Reprinted from our weekly Chart Junkie submission at Wall St. Cheat Sheet.

The anchored VWAP line in blue provided good support over the years, including the 2002 low after the tech bubble crash (8).  However, price clearly broke through the line at times, most recently in March 2009 (9).  The lower panel plots the percentage deviation of price from the VWAP line, beginning from the July 1932 low.  Interestingly, the % deviation to the down side has never exceeded the -16% to -24% support area, the lower end of which was precisely hit this March (-22%).  This support level also caught the major low in 1974 (5) as well as some early lows in the 1930’s (1, 2 & 3). 

Just as the yellow horizontal lines can act as support or resistance, so can the green trendlines.  The 1966 top came after a break through major trendline support (4) and retest of the 110% level.  On the 2000 top (7), there was no upward retest and this did mark the high.  Eventually, the current rally will peter a bit, and we would expect a long period of sideways action until the far right green downward trendline is finally broken.  Unfortunately, this could take years (points 5 to 6 span eight years). 

What will be the high of this rally?  We would expect it to come on a test of one of the two far right green trend lines.  If price were to continue up at the same pace, this would be at Dow 10,700 or 12,500.  However, if the trend slows or stops altogether, these figures will be less of course.  We will definitely be keeping an eye on this indicator for some time.  For background on the powerful support that anchored VWAP can provide (a component of the Paul Levine MIDAS method), please see our Free Resources page (includes free TradeStation indicator).

The Financial Times recently reported on the Fed’s latest exit strategy to eventually contain the inflation zombie:

During the crisis, the Fed created roughly $800bn of additional bank reserves to finance asset purchases and loans. This total is likely to rise in the coming months as the central bank completes its asset purchases and the Treasury unwinds financing it provided to the Fed. Fed officials think they could raise interest rates even with this excess supply of reserves by offering to pay banks to deposit their surplus funds with it rather than lend them out. However, they also want to use reverse repos in tandem to soak up some of the excess reserves. Policymakers call this a “belt and braces approach”. [The latter, clearly a nod to the great Gekko.] 

Tyler Durdan touched on this last Thursday, and we will expand upon it here as it is particularly relevant to our ongoing theory that it is the proceeds from permanent open market operations (POMOs) and their close cousins that are driving equities.  Though this may be received wisdom to ZH readers, the Fed has done us the favor of providing additional evidence through the FT story.  A bit of background, as we are new contributors to this forum:

Money Supply:  Based on our previous research on the effects of swings in M2 non-seasonally adjusted money supply (M2) on the stock market, we were a bit surprised in July 09 by the resiliency of the rally, which continued in the face of such a dramatic contraction in M2.  The dismal Durable Goods report from last Friday confirms that the capital goods sector is still under significant pressure as a result of a lack of money in the general economy.  With banks not lending to normal businesses and consumer credit contracting equally as violently, what is the basis for this rally and from where does the never-ending flow of equities juice flow? 

Bank Non-Borrowed Excess Reserves:  The Fed statistic that most closely correlates with the 2009 equities run-up appears to be bank non-borrowed excess reserves (bank NBER), which is a component of the monetary base (M0).  As explained by the Fed, bank NBER is simply total bank excess reserves minus bank borrowed excess reserves (bank BER).  This resulted in bank NBER going negative throughout much of 2008 because banks acquired most of their excess reserves through participation in Fed lending programs.  As the Fed has wound down these programs in 2009, bank BER has steadily declined and has been a drag on M0.  Concurrently, though, bank NBER has advanced since late March 09 with only one brief material pause in June, and reflects those excess reserves that need not be repaid as part of any Fed lending program.  The Fed purchases of MBS, Agency and Treasury securities netted $990 billion trillion since March 09.  The distinction between borrowed and non-borrowed excess reserves is critical because the latter would be ideally suited for leveraging and lending out to hedge funds and the like to “invest” in the high beta stocks that have led the rally.

The primary conclusion is simple—the stock juice flows from steadily increasing Bank NBER, which is hidden to even astute observers that focus on only M0 or M2.  Though we previously found no historical correlation between M0 (or its constituent components) and the stock market, we have witnessed an historically unprecedented set of circumstances.  Now that the Fed has become the world’s largest hedge fund, we are prepared to accept unorthodox conclusions.

