Weekly Economic Update 08-11-2017

The Bank are Creating a Recession (Part 1)

If you ask the average person what triggers a recession, they might say a fall in consumption, a rise in unemployment, or even the bursting of an asset bubble. Those things don’t trigger a recession, they are the consequence of a recession, which is nothing more than a decrease in the money supply.

When the amount of money circulating in an economy contracts, that economy must contract. Since the banks create most of the money in our economy, when lending contracts, the economy usually recesses. In mid-2016 bank lending started to contract, which historically leads to a recession within months. This time, however, our country has experienced the largest drop in bank lending without a recession. What that tells me is that a recession isn’t too far off, and when it happens, it’s going to catch people by surprise.

To illustrate how important the money supply is, let’s revisit the small, two-person fledgling nation made up of you and me. Let’s say our nation has 100 ‘Metremarks’ as our currency that circulates between us. If the number of Metremarks circulating in our economy increases by 10, to total 110 Metremarks, then our economy will grow by 10%. By the same manner, if the number of circulating Metremarks decreases by 10 to 90 Metremarks, then our economy will contract by 10%. The growth of the circulating money supply is critical if we want our economy to grow.

The challenge for the United States and the governments of other developed nations is that governments don’t create most of the circulating money and therefore they don’t have the ability to make their economies grow. Governments create coin and paper money, but that only makes up about five percent of the money that circulates in our economy. The banking system creates the rest of the money by lending money to businesses and consumers. As a result, governments are at the mercy of their banking systems who can expand or contract their economies by increasing or decreasing the amount of lending.

To illustrate how a bank creates money, let’s look at an example of a new loan being created. If you were to borrow $20,000 dollars for a new car, the bank creates a positive +$20,000 credit to the seller and a -$20,000 debit to you, the buyer. It is at that moment of time money is created and the money supply of the country expands. To contract the money supply, a bank lends out less money than it receives in payments. As payments come in on existing loans, that money is removed from the money supply. With fewer loans being created, the money supply contracts.

As you’ve probably figured out by now, our economy grows as long as the circulating money supply grows. To continue growing the circulating money supply, our banking system needs to create an ever-increasing amount of loans. That means businesses and consumers need to take on more and more debt. It’s hard to believe prosperity is just another loan away!

You might also be asking why the stock market is continuing to rise as banking lending contracts and the money supply contracts. Good question. Banks prefer to lend on appreciating assets and since the stock market is rising, banks are willing to lend. The amount of margin debt, or money a person can borrow against their brokerage account, is growing at a rate of 20% per year. This means the stock market will continue to rise until the banks restrict the amount of credit. But beware, when the market does go down, banks are quick to call in these lines of credit. When that happens the stock market usually falls very quickly.

Now you know why banks are critical to the growth of our economy and why the governments of the world tend to bail them out when things go wrong. Our government can’t force banks to lend, but they can incentivize them to lend by changing regulations to encourage lending into certain aspects of the economy and by adjusting policy rates through the Fed.

Normally recapitalizing banks and encouraging them to lend after a recession is a good idea, but the problem throughout the history of central banks is that easy-monetary policy is allowed to run for too long. Central banks allow their easy-money polices to go on for extended periods because they fear a double dip recession. When central banks’ policies are too loose for too long, they lead to speculative asset bubbles, which never last. When an asset bubble pops, those assets fall in value, which forces the banks to cut lending to increase their reserves. Once that happens, a recession is imminent.

The reason an economic contraction isn’t far off is that the money supply has been falling since 2016. When the money supply falls, the circulating money supply falls even faster. Circulating money is the life blood of every economy. In our monetary system, we end up with two types of money: circulating and, for lack of better term, hoarded. When money is hoarded it ceases to circulate and when it ceases to circulate, the “blood-pressure” of the economy falls, so to speak.

Let’s go back to our fledgling two-person economy that has 100 Metremarks as its circulating currency. One day I decide to take 40 Metremarks and hide them under my mattress which effectively removes them from the circulating money supply. Now only 60 Metremarks are being exchanged which leads to a 40% contraction in our economy. What is interesting is that our government report shows a money supply of 100 Metremarks, but you and I noticed a severe economic contraction.

To solve the problem we agree that our bank should print more Metremarks to increase the money supply to counter the economic decline. Fifty more Metremarks are printed which brings our total money supply to 150 Metremarks and our circulating money supply to 110 Metremarks. Our economy starts to prosper once again. But as the money flows through my hands I decide to hide another 60 Metremarks under my mattress. Our circulating money supply drops to 50 Metremarks and our economy is suddenly back in a recession.

This story is very similar to what has been going in on in our economy since the Great Financial Crisis. The Fed printed money to recapitalize the banks which caused an economic rebound. Our economy peaked in 2014 and has slowly been falling since. Unfortunately, most of the money ended up in the hands of the wealthiest who are hoarding it.  This is why our economic growth has been rather weak despite the Fed recapitalizing the banking system with trillions of dollars. The problem is, the Fed doesn’t understand why the money supply is contracting, nor is there any metric to show that less money circulating.

