Markets were distinctly underwhelmed by “operation twist” but may be underestimating a recent and prospective shift in central bank policies:

• The Swiss National Bank has injected CHF220 billion into the domestic money market since the start of August, equivalent to 39% of Swiss annual GDP.

• Yen strength is likely to prompt Swiss-style action from the Japanese authorities – a surge in bank reserves this week suggests that a policy shift is under way.

• “Operation twist” is probably part one of Fed Chairman Bernanke’s ploy to launch QE3 by the backdoor, part two being the Fed / ECB dollar swap lending operations scheduled to begin on 12 October – these should boost the Fed’s balance sheet and US bank reserves.

• The Bank of England is on course to launch a further round of reserves-financed gilt purchases at its October meeting.

• Dramatic economic and financial deterioration in Euroland is likely to prompt a cut in ECB official interest rates in October along with further measures to support the banking system including the reintroduction of 12-month repos.

• Central banks in emerging economies are shifting focus from inflation control to supporting growth in response to G7 recession fears.

The increase in Japan has pushed G3 plus Swiss bank reserves to a new record in the latest week – see first chart.

A previous post suggested that a policy U-turn by the ECB would be required for a sustainable equity rally. The Dow Industrials index, meanwhile, is now close to the scheduled late October low of the “six-bear average” – second chart. 

A previous post contrasted the Swiss National Bank’s decision to inject massive liquidity and commit to unlimited intervention to cap the franc against the euro with Bank of Japan policy inertia, reflected in a decline in bank reserves. The post suggested that markets would continue to pressure the yen higher to force a Swiss-style policy U-turn.

The yen has appreciated by a further 2.0% in trade-weighted terms since the Swiss currency cap announcement on 6 September (as of yesterday’s close).

The Japanese authorities may be starting to capitulate. Bank reserves shot up by ¥6.8 trillion on Tuesday – the largest one-day rise since March. On closer inspection, this was due to an injection of “Treasury funds”, which includes the impact of foreign exchange intervention. Have the authorities been selling yen covertly?

A policy shift would be confirmed by reserves maintaining their higher level or rising further. Increases in March, June and August were associated with yen weakness but were subsequently reversed, causing the currency to restrengthen – see chart.

The “MPC-ometer” wrongly suggested that a narrow majority would vote for more QE at this month’s meeting. Yesterday’s minutes, however, revealed a further significant dovish shift, with most members now inclined towards action.

Although Adam Posen remained isolated in the vote, “for most members, the decision of whether to embark on further monetary easing at this meeting was finely balanced”, while “for some members, a continuation of the conditions seen over the past month would probably be sufficient to justify an expansion of the asset purchase programme at a subsequent meeting”.

The European banking crisis, of course, has deepened since early September while domestic economic news has been mostly downbeat. An October QE2 launch, therefore, looks odds-on. Based on seven of the 12 inputs, the MPC-ometer continues to suggest a 6-3 majority in favour of action. The five yet to be released are unlikely to be any less dovish than last month.

The view here remains that UK economic woes reflect an inflation squeeze on real incomes and negative confidence effects from the eurocrisis rather than a shortage of money – a broad liquidity measure rose by a respectable 4.5% in the year to July. A further cash injection could prove counter-productive by triggering renewed downward pressure on the exchange rate, thereby boosting import prices and delaying much-needed inflation relief.

The latest reassessment by equity analysts of the outlook for Eurozone company earnings suggests that it is now too late for the region to avoid a recession.

The “revisions ratio” – the number of analyst upgrades to earnings minus downgrades expressed as a proportion of all estimates – correlates with the Eurozone manufacturing purchasing managers’ new orders index but is available on a more timely basis. The ratio has plunged further in September, suggesting a fall in PMI new orders to below the 45 level indicative of a whole-economy recession – the “flash” PMI survey is released tomorrow.

The slump in activity was foreshadowed by a contraction in Eurozone real narrow money, M1, discussed in a post in December and several subsequent updates.

