Weekly Economic Update 08-10-2018

Our Financial System is Broken & I’ll Prove It, Part 2

In last week’s update, Our Financial System is Broken & I’ll Prove It, I examined how the best determinant of inflation in our monetary system is the Money Multiplier. While nearly every expert and analyst are forecasting double-digit inflation in the coming years, in my opinion our financial system is fundamentally broken to the point where it cannot generate inflation at a level much higher than today without actually breaking the system. Understanding how money multiplies within our financial system is key to understanding how inflation is generated.

The Money Multiplier is how many times a new dollar multiplies within our financial system before dying. A new dollar enters our financial system when a loan is taken out and the proceeds are spent in the real economy. A dollar dies when it goes to repay the principal of a loan. The creation of money doesn’t explain how money multiplies – it is just the first step in the process.

Money multiplies when money is borrowed from Bank A and deposited into Bank B. Bank B can count the newly deposited money as reserves and lend nine-times against it. The process continues as money from one bank is deposited in another bank, then lent out and deposited in a different bank. Money multiplies within our financial system as it is borrowed and deposited from bank to bank.

Back in 1985 when the Money Multiplier was at its highest level since the early 1900s, a new dollar entering our financial system multiplied 12.1 times. Today, the same new dollar entering our financial system will only multiply by 3.88 times before dying.

If a dollar is multiplied by moving from one bank to another, then it is reasonable to assume the mechanism for creating inflation is tied to the number of unique banks within our financial system.

When I came up with this hypothesis, it made perfect sense to me. If I could determine the historical number of banks in our financial system, then I should be able to validate the accuracy of my hypothesis. Much to my surprise, the St. Louis Federal Reserve has records indicating the number of commercial banks, by quarter, going back to the early 1980s.

In 1985, when inflation peaked, there were approximately 14,000 commercial banks in the United States. Since 1985, the number of commercial banks contracted at a rate of about 3-4% per year. Today there are approximately 4,800 commercial banks in the United States.

I graphed the number of commercial banks against the Money Multiplier and the correlation was nearly perfect. There were times the Money Multiplier deviated from the number of commercial banks, but it always adjusted back to a level matching the number of commercial banks.

This was quite an exciting revelation! I have not read, watched or heard any financial expert tie the number of commercial banks to the Money Multiplier as a reason for how inflation is created within our financial system. The evidence is clear – the two are strongly correlated and the logic behind the correlation is sound.

My research suggests the level of inflation in our economy cannot go much higher because our financial system cannot generate inflation to support higher rates. It also explains why inflation has fallen since 1985 and why we will not experience a repeat of 1980’s inflation.

To further validate my research, I charted 10-year Treasury yields against the Money Multiplier. Interest rates Interest-rates are a function of inflation; interest-rates rise in response to high inflation and fall in response to low inflation. As I expected, 10-year Treasury yields are correlated with the Money Multiplier.

Treasury yields do not follow the Money Multiplier perfectly, because investors and speculators bet against the bond market in hopes to profit from rising or falling Treasury yields. While speculative bets can move Treasury yields above and below the Money Multiplier for a period of time, Treasury yields eventually move right back to the level of the Money Multiplier.

Currently, 10-year Treasury yields are trading at approximately 3% which is above the level of the Money Multiplier. To bring yields in line with the Money Multiplier, 10-year Treasury yields would need to fall to 2%. This means all the experts and analysts that are predicting higher Treasury yields in response to higher inflation, are completely wrong. Based on my hypothesis regarding the correlation to the Money Multiplier, Treasury yields will fall in the future.

There was one nagging question I needed an answer to – where did all the banks go? I did not expect to find an answer to this question, but the Richmond Federal Reserve published an essay in 2015 titled, Explaining the Decline in the Number of Banks since the Great Recession.

According to the Richland Federal Reserve, the decline in commercial banks is partially due to bank failures, but mostly due to consolidation. The primary driver of bank-consolidation was a change in banking regulations that culminated with the passing of the 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act.

