The Decelerating Money Supply Does Matter
A few months back I met with a prominent local financial advisor and when the conversation came to the economy, he felt the economy was poised to grow, while I felt it was headed towards a recession. When I mentioned the deceleration of the money supply as a catalyst for my view, he looked at me and said, “You have no idea what you are talking about.” He said the money supply has nothing to do with the health of the economy or how stock prices are valued. He cited the normal talking points: unemployment is low, earnings are strong, and inflation is rising; all of which should lead to economic acceleration.
Quickly realizing he didn’t understand how the money supply works, I attempted to explain it to him. The current M2 money supply, which includes cash, checking, savings, money market and time deposits, is approximately $14 trillion. The M2 money stock represents all the cash or cash equivalents in our country. No person or item in this country can be valued at more than $14 trillion. At the end of 1980, the M2 money supply was approximately $1.6 trillion, or 8.75 times less than it is now. This is why asset prices in 1980 were less than they are today. Asset prices are determined by supply, demand, and the amount of money in the system.
To further prove this point, if the total supply of money was reduced to $1,000 tomorrow morning, no asset could be worth or sell for more than $1,000 and no person could have more than $1,000 – it would be mathematically impossible!
I like to think of the money supply as a large river of money. As money flows down the river, people set up traps in the form of businesses in an attempt to capture as much money as possible. Those near the mouth of the river with the most money traps become the wealthiest. Those at the end of the river, where there is very little money left, are the poorest. The challenge for many is the wealthy are good at gathering money, which creates an imbalance in our economic system. Even the government knows the current system is ineffective, which is why we have a tax system designed to take from those who are efficient at capturing money to give to those who aren’t.
Neither the Federal government nor the Federal Reserve has the ability to print money. The Federal government uses the tax system and its ability to borrow money to redistribute money. The Federal Reserve Act of 1937 prevents the Fed from printing money, but they can create excess bank reserves. In our monetary system, the banks are the sole creators of money. While the Fed can enact policies to encourage or discourage lending and expand or contract the monetary base, they cannot force the banks to lend.
The reason the Fed is decelerating the money supply is because the unemployment rate has been falling and the Fed is anticipating those newly employed workers will want to borrow large sums of money. Based on the design of our monetary system, the banks can multiply money which is represented by the M2 money multiplier. The M2 money multiplier is currently less than 4, meaning every dollar borrowed has the potential to become a little less than four dollars in our economy. The more money that circulates, the higher inflation will be. While the Fed does want inflation, they want the inflation rate to remain near 2% per year.
By slowly removing emergency monetary support, the Fed is attempting to hand the “baton” of the economy off to the public. The Fed used its powers to lower interest rates and create excess bank reserves to save the economy from the Great Financial Crisis, but they now believe the economy is strong enough to begin standing on its own two feet. With the unemployment rate at the lowest level since April 2000, the Fed also believes the public will soon increase their lending demand, which will multiply the potential newly lent money into the economy.
On its own, the M2 money supply accelerates and decelerates as a function of lending demand. When the public is borrowing, the growth rate of the money supply accelerates and when the public isn’t borrowing as much, the growth rate of the money supply decelerates. If the fluctuations in the money supply were merely representative of the public’s lending demand, any decelerations would likely be temporary; the growth rate of the money supply would self-balance. When the Federal Reserve actively intervenes to manipulate the money supply, problems occur.
Seventeen out of the last twenty-one decelerations in the M2 money supply have led to a recession, meaning the current deceleration in the money supply indicates there is a high probability our economy will enter a recession, unless the public increases its borrowing demand. The M2 money supply has been decelerating since October 2016, despite the recent tax cuts. Based on the Fed’s current trajectory, the growth rate of the M2 money supply should reach zero by year’s end or in the first quarter of 2019 at the latest. The reason this is significant is because the probabilities of a recession increase when the growth rate of the M2 money supply falls below 3.70%, which it did during the first week of May. The simple solution should be for the Fed to make sure the M2 money supply continuously grows.
Professor Milton Freidman, whose interest-rate theory best explains where interest rates should go during periods of monetary expansions and tightenings, suggested the Fed should maintain a constant growth rate of the M2 money supply. In theory, a constant growth rate would prevent the growth rate of the money supply from falling into levels normally associated with recessions. There is one major flaw with Friedman’s idea.
If the growth rate of the money supply was constant, over time it would create a huge wealth gap, not unlike what we see today. Those at the mouth of the money river would get richer and everyone downstream would slowly get poorer until a small number of people controlled all of the wealth. The constant expansion of the money supply would raise asset prices well beyond the affordability of most, leaving a large part of our nation in poverty. Instead, the Fed attempts to manage the money supply, but their track record is full of economic failures.
