The Money Supply Flashes Red (Again)
For the second time in the past twelve months, the growth rate of the money supply has fallen below a critical level where historically the economy experiences recessions and worse, depressions. Our economy is built on the continuous expansion of money, or more accurately—credit. If the amount of public and private debt continues to increase, then our economy will grow and asset prices will rise. When the growth rate of the money supply begins to slow, investors should take notice, as seventeen of the past twenty-one decelerations of the money supply have led to a recession.
When President Nixon took the United States off the gold standard in 1971, our economic growth became tied to the expansion of U.S dollars. Since banks are the only entity in our country that can create dollars, without the limitations of the gold standard, banks began creating new ways for consumers to borrow money. As consumers borrowed an ever-increasing amount of money, our economy expanded. To maintain a continuous economic expansion, however, there must be a continued expansion of credit to create more dollars.
The growth rate of the money supply tells us if more money is being created than destroyed and by how much. Money is created when a new loan is originated and money is destroyed when principal payments are made or when a loan defaults. As long as there is enough money to fuel the economy, the economy expands. When there is insufficient money to fuel the economy, it starts to contract.
When central bankers attempt to increase the amount of money in the economy by lowering interest rates or by injecting cash into the banking system through Quantitative Easing, it is to spur lending growth. When central bankers raise the interest rate and remove cash from the banking system, it is to slow down lending growth. The Federal Reserve has embarked on a path towards slowing lending growth which is slowing the growth rate of the money supply. By slowing the growth rate of the money supply, the Fed risks plunging our economy into a recession.
Recessions occur when the growth rate of the money supply falls below 3.7%. As of October 18th, the growth rate of our money supply has fallen to 3.5%, back where it was just before the Tax Cuts and Jobs Act of 2017 were passed. A low rate of money supply growth causes recessions because money stops flowing to money-losing entities.
When the Fed maintains a loose monetary policy for an extended period, excess money flows to money-losing entities. These businesses may have a good product or service, but without access to a seemingly unlimited amount of cheap money, the product or service would never make it to the marketplace. With access to easy money, these businesses come to life until the money stops flowing. The past two recessions clearly demonstrated what happens to money-losing, or marginal activities, when the money supply decelerates.
In the 1990’s cheap money flowed into tech stocks of companies that weren’t making any money. As the money supply decelerated, so did the ability of those profitless tech companies to access more money. In the ensuing recession, the Nasdaq-100 would drop 80%. Following the dot-com bubble, cheap money flowed into housing. As the money supply decelerated, so did the ability of borrowers to continue making their mortgage payments. In the ensuing recession, housing prices fell on average 40%. The current monetary deceleration will affect all the sectors of the economy where the cheap money flowed which will then cause asset prices to plummet, just like during the prior two recessions.
In the current cycle, cheap money flowed into the stock market, mostly into technology stocks. Money flowed into corporate bonds, where the credit quality is far worse than most corporate bond investors realize. Real estate was also a benefactor, with money flowing into high-end developments. However, as the money supply decelerates, these sectors of the economy should show the first signs of stress before they ultimately collapse during the next recession.
It isn’t the collapse of bubbles caused by the deceleration of the money supply that concerns me. It is the outright contraction of the growth rate of the money supply during the next recession which will cause a serious problem. On a year-over-year basis, the money supply rarely contracts. There are occasions during the bottom of a recession where it happens, but by that point, the Fed is already easing monetary policy to help turn the economy around. There have been three recessions where the growth rate of the money supply contracted, with the last major one being the Great Depression.
When the growth rate of the money supply contracts, asset prices rapidly fall. Once asset prices start falling, the contraction in the growth rate of the money supply accelerates. To avoid an outright collapse in asset prices, a recession should occur when the growth rate of the money supply is higher.
Back in late 2016, the economy tried to recess and the growth rate of the money supply was over 7% on a year-over-year basis, which would have given some margin to hopefully prevent a contraction in the money supply.
In December 2017 the economy tried to recess again, but the growth rate of the money supply had fallen to slightly less than 5% on a year-over-year basis, leaving a much smaller margin for error.
Today the growth rate is 3.5% on a year-over-year basis and there will be no way to avoid a contraction when the next recession hits.