As also predicted by monetary trends, economic weakness has spread from the periphery to the core, reflected in large earnings downgrades in France and Germany – second chart.

The disastrous decision by the ECB to tighten policy while real money was contracting has exacerbated current woes. Departing chief economist Juergen Stark bears significant responsibility for this blunder – stronger grounds, arguably, for his resignation than the suggested reason of opposition to Italian and Spanish bond purchases.

The ECB must now ease aggressively, slashing rates and continuing to buy bonds, though with the aim of injecting liquidity rather than providing fiscal support to the periphery – this argues for spreading purchases across Eurozone markets in proportion to economic size.

Globally, Eurozone weakness could yet be offset by stronger US growth in response to recent faster monetary expansion, discussed in yesterday’s post.

The Federal Reserve’s flow of funds accounts for the second quarter, released on Friday, confirm a solid pick-up in the US broad money supply, suggesting liquidity support for the economy and markets.

The flow of funds accounts provide detailed information on the financial holdings of US households, businesses and financial institutions, permitting the calculation of a comprehensive broad money supply measure with an accompanying sectoral breakdown. The definition used here comprises currency, US bank deposits (checkable, time and savings), foreign deposits, money market mutual funds and security repurchase agreements. The official M2 definition, by contrast, omits US large time deposits, foreign deposits, institutional money funds and repos. M2, moreover, includes money holdings of foreigners while containing an element of double-counting (to the extent that retail money funds invest in other M2 assets).

The flow of funds measure contracted during the first half of 2010 but returned to expansion in the second half and has picked up speed this year, rising at a 9.9% annualised rate in the second quarter – see first chart. The annual rate of change climbed from -0.8% in mid 2010 to 5.8% a year later – the fastest since the fourth quarter of 2008.

Strength has been focused on the non-financial business sector, whose money holdings grew by 14.8% in the year to mid 2011 – second chart. Low corporate confidence may delay the impact but rising business liquidity, historically, has been associated with stronger investment and hiring, along with an increase in cash take-over activity and stock buy-backs.

Fed Chairman Ben Bernanke may have kicked off “QE3” last week by sanctioning currency swap arrangements to relieve the dollar shortage in Europe.

The Fed is expected to launch “operation twist” – involving swapping short- for long-term securities to increase the duration of its portfolio – at this week’s open market committee meeting. This, however, will not expand the Fed’s balance sheet or the monetary base, so arguably does not qualify as “quantitative easing”.

It is possible that the Fed Chairman and his fellow doves would prefer full-scale QE – i.e. further securities purchases financed by creating bank reserves – but feel constrained by likely opposition from the three regional Fed presidents who dissented from the decision to extend the low rates commitment at last month’s meeting. More QE would also raise the ire of congressional Republicans, many of whom share Texas Governor Rick Perry’s view that such action would be “almost treacherous, or treasonous”.

Professor Bernanke, however, may have outflanked his opponents by agreeing to extend dollar loans to foreign central banks for onlending to local financial institutions experiencing funding difficulties. Barring offsetting Fed actions, such loans will expand US bank reserves and hence the monetary base. Coupled with “operation twist”, the net effect would then be identical to QE3 – increases in the monetary base, the Fed’s overall balance sheet and its aggregate duration exposure.

A minor disadvantage relative to explicit QE3 is that the Fed has no control over the size of the initial boost to the monetary base, which will depend on banks’ demand for dollars at the central bank auctions. The impact, however, is potentially large: dollar swap operations in late 2008 expanded to a peak of $583 billion, driving a similar increase in bank reserves – see chart.

Another difference compared with explicit QE3 is that the monetary base boost would unwind if dollar funding markets normalised, allowing banks to repay central bank loans. Such automaticity, however, might have appeal – normalisation, presumably, would occur in the context of an improvement in economic and financial prospects, implying less need for monetary policy stimulus.