So why not inflate both equities and the general economy simultaneously?  It was most likely a race against time.  The administration and Fed needed to replace the incredible evaporation of wealth that occurred in late 2008/early 2009 to quell the voting and investing masses.  They could not reflate the entire economy this quickly without jeopardizing their ability to borrow cheaply and restart the housing bubble.  To keep long term yields low, they reflated the stock market only, with the hope that the general economy would eventually catch up in 2010 and be able to sustain the stock market gains.  The problem with rising yields has not been solved, but was postponed. 

As we noted in previous research, we are toward the end of a seasonal drain on M2.  Once over the October hump, it should be easier for the holiday season to carry the market into March 2010, especially with the help of another $634834 billion in MBS and Agency POMO into next March (not to mention the possible Treasury SFP wind-down effect to the tune of $114 to 185 billion).  The Fed must be perfect, however, as any new panic will quickly feed on itself and likely lead to another mass exodus from equities.  This is quite simply because currently, there is absolutely nothing else to back up this rally in the general economy if the Fed funny money cannot do its trick.

Back to Money Market Funds:  If bank NBER is materially tied up in equities, then the Fed cannot drain from this source to mitigate inflation, or it risks the resulting cascade of sell orders that accompany the typical panic.  According to the FT article:

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets.  By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure [at gunpoint] from regulators and investors to stick to low-risk liquid investments. 

The Fed Helps Build Our Case:  As of September 17 09, bank NBER had increased by $563 billion since the March 09 rally began.  With M2 net flat during this period, the $563 billion has not made its way into the general economy by any stretch.  Perhaps it is sitting idle; however, the Fed says only $100 billion would be available from primary dealers in the future?  As the vast bulk of bank NBER is concentrated in primary dealers, this begs the obvious question of what will be tying up the remaining $463 billion (and we are not including the expected increases in bank NBER into next March, which could double this amount)?  Given a conservative lending leverage ratio of 10 to 1, there is potentially $4.63 trillion already sloshing around.  Even if we are much more conservative, given the roughly $2 trillion increase in the US stock market since Mar 09, it is not only easily conceivable, but probable, that a substantial portion was courtesy of the Fed ATM machine.

As Gekko closed his famous speech in Wall Street, “Greed – you mark my words – will save Teldar, and that other malfunctioning corporation, the U.S.A.”  While we have focused here only on coercive greed, it will be interesting nonetheless to see how this works out.

——————————-

This article was originally posted here on zerohedge.com.

Update:  A reference to “trillion” above was revised to “billion” and is marked.

As we wrote last week, the wind down of Treasury’s Supplementary Financing Program (SFP) begins today, with $35 B in the program not being rolled over, $24.3 B of which was initially allocated to primary dealers.  We have speculated that the effect will be similar to that of the quantitative easing/permanent open market operations (POMO) of the Fed whereby the resulting excess reserves are plowed into equities.  The impossibly high correlation of paint-the-tape closes to POMO days in the first few months of the rally made for an easy trading edge.  Equities have, of course, continued their tear, but the timing of equity ramps has become increasing erratic and can no longer be easily correlated with Fed operations.  This is expected because an easy trade cannot exist for too long when many know of it.  At best, for now we can only remain generally bullish until the operations are scheduled to stop.  For SFP, this will be the last Thursday of October.  However, the FOMC announced yesterday that Agency (Fannie/Freddie) and mortgage backed securities (MBS) buybacks (both permanent liquidity ops) will continue until the end of March 2010, with a gradual wind down.  The Fed may purchase a further $75 B in the former and another $600 B in the latter.  All in all, there is much more liquidity coming down the pipe.  We will likely not become long term bearish again until we see a steep drop in bank non-borrowed excess reserves, indicating the juice for the rallies has dried up.  Until then, corrections will be buying opportunities, though we expect some will likely be violent.

While much has been made of the expiration of the Federal Reserve’s $300 Billion quantitative easing program, there are still many more ways in which the Fed can pump the markets with liquidity that need never be paid back to the recipients.  In this article, we take a look at the ramifications of some recent developments with regard to the Treasury and Federal Reserve that will again provide fodder to the equities markets, as well as revisiting our previous work on how money supply has impacted the economy and what it tells us of the potential correction down the road.

