Weekly Economic Update 08-17-2018

Our Financial System is Broken & I’ll Prove It—Part 3

The Federal Reserve is attempting to reverse the policies they implemented to rescue our economy from the Great Financial Crisis of 2008-09. However, I believe the Fed is embarking on a path that will not only put strain on our system, but likely break our financial system in half.

In my last two weekly updates, Our Financial System is Broken & I’ll Prove It—Part 1 & 2, I explained how the Money Multiplier works which is the mechanism for creating inflation in our economy. This inflation-creating mechanism has been slowly breaking for the past forty years and, during the next recession, it will likely snap due to the policies of the Federal Reserve.

The Federal Reserve Act of 1913 created the Federal Reserve system as a lender of last resort to the public banking system. Prior to 1913, inflation was an ongoing problem and concern, and governments often resorted to money-printing to solve financial problems. The Federal Reserve was granted two primary policy tools to combat true inflation: the ability to adjust the Federal Funds rate and the ability to buy or sell government insured obligations.

Since 1913, Congress has dedicated the Federal Reserve to three objectives: to sustain maximum employment, maintain stable prices, and moderate long-term interest-rates. Once you understand how their policy tools work, you will realize that it is impossible for the Fed to accomplish these goals. Furthermore, once you realize how the Fed has damaged the banking system and the Money Multiplier, you will also understand how the Fed’s policies will likely break our financial system during the next recession.

The Fed’s policy tools were properly designed to fight true inflation, as defined by consumer price increases due to an expansion of the money supply. Money is created when a new loan is originated by a bank. As the borrowed money enters the money supply, it is multiplied through our financial system by the banks, as algebraically defined by the Money Multiplier.

The Fed can adjust the Federal Funds rate and the Monetary Base to combat the effects of inflation. By raising the Federal Funds rate, or the bank-overnight-lending rate, short-term interest-rates rise. The Fed does this to reduce the origination of new loans. With fewer loans being originated, less money enters our financial system. Less money entering our system means fewer dollars are being multiplied, which reduces the rate of expansion of the money supply, or inflation.

The Fed can also reduce the Monetary Base, or the total amount of circulating money, by selling U.S. Treasuries. Prior to the Great Financial Crisis, the Fed held a relatively stable amount of U.S. Treasury debt as a policy tool. To reduce the Monetary Base, the Fed simply sells some of their Treasury bonds to the public. By exchanging circulating dollars for these bonds, it reduces the number of dollars in our system. By reducing the number of circulating dollars, the Fed can reduce the expansion of the money supply, or inflation.

It is important to understand that raising the Federal Funds rate or reducing the Monetary Base does directly impact the number of times money is multiplied in our system. The Money Multiplier, which determines the number of times new money is multiplied in our system, is ultimately a function of the number of Commercial banks within the banking system. As I mentioned in last week’s update, since the mid-1980’s, the number of Commercial banks in our financial system has fallen from a little over 14,000 unique banks, to a little over 4,800.

While the Fed’s policy tools can directly impact the number of times money is multiplied in our system, there is a correlation between the number of Commercial banks and the Money Multiplier. Since the Money Multiplier is algebraically defined, we can extrapolate what impact the Fed’s policy tools are having on the financial system.

Money Multiplier = M2 Money Supply ÷ Monetary Base

It is important to understand the Fed is currently fighting the effects of price inflation, not inflation due to the expansion of the money supply. Forty years ago, the Fed abandoned using the money supply to determine proper monetary policy. Instead, the Fed focuses on other macro data, which includes the Consumer Price Index (CPI). The three largest components of the CPI are housing, energy and medical. When you hear the Fed is responding to inflation, they are trying to reduce housing prices, energy costs, and medical costs.

What concerns me is the Fed is using policy tools designed to combat true inflation, to reduce the rate at which housing, energy, and medical prices are rising. The Fed is using the wrong tools to combat rising prices, which will lead to a recession, a collapse in asset prices, and a collapse in the Money Multiplier. When the Money Multiplier falls next time, it will break our financial system.