Many believe the Fed will come to the rescue again by lowering the Federal Funds rate and engaging in another round of Quantitative Easing. I believe the Fed will quickly lower rates to 0%, but they do not have the ability to take the Federal Funds rate negative. Even if the Fed were to lower rates to zero and implement Quantitative Easing 4, it would be too late. Due to the long lags in monetary policy, it will take at least six months, if not twelve, before any changes in monetary policy could truly affect the economy.
The next recession and contraction in the growth rate of the money supply are already baked in. The shorter-term three-month growth rate of the money supply is rapidly nearing contraction, as the Fed plans to increase their balance sheet unwind at the end of this month. Based on the recent minutes from the last meeting of the Fed, they plan to continue unwinding their balance sheet and they are likely to raise the Federal Funds rate during their next meeting in December.
As the growth rate of the money supply heads towards contraction, the Fed will be unable to prevent it. The recent weakness in the stock market, which is being blamed on the corporate share buyback blackout, may be in response to the resumption in the deceleration in the money supply. Unfortunately for stock market bulls, corporate share buybacks do not add to the money supply. Corporate share buybacks are simply an exchange of money between the buyer, the corporation, and a seller. Money is not created nor destroyed in that transaction.
The Fed’s tightening cycle isn’t the only reason the growth rate of the money supply is going to contract. It actually has more to do with the Fed’s long-standing zero interest rate policy. The Fed tried to reignite the economy by lowering short-term interest rates to zero, but by keeping them low for so long, the Fed’s solution has increased the speed the money supply is decelerating.
With both short- and long-term interest rates rising, loan growth is also decelerating. To keep the growth rate of the money supply increasing, the economy requires more money to be borrowed than is being destroyed. The proliferation of low-interest debt is going to ultimately going to be part of the problem, as lending growth is rapidly slowing.
It’s odd to think the Fed’s solution to the Great Financial Crisis will end up creating the next financial crisis. With the money supply flashing red, investors should take notice, as this is a major warning sign. One of the reasons the next recession will be the worst in our lifetimes is due to the outright contraction of the money supply. But for those who have prepared for this, opportunities will abound as both asset prices and interest rates tend to collapse when the money supply contracts.
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Daily Market Briefs
- Thoughts from the Weekend
Next week approximately 150 S&P 500 companies are expected to announce their third-quarter earnings. Forward earnings guidance hasn’t been overly bullish, with fourth-quarter earnings expected to see a sharp deceleration as the global economy slows down.
Also next week the U.S. Treasury will auction off $276 billion of debt, which is believed to be the largest weekly bond auction in U.S. history. When the government borrows, it borrows from the wealth generators of the world – those who have U.S. dollars. Government borrowing also has the effect of draining liquidity from the financial system that might otherwise be used to buy equities.
The recent slowdown in economic activity may be partially attributed to the large government deficits. This is also perhaps why President Trump asked his cabinet to reduce their budgets by 5% or more, as someone probably told him the recent weakness in the stock market is due to how much borrowing we are doing.
Many analysts are indicating corporate share buybacks will be coming back online in the weeks to come and this will cause stock prices to rise. Remember, when a corporation buys their stock back, they are just transferring money to the seller. No new money is created. With market liquidity at very low levels and the money supply resuming its deceleration into the “danger zone,” stock prices may continue falling just like they did in late 2007 when corporations were massively buying their stock back.
- What happened to the stock market on Monday?
The S&P 500 closed below its 200-day moving average for the second day in a row. Retail investors continue to buy, as they believe this recent weakness in the stock market is a buying opportunity. Large investors are selling to the retail investors, which is evident by the increase in trading volumes.
The other factor investors should be aware of is how the rallies over the past four days have faded into the close. The daily highs have been lower each successive day. This is a sign that buyers are running out of energy. Without a catalyst to drive stock prices higher, this is an indication stock prices are headed lower. With another round of CTA selling hiding below, buyers need to step up their game quickly.
The Nasdaq-100 held over its 200-DMA, while the DJIA has closed three consecutive days below its 100-DMA. The Russell 2000 small-cap index barely moved all day.
Treasury yields were down slightly on low volume. A low volume day after heavy selling is an indication that the sellers have reached an exhaustion point.