As we wrote two days ago, Treasury is effectively winding down its Supplemental Financing Program, the stated intention of which on its inception in September 2008 was to, “drain reserves from the banking system, and therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.”  Delving into the mechanics of it, here is what happened:

Treasury announced special auctions for cash management bills, the proceeds of which were placed on deposit with the Federal Reserve in a special account (as opposed to the proceeds being kept by Treasury to fund the government).  This allowed the Federal Reserve to use these funds (which topped out at $558.9 Billion in November 2008) to borrow or buy securities primarily from banks and broker dealers to help “unfreeze the credit markets.”  The Fed could have simply borrowed or bought securities with money it printed, but this would have expanded its balance sheet by creating excess reserves in the accounts that banks are required to keep with the Fed.  These reserves can be multiplied by at least ten times and used by banks for lending.  At the time, the Fed was rightfully concerned about inflation becoming unmanageable once the credit markets thawed, and about being able to keep the Fed overnight lending rate (fed funds target rate) above zero.  Accordingly, Treasury’s SFP helped to keep the Fed balance sheet under control (if you can call a multiple hundred percentage increase “under control”).  The amount of money that flowed into the financial markets from the SFP was the same as it would have been had the Fed printed the money; however, SFP money could not be multiplied by banks.

Congress granted the authority to the Fed to pay interest on excess reserves held by banks on deposit with it as of October 1, 2008.  This new tool obviated the need for the SFP as the Fed could now simply incentivize banks to not lend against their excess reserves (by paying them interest to keep their reserves at the Fed).  Accordingly, in November 2008, Treasury announced it would reduce the SFP, and it has held steadily at $200 Billion for most of 2009.

On Wednesday, Treasury announced that it would allow the SFP to “decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over.”  As we wrote above, Treasury issued special cash management bills as opposed to its standard arsenal of regularly auctioned bills (such as the 4 Week, 3 Month and 6 Month Bills).  We have identified these bills (all were 70 day duration) by their CUSIP, auction amount, primary dealer take (to be explained later) and maturity date (each of which is a Thursday):

Upon maturity, the SFP account at the Fed will be deducted by the total auction amount with the funds returned to the purchasers of the bills.  The consequences of this are:

1. Should the Federal Reserve require additional funds to finance its buying and borrowing of securities (Agency POMO, MBS purchase, TALF, etc.), it will need to print money in the amount that the SFP has been decreased.  This is not too much of a long term issue since, as we wrote above, it is able to pay interest on excess bank reserves to keep inflation in check.
2. Treasury can now issue longer term Notes and Bonds to replace the shorter term 70 day cash management bills.  This is more important to Treasury’s long term objectives, especially as it quickly approaches the $12.1 Trillion debt ceiling this fall.
3. Without the rollover of the $185 Billion in cash management bills, assuming constant demand for shorter duration bills, the regularly scheduled Treasury Bill auctions (4 Week, 3 Month, 6 Month, etc.) should experience increased demand, which will put downwards pressure on short term rates and keep the US Dollar carry trade alive and well (a topic for another article).
4. Because primary dealers will not be expected to buy any more of these SFP cash management bills, they may use these funds for other purposes.

As to 4, above, what might these purposes be?  As we have seen with the permanent open market operations (POMO), it appears that much of the stock market ramp (at least for the first half of the 2009 rally) was demonstrably accomplished with POMO funds paid to primary dealers that plowed the money into stocks.  We have also correlated large increases in bank non-borrowed excess reserves (green in chart below) with stock market ramps.  The chart from the previous post is updated here:

Indeed, because the major primary dealers are US banks, most of the $114.1 Billion returned to them upon maturity of the SFP bills will end up in this category of non-borrowed excess reserves.  Some of it may be required to support future Treasury auctions, especially if Treasury ups the longer dated auctions that have less foreign support (primary dealers are required to soak up excess supply at auctions).  Indeed, next week, the 2 Year, 5 Year and 7 Year offering amounts have each been increased by $1 Billion.  However, the potential is for at least a sizable portion of the $30 to $35  Billion to hit the equities markets each of the next six Thursdays after having been leveraged by 10 to 100 times or more.

Also, though quantitative easing in the form of Treasury POMOs is ending soon as it approaches the $300 Billion ceiling, the Fed is compensating with increased Agency POMOs (another $4 Billion bought today, $285 Billion to date), not to mention a total of $651 Billion in mortgage backed securities bought by the Fed this year.

The above is our warning to the shorts.  Now, our warning to the longs.  Below is our updated chart of M2 Money Supply Volatility, that we first brought to our readers’ attention in late July 2009.