The Money Multiplier peaked in 1985 at 12.1. Its low was set in 2014 at 2.77. Today the Money Multiplier is 3.88, which means a new dollar entering the economy becomes $3.88 before dying.

During the next recession, I expect the Money Multiplier to fall below two, which means a new dollar entering our financial system will marginally become more than one dollar before dying. Should the Money Multiplier fall below one, a new dollar entering our financial system will become less than one. A Money Multiplier below one is where our financial system self-destructs. To rescue our economy from the next recession, I believe the Fed will inadvertently drive the Money Multiplier below one.

The Fed has been slowly increasing the Federal Funds rate to slow down the effects of inflation. Ideally, they want our economy to grow into these higher prices, but they need to slow down the increase in prices to allow our economy to catch up. When the Fed raises the Federal Funds rate by 0.25%, it has the equivalent effect of reducing the Monetary Base (the divisor in the Money Multiplier formula) by approximately $60-70 billion.

The Fed raises the Federal Funds rate to reduce the rate of new loans being originated. This reduced pace allows the existing money in the system to work its way through before dying. A good analogy is using a stoplight to regulate vehicles entering a busy freeway to break up bottlenecks created by having too many vehicles on the freeway at the same time.

The Fed is also reducing the Monetary Base through Quantitative Tightening, by selling off $40 billion per month of its bond holdings, which will increase to $50 billion per month in October. Each month the Fed allows $40 billion of its U.S. Treasury and Mortgage-Backed Securities holdings to mature, then destroys the principal payment it receives for those bonds.

The Fed is attempting to reduce the growth rate of the M2 Money Supply and contract the Monetary Base. If the Monetary Base contracts faster than the M2 Money Supply decelerates, the Money Multiplier will rise. A rising Money Multiplier leads to higher inflationary effects. Should the M2 Money Supply contract faster than the Monetary Base contracts, the Money Multiplier will fall. This will lead to disinflation, or deflation.

The M2 Money Supply should contract faster than the Monetary Base contracts due to the Fed’s Zero Interest Rate Policy (ZIRP). Under ZIRP, the Federal Funds rate was 0%, and when loans are made at very low interest- rates, money is rapidly destroyed. Money is created when a new loan is originated, and the principal of the loan is destroyed as it is repaid.

Currently, there is a record amount of public and private debt at historically low interest rates, which means money is rapidly being destroyed. As the Fed seeks to decelerate lending growth, money will be destroyed faster than ever.

During the next recession, many experts believe the Fed will reinstate its Quantitative Easing program. Stock investors salivate at this notion because they believe it will lead to sky-high stock prices. Japan has been running various forms of Quantitative and Qualitative Easing (QQE) programs for over 30 years and their stock market is 50% below its all-time high. There is a point where monetary policy will fail.

During recessions, the M2 Money Supply rapidly contracts. The long-term growth-rate of our money supply is between 6-7%. Today it is about 3.8% and when the growth-rate of the money supply falls below 3.7%, historically recessions and depressions occur. When the growth-rate turns negative on a year-over-year basis, it rapidly contracts.

To offset this, the Fed will likely attempt further rounds of Quantitative Easing at an unprecedented scale compared to what they did during QE 1-3. The Fed will do this to raise the Monetary Base at a time when the M2 Money Supply is contracting. Should the Fed raise the Monetary Base high enough, they will cause the Money Multiplier to fall below one.

It is entirely possible this will happen. The M2 Money Supply is about $14 trillion. The Monetary Base is $3.6 trillion. Assuming the M2 Money Supply is stable at $14 trillion, the Fed would need to buy more than $11 trillion of US Treasuries and Mortgage-Backed Securities for the Money Multiplier to become one. Any amount higher and the Money Multiplier becomes less than one. When you consider the Fed bought $3.6 trillion to get us out of the Great Financial Crisis, buying $11+ trillion may just be the beginning of what they do to get us out of the next recession.

Should the Money Multiplier fall below one, which I believe it can, the Federal Reserve and the Federal government will be faced with a limited amount of options to fix our financial system. The most likely option is likely to be direct money printing, which I’ll discuss in a future update.

Stay tuned!