Physical gold tried to move over its 100-DMA and was rejected once again. Gold mining stocks were down on the day, but beneath the mining stocks and physical gold is a rising 50-DMA. A confirmation against the 50-DMA should be considered bullish.
Agricultural commodities successfully defended their 100-DMA and should start moving higher.
- What happened to the stock market on Tuesday?
Following a global routing of stocks, U.S. stock indices opened below their 200-day moving averages, which are key technical levels investors watch to determine the strength in a market. When a security continuously trades below its 200-DMA, it is considered a bearish signal.
Buyers stepped into the markets early to take advantage of this drop in stock prices, as most believe strong earnings will propel the equity markets higher. Corporate earnings don’t matter when liquidity is high, but when liquidity is low as it is now, earnings start to matter. The markets will ignore a positive earnings print if the markets sense weaker earnings in the coming quarters due to tighter financial conditions.
With the Fed raising the Federal Funds rate and unwinding their balance sheet, and the Federal government running massive deficits, financial conditions are tightening. The evidence of tighter financial conditions is in the money supply, where the growth rate is about two-thirds its long-term average.
Today’s 2-year Treasury auction was met with decent foreign demand, as foreign investors took 52% of the auction. Domestic investors largely ignored the auction, leaving most of the remainder to the securities dealers. As dealers take on more inventory, liquidity conditions tighten.
Tighter liquidity is bearish for stocks and bullish for bonds.
The equity markets are in a distribution phase, which is where the “Smart Money” exits the last of their positions. The evidence is in the large downward moves, followed by retail investors buying. At some point, retail investors will be tapped out. They keep buying as the big money sells.
The S&P 500 remains below its 200-DMA, while both the Nasdaq-100 and DJIA closed above theirs. Treasury yields were down slightly on the day as short-sellers came in to defend their short positions.
Physical gold and the gold miners started the day over their 100-DMA but closed below it. Agricultural commodities successfully defended their 100-DMA for the second time.
- What happened to the stock market on Wednesday?
Stock prices are a function of liquidity, or how much money is sloshing around the financial system, and not earnings. Even though earnings are positive, stock prices are falling due to a lack of liquidity. Even with the lack of liquidity, stock prices are trading well above where they should be based on their earnings. Earnings don’t matter until they do.
New home sales plunged -5.5% MoM or even worse, -13.2% YoY. To make matters worse, mortgage applications tanked -16% from a week ago! With residential lending being the largest consumer money-generator in our economy, this is a huge signal of an economic contraction. It also indicates the resumption of the deceleration in the money supply is going to continue.
Today’s 5-year Treasury auction saw indirect, or foreign bidders, snap up a reasonable 59% of the auction. What is unexpected is that direct, or domestic bidders, were nearly non-existent. One view is direct bidders want a higher coupon for their money. The other view is that liquidity is at a premium and domestic investors are all tied up in stocks. The remainder of the auction when to the dealers, who will look to sell to their clients. Based on the reaction from the stock market, it appears liquidity is shrinking.
All major stock indices were down hard today as liquidity drained from the market and stocks gave back their gains for the year. Treasury yields were down a bit, but not as much as one might expect from a risk-off position. The speculators who are betting against Treasuries are extremely convicted about their position. When they are flushed out, and the will be, stock prices will fall even faster as they are forced to buy Treasuries to cover their short positions.
Physical gold finally made it over its 100-day moving average, but the gold miners got stuck in the equity downdraft. Nothing is signaling a move in just yet.
Agricultural commodities jumped in early trading but ran into a wall of sellers at a previously defined area where the sellers are at. Trading volumes have been relatively light, indicating the sellers are nearly tapped out. If the bulls can break through the remaining sellers, prices will quickly move higher.
Based on the information I have on the CTAs, which is probably a bit out of date as I believe they adjust their parameters daily, they should deleverage tomorrow by selling more S&P 500 futures. I suspect they will do the same with the Nasdaq-100, DJIA and Russell 2000.
Risk happens fast.
- What happened to the stock market on Thursday?