The unprecedented contraction in money supply, as measured by 13 week percent change M2 non-seasonally adjusted money supply(yellow in chart), only intensified into early September 2008, as evidenced by the double dip at the far right edge.  What this tells us is that the equities rally is running on vapors (likely in large part from the bank non-borrowed excess reserves portion of M0), with nothing to back it up (in the form of money circulating in the broader economy) once the vapors disappear.

Interestingly, Wednesday’s rally to 1074 in the cash S&P 500 touched a crucial level in the heavily traded SPY (S&P 500 exchange traded fund), which is the volume  weighted average price (VWAP) of the entire down move from the October 11, 2007 high.  The bulls and bears are thus at a crucial equilibrium point, and the coming weeks will announce the medium term winner.

In short, traders should be mindful of the potential for massive buying sprees as the $114.1 Billion is returned to primary dealers over the next six weeks (along with continued Agency POMO and MBS purchases) and also of the potential for the floor to fall out from under this rally once the funny money dries up.  The next downturn will not be instantaneous, and there will be warning signs, which we will report on as always.

We are neither perma bears nor perma bulls, but are fortunate to have the luxury of reevaluating the markets on a day to day basis and to be able to adjust accordingly.  True to history, it will be the longer term investors that will ultimately bear the brunt of this monetary and fiscal malfeasance.

Disclosure: No positions as of time of publication.

The US debt ceiling currently rests at $12.104 Trillion, of which $11.792 Trillion is outstanding as of September 14, 2009.  The debt ceiling is the maximum debt allowed by statute (not including future liabilities, such as Social Security and Medicare).  Any change must be enacted by Congress, and as we quickly approach the ceiling this fall, such a debate would be easily politicized.  In anticipation of such friction, Treasury will be cutting corners wherever it can to continue to issue debt at a record pace, preferably on the long end of the yield curve.  One such corner is the Treasury’s Supplementary Financing Program, which was created in September 2008.  The original press release (emphasis ours):

September 17, 2008

Today, the Treasury Department announced the initiation of a temporary Supplementary Financing Program. The program will consist of a series of Treasury bill auctions, separate from Treasury’s current borrowing program, with the proceeds from these auctions to be maintained in an account at the Federal Reserve Bank of New York. Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives. Treasury Announces Supplementary Financing Program

The program’s original purpose was twofold: (1) it was an accounting trick to help keep the Fed balance sheet in check, and (2) it helped the Fed keep the effective fed funds target rate from slipping to 0% (this was prior to the Fed’s ability to pay interest to banks on excess reserves which eventually allowed it to do the same thing).

In November 2008, as the program hit its peak amount at $558.9 Billion, Treasury announced it would wind down the program.  As of September 9, 2009, there was $199.9 Billion under this line item.  Just released this morning, Treasury will allow the Supplementary Financing amount to drop to $15 Billion as maturing bills are not rolled over, thus creating room for an eventual $185 Billion in longer term debt issuance to the public (emphasis ours):

September 16, 2009
TG-289

Treasury Issues Debt Management Guidance
on the Supplementary Financing Program

Washington – The U.S. Department of Treasury today issued the following statement on the Supplementary Financing Program:

“Treasury currently anticipates that the balance in the Treasury’s Supplementary Financing Account will decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over. This action is being taken to preserve flexibility in the conduct of debt management policy.”

###

However, it will take Treasury some time to roll the $185 Billion into longer term issues (assuming that’s what it wants to do).  And, if the Fed does not concurrently offset the $185 Billion drop on its balance sheet, it will likely be reflected over the coming weeks as a $185 B increase in bank non-borrowed excess reserves (which are by definition total reserves minus borrowed reserves).  As we have noted before, we have found large increases in bank non-borrowed reserves to be correlated with equities gains in this 2009 rally.  The money will need to find a short term home somewhere and, if it is in the hands of the large financial institutions, it can easily be leveraged 100 times or more and pumped into the stock market.

Bottom line–though we believe in the possibility of a correction from the 1066 area of the S&P 500 by tomorrow, this development could be another shot in the arm to subsequently ramp equities in the face of dwindling permanent open market operations, with the side benefit of allowing Treasury to eventually rollover $185 B of short term debt into longer term as it approaches the debt ceiling.

