Correlation and Causation Deniers, Chickens and Eggs

by Lee Adler, Wall Street Examiner

This post is for those fond of repeating the axiom “correlation does not imply causation,” because while correlation may not prove causation, it certainly can imply it. In fact, there are instances where the denial of any linkage between correlation and causation proves only that the deniers have their heads in the sand. There are other ways to characterize it, but I’ve written this piece for a polite audience.

The following excerpts from the Wall Street Examiner Professional Edition Fed Report are dated according to when they first appeared in the report. Together they form a narrative that illustrates the point. The chart is current. It certainly illustrates correlations. I leave the judgment of cause and effect up to you. I report. You decide.

4/30/13 The 3 big central banks deal with the same banks. Some of the money that the BoJ prints not only can but does move into US paper, whether Treasuries or stocks. It will show up in the FCB measure and in banking measures. There’s a strong correlation between the BoJ balance sheet and US stock prices, both over the long term and in intermediate swings.

The BoJ printed the rally since mid 2011 with help from the ECB in 2011 and early 2012, then the Fed since November 2012. The correlation between the direction of stock prices and the size of these central bank balance sheets is remarkable.

5/8/13 The correlation between the size of the ECB, Fed and BoJ balance sheets and the direction of financial asset prices is no accident. Treasury prices have mostly correlated with the ECB’s balance sheet, while stock prices have marched almost in lockstep with the Fed’s and BoJ’s.

Markets Follow The Fed, ECB, and BoJ - Click to enlarge

Markets Follow The Fed, ECB, and BoJ – Click to enlarge

6/4/13 Treasury prices rallied in late 2011 and early 2012 as the ECB floated its massive loan program known as LTRO. The banks apparently used some of that cash to purchase Treasuries. The ECB has allowed those banks to pay off those LTRO loans since the beginning of the year. The banks that purchased Treasuries could liquidate those Treasuries and pay off the loans. That appears to have been one of the driving forces behind the Treasury market selloff. There could be ongoing pressure on the Treasury market as the ECB continues to allow its balance sheet to shrink with the payoff of these loans.

The ECB/Treasury market correlation at times involves the age old chicken/egg question. In 2011, Treasuries moved up in price, down in yield, before the ECB expanded its balance sheet. In that case the first response of investors and financial institutions to the European crisis flare-up was to get the hell out of Dodge and buy US Treasuries, aka The Last Ponzi Game Standing. The ECB moved shortly thereafter to radically expand its balance sheet. Hence the increase in the balance sheet followed the rise in Treasury prices, instead of leading at that time.

Later when the ECB instituted the 2 tranches of the LTRO, first in December 2011, then January 2012, the Treasury market rallied subsequently. The LTRO funds were, in many cases, actually deployed in a Treasury carry trade, boosting the Treasury market in a final buying frenzy that pushed yields on the 10 year below 1.5%.

Not all banks needed the funds. The ECB “encouraged” all members of the system to take the funds regardless of need, in solidarity with the sham that all were equally in need and that no stigma should be attached to any one institution because they took the funds and another did not. So they all took the money, and some parked it in Treasuries. It seemed that it would be safe and profitable to do so for a year because of the ECB’s stipulation that the funds could only begin to be repaid one year from the date of issuance. However, that only worked for those who got in first and got out first.

Lo and behold, some banks did begin repayments a year later, unwinding their carry trades to do so. Thus ended the Treasury buying panic that capped a 30 year bull market. The continuing paydowns of LTRO loans have been associated with what could be the first leg of a Treasury bear market that may also last decades.

Meanwhile, stocks go on their merry way, tracking the Bobbsey Twins of Central Banking, the Fed and the BoJ.

6/4/13 The BoJ’s massive new QE program has also added to US market liquidity.

7/3/13 The Fed and BoJ have pumped and are likely to continue to pump massive amounts of cash into the market. These flows should be sufficient to put a floor under any selloffs in stocks and trigger counter rallies. Big cross currents are now likely as liquidity inflows from the big two, the US and Japan, run head on into the selling rolling out of China, debt liquidation in Europe, and a BoE that’s holding its balance sheet in check. There’s always a chance of contagion and a runaway spiral of debt liquidation taking hold, but as long as the Fed and BoJ are pumping, these negative forces should be buffered, and for the time being, overcome.

2/18/14 The BoJ is still putting out. They and the Fed are the double trouble boys. As long as they continue to pump, the bias should remain to the upside for stocks. At some point, the distortions this causes will force them to hit the brakes.

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