Declarations in the money supply are not the cause of recessions, although an outright contraction of the money supply would likely cause one. Recessions occur as a result of easy-monetary policies. When the Fed decides to “print” money, money begins to flow into unprofitable activities. The longer the Fed maintains an easy-money policy, the more unprofitable activities that are created. As the growth rate of the money supply falls and money is diverted from unprofitable activities, those unprofitable activities are forced to survive on their own. Most of the time they don’t.
In the 1920’s the Fed’s easy-money policies caused money to flow into the stock market where investors borrowed large sums of money to buy stocks on margin. When the Fed tightened the money supply, asset prices eventually fell and the stock market crashed. The once profitable activity of buying stocks became unprofitable when the realization came that the elevated stock prices were a function of the Fed’s easy-money policies and massive amounts of leverage.
In the 1990’s, the malinvestment was in the form of tech stocks. Once again the Fed began tightening the money supply and the dot-com bubble burst. Two years following the bubble bursting, technology stocks were trading at 20% of their previous value.
In the mid-2000’s the malinvestment went into the housing market. The Fed, following their typical pattern, tightened the money supply. As the Fed tightened, short-term interest rates rose which caused the mortgage bubble to burst. Housing prices fell approximately 40% nationwide.
Today the malinvestment is back in the stock market. Investors believe the stock market has been made safe under the watchful eye of the Fed, but investors are seemingly unaware of the huge amount of borrowed money that is propping up the stock market. Investors are also unaware of how much debt corporations are holding. The bubble today is in corporate balance sheets, at a time when the average investor has 90% of their investable assets in stocks. Once again the Fed is tightening the money supply, and just like investors did in the late 1920’s, they are ignoring the risks of a decelerating money supply.
Asset prices are determined by the amount of money in an economy and the price the next buyer is willing to pay. Recently Apple announced a $100 billion share-buyback program and days later Warren Buffet announced he was the third largest shareholder of Apple stock. Following the news, investors rushed to buy Apple stock knowing Buffet will not sell his holdings. Investors believe Buffet can put a floor on Apple’s stock price. Based on the growth rate of the money supply, there is no evidence to support this claim. Even as the stock market was crashing in 1930, large investors stepped in to halt the decline. Each one failed.
Investors forget Buffet was a large owner of IBM stock, who was a prolific purchaser of their own stock. The fact IBM was buying their own stock didn’t keep their stock price from falling. General Electric purchased approximately $50 billion of their own stock, and after they were done with their repurchase program, GE’s stock fell 50%. No one man or group has the power to fight the forces of a decelerating money supply.
The risk of the current declaration in the money supply has to do with the huge amount of debt that was borrowed by investors to purchase equities. By design of our monetary system, any time a loan payment is made, a loan is paid off or a loan is defaulted on, money is removed from the system. In 2009-2010, the growth rate of the money supply collapsed due to all of the mortgages that went into default. In 1929-1932 there was a massive collapse in the growth rate of the money supply due to a large number of margin loans that were paid off.
Today we face the same risk as investors did in the late 1920’s. We have a record amount of debt supporting the equity markets that will inevitably be paid off which will accelerate the collapse in the growth rate of the money supply. Despite what the other local financial advisor had to say, asset prices and interest rates follow the money supply. Based on the immense amount of debt in our economy and the Fed’s plan to decelerate the growth rate of the money supply, we can predict lower asset prices and lower interest rates in the future. Maybe this will begin in the next couple of months, but by year’s end, the deceleration of the money supply will matter.
Q&A with Steve – Your Questions Answered
- What happened to the stock market on Monday?
Over the weekend there were plenty of experts saying the equity markets were making a Bullish breakout and stock prices were headed higher. What’s odd about that statement is Bullish breakouts occur on strong volume, not weak volume. One technical analyst stood out from the crowd by saying the market can’t move higher until it clears the overhead “Sell Zone.” He is correct.
Based on Professor Robert Shiller’s Cyclically-Adjusted P/E Ratio, stock prices are now at the second most overvalued point in history, with the dot-com bubble being the highest. As one might expect, the public gets Bullish when valuations are among their highest.
One hour before markets closed, I noticed the volume on the largest S&P 500 ETF (symbol SPY) was half the level it closed at on Friday. If the Bulls want to take the market higher, they need to start buying. Volume on SPY was 10 million fewer shares today. Wow.
The bond sellers returned and tried to push yields higher. Retail sales are out tomorrow which I expect will show further erosion in spending because retail sales follow the growth rate in the money supply. Every dip in bond prices is met with buyers, which continues to act as price support.
