock prices seem to also be getting the benefit of the most recent ECB pumping operations. If another massive ECB long term refinancing operation is indeed forthcoming, as many are speculating, that could blow the roof off the US market in the weeks ahead.

This is just a small sample of the dozens of illustrative charts and analysis that are in the Fed and Treasury updates every week including charts and analysis of each of the components of the macroliquidity indicator. You can stay up to date with these liquidity flows along with the machinations of the Fed, Treasury, Primary Dealers and foreign central banks in the US market in the Fed Report. Try it risk free for 30 days. Get the research and cutting edge analysis you need to understand these critical forces. Be prepared. Stay ahead of the herd. Click this link and begin your risk free trial instantly!

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Pedro da Costa, maybe the smartest and best reporter covering the Fed, and who seems like a good guy, has a blog post out today suggesting that the $50 billion ECB dollar lending operation today will cause the Fed’s balance sheet to expand. He’s piggy backing on Mike Derby’s column in the Wall Street Journal, most of which is behind a paywall, so I don’t have the full story on that. I think that the conclusions are unwarranted, or at least premature, until we see the Fed’s H41 statement for this week or next, depending on when the funding settles. If not same day, the effect would not show up until next week’s H41.

Da Costa’s piece implies that one result of the loan will be a jump in the Fed’s custody accounts of foreign central bank holdings of Treasuries and Agencies and that that would somehow imply an increase in the size of the Fed’s balance sheet. First, even assuming all of the $50 billion came via swaps with the Fed, custody holdings are custody holdings. They are assets of foreign central banks. They are not part of the Fed’s asset base. There is no direct connection between the swaps and the custody holdings. I have no clue why he thinks that the ECB lending dollars to its constituent banks would cause an increase in FCB holdings of Treasuries and Agencies. If the ECB is investing those dollars in loans to banks, then they can’t be buying Treasuries with them. The point he makes there, makes no sense in that respect.

In fact, sale of those custody holdings would be one means by which the ECB could have raised the $50 billion in USD to fund these loans. That would have NO IMPACT on the Fed’s balance sheet. It would not involve the Fed supplying one red cent.

Even if we assume that the Fed does fund the swaps, there are a number of ways that can be done and simultaneously sterilized. Even beyond sterilizing the impact, there are ways it may be accomplished which would actually shrink the balance sheet!

In fact, the Fed’s balance sheet has been shrinking since June as MBS holdings have been paid down, and the replacement MBS purchases have apparently all been 60 day forwards. As a result, the Fed’s assets have shrunk by about $50 billion since July, and, all other things being equal, would not begin to rebuild to the $2.654 trillion SOMA target until the purchase program is complete this coming June, and the settlements continue through August. The point here is that the Fed has shown no inclination to grow its balance sheet. There’s been a lot of hot air about it, but they haven’t pulled the trigger.

I reported to Professional Edition subscribers last month the big withdrawal from the bank reserves deposits at the Fed that went into Other Deposits. I tried, but failed, to interest any mainstream reporters, including your friend and mine Mike Derby of the Wall Street Journal, and Greg Robb of Marketwatch, in this massive transfer. There have now been several massive deposits and withdrawals between bank reserves and Other deposits on the Fed’s balance sheet in the past several months. The net amount remaining in Other was $52.8 billion last Wednesday. That’s a sea change from the nominal amounts typically held in Other deposits.

“Other,” as defined by the Fed, includes “foreign official organizations,” along with GSE direct deposit accounts at the Fed, and the account of the US ESF, aka the Plunge Protection Team.

Since we are making assumptions, let’s assume that the $52 billion are mostly funds of “foreign official organizations.” If these are ECB funds and the ECB withdraws them to fund these dollar loans, this would force the Fed to either borrow the dollars itself, which would seem to be a non starter under current market circumstances, or sell SOMA Treasury holdings outright, thereby SHRINKING rather than expanding the Fed’s balance sheet. The Fed could not on the one hand see its liabilities reduced and its assets increased. It cannot “reprint” a withdrawal of money that was already in existence and on deposit. The immutable law of double entry accounting would not allow it. The Fed would have to sell assets to fund the withdrawal, i.e. the reduction of the existing deposit liability under this scenario.

Now I have no clue what WILL happen, but neither does Mike Derby, unless he just got off the phone with the Fed’s media leak line. Maybe he’s right, maybe not. If they are right, then the commodity speculators will swing into action. But if they are wrong, and the loans are funded via means such as described above, the implications would be bearish for stocks and commodities. Because I like Pedro, I want to warn him that we should wait until the data is in before we jump to conclusions and maybe end up with reportorial contusions.

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Stay up to date with the machinations of the Fed, Treasury, Primary Dealers and foreign central banks in the US market, along with regular updates of the US housing market, in the Fed Report in the Professional Edition, Money Liquidity, and Real Estate Package. Try it risk free for 30 days. Don’t miss another day. Get the research and analysis you need to understand these critical forces. Be prepared. Stay ahead of the herd. Click this link and begin your risk free trial NOW!