Summary:

• Improvements seen in semiconductors, entry-level housing and, of course, autos
• IT services, health care/pharma, aerospace and discount stores remain solid
• Anything to do with finance, commercial and residential construction and high-end products remain weak

A LIGHTER SHADE OF BEIGE

The Fed’s Beige Book is a wonderful collection of real-time anecdotes and insights regarding the Fed districts’ assessment of the economy and financial markets. In particular, we have long used the report as a vehicle to isolate sector shifts.

Sectors that were WEAK but are now IMPROVING:
• Tourism
• Staffing firms
• Railroads (over trucking and air freight)
• Small parcel service firms
• Automotive (cash for clunkers)
• Paper products/containerboard
• Chemical manufacturing
• Semiconductors
• Entry-level housing
• Grocery chains
• Apparel retailing (youth)

Sectors that are SOLID and remain SOLID:
• IT Services
• Health Services
• Pharma
• Aerospace
• Discount stores
• Public construction (roads)
• Food manufacturing

Sectors that were SOLID but are now WEAKENING:
• Tobacco
• Oil and gas drilling

Sectors that remain WEAK:
• Financial services
• Commercial construction
• Luxury goods retailers
• Appliance manufacturers
• Home and garden centers
• High-end real estate
• Multi-family housing
• Commercial real estate
• Coal mining producers
• Electric utilities
• Heavy trucks
• Restaurants

After posting our three scenarios yesterday, we have been alerted that the panic into gold may have been caused by the belief that the CFTC will curtail or eliminate the ability of funds to use commodities as a speculative asset class.  The official CME/NYMEX reason cited by a Reuters story is:

NEW YORK, Sept 2 (Reuters) – The CME Group will not list additional futures contract months for the New York Harbor No. 2 Heating Oil Futures contract beyond the August 2012 contract due to proposed sulfur-content specification changes.

“The proposed legislation, currently pending in New Jersey and New York State, intends to reduce the sulfur level in heating oil,” CME Group, which owns the New York Mercantile Exchange, said on its website.

“The existing New York Harbor No. 2 Heating Oil Futures and corresponding Option contracts, listed below, will continue to be listed for trading through August 2012.”

We have not been able to confirm the rumors that the CFTC will lock out speculators, though they have certainly made overtures to that effect before, and the belief in the rumor would be justified.

Once again, we repost our three scenarios and revise the conclusion slightly:

1)  Recent correlations hold and gold is simply forecasting another inflation-led [stock] rally that will begin in the next few days (meaning yesterday’s correction is not the bearish bellwether everyone thinks it is), or

2) Recent correlations hold and the move today in gold is a bull trap that will be reversed in the next few days, or

3) Recent correlations have broken and gold is decoupling from other markets, including equities.  Because correlation-changing paradigm shifts are rare, this is the least likely scenario; however, should it end up being the case, the significance is tremendous.  A break above 1,000 on a declining stock market would be definitive evidence for this scenario.

As to 3, because the move in gold may be a result of large investment funds looking for the most liquid commodity play that is the least likely to be subject to overt government interference, a breakdown in the correlation between equities and gold is no longer remote, and it would be possible for gold to advance, equities to decline, and the US Dollar and bonds to rally.

To confirm that gold is advancing on its own merits and not the result solely of US Dollar weakness, we want to see eventual confirmation of an up move in gold priced in other currencies.  Below shows gold priced in the Canadian Dollar (CAD), Australian Dollar (AUD), Japanese Yen (JPY), and the Euro (EUR).  When gold began its last advance in November 2008, it was confirmed by higher lows in the commodity currencies of the CAD and AUD, as well as the EUR (even though there were lower lows in the JPY and USD gold).  Eventually, there were higher lows in the JPY and USD gold at the beginning of December 2008.  Accordingly, for the gold bull case, early confirmation would be to see current lows in AUD, CAD and EUR gold respected on the first pullback, especially in the former two as they are commodity currencies.

* Thanks to the members of the Value in Time group for their comments and postings on this issue.

Thanks to reader Billy for pointing out (in response to our prior post on gold’s correlation divergence) that there is a seasonal bullish tendency in gold that begins in September and for providing the following links:

http://www.321gold.com/charts/seasonal_gold.html
http://www.tradersnarrative.com/gold-seasonality-turns-positive-2909.html

We did our own analysis and confirmed this is indeed the case (see chart below).  Over 20 years, there is an expected push beginning in early to mid-September that tops in mid-February of the following year.  We can see that the predicted seasonality for the past year (red) was changed very little after adjusting to add the current year’s data (white), so seasonal factors should definitely be given weight in our analysis.  However, it is very difficult to time markets based on seasonality.  For instance, last September had a huge rally that was reversed in October, only to be reversed again (to the upside) into February.  So, while the seasonal pattern held, there was much consternation for the small and short term traders.  Accordingly, we believe it takes at least two weeks of data to confirm a seasonally-induced move.  Today may simply be the beginning.