Prior to the late-1980s, state banking laws prohibited banks from opening branches across state lines, and some states even prohibited intrastate branching. As these laws were relaxed and eventually removed, larger banks began buying smaller banks.

The trend of bank consolidation is not going to stop any time soon. Due to the Fed’s low-interest-rate policy, increased regulation and increased compliance, banks are increasingly turning to consolidation to grow. With the bar for entry set rather high, few experienced bankers are willing to take the risk of opening a new bank.

As the number of commercial banks continues to fall, the ability of our financial system to multiply money declines with it. We can conclude based on my research and the Richmond Fed’s research that both interest-rates and inflation will remain low for the foreseeable future.

The Money Multiplier is currently trending above the number of commercial banks. To bring the two in sync, the Money Multiplier would need to be somewhere between two and three, which would be near its historical low of 2.77.

I expect the number of commercial banks to fall during the next recession. The Fed pumped asset prices through Quantitative Easing, and by lowering interest-rates, many banks have lent against these higher asset prices. When the economy recesses, asset prices will likely fall below the amount lent against them, which will cause some banks to become illiquid. To solve the problem, banks will be bought out or consolidated with larger banks. We learned in the Great Financial Crisis that the Fed prefers to bail out the largest financial institutions.

Just like in 2008-09, the Money Multiplier will come crashing straight down to correlate to the number of remaining commercial banks. This will further reduce the ability of our financial system to create inflation and cause interest-rates to fall.

Depending on the severity of the next recession, which I believe will be one of the worst in our country’s history, the Money Multiplier may fall below two, which would cause major problems. When the Money Multiplier is greater than one, but less than two, a new dollar entering the financial system becomes barely more than one dollar before dying.

Under those conditions, interest-rates will continue to fall and the financial system will start to grind to a halt. Why? Because the amount of debt being repaid will exceed the amount of new money entering the economy and multiplying within our financial system.

We are facing a crisis if the Money Multiplier falls below one. This could happen if the Fed turns to more Quantitative Easing to solve the next financial crisis. Quantitative Easing, which was supposed to spur inflation, can actually lead to the exact opposite. Should the Fed raise the Monetary Bases high enough, they can push the Money Multiplier under one. Should the Money Multiple fall below one, a new dollar entering the financial system will become less than one dollar.

When a dollar becomes less than one dollar, our financial system effectively fails. The Federal government and Federal Reserve will be forced into changing laws to implement extreme money-printing measures to keep our financial system running.

As far as Treasury yields go, should the Money Multiplier fall below two, 10-year Treasury yields will approach zero. If it dips below one, yields will go negative. In either case, anyone owning long-term Treasury bonds will see double-digit returns during a period where stock prices are crashing.

In a future update, I’ll explain how the Fed can drive the Money Multiplier below one and what options the Fed will have to rescue the system.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

Over the weekend China’s largest refiner said they will cease buying US crude for the month of September and purchase oil from Iran instead. There was also a growing number of experts pointing out that speculators are extremely short U.S. Treasuries while yields are no longer rising. A Treasury short squeeze could rapidly bring bond yields down, which would drain liquidity from the equity market.

Today’s 3- and 6-month Treasury auctions saw demand plummet. The lack of demand is partially due to expectations the Fed will continue raising short-term interest rates. The other explanation is due to the lack of demand for cash equivalents. With brokerage account cash levels near record low levels and deposit growth at banks also very low, there is little demand for these types of bonds. Long-term bond yields fell going into the auction and yields remained down after the auction completed.

The S&P 500 had a gap between the closing price on January 29th and the opening price the next morning. As of today, the gap has been filled. After two unsuccessful attempts to rally past the gap, the S&P 500 closed below its intra-day high. Trading volume on the largest S&P 500 spider (symbol: SPY) came in at a mere 36 million shares when 100 million is the average. The lack of trading volume is a clear sign there aren’t many buyers left.

Chinese stocks continue to fall due to the tariffs and the Fed draining dollar liquidity from the global economy. Keep in mind, when the stock market for the world’s largest exporter falls, the world’s largest importer can’t be far behind.