If there was ever a day the stock market needed to rally, then today is that day. With the major indices giving up their gains for the year and all below their 200-day moving averages, a bearish signal, leveraged investors likely received delinquency notices from their brokerage firms last night. A delinquency notice, or margin call, gives investors 24 hours to satisfy their delinquency.
Rather than prepare for such a notice, retail investors plowed $4 billion into the two largest S&P 500 ETFs yesterday. There are several ways to deal with a margin call: add cash to your account, sell shares or hope the market goes up enough the following day. Investors in this position will hold out until a couple hours before markets close to see if they need to sell or not.
Pending home sales fell for the fifth straight month and are now down -3.4% on a year-over-year basis. While investors believe interest rates need to rise, the housing market is indicating it is about to implode as we head into what are normally weak months for housing sales. With housing driving credit growth, any weakness here means the deceleration of the money supply will continue.
The trade deficit widened to the lowest since July 2008, when we were knee deep in a recession. Durable goods orders were up +0.8% MoM but were only up +0.1% MoM after stripping out defense spending.
Today’s $31 billion 7-year Treasury auction saw a strong showing from foreign bidders who took 64.6% of the auction. The Fed unwound just under $24 billion of Treasuries, falling just short of their monthly cap of $30 billion. The Fed didn’t have enough maturing Treasuries this month to reach their cap, but they will have no problems hitting their cap in the months that come. Not see in this auction is the first round of $20 billion in Mortgage-Backed Securities that should have also been sold today.
Normally on Fed redemption days the stock market and Treasury yields fall. With $4 billion dumped in yesterday, the market found legs. What I find notable are the last 30 minutes where the market dropped from its highs, which is usually when the “Smart Money” does its selling. Despite today’s bounce, all major indices remain below their 200-day moving averages.
Treasury yields were up slightly on the day as higher interest rates are rapidly slowing down the economy now that the fiscal stimulus from the tax cut has passed through the economy.
Alphabet (Google) and Amazon posted quarterly earnings after market close and both stocks moved down. Just as investors celebrate today’s move, two of the biggest stocks in the indices just shot straight down in after-hours trading.
Physical gold finally made it over its 100-day moving average, which has been a major headwind for a couple weeks now. Last night several gold mining companies posted earnings which were rather positive, but investors dumped their gold mining stocks today. This is setting up a confirmation of the recent bottoming pattern in the mining space. A hold here would support a move back in.
Agricultural commodities dipped slightly today but remain over their 100-day moving average. Trading volume remains light, which is an indication there aren’t many sellers left in this space. With its 50-day moving average curving up, this sector remains positioned to rally.
- What happened to the stock market on Friday?
Stocks reversed their gains from yesterday shortly after markets closed on Thursday as Asian stocks failed to rally after U.S. stocks had a strong reversal. When the Fed unwinds their balance sheet, as they did yesterday, it causes the Monetary Base to be reduced. As the Monetary Base falls, so do asset prices. Even though U.S. equities didn’t react during the day, it didn’t take them long to follow suit.
Third-quarter GDP growth came in at +3.5%, above analysts’ expectations. Underneath, 2.07% of the 3.5% increase was due to inventory building. With inventories continuing to build without sales to deplete them, the economy will likely rapidly slow down in the fourth quarter.
The University of Michigan’s buying conditions report showed consumers desire to buy homes and cars is continuing to fall. As the two largest money generators fall, so will the economy.
After two years of hearing about how Treasury yields were only going higher, the bond market staged the beginnings of what could be the largest short-squeeze in the history of the bond market. Treasury yields were down on the day as inflation expectations are quickly disappearing. This should come as no surprise to my long-time readers, as the deceleration in the money supply has already predicted there won’t be rampant inflation.
Stocks closed down on the day but they fought back against their early losses. Investors continue to buy every drop in stock prices, only to have stock prices fall again in the days that follow. Investors have been conditioned to buy every drop in stock prices, even though they don’t understand why stock prices are going to continue falling.
Both physical gold and the gold miners tried to rally but were both rejected. Agricultural commodities tried to break past the wall of sellers but also didn’t make it today. Both keep knocking at the door and eventually they will break through.
If stocks don’t rally early next week, expect more delivering. At some point, retail investors will be out of money to buy every dip, and that’s when buyers start to turn into sellers.