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

The US equity market remains an island to itself as Emerging Markets currencies from Turkey to Brazil begin to self-destruct. Asian stock markets took notice and were mostly in the red last night. European markets were down too. US markets started lower, but pushed higher, only to close slightly lower. The belief is these EM currency problems will remain isolated to US investors. Until they don’t.

Treasury yields closed slightly higher on the day, but not by much. There is a clear head and shoulders reversal pattern and yields are coming down from the right shoulder. Should 10-year Treasury yields move much below 2.85%, the pattern will complete, which should lead to lower yields.

The US dollar, which is creating all the problems for EM currencies, finally popped over $95. The reason the fallout in EM currencies is going to be a problem is due to a large amount of dollar-denominated debts held by those countries. A rising dollar means higher repayment costs during a time where the Federal Reserve is pulling dollars out of the global system.

Physical gold quickly fell to $1,200/oz and the price action is suggesting there could be more downside to come. The short-sellers are winning and if they continue, could force the Commercials (or smart money) to turn into sellers. Should this happen, gold will fall much further.

The large gold miners made a large move down to the bottom of their trading range I highlighted last week. They too show no signs of major buying support. Like the physical metal, without buyers, selling pressure could take prices down much further. I’m all for a lower entry point.

  1. What happened to the stock market on Tuesday?

I made the call to bring those with cash into the portfolio models today. Treasury yields have been holding and slowly finding buyers, so its unlikely yields will move higher. Agricultural commodities also appear to be setting a bottom, so it was time to bring everyone into sync.

I read an interest report from an analyst out of China who said China can ride out parts of the trade war. Even though the Chinese like iPhones and Boeing airplanes, there are many smartphone alternatives and Airbus will be happy to sell them planes. He did point out the only alternative to soybeans is US soybeans. Soybean prices fall after China announced their tariffs, which caused China to buy a huge number of soybeans before their own tariffs went into effect. The soybean speculators ended up helping China by shorting soybean prices down.

The fear of an EM currency crisis faded last night as the Fed quietly injected dollar liquidity into the global markets. This liquidity won’t last as the Fed is scheduled to unwind some of its balance sheet tomorrow. It’s clear that EM countries need dollars to pay their dollar-denominated debts, at a time the Fed is reducing the number of dollars in the global financial system.

US equities bounced on the lack of news and Treasury yields rose a little, but not much. With Treasury yields holding, it’s a sign that short-sellers have run out of ammunition. This continues to set up a monster short-squeeze, which could be triggered by a fall in oil prices.

Physical gold closely marginally higher on the day, but the gold miners continued to sell. Based on price charts alone, this suggests the gold miners are likely to further fall before setting a bottom. I have mentioned about taking a position in silver miners when we go to buy in, but the trading volume on the large and small silver miners is so light that it would put us in a potential trap if I took a large position in them. For that reason, I am going to stick with the large and junior gold miners when the appropriate time comes. Unless trading volume picks up, then I’ll re-evaluate.

The US dollar has the same trading volume issues, but I was able to find a happy medium of where we can take a small percentage without being overexposed if the need arises to sell. This will be one of the next moves now that all the portfolios are in sync.

  1. What happened to the stock market on Wednesday?

The fear of an EM currency crisis came back last night, which saw foreign stock indices in the red. The US stock market opened down, then got hit with a double-whammy of a surprise crude oil build and the Fed selling off approximately $20 billion of its bond portfolio.

The budding EM currency crisis is due to the Federal Reserve pulling dollar liquidity out of the global economy at a time when there are massive dollar-denominated debts. With fewer dollars in the global economic system to cover these debts, there are bound to be losers. As liquidity gets pulled, the risk of default on these dollar-denominated debts increases.

I have been expecting oil to reverse course even though government data has been showing a draw in US crude inventories. The reason crude inventories have been falling is because a large amount of this oil is in floating storage. Floating storage is a fancy word for oil sitting on a ship out at sea somewhere without a buyer. Floating storage is not counted in the weekly government inventory reports.

China’s largest refiner said recently they will not be purchasing US oil in September out of fears of tariffs. Instead, they plan to purchase Iranian oil. At some point, all the ships that can hold oil get filled, which means land storage facilities should start to show an inventory build. Factor China’s largest refiner switching providers, US crude inventories are poised to rise.

