The March of the Monetary Lags

Ask any investor if they want to repeat their losses following the dot-com and mortgage bubbles, and they will quickly say no. Somehow wiser, those same investors believe they know exactly when to jump ship, as they have learned from their mistakes of the prior two Bear markets. Despite obvious signals over the past two years, investors continue to focus on stock prices, rather than the economic data.

The mistake is waiting for stock prices to drop prior to selling, rather than understanding the deep and long lags associated the Fed’s monetary tightening that would suggest selling before stock prices fall. While Fed Chair Powell has mentioned the monetary lags are about twelve months in length, there is a lack of understanding by retail investors and most industry professionals.

Take the Nonfarm Payroll reports for example, which have a four-month lag. After a blowout payroll report in January, which showed the U.S. economy was firing on all cylinders, the February report was a complete flop. Many analysts were left perplexed as they tried to grasp the sudden drop in hiring, but it is the lags associated with hiring employees that caused the unexpected drop in the payroll report.

The decision to hire in September 2018 led to a large number of new employees on the payroll report in January. When the February report hit last week, it reflected how employers felt in October 2018. Unlike the Federal Reserve, who uses lagging government data, corporations have real-time sales data.

With the stock market giving up its strength in October 2018 and consumer spending slowing at the same time, due to the stimulative effects of the tax cuts fading from the economy, employers had little reason to hire. Based on the retail sales data from November and December, anyone expecting a blow out payroll report in the coming months will be in for a shock.

When factoring the government shut down in January, employers likely had little reason to add staff in January, which means the payroll reports through May should disappoint. It is hard to speculate if the payroll reports in the coming months will be positive or negative, but they will not be as large as they have in the prior months. Should hiring rebound, it will not be until this coming summer if the economy continues to hold up.

The lags are not just in the payroll reports, but they also show up in the money supply, in the Fed’s monetary tightenings, and in World Dollar Liquidity. The challenge with predicting monetary lags of any type, is the lags lengthen based on the amount of debt in an economy.

The reason debt is a huge factor with monetary lags is due to how society views debt. When a borrower misses enough payments on an asset, the lender takes the asset back, which puts a priority on making loan payments over discretionary spending. When the government or Fed attempts to stimulate an overindebted economy, such as ours, the effects are minimal and can take long periods before they show any benefits, simply due to the prioritization of paying debt.

Very few people understand the money supply and how it affects asset prices. If there was half the amount of money in our economy, then asset prices would eventually be half their current value. It can take time for a decelerating money supply to take hold, but when it does, the effects can be devastating.

Investors want stock prices to appreciate indefinitely, but when the money supply is decelerating, there are fewer investors who can pay a high price to buy a share of stock. During periods of monetary decelerations, high stock prices and high trading volumes do not go together. To have rising stock prices with rising trading volumes, the money supply needs to expand. Otherwise, stock prices eventually fall during periods of monetary decelerations.

What is interesting about stock prices and trading volumes, is that during prior Bull markets, trading volumes rose to the point where the bubble is burst. Since 2009, trading volumes have fallen, which suggests the recent 10-year rally in stocks is this largest Bear market rally in history.

Even real estate prices are negatively affected by a decelerating money supply. Everyone wants their property to appreciate, but during periods when the money supply is decelerating, high property values cannot be met with strong buyer demand. Without strong demand from buyers, real estate prices eventually fall as supply outpaces demand.

In an ideal world for the Federal Reserve, demand would continