Weekly Economic Update 08-03-2018

Our Financial System is Broken & I’ll Prove It

Every day I hear how the stock market is going to rally indefinitely, how stocks are now the safest investment on the planet, and how interest rates are on the cusp of soaring to double digits. Yet many of these so-called financial professionals, more than 10 million of them, entered the industry after the Great Financial Crisis. In my opinion, not many of them have bothered to do much research.

I find myself baffled how everyone has recently turned into an inflationist, yet in prior weekly updates, I have shown historical data, laws, and financial theory validating we are not going to see higher inflation. Arguably, the recent increases in consumer prices have nothing to do with inflation. As you can imagine, such an opinion puts me in puts me in an unpopular and lonely position within my own industry.

It is entirely possible a majority of industry professionals are correct. But they’re not. In fact, they are completely wrong. I realize that is a bold statement, which may take several weeks to explain, so I ask for your patience as I attempt to prove my position.

I have spent a great deal of time lately trying to understand inflation and whether or not we going to experience a repeat of the 1970’s to early 1980’s inflation. Once I figured it out, I quickly realized that our financial system is broken, which will prevent inflation from skyrocketing.

It further concerns me how unstable the path is that our financial system has been following for the past forty years. So unstable, in fact, the next recession is going to be severe. I now believe the Fed’s zero-interest-rate policy and bank bailouts are creating an even more unstable system that will ultimately lead to a deflationary shock.

Now that I can substantiate we are headed for a deflationary shock and another financial crisis which will make the Great Financial Crisis look like a preview, it reinforced my continued view that the best asset classes to invest in are all the ones I have shared with you over the past two years.

Modern-day inflation is defined as an increase in consumer prices, regardless of the cause. However, inflation is truly defined as the expansion of fiat currency.

In past times, King’s would round up all the currency in their kingdom, melt it down, then redistribute it back to its subjects with a lower precious metal content. The additional precious metal would go into new coinage which the king would spend himself. This is where we get the concept of inflation.

Within the United States’ monetary system, the Federal government can only borrow money, as governed by the Constitution, and the Federal Reserve can only create debt, as stipulated by the Federal Reserve Act of 1937. Neither have any legal authority to create money, meaning neither entity can inflate our currency.

The expansion of our currency occurs within the banking system. When a bank funds a new loan, new money enters our economy. Banks can lend approximately nine times against their reserves. If a bank has $1 billion in reserves, they can lend out $9 billion. When the $9 billion enters the economy, it is new money and it is inflationary.

On a side note, if you ever wondered why the big banks get bailed out every time there is a financial crisis, it is because the banks are the only creators of money within our monetary system. Without banks, our financial system would ultimately fail.

Money “dies” in the opposite fashion from which it is created. When payments are made against a loan, the principal value is destroyed and the interest remains in the system, as profit to the bank. This is a critical concept to understand. Principal repayments are always removed from the money supply.

Let’s say I purchase a $60,000 car with a zero-percent, 60-month loan. Upon origination of the loan, $60,000 of new money enters the money supply. Every month I make a payment of $1,000 (60 months times $1,000 = $60,000), that money is removed from the money supply until the entire $60,000 is removed with my last payment.

Using the previous example, let’s say the loan has a ten-percent interest-rate.  Interest is front-loaded on fully amortized loans, which allows the bank to recover their expenses in the first couple years of the loan. Once the loan is paid off, the 10% interest is revenue to the bank and the $60,000 is removed from the money supply.

Where does the money come from to pay the interest on the loan? From the existing money supply, or from my income. Interest is just money from the existing money supply that goes to the lender as profit. Nothing more. The interest goes to cover the bank’s expenses and the remaining amount is their profit.

Inflation can only occur when banks lend. As long as banks lend an increasing amount of money each year, the money supply of our country grows. As our money supply grows, we, as consumers, experience the effects of inflation. If our money supply grows rapidly, we experience high levels of inflation and if it grows slowly, we experience minuscule levels of inflation.

There’s one big problem. After the Great Financial Crisis of 2008-09, the Fed has desperately tried to create inflation. Even though they don’t have the tools or ability to do so, we are just starting to feel the effects of rising prices some nine years after the crisis.

However, what we are experiencing today is not the true definition of inflation. We are experiencing higher prices, but not higher prices due to inflation.

The Fed injected $3.6 trillion of excess reserves into the financial system and lowered interest-rates to zero and didn’t create inflation. If that doesn’t create inflation, then what does?! I decided to look back to the 1970’s and early 1980’s for the answer. My conclusion is the financial system is broken and has been unintentionally sabotaged by the Federal Reserve.

We know banks create money when they lend and, as long as they lend more each successive year, the money supply can expand. But that doesn’t tell us how money multiplies, it just tells us how money is created.

Inflation in our monetary system is a function of how many dollars are created from one new dollar when it enters the financial system. Fortunately, the money multiplier tells us how many dollars are created when a new dollar enters the economy before it dies. As long as the Federal Reserve Act of 1937 is not repealed or modified, the money multiplier is algebraically defined as:

Money Multiplier = M2 Money Supply ÷ Monetary Base

The St. Louis Federal Reserve provides the data for both the M2 Money Supply and the Monetary Base. It’s free and available to the public. So, I found the numbers and did the math to calculate the money multiplier at different points in history.

At its peak in the first quarter of 1985, the money multiplier was 12.1. In other words, in 1985, every time a new dollar entered the economy, it would become twelve dollars before dying. When reviewing the data going back to the early 1900’s, 1985 was the highest point for the money multiplier. This validates the money multiplier is the most accurate means of determining inflation in our economy.

Since 1985 the money multiplier has been slowly declining. Today the money multiplier is 3.85, meaning every new dollar entering the economy turns into $3.85 before dying. Based on the money multiplier alone, we are not experiencing high inflation nor will we experience high inflation now unless the money multiplier significantly rises!

Since 2013, the money multiplier has previously peaked twice at its current level before decelerating. The lowest point the money multiplier has ever been, since 1900, was back in September 2014 when it was a mere 2.77.

The money multiplier tells us many things. When I chart U.S. Treasury yields against it, the money multiplier validates why interest rates have continued to fall since they peaked in the 1980’s. Even oil prices show a correlation with the money multiplier.

This exploration of inflation and what drives inflation led me to wonder why the money multiplier is, and remains, low. The quick answer is that neither the Federal government nor the Federal Reserve can print money. But that doesn’t explain why money isn’t multiplying. There’s a big difference between money being created with a new loan and money multiplying within the financial system.

Late one night when I was unable to sleep, the potential answer came to me: if money multiplies by moving from one bank to another, then perhaps the answer has to do with the number of commercial banks in our country. If the number of commercial banks is falling, then it explains why money can’t multiply regardless of how hard the Fed tries.

I haven’t read or seen any work on the number of banks being correlated to the money multiplier. I also didn’t think I’d be able to find historical information on the number of commercial banks in our country, but the St. Louis Fed has been tracking the number of commercial banks since the early 1980’s.

What I discovered was absolutely shocking and has led me to believe there is a structural problem within our financial system. My findings also explain why the Fed remains unable to stoke any flames of inflation, outside of short intervals, and why $3.6 trillion dollars didn’t create any inflation.

I will share my findings with you in next week’s update. However, I’ll leave you with this: the money multiplier is directly correlated to the number of commercial banks in our country. And due to the relationship between commercial banks and the money multiplier, the Fed will not be able to create inflation.

Stay tuned!

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

Ever since Facebook and Netflix announced their earnings, the tone of the market has changed. Equities used to rally early in trading, then fade going into the market close. Now equities are falling in early trading and buyers are stepping in late trading. Some investment banks are seeing this as a sign of a broader sell-off.

Treasury yields are being pushed higher as speculators continue to short bonds while commercial hedgers continue to buy bonds. The commercial hedgers, or the smart money, are always on the right side of the trade.

The dollar looks to be fading its recent rally, which should see a retest of $93 on /DXY. If buyers show up around there, get ready for a dollar rally.

Physical gold was flat for the day, but that didn’t stop the gold and silver miners from falling. Over the weekend, news that Vanguard is changing the name of their mining fund and selling down their mining holdings, garnered interest from those who are looking to buy the miners. This is setting up for a strong rally once the selling subsides.

Agricultural commodity traders are now saying that all the bad news has been priced into commodities and that a rally could begin from here. UK farmers are starting to dip into their winter stocks to feed their animals because drought conditions are damaging crops. With the United States soon to be the last supply of agricultural commodities as China gobbles up the global supply, prices here could easily skyrocket when demand outstrips supply.

  1. What happened to the stock market on Tuesday?

Most of the market was waiting for the closing bell to see if Apple beat their earnings expectations, and they did. In after-hours trading, Apple is at new all-time highs, which should push both the S&P 500 and Nasdaq-100 up tomorrow morning.

The bigger risk is the Federal Reserve meeting tomorrow and the SOMA, which is the one day of the month where the Fed does the bulk of its monthly balance sheet selloff. Prior SOMA days haven’t been good for stock prices. The Fed continues to drain liquidity which should put downward pressure on asset prices and interest rates.

The large gold miners tried to rally today but were rejected. They are getting close to bottoming out.

Agricultural commodities are holding up, even as sellers continue to try to push prices down. This is a positive sign.

  1. What happened to the stock market on Wednesday?

The stock market shrugged off the Fed’s big balance sheet unwind and the Fed’s strong view on the economy, due to Apple beating expectations yesterday. With factory surveys trending down and construction spending slumping, the best news for the economy may be in the rearview mirror.

The Fed held interest rates today, but signaled the economy is “strong.” The Fed usually hikes rates in September, so expect another 0.25% increase in the Federal Funds rate next month. The Fed will continue tightening monetary policy by unwinding their balance sheet. So far there have been minimal disruptions in their balance sheet unwind, which is giving the Fed the signal to continue.

Speculators attempted to push Treasury yields higher on news the Treasury will be increasing the size of their upcoming auctions. Speculators don’t seem to understand the government does not care about how much interest they are paying nor are they concerned about selling new debt. The market will take it at any yield. The bigger issue is all the liquidity that will be drained from the economy by year-end as the tax cuts fade.

The large gold mining ETF slipped under its 200-weekly moving average which for the last two years has been a buying signal when prices stop falling. Meanwhile, physical gold fell to $1,215/oz and is on its way to $1,200/oz. Where these two stop is where I get very interested in buying.

  1. What happened to the stock market on Thursday?

Congratulations to Apple for being the first company to have a $1 trillion valuation. Of course, they got there by buying their stock back, which is evident when the share buyback window opens, their stock rises.

The Bank of England raised interest rates 0.25% this week, even though their economy nearly slipped into a recession in Q1. Regardless of what they said, the BoE’s decision to hike rates has to do with the Federal Reserve.

In the late 1920’s, the Fed was tightening and there was so much excitement about US stocks that money flowed in from all over the world, even though the Fed was raising interest rates. To keep easy money from flowing out of Europe, European central banks were forced to hike interest rates, which led to the Great Depression.

If any of this sounds familiar, it should. We are seeing the same scenario play out just as it did in the 1920’s.

10-year Treasury yields tagged 3% again and were rejected for the third time in the past twelve months. Despite record short interest, the smart money continues to buy bonds. If 3% can hold, I’ll be looking to bring the cash in and add a small US dollar position.

The US dollar (/DXY) continues to try to break upward through $95, which it should eventually. Fed tightening, and tariffs will lead to a stronger dollar, even though President Trump seems to want a weaker dollar.

Last night on FinTwit (the financial subsector of Twitter), there were posts about shorting the gold and silver miners. I love it! Bring prices down more!

The large gold miners closed right at the bottom of my targeted “Buy Zone.” In the past, when prices have reached this level, trading volume has increased as buyers started buying. So far that hasn’t happened. Maybe tomorrow? If buyers don’t step up, there will be another leg down in the miners, which is fine with me, because I’d prefer to buy them at the lowest possible price.

Physical gold fell to $1,215/oz and is showing no signs of slowing down. It should find support at $1,200/oz, which could mean further downside for the miners.

When the time comes, we’ll make small moves into the miners and buy as prices rise. For now, all eyes are in price and volume to see where the downward slide ends.

  1. What happened to the stock market on Friday?

All eyes were on the July Nonfarm Payrolls report which showed +157,000 jobs added last month. The BLS’s Birth-Death model, which estimates the number of newly self-employed workers, showed +146,000, meaning +11,000 jobs were actually created last month.

Adjusting for the birth-death model, both the three and six-month average net job creation has been +69,000 per month, well below the headline numbers. Once job growth falls below +150,000 per month, it is a sign the labor market is tapped out and that layoffs are not far off.

Wage growth hit expectations, but it wasn’t very strong. Weak wage growth tells us the jobs being created are low-quality jobs. That view was confirmed in the employment report, which showed most of the jobs went to those with a high school education or less.

The past ten years of this market has been one thesis: buy stocks, sell bonds and short volatility. Trading volume today is very light and the VIX volatility index is being crushed below 12. The lowest the VIX index has ever been was set back in November 2017 before the volatility explosion occurred in February 2018.

The markets are back trying to suppress volatility and running into a wall of how hard they can push it down. When the Federal Reserve eased monetary policy by lowering interest rates and buying bonds, volatility fell. Now the Fed is tightening monetary policy by raising interest rates and selling bonds, so volatility should be rising.

This is a dangerous position as most investors are heavily allocated to stocks and as the Fed continues to tighten, it should lead to a surge in volatility which will cause stock prices to fall.

As foreign stocks fall, US stocks continue to grind higher as volatility is aggressively suppressed. After touching 3% on the 10-year Treasury yield, buyers once again stepped in. With a new record short position in Treasury yields set this week, speculators are finding there is strong buying support at 3%.

Based on my models using the Money Multiplier, Treasury yields should be at 2%. Should buyers continue to step in, the speculators will get flushed out and yields will plummet.

Physical gold got a bump today as China came to rescue its currency from further devaluation. I don’t believe China can hold this position as a tighter US monetary policy and tariffs lead to a weaker Yuan. The gold and silver miners popped up again, but quickly found sellers. Until the sellers give up, we can’t make a move in, but we are close.

Agricultural commodities also found buyers today, as all the bad news is more than priced in. As it turns out, China has been a big buyer of our soybeans ahead of the tariffs. As China consumes the global supply of soft commodities, we will be the last supply in the world, which should drive prices higher. Especially against record global temperatures and global drought conditions.

Portfolio Shield™ Update –

The August rebalance went smoothly. The strategy is 100% allocated to equities for the remainder of August. The most recent Morningstar® Investment Detail report is attached.