There is a huge amount of speculative futures contracts positioned for an increasing rise in oil prices. As oil inventories build, those speculators will start to rush to the exit. As they do, oil prices and inflation expectations will fall. Remember, energy prices are one of the largest components of the Consumer Price Index.

A rising oil inventory is bullish for Treasury bonds, meaning yields should fall and bond prices should rise. Given there is the largest speculative short position in US Treasuries right now, as oil falls and inflation expectations fall, yields will fall. Those speculators will be forced to exit their short Treasury positions, which should cause 10-year Treasury yields to fall back to somewhere between 1.5-2.0%. For those invested in Treasuries, that’s a double-digit return as the speculators flee.

The build in oil inventories tells us the global growth narrative and the global inflation narrative is overblown. Oil demand and price should rise as the global economy expands. In a contracting global economy, oil prices should fall. Keep in mind, the Fed is fighting “inflation” or rising energy prices. Get ready for lower oil prices and lower interest rates as a shakeout of the speculators is building rapidly.

Stocks were down for the day and Emerging Markets (symbol: EEM) officially entered a Bear market as EEM is down 20% from its peak. Treasuries were up today as yields fell. Volatility was also up today but was pushed back down a bit before close.

Buyers came in prior to close to push the broad indices up off their lows but mainly to reduce the VIX or volatility index. Last year I wrote a piece about how rising volatility will trigger a massive movement out of stocks and into bonds. In the past, volatility has been easily suppressed back down whenever it spikes. This time, the markets couldn’t push back very much. This is a clear sign the Fed’s tightening is starting to affect the markets.

Physical gold fell below its key support at $1,200/oz and is looking like it may revisit its 2015 low. When sellers overwhelm buyers, weak buyers begin to flee. This is often referred to as a distribution phase, which is any period where people who normally wouldn’t sell, start to sell. Prices can fall rapidly during distribution phases.

The gold miners were whacked hard today and appear to be entering a distribution phase. Some people will try to buy this drop, but it’s more likely there will be one final blow-off move to the downside. This is where we want to buy; when all the sellers have been exhausted.

I mentioned yesterday I won’t be buying into the silver miners which is mostly due to a lack of trading volume. While I think silver may outperform gold, it won’t do it by a wide margin. I have to be mindful before taking a large position in any security that we can get out when the time comes. Between the large and junior gold miners, there are about 40 million shares traded a day. The large and junior silver miners trade about 400,000 shares a day, which isn’t much. It’s possible to get trapped in the silver miners when it comes time to sell. For that reason alone, if we take a position in them, and I don’t believe we will, it will be very small.

Agricultural commodities looked like they were moving off their bottom the last two days but decided to revisit their bottom today. I expect prices to hold at some point because these are trading somewhere around their 50-year low. If these don’t take off and the gold miners do, I may cycle out of this position for the miners. Historically agricultural commodities go straight up when economies crash, so that’s why we have them.

  1. What happened to the stock market on Thursday?

After yesterday’s drop due to the Fed unwinding $20 billion of its balance sheet, US stocks opened higher and are reaching for the stars. After markets closed yesterday, Cisco and Walmart posted positive earnings and US news sources found out China will be sending a trade delegation in late August. When the economy slows down, Walmart always does better.

The news of a trade delegation is not new, but the markets are spinning this as a concession by the Chinese. Hardly. The meeting is between a low-level US diplomat and a low-level Chinese diplomat. This is a planned meeting, nothing more. Keep in mind, the last time China came here, Trump slapped tariffs on them.

The real news is China isn’t buying US oil. Last night I saw a report from a group who tracks oil tankers and they currently see no new shipments headed out of the US to China. This is following an announcement by the largest Chinese refiner that they will not buy any US oil in September.

With oil inventories showing a build this week and the largest consumer of oil suddenly not buying US oil, oil inventories should continue to rise, and inflation expectations should fall. This will be a big hit to the red-hot oil industry going into the mid-term elections. The timing of the Chinese delegation will be interesting because oil inventories should continue building.