Treasury yields fell despite a huge push last week from the speculators who are trying to short Treasury yields higher. Jamie Dimon, JPMorgan’s CEO, tried to talk Treasury yields up today, but it didn’t work.

Physical gold fell again as speculators continue to back out of their long positions, which will set up a strong buy into gold or the gold mining stocks in the near-term. Gold and silver miners fell today, and the gold miners breached the bottom end of the supply zone. Unless buyers’ step in, the gold miners should fall to the next supply zone around $19.50-20. Every time the speculators dump gold, it sets up a strong buying opportunity. I just need prices to stop falling so we can start buying.

Agricultural commodities are running out of short sellers, which was evident in last week’s price and volume action. Buyers have arrived over the last two trading days and managed to move prices up on low volume. Another sign there may not be any further interest in shorting agricultural commodities. Given a large number of short positions underneath, this could set up a nice short squeeze.

The dollar index made another run at trying to break $95.5x (/DXY) but was rejected for the fourth time since mid-June. This supports a drop in the dollar to $94 before another attempt to break $95 comes.

  1. What happened to the stock market on Tuesday?

The Chinese stock market kicked off the global equities rally as the Chinese government talked up their stock market. This move was in response to President Trump’s claim the reason the Chinese stock market is down more than twenty percent is due to the tariffs. The Chinese stock market started falling before any tariffs were announced. Its fall is more likely due to the Fed draining dollar liquidity out of the global markets.

The Trump administration announced this afternoon that there will be an additional $16 billion in tariffs applied to Chinese imports on August 23rd. So far, the US stock market has ignored the threat of tariffs, even as the US economy is slowing down.

Today’s 3-year Treasury auction sold with yields as high as they were in May 2007. Foreign bidders backed away from this auction, which left securities dealers with 45.2% of the auction. The poor results caused long-term bond yields to rise a bit. All eyes will be on tomorrow’s 10-year Treasury auction.

With dealers being forced to take these bonds, look for the stock market to change direction in the not-to-distant future. Dealers will be looking for ways to unload their inventory.

Physical gold was flat on the day, but the large gold and silver miners were down. The large gold miners broke the bottom end of their supply zone, which suggest they are likely to take a hard fall to the next supply zone. The large silver miners are hovering just above their supply zone, and should the gold miners fall further, the silver miners should fall right to the bottom of their supply zone. The junior gold and silver miners also took a hit today. This is just setting up an even better buying opportunity when prices stop falling.

  1. What happened to the stock market on Wednesday?

China announced $16 billion of 25% retaliatory tariffs to go into effect on August 23rd. These tariffs will target crude oil, coal, diesel, bikes, cars and medical equipment.

After yesterday’s dismal 3-year Treasury auction, all eyes were on today’s 10-year Treasury auction which is the largest in history. Foreign bidders took a little over 61% of the auction, which is right in line with their six-month average. Overall the auction was well received with yields below 3%. Based on this auction, it’s unlikely 10-year Treasury yields will move above 3%.

Even though yields fell after the auction, Treasury yields closed flat across the board.

Stocks barely moved today. Trading volumes continue to be unusually low. When volume falls in a rising equity market, it’s a sign that buyers are becoming exhausted, or unable to push prices higher. This is where sellers come in to push prices lower. Despite the persistently low trading volume, with today being one of the lowest in the past 12-months, sellers aren’t selling. Then again, buyers appear to be low on funds. I would expect stocks to start falling, but nothing seems to be able to rattle this market – for now.

The dollar still can’t break out of its trading range between $95-95.50.

Even though the gold and silver miners tried to rally today, they were unable to. Physical gold barely moved, but relative to stocks, gold is at its cheapest price in 11 years.

  1. What happened to the stock market on Thursday?

Wholesale Trade fell in June and Wholesale Inventories grew less than expected. Both were expected to rise to indicate signs of a growing economy. When the money supply is decelerating, consumers will ultimately reject higher prices.