- What happened to the stock market on Tuesday?
Today was a technical analyst’s (someone who attempts to predict prices based on charting) dream. The S&P 500 touched the top end of its descending right triangle pattern, which is still Bullish for the moment. The Nasdaq-100 is showing a 5+ month long head-and-shoulders reversal pattern, which is Bearish. The DJIA slid back below its 100-day moving average, which is Bearish. And the Russell 2000 formed a triple top.
The catalyst was the retail sales data which showed consumers were still spending but at a slower pace. Why this is necessarily bad for stocks, I’m not sure. It wasn’t a great report, but it wasn’t bad either.
Japan continues to sell off Treasuries, which has brought yields up in overnight trading. Chartists noticed a break in yields and piled in on the short side. Even though interest rates were higher across the curve, they aren’t going as much as one might think based on the record level of short positions on Treasuries. Japan is selling Treasuries out of fear of a weaker dollar. I believe their fears are unfounded in the long-term, but the Japanese seem to be concerned.
The 30-year Treasury bond hit a resistance level for the fifth time. Usually, after prices (or yields in this case) bounce of a level two or more times, it’s a clear signal to investors that prices or yields aren’t going any further. I thought after the third or fourth peak in yields the show would stop, but now speculators are hoping to push through a fifth top. We’ll see. Buyers did show up in late trading again.
The big surprise was late day buying of equities. The “smart money” has been selling in the last 30-60 minutes of trading, but someone came in today to buy.
As far as Treasuries go, it’s strange yields are rising after last week’s bond auctions that showed demand at a lower yield then bonds are trading today. Odd.
Gold got dumped and it’s making its way down into my target buy zone.
- What happened to the stock market on Wednesday?
The public was buying again, but the large institutional investors held off again. The way you can tell is through trading volumes, which were even lower than they have been last week. Trading volume on the largest S&P 500 ETF (symbol SPY) was below last week’s average and the largest Dow ETF (symbol DIA) was half its normal trading volume. This is a sign that large investors are sitting out.
The large investors are selling into the close, but not too heavily. But what’s interesting is volumes in Treasury ETFs increase in the last 30-60 minutes of trading to match the increased selling volume on the equity ETFs.
Industrial Production numbers came out this morning showing a slight increase. Industrial Production is a proxy for real wealth-generators in the economy. Stock prices should follow Industrial Production, and if they did, the equity markets would be no higher today than they were in 2008 and 2015 where Industrial Production peaked at current levels.
Mortgage applications slid to a 10-year low and yet Speculators saw this as a reason to further short Treasuries. Falling demand should push interest rates down. Housing starts and permits both fell last month, again, confirming demand is falling against higher interest rates. This is evidence that the Speculators are on the wrong side of the trade.
The Russell 2000, which is a small-cap index, made new all-time highs on today’s news. I’m not betting it holds.
- What happened to the stock market on Thursday?
Markets bounced around but closed in the red on slightly more trading volume than yesterday. Despite the US and Eurozone CPI’s rolling over, Speculators continue to press hard on their short Treasury positions to push interest rates higher. Time will prove them wrong!
The S&P 500 held its 100-day moving average. The Nasdaq-100 was rejected at its “Sell Zone.” The DJIA tried to breach its 100-day moving average but failed. The Russell 2000 is trying to break out to the upside.
The Fed dropped $21 billion in bonds this week. The last time the Fed did that, stocks had a strong negative reaction. I’m impressed that investors want to buy into this market despite the Fed unwinding. Never fight the Fed.
The Philly Fed data was positive, showing a strong surge in new orders, but prices paid fell. My hunch is wholesalers are ordering in advance of price hikes. The fact prices paid fell show inflation is cooling.
Agricultural commodities fell on news of trade issues with China. Oddly, if there are tariffs and agricultural commodity prices rise internationally (due to insufficient supply to meet global demand), domestic prices will rise.
Gold is slowing falling, which is good. It’s headed towards its final “Buy Zone” on an ascending triangle pattern. The mining stocks should fall too which will present an excellent buying opportunity.
- What happened to the stock market on Friday?
Equity markets closed down for the week. Treasury yields had a strong reversal and closed below Tuesday’s high. Agricultural commodities found buyers in their “Buy Zone.”
Equity volumes were slightly higher than yesterday, but overall still low. If the Bulls are as convicted as they act, they need to buy strongly into next week or face another move down in stocks.
Video Topic of the Week –
Does a low unemployment rate mean there will be high inflation? Tune in this week to get my opinion.
Chart of the Week –
Gold and gold miners… this week we take a deep dive into when and why we will be investing in this sector.