UBS Investment Research :: Show me the money

UBS Investment Research
Macro Keys
Show me the money
The announcement of the Federal Reserve that it might, at some point this year,
consider buying fewer bonds in the US Treasury market has been met with
consternation in some quarters. There is a common misperception that the
Federal Reserve’s liquidity pumping operations must surely have flooded the
world with a tidal wave of cash, and so the turning off of the taps will lead to
some kind of draining of that cash with significant implications for markets.
As Stephane Deo and our asset allocation team have pointed out, there are
clearly implications from the Fed slowing its liquidity purchases. Implications
for the domestic US economy were covered by Maury Harris in the Macro
Keys “Life after QE” (21 June). However, the direct impact of dollar cash on
the global economy is conspicuously absent. Following the money trail does
not lead to tidal waves of cash floating the world’s financial market. US cash
flooded domestic checking accounts, not international markets
The following chart shows the quarterly acquisition of financial assets by the
Federal Reserve, accompanied by the quarterly acquisition of foreign bonds
and equities by US nationals. Clearly, the money printed by the Fed has
massively outstripped the inclination to purchase foreign securities from US

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Putting this in another way, in the 21 quarters since the start of 2008 US
investors have acquired USD588bn of foreign bonds and equities. However, in
the 21 quarters prior to the start of 2008, US investors acquired USD1,324bn of
foreign bonds and equities. Since 2007 the Fed expanded its balance sheet by
USD2,049bn. Thus the period of dramatic balance sheet expansion coincides
with an equally dramatic slowdown in foreign asset purchases. There was also
a sharp increase in domestic US cash holdings – checking accounts and cash
holdings by US corporates and households rose by a cumulative USD887bn
over the period (time savings accounts rose even more).

A word of caution is needed here. If money is spent, it does have to end up
somewhere. Thus if a US consumer had taken money and purchased
international equities, and the seller of international equity had then purchased
US goods with the cash, then the cash would show up as an increase in deposits
of US corporates in some form. Looking at bank deposit accumulation alone
does not tell us whether the Federal Reserve’s quantitative policy went directly
to bank accounts to lie inert, or whether it was actively purchasing assets before
ending up in a US bank account. However, the fact is that the increase in
corporate and household cash balances account for over 43% of the Fed’s
increased liquidity provision over the quantitative policy period. That strong a
degree of liquidity preference would sit oddly with the idea that the money was
used for risk appetite prior to being deposited. The idea of the money going into
risk assets is also inconsistent with the capital flow story.
The good news to take from this is that if the Federal Reserve’s quantitative
policy did not leak out of the US economy in any meaningful way, then the loss
of quantitative policy is unlikely to drain dollars from the rest of the world. This
does not mean that the Federal Reserve’s policy has had no impact on
international markets. What the Federal Reserve did do is reduce liquidity risk,
and the risk of bank runs in the US, in turn increasing the risk appetite of
investors. The Federal Reserve has also directly brought down the long end of
the US yield curve, which has implications for international financial markets.
In short, as the Federal Reserve looks to slow its quantitative policy measures,
the rest of the world does not need to obsess about what is happening to dollar
money supply. The international transmission mechanism is, instead, likely to be
via the bond market and the level of investor risk appetite.