The Producer Price Index, which is an index that tracks factory input prices, came in below expectations. The PPI is used to gauge inflation, which the market is expecting to go higher. The Money Multiplier, which is the proper gauge of inflation, suggests both producer and consumer prices can’t go much higher. This is an early sign of consumers rejecting higher prices due to insufficient wage growth.

Today’s 30-year Treasury auction went fairly well with foreign bidders taking over 62% of the bonds. Despite trade wars and tariffs, foreign demand for US debt remains strong. Speculators should start to worry as this is setting up a major short squeeze against the heavily shorted Treasury bond market.

Dr. Harald Malmgren, a former advisor to two Presidents, said on FinTwit today that foreign governments are buying US Treasuries because they believe the US dollar is going to collapse. Foreign governments hold US dollars for trade but can recycle them into Treasuries. Should the dollar collapse, interest rates will fall, bond prices will rise, and the foreign governments will sell their Treasuries for more dollars than they have today. Meanwhile, American investors are shunning bonds as they dump all their money into stocks. One side will be correct.

I watched an interesting interview with an analyst who is bullish on agricultural commodities, but not for any reason I’ve ever heard of. He said about every 200 years our sun goes through a “sunspot cycle” where its magnetic fields cancel each other out. When the sun’s magnetic fields cancel each other out, it doesn’t generate any sunspots. Without sunspots, summer temperatures rise, which leads to heightened drought conditions and lower crop yields. The last time this happened was in the early 1800’s and our sun is expected to be in this cycle for the next couple years. He advised taking a position in agricultural commodities and then selling into the gains.

Trading volume on the largest S&P 500 ETF (SPY) closed out at 32 million shares, which is marginally higher than the lowest trading day in the last 12-months. Clearly, buyers are indicating the market is overpriced. As long as corporations and foreign central banks continue buying stocks, they can prop the market up for a little while longer. What they can’t prop up is the American consumer.

Treasury yields were down for the day and this could be the beginning of a major move down. There are a couple key moving averages that need to be broken, which should drive buyers into Treasuries.

While physical gold was mostly flat for the day, the large gold and silver miners tried to rally. As I expected, both rallies were strongly rejected. All indications point to lower gold and silver miner prices, which is good for those of us who want to buy at the lowest possible price.

  1. What happened to the stock market on Friday?

Currency markets are driving trading today as President Trump escalated tariffs against Turkey. The bigger issue isn’t the tariffs, it’s the lack of global dollar liquidity that is driving global stock prices down. When liquidity drops, the dollar tends to rise. I want to take a small position in the dollar unless the gold and silver miners bottom out first, but due to low trading volume in the dollar ETF, I may only be able to take a very small position.

When liquidity begins to dry up, interest rates fall, which is evident in today’s drop in Treasury yields. This moving in yields is setting up a huge short squeeze, so I am anticipating bringing the cash in early next week to get our positions set correctly before this bigger move takes place.

Consumer prices continued to move higher at a +2.4% year-over-year rate. With both producer and consumer prices moving higher, the Fed will be forced into hiking at next month’s meeting. This will further tighten the money supply and reduce global dollar liquidity. The Fed doesn’t realize they are fighting the modern version of inflation with their tools designed to fight the true definition of inflation.

For once stocks fell, volatility rose, and Treasury yields fell – as markets should behave. 10-year Treasury yields are on the cusp of breaking the neckline of a head and shoulders reversal pattern, which would cause money normally going into stocks to shift to bonds. With a record short interest in Treasuries, this could be the beginning of a massive short squeeze that would lead to lower Treasury yields and higher Treasury bond prices.

Even though physical gold was flat for the week, both the gold and silver miners continued to sell off. They are both fast approaching another supply zone where if buyers’ step in, will make a nice entry point for us.

Agricultural commodities fell today, which is likely a reaction to a stronger dollar. I’m not sure how much further agricultural commodities can fall before buyers’ step in. After all, they are near their 40-50-year low in price.