Should WTI oil fall below $60/barrel, look for those holding long speculative oil contracts to bail. A fall in oil prices will reduce inflation expectations and drive Treasury bond prices higher.

The DJIA closed a gap this morning and the S&P 500 appears to be trying to close a gap 2,851.98.

Last night some volatility-controlled products began moving out of stocks and into bonds as the volatility index broke over 14. It’s all-hands-on-deck to bring volatility down and that money back into stocks. Last night foreign investors began buying agricultural commodities, which is interesting, considering foreigners are large importers of our crops. American investors continue to short agricultural commodities, but perhaps our foreign counterparts know something we don’t.

President Trump this morning was touting how good a strong dollar is for American workers, which is odd since he has previously stated he wants a weaker dollar. Perhaps someone told him tariffs and monetary tightening are dollar bullish.

Housing starts were up +0.9% and missed analyst expectations of a +7.4% rebound. Housing permits rose +1.5% which met expectations. As housing slows, so does our economy.

The Philly Fed survey crashed to 11.9 which is the lowest level since November 2016. Analysts were expecting the survey to come in at 22.0. A stronger dollar and tighter monetary conditions are signaling an economic slowdown.

Equities closed higher on the day but did fade into late afternoon trading. Treasury yields started the day higher but also faded. When the bond market doesn’t react to the equity hype, it’s a sign the equity market is mispositioned.

Physical gold closed down at $1,180/oz and the gold miners took another dump. The large and junior gold miners are trading at the lowest point in two years and are headed towards their 2015 levels. Should they get to their 2015 lows, it will be an opportunity to back the truck up to load up. Opportunities like this don’t come too often. In the meantime, I expect gold and the miners to continue to sell off.

  1. What happened to the stock market on Friday?

The stock market was relatively quiet this morning until the announcement of a US-China roadmap being established to end the trade disputes which will end with a November meeting between President Trump and President Xi. Don’t hold your breath this will end the dispute.

As I previously mentioned, China is going to buy Iranian oil next month, which President Trump is not happy about. For the moment, investors are back buying US stocks, which is pushing volatility back down. While I thought the volatility-controlled products might switch back to stocks today, they did not. Perhaps they will tonight. The goal remains: get everyone into US equities.

For all the talk about how US agricultural commodities are dead, China just paid their own self-imposed 25% tariff to offload a supply of US soybeans. As I mentioned previously, the only solution for China’s soybean demand is US soybeans.

Argentina, who is also a large exporter of soybeans and soybean byproducts, lost one-third of their soybean meal crop due to drought. To meet their export demand, they are buying US soybean meal.

French wheat is rising in price due to drought conditions in Germany, which should be a boost for US wheat producers as global wheat demand remains strong.

As global drought conditions persist, it should be bullish for US agricultural commodities.

With the renewed excitement over the end of the trade war by November, the S&P 500 closed the gap from July 9th which was at 2,851.98. Why markets tend to close gaps I don’t know, but it has been done. This market used to be lead by five stocks, but after today, there is only one stock to own – Apple. Facebook, Amazon, Netflix and Google all were in the red today, but Apple hold a large enough portion of the S&P 500 and Nasdaq-100, that it can prop the market up by itself.

Treasury yields were down in early trading but went higher after the news about China broke. By market close, yields were down slightly. Treasury short-sellers have been trying to push yields higher, but they aren’t moving. The set up for a major Treasury bond rally is in place.

Agricultural commodities jumped on the news of the trade dispute coming to an end, even though nothing may happen. With persistent global drought conditions, prices on US crops should rise.

Physical gold was up slightly, and the gold miners tried to rally but were rejected. Data on gold futures contracts show short-sellers increased their short position while long contracts held. As I mentioned in the video portion, when the long contracts give up, prices sink. For the moment, this battle is at a stalemate. I will not be opposed to seeing gold dump, so we can buy in at a lower level. Dry powder here is key!

Everyone now believes the end of the trade wars is key to global economic growth. What matters is the Federal Reserve is tightening monetary policy and the money supply is decelerating. Trade wars or not, the Fed is on track to tighten financial conditions until we have a recession.