Weekly Economic Update 11-10-2017

The 255 MPH Economy

The Bugatti Veyron is a $1.4 million+ hypercar that gets an impressive two miles per gallon when traveling at its top speed of 255 mph. But the Veyron can only sustain its 255-mph speed for 12 minutes before running out of gas. Unlike our economy, the Veyron can’t refuel without coming to a complete stop. Whereas our economy can continue to sustain a high rate of growth if the Fed continues to print money. When the Fed stops printing, the economy will come to a grinding halt just like the Veyron would if it runs out of gas while flying along at 255-mph.

Over the last several updates I set the stage for the looming liquidity crisis that will face the global economy during the next recession. Few people understand that liquidity is the primary driver of asset prices. While supply and demand are important in establishing asset prices, liquidity trumps all. After all, without enough money, demand can’t be satisfied. Central bankers have set the stage where a systemic crisis could evaporate liquidity overnight which could cause asset prices to plummet faster than anyone can imagine.

The reason the Fed wants to drain liquidity from the economy is because they fear creating hyperinflation from printing too much money. High rates of inflation or hyperinflation occur when there is a large amount of money chasing too few goods and services. The problem for the Fed is it doesn’t know how much money is in circulation nor does it know the location of all of the money. Since money isn’t tracked, the Fed doesn’t know if they have printed too little or if we are on the verge of hyperinflation.

Fortunately, the Fed has plenty of tools to deal with hyperinflation, all of which involve crashing our economy, but that’s a story for another update.  Most people don’t understand liquidity or where it comes from. There are five primary ways liquidity is created in our economy: when the Fed lowers interest rates, when the Fed monetizes debt (i.e. Quantitative Easing), when banks lend, when market-based interest rates fall and when the dollar loses value. Liquidity is drained from the economy when the opposite of all those methods occurs.

After the Great Financial Crisis, the Fed lowered the Federal Funds rate to zero to increase liquidity. Since December 2015 the Fed has hiked the Federal Funds rate four times and is expected to hike a fifth time at their December meeting. By raising the Federal Funds rate, which is the bank overnight lending rate, banks are being paid an increasing amount of interest to hold excess reserves. When banks are paid to hold excess reserves, they tend to reduce lending, which decreases liquidity.

Quantitative Easing is when the Fed purchases debt, either government debt or public debt, on the open market. This is a forced exchange where the bond holder is given dollars for their bonds. This has the implicit intent of forcing money into the economy. The Fed engaged in approximately $4 trillion worth of the Quantitative Easings since 2008. As of October, they are now selling those bonds which have the effect of removing liquidity from the system.

The plan is to remove $30 billion worth of bonds from the Fed’s balance sheet by the end of the year, which will have the effect of removing $100 billion from the growth rate of the money supply. This means that the growth rate of our money supply is expected to fall below the rate at which the Fed felt it necessary to implement QE3, by year-end. It should be worth noting that no central bank in history has ever attempted to “unwind” their balance sheet by selling bonds. If the intent of QE was to increase asset prices, then the corresponding reduction of bonds should decrease asset prices and liquidity.

Bank lending is the single largest creator of money. When a new loan is funded, money is instantaneously added to the money supply and when a loan goes into default, money is removed from the money supply. The reason the money supply collapsed during the Great Financial Crisis is due to the cascading wave of defaults that flowed through the financial system. Those defaults were also the reason the Fed recapitalized the banks through QE 1-2. The Fed did that to avoid a total collapse of the financial system.

In early 2015 the rate of growth of commercial and industrial loans on a year-over-year basis began to slow and now, nearly three years later, the rate of growth is on the edge of turning negative. This is significant because bank lending remains the last mechanism of money-supply growth. Once bank lending turns negative, it will become a rapid drain on the money supply. The reason this happens is because loan repayments are removed from the money supply and when there are fewer loans being created than a year ago, the money-supply growth rate will continue to contract. This contraction in commercial lending is setting up an even larger contraction than 2008 when the next recession hits.

What concerns me is that the last three recessions saw the stock market fall in advance of a collapse in commercial- and industrial-bank lending. This time bank lending has nearly turned negative as the stock market continues to rally. Consumer loans aren’t doing much better. While the rate of growth in consumer loans has slowed, the bigger issue is that delinquency rates are continuing to rise. If those delinquencies turn into defaults, it could easily trigger a cascading wave of defaults through the financial system.

The U.S. dollar can also increase and decrease the money supply. Over the last year the dollar has significantly dropped, but that trend has started to shift as the dollar increases in value. When the dollar is falling or losing value, those who have dollars are more eager to spend them before they become worth even less, which creates easing conditions. When the dollar is rising in value, those who have them are more likely to hold on to them, rather than spend them. Generally, the dollar rallies during a recession, which makes sense because the money stock is destroyed as borrowers default on their loans. As the money supply vanishes, the remaining dollars become worth more, further tightening conditions.

When a Bugatti Veyron runs out of gas at top speed it will lose momentum and slowly come to a stop. The economy doesn’t work that way. Every attempt in the past to slow down an economy in the late stages of the business cycle, with this being the third-longest expansion in history, have always been met with an economic collapse. I’m not sure why people think this time will be different, other than they are hoping it will be different. After all, the Boomers have their wealth concentrated in real estate and in the stock market, and they have never been more bullish on stocks. Perhaps it is the case that the average Boomer can’t afford for stocks to go down and are fearful of what they might mean to their retirement. But if history is a guide, you can consider yourself forewarned.

Video Topic of the Week – The Tide and Interest Rates

With the tide headed out and liquidity is drying up, I discuss what that means for interest rates.

Chart of the Week – Commercial & Industrial Loans

Loan growth has been trending down for the past year and is about to go negative, which has serious repercussions for the money supply.

Portfolio Shield™ Update

The updated algorithm is in place and while working on the version that rotates through the money supply cycles I came up with another way to improve upon Portfolio Shield™. I may sideling the money cycle version in order to continue enhancing Portfolio Shield™.

Weekly Broad Market / Economy Commentary

Last week I mentioned that I thought our economy saw peak liquidity on October 23rd and then liquidity began to fall. Over the next week and a half, the public added liquidity to the markets, but as I expected the public appears to be running dry. The liquidity drain is more noticeable in countries that use the dollar for trade, such as South America, where I first noticed the effects of the liquidity drain in their stock prices. That trend has slowly moved to Asia, Europe and has now come home, which is rather impressive when you consider how far reaching the effects of Quantitative Easing were. Everyone around the globe benefited from the immense amount of Fed liquidity and now that liquidity is being taken away.

What I expect to see is the market will start to consume itself to keep the market up. Meaning I expect traders and investors to sell off their underperforming assets to buy those that are strong performers. Since the stock market is being held up by a handful of mega-cap stocks, selling losers to buy the mega-caps can keep the market up for a bit longer. In the end, the falling money supply will drive asset prices lower.