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EUR/USD falling or more Fed QE?

A post went up on Zero Hedge yesterday showing the chart below as proof that the Fed will be doing a $700bln QE3 operation. It shows the ratio of the Fed to ECB balance sheets (white line) relative to EUR/USD (orange line). The argument goes that in order to bring the relationship back in line, the Fed will have to do QE.

Here’s the thing, though. Notice the two other circled times when the two lines deviated. What happened to bring them back together? Ummm…EUR/USD sold off – and fairly sharply. Why does the blog author expect something different this time? Given the Commitment of Traders figures that have shown the short bias among euro traders, it certainly looks like the major players are leaning in that direction.

This strikes me as someone looking for proof of their thesis rather than developing a thesis from the evidence, which is a major pitfall we all face in the markets.

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It’s not QE 2, QE 1.5, QE Lite or anything like that!

In case this post’s title didn’t tip it off already, I’ll state my position as clearly as possible.

What the FOMC said today about using the principal payment from the MBS and agency holdings to purchase longer-dated Treasuries is NOT NEW QUANTITATIVE EASING.

With all due respect – realizing that in some cases none is due – anyone who suggests otherwise is being a moron. (I do like Mish calling it “quantitative nothingness”, though)

The Fed is not expanding their balance sheet at all with this move. They are simply shifting assets from one category into another. Yes, the implications for the rates market are significant. That is a structural thing, however. If you shift from one asset to another, it is naturally going to cause an impact in pricing when you’re dealing with Fed-level size.

As Dennis Gartman noted on CNBC’s Fast Money program this afternoon (which I caught while seated in the barber’s chair), it means nothing anywhere else. Actually, let me correct myself. It does indicate the Fed’s unease about the current economic environment, but the markets already knew that. That’s why stocks, Treasury rates, and the dollar have all been working mainly lower the last few weesk.

Gartman was specifically addressing gold with his comments, however, and by extension the dollar. Those two markets tend to move in opposite directions in the face of monetary expansion because of currency devaluation/inflation concerns. Today’s action by the FOMC has no impact there because it didn’t change anything – and that’s the whole point. The Fed is keeping it’s balance sheet stable – no expansion or contraction of money supply. Had the Fed not decided to roll the principal repayments over it would have done the latter.

So we’re still in QE 1.0 as far as I’m concerned. When all the MBS/Agency/Treasury buying was going on there were all kinds of questions about the unwind. Letting the securities mature is a natural unwind. What the Fed did today was to tell us that they are not prepared to start that unwind process just yet. No new balance sheet expansion is going to take place, so we can’t say another round of QE is going to happen.

Does this open the door to a QE 2? I’d say that door was never really closed after the  QE1 purchases ended. It could still happen, though the odds are not good.

Here’s something to keep in mind. The Fed didn’t say anything about reinvesting the coupon payments from the securities they hold. Had they done that, and thus expanded the balance sheet in the process, I’d have called it a new round of QE. As it stands, every time the Fed receives one of those coupon payments it’s decreasing the money supply a bit. It’s not as big an amount as the principal would be, of course, but it is still a slow drain.

So why did the market’s react as they did Tuesday? Treasuries went up because the Fed will be buying them again. I didn’t see the figures, but my guess is that mortgage spreads may have expanded a bit as a result. Stocks rebounded some, but never really got close to going positive. The dollar took a hit, but was already working lower after some overblown gains earlier in the day. None of the moves really persisted much beyond the initial reaction, which tends to support my view that this isn’t a big deal. The implications of the Fed calling the economic recovery weaker than expected and not likely to improve any time soon are more important going forward.

P.S.: As you may have gathered, I actually wrote this Tuesday evening, but didn’t publish it right away to let my thoughts settle out overnight. Listening to things this morning, it sounds like a few more folks are of a view similar to mine (including BoE boss Mervyn King) given how they are avoiding the use of any variation in “quantitative easing” in their commentary.