Has QE3 Really Come To An End?

Includes: HYG, SPY
by: Eric Parnell, CFA


In October, the U.S. Federal Reserve carried out its final asset purchases as part of its latest asset purchase plan designed to help stimulate economic growth.

Yet the Fed's balance sheet has continued to expand in the weeks since, increasing by more than $15 billion through mid-December.

As a result, it is reasonable to explore whether QE3 has really come to an end and if the Fed is still engaged in outright asset purchases.

In October, the U.S. Federal Reserve carried out its final asset purchases as part of its latest asset purchase plan designed to help stimulate economic growth. This included the purchase of $10 billion in U.S. Treasuries and $5 billion in Mortgage Backed Securities in the final month. Given that the program is now over, it would be reasonable to expect that the Fed's balance sheet would no longer be expanding in a meaningful way. But this has not been the case in the weeks since the end of the program. As a result, it is reasonable to question whether QE3 has really come to an end.

Liquidity Continues To Flow

The balance sheet of the U.S. Federal Reserve continues to expand despite QE3 having drawn to a close many weeks ago. At the end of October, the Fed's balance sheet stood at its all-time high of $4.486 trillion. But seven weeks later as of December 18, the Fed's balance sheet managed to expand further to a fresh record of $4.502 trillion. This represents a $16 billion increase in the size of the Fed's balance sheet over the past month and a half after QE3 came to an end. This amount is roughly equivalent to the total asset purchases scheduled for October. In other words, this is a significant amount.

So what exactly is going on here? Is the Fed conducting covert asset purchases to stimulate the economy despite having publicly announced that their latest stimulus program had ended?

The answer to this question is no. The Fed is not engaged in any under the table liquidity injection practices at least according to these readings. Instead, it is a result of the mechanics behind how the Fed's asset purchase program works. In short, the actual liquidity injections associated with the Fed's QE3 program did not end in October. In fact, the last of the liquidity flows finally made their way into the financial system over the last few days.

The Mechanics Of The Fed's Asset Purchase Programs

So how exactly are we still seeing liquidity flows from Fed asset purchases so long after the end of QE3? This is a result of the fact that just because the Fed has executed the trade to purchase Treasuries or MBS does not necessarily mean that the trade is settled right away. And the key to the liquidity flowing into the financial system is not necessarily the trade announcement but the actual settlement of the trade where the cash has exchanged hands from the Federal Reserve to the receiving financial institutions.

In regards to U.S. Treasury purchases, the turnaround time between the trade date and the contractual settlement date was almost instantaneous. For if the Fed committed to purchase Treasuries on a given day, these purchases were almost always settled the next business day. This is one of the reasons why Treasury purchases as part of the Fed's various QE programs were so effective in melting the markets higher seemingly day after day, as financial institutions were receiving this steady stream of liquidity nearly each and every trading day.

But the mechanics of the Fed's MBS purchases worked very differently in two distinct ways.

First, the settlement of these MBS purchases does not happen nearly every business day. Instead, they are all clustered into three specific business days every month. Toward the middle of the month, the settlement of all Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) 30-year MBS securities all take place on the same day. Then early the next week, all Fannie and Freddie 15-year MBS securities are settled. Finally, later that same week, all Ginnie Mae 30-year securities are settled. So unlike Treasury purchases that result in liquidity flowing steadily into the financial system each day, the liquidity injections resulting from the Fed's MBS purchases come in three big lumps every month.

Second, unlike Treasury purchases that settle quickly, the settlement of an MBS purchase by the Fed can take a good deal of time. In some cases, it could take as long as a couple of months.

These two points help explain why the Fed's balance sheet is still expanding and liquidity resulting from QE3 asset purchases were still flowing into the financial system over the last several days. For example, some of the MBS securities purchased by the Fed with trade dates as far back as October 14 did not reach their contracted settlement date where the cash in the transaction actually exchanged hands until this Thursday, December 18.

Knowing that the Fed's QE asset purchase programs have gone a long way in supporting higher asset prices including stocks (NYSEARCA:SPY) and high yield bonds (NYSEARCA:HYG) since the financial crisis quieted down in March 2009, this has important implications for the market that we have just experienced in recent days. For example, financial markets received an injection of $12.1 billion in cash resulting from the settlement of Fed MBS purchases over the period from last Thursday, December 11 to this Wednesday, December 17. And financial markets received yet another liquidity boost resulting from Fed MBS purchases totaling roughly $6 billion on Thursday, December 18. Given that the stock market was enduring some heavy downside volatility in recent weeks, the injection of more than $18 billion in cash from the Fed into the financial system certainly could not have hurt.

That's Finally All For QE3 Folks

So while asset purchases associated with QE3 came to a close in October, the settlement of these purchases have also now finally come to an end, as this Thursday, December 18 represented the final day that the settlement of outright MBS asset purchases were scheduled. So starting Friday, December 19, financial markets are now officially on their own without any further direct liquidity flows from QE3. And if the capital market volatility of recent months is any indication of what is to come, it could make for an exciting year of trading ahead in 2015. It will be interesting to see now that the Fed is fully out of the way of the market at least from an asset purchase perspective.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long stocks via the SPLV and XLU along with selected individual names. I also hold a meaningful allocation to cash at the present time.