The Fed has a simple game plan that they’ve been following for decades. When there is an economic downturn they recapitalize the banks and lower interest-rates. The Fed usually keeps interest-rates too low for too long and they frequently overcapitalize the banks. As the banks increase lending, this excess money turns into one or more asset bubbles. The wealthy see this as an opportunity to equity-strip their companies by borrowing cheap money to buy shares in their companies and to pay themselves big dividends.

As the cycle matures, the Fed starts to get nervous that all their money printing is going to turn into high inflation, so they begin to tighten the money supply by raising interest-rates and by stopping their bond purchase programs. The banks start to get nervous as asset bubbles get larger and as they run out of creditworthy borrowers, they begin to decrease lending. The combination of the wealthy hoarding money, the Fed tightening the money supply and the banks constricting lending causes the circulating money supply to fall. We then experience a recession.

With the recent fall in business and consumer lending, it’s not a matter of if there will be a recession, it’s a matter of when. The evidence is everywhere in the economy outside of the stock market. Auto inventory sales are at the highest level since the Great Financial Crisis. Debt levels are a record levels. Wage-growth is contracting. Full-time jobs are being replaced with part-time jobs. Retails sales are falling. Inflation is falling. In addition, with every month that passes by, it’s another month where the circulating money supply continues to fall. What will end up happening is some part of the economy will abruptly seize up. Perhaps we’ll have another Lehman Brothers moment and that will be the beginning of a Bear market.

The problem for the Fed is that they’ve boxed themselves into a corner. The Fed has held the Federal Funds rate so low for so long, it’s only at 1%. They already ballooned their balance sheet to $4.5 trillion and are still reinvesting all the dividends off that bond portfolio back into new bonds each month.

If I am right and there is another recession on the horizon, the Fed will be trapped. Their normal move is to lower interest-rates 3-4% and buy more bad debt. With the Fed Funds rate at 1%, the lowest they can take it without Congressional approval is 0%, which is where we’ve spent most of the past eight years. Dropping the Fed Funds rate by 1% won’t have much effect on the recession, but will likely cause interest-rates to move back to their all-time lows. And as for buying more bonds, well the Fed already owns $4.5 trillion and buys more every month. Perhaps they will buy all the remaining supply?

Banks are in the process of creating a recession by issuing fewer loans to consumers and businesses. As payments come in on existing loans that money leaves the money supply and “dies.” Since there is a record amount of debt, a contracting money supply, specifically a contracting circulating money supply, means there will be fewer dollars chasing payments on this debt. This leads to an economic contraction or recession. Once you understand how money is created and how money dies, it’s easy to understand how the next recession isn’t an if, it’s a when.

Client Update

Portfolio Shield™ Update

No major changes to report. The algorithm is currently recommending an allocation to 100% equities, which is why we are not implementing it today, because the equity markets appear to be at their peak. At some point, I will phase it into the portfolios. In the meantime, I will append updated Investment Detail reports in the Friday updates and I plan to begin work on the website.

US Equities

The major US indices look like they are topping out. There are now about seven or eight billionaires who have warned investors that this market is overvalued. I am prepared to start building short positions on the S&P 500 and Nasdaq-100 once I have more conclusive signals that this is the beginning of a major Bear market. Chances are that signal won’t occur until there’s a bad sentiment or factory gauge report. I plan to use the Portfolio Shield™ algorithm to weight those positions, then build positions as the market moves down.

US Treasuries

I still like the long-term defensive aspect of US Treasuries. With bank lending contracting and the money supply contracting, specifically the circulating money supply, interest rates are most likely to fall. Japan is a good gauge of where we are headed since we are following the policy mistakes they make over the past 27 years. If that is any indication, I expect the 10-year Treasury yield to fall to 0.5% or lower. That would send Treasury bond prices to all-time highs.

European Equities

No change on my view here. When US equities sell off, so do European equities.

Emerging Markets

They hit a major ‘resistance’ level and have backed off. With the US dollar looking to rally after falling nearly 10%, this isn’t good news for EM equities.

Agricultural Commodities

I still like this sector which is priced near its 9-year low and is the most undervalued sector in the market. On a price chart, it appears to be forming an ‘inverse head and shoulders’ pattern which is a bullish indicator. It’s a pattern formed when large investors try to flush out smaller investors to buy at a lower price. If it doesn’t break out on the next move up I may be inclined to sell and revisit this space when it does break out. Notably Pimco recommended their clients increase their exposure to commodities, so perhaps buyers will step in as the equity market weakens.

Commodity Producers

In both the gold and silver miners, prices have been following a descending right triangle pattern. Based on classical charting techniques, this is a bearish pattern that suggests prices are likely to further fall. It won’t surprise me if mining stocks fall as the market falls, but at some point, that will change. There is likely to be a global recession, global deflation, and a global financial crisis. Precious metals like those things.

In the short-term, as I’ll outline in the video, prices are attempting to break to the upside of the triangle. It’s important to understand there are false breakouts when prices near the apex of the triangle. What we want to see is a strong volume move of buyers or sellers. That will tell us which direction the market wants to take prices. I plan to use the Portfolio Shield™ algorithm to weight these positions, then build into gold and silver miners once a clear signal occurs.