The Fed Falls Back Again

by: Eric Parnell, CFA

The expansion of the Fed's balance sheet took a step back this past week. According to the latest balance sheet data released by the U.S. Federal Reserve for the week ended November 28, 2012, the Fed's balance sheet actually contracted fairly sharply by -$19.8 billion to $2.853 trillion. As a result, since the beginning of QE3 in mid-September, we have now seen a net increase in the Fed's balance sheet to date of just +$27.7 billion.

So where did the decline originate from this past week? Ironically, it came almost exclusively from the one line item that is supposed to be increasing at a rate of $40 billion per month under QE3. During the past week, the Fed showed a net decline of -$17 billion in Mortgage-Backed Securities. And this occurred despite the fact that the Fed through its Open Market Trading Desk at the Federal Reserve Bank of New York carried out $16.9 billion in gross purchases of MBS securities over the past week.

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As has been discussed in past articles, the reason for the disconnect between Fed MBS purchases and its balance sheet expansion to date is due in large part to the nature in which MBS securities trade. They have long periods until settlement and tend to come through the system in big chunks all at the same time. This has certainly been true thus far with QE3. Also, the Fed also continues to hold MBS securities from past purchase programs that are either being called or are reaching maturity, which is also dragging on the pace of the Fed's balance sheet expansion.

But as each week passes, an increasing reservoir of liquidity is building behind the Fed dam. To date, the Fed has made net purchases of $184.0 billion in MBS securities, yet a net increase of only $39.8 billion is currently reflected on the Fed's balance sheet. In other words, only 20% of the Fed's MBS purchases to date have even started to make their way through the financial system.

As the Fed continues to purchase MBS securities each week at an average rate of $17.4 billion per week, the liquidity flood waters will only continue to silently build behind. And as the flood gates increasingly open and this liquidity flows into the financial system, the impact on stocks (NYSEARCA:SPY), high yield bonds (NYSEARCA:HYG) and precious metals including gold (NYSEARCA:PHYS) and silver (NYSEARCA:PSLV) is likely to become only more pronounced. For those interested in owning gold and silver, the Central GoldTrust (NYSEMKT:GTU) and the Central Fund of Canada (NYSEMKT:CEF) are also suitable securities.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long HYG, CEF, GTU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.