The ECB’s Shrinking Balance Sheet

Tom McClellan – McClellan Market Report

The news this week out of Europe has to do with upcoming elections in Italy, and what that might mean for the future of the euro.  But few news stories are covering the really important development in Europe, which is the shrinking size of the European Central Bank (ECB) balance sheet.

The U.S. Federal Reserve has been doing its part to inflate the banking system, most recently with its announced program to purchase $40 billion per month of mortgage backed securities (MBS).  But the Fed’s total balance sheet size of $3.02 trillion pales in comparison to the size of the ECB’s balance sheet, which equates to $26 trillion as of December 2012.  While the Fed’s holdings have increased 6.7% since the September 2012 Jackson Hole conference, the shrinkage of the ECB’s balance sheet over that same time period has more than made up for the Fed’s money printing.

The reason why this is important is because there is a very strong correlation between the combined size of the ECB and Fed balance sheets and the movements of the world’s stock markets.  When the balance sheets are growing, that is overwhelmingly a bullish factor for stock prices.

When balance sheets stop growing or start shrinking, it is a little bit more complicated.  Past episodes of shrinking balance sheets in 2008, 2010, and 2011 all were associated with big drops in the SP500 and other indices.  As 2013 gets underway, the SP500 is continuing higher and challenging its 2007 all-time high, but it is doing so in an environment when the combined balance sheet size has not been rising.

This creates a bit of an analytical quandary.  Is this stock market strength with no balance sheet rise a sign that the stock market and the world economy are finally able to proceed on their own, and without central bank stimulus?  Or is this just another example of what we saw in early 2010, when the stock market continued higher for a few months after the faucet was turned off?

In that 2010 example, what resulted was the Flash Crash in May 2010, and a lower bottom in July 2010, after which the stock market started upward again when the Fed announced its QE2 program, and when the ECB jumped in with similar monetary stimulus.  So to bet on the hypothesis that the stock market can now fly on its own is to say “it’s different this time”, which is one of the more dangerous phrases for investors to ever utter.

ECB And Fed Balance Sheets Combined

 


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The McClellan Market Report and its companion Daily Edition are produced by Sherman McClellan and Tom McClellan. Both are technical analysts and educators whose innovative insights have helped countless investors succeed. The McClellans' work has been repeatedly quoted in Barron's, and their market timing signals have ranked them in the top ten timers for both intermediate and long term by Timer Digest.

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Comments

  1. “In that 2010 example, what resulted was the Flash Crash in May 2010, and a lower bottom in July 2010, after which the stock market started upward again when the Fed announced its QE2 program, and when the ECB jumped in with similar monetary stimulus. So to bet on the hypothesis that the stock market can now fly on its own is to say “it’s different this time”, which is one of the more dangerous phrases for investors to ever utter.”

    I don’t understand this analysis. Are we to expect another sudden computer glitch (Flash Crash) as a result of reduced balance sheet size of one of the largest central banks?

  2. We’re mere points away from a major top and the market’s underlying structure is such that that it makes a steep collapse very likely.

    • $26tr? What BS. The European economy is ~ size of the US economy, so no way the ECB has a BS that is 8.5x the Fed’s!

  3. How does the author come to the conclusion that the size of the ECB’s balance sheet is $26 trillion?

  4. In the short run, stock market is a voting machine; In the long run, it’s a weighing machine.

    For investors, all QE analysis is ultimately wasteful. You are just counting votes, instead of weighing. Sure, you may claim that such analysis would give you better entry and exit points.

    But, Mr. Graham, has provided a simple rule for that too.

    Be greedy when others are fearful and fearful when others are greedy.

  5. I don’t know how the ECB’s balance sheet is measured as it may depend on whether one includes the balance sheets of the individual NCBs and how one accounts for ELA and TARGET2. But I find the following article interesting

    http://www.zerohedge.com/news/2013-02-09/feds-bailout-europe-continues-record-237-billion-injected-foreign-banks-past-month

    It seems that in net, all the new $ injected into banks by the Fed’s QEternity has ended up as deposits in US subsidiaries of European banks.