Does all this change our previous analysis?  Only slightly because we must still wait for confirmation, but we now have a slight bias in the three three possibilities we previously outlined:

1)  Recent correlations hold and gold is simply forecasting another inflation-led [stock] rally that will begin in the next few days (meaning yesterday’s correction is not the bearish bellwether everyone thinks it is), or

2) Recent correlations hold and the move today in gold is a bull trap that will be reversed in the next few days, or

3) Recent correlations have broken and gold is decoupling from other markets, including equities.  Because correlation-changing paradigm shifts are rare, this is the least likely scenario; however, should it end up being the case, the significance is tremendous.  A break above 1,000 on a decling stock market would be definitive evidence for this scenario.

If today’s surge in gold has follow through and is the beginning of a seasonal move, then scenario 1 is most likely, which means the current stock market correction will be shallow and we will have another short covering rally that has characterized this year’s run up.  However, the if’s must be confirmed and, as we said before, all we can do is watch closely for now.

11:43 am EDT:  We expected rotation around the 995.25 highest volume point of control, and that is what has happened so far, with the ES having first traversed 5.25 points lower than 995.25, then 4.25 points higher.  The range should stay tight until the 2:00 pm FOMC minutes are released.  If a strong move develops on the release, we won’t fight it.  However, if the reaction is calm, we would still fade short 1004.00 to 1006.00 and would now fade long 988.00 to 992.00.

Gold has broken above its consolidating wedge and previous swing high of Aug 6 09.  The significance is that it is in the face of a declining stock market.  A strong distribution day in equities suggests deflation, which should push gold down.  Gold was our only leader yesterday that did not move as expected (according to correlations that have held for the last year).  Markets needn’t move in lock step even when they are correlated; however, today’s action must be paid heed.  To break an important technical level in a direction when the reverse is expected is significant.  The three likeliest explanations are:

1)  Recent correlations hold and gold is simply forecasting another inflation-led rally that will begin in the next few days (meaning yesterday’s correction is not the bearish bellwether everyone thinks it is), or

2) Recent correlations hold and the move today in gold is a bull trap that will be reversed in the next few days, or

3) Recent correlations have broken and gold is decoupling from other markets, including equities.  Because correlation-changing paradigm shifts are rare, this is the least likely scenario; however, should it end up being the case, the significance is tremendous.  A break above 1,000 on a decling stock market would be definitive evidence for this scenario.

We’re assigning equal weight to scenarios one and two for now, watching closely gold and the S&P 500 for clues as to which will play out.

Our submission for this week’s Chart Junkie on Wall St. Cheat Sheet (to be updated this afternoon) features “Bank non-borrowed excess reserves” from the Federal Reserve’s H.3 Statistical Release and how they correlate with the S&P 500.  We explain as follows:

US banks are required to keep money in reserve based on requirements set by the Federal Reserve (the Fed).  Anything beyond that is considered excess reserves and is generally held on deposit with the Fed.  Since last September, with the myriad Fed programs initiated, excess reserves have exploded (and along with it the Monetary Base, which includes excess reserves).  Some of these excess reserves are borrowed–for instance, the Fed may lend money to a bank based on collateral posted by the bank to the Fed, which could be a Treasury Security, an Agency Security, or even a Mortgage Backed Security.  Eventually, this money must be repaid and the collateral is returned to the bank by the Fed.  However, banks also maintain non-borrowed excess reserves, which is money on deposit with the Fed that they can use for any purpose without the need to repay it.  Banks might lend it out or, as seems to be the case this year, use it to ramp the stock market.  This money has come largely from permanent open market operations, whereby the Fed purchases Treasury, Agency and Mortgage Backed Securities from banks and deposits the proceeds from the sale in the banks’ accounts at the Fed.  As is demonstrated by the thick green line, non-borrowed excess reserves have increased dramatically over the past year and appear to be correlated with movements in the stock market.  We will soon be posting a more detailed analysis of the ramifications of this correlation along with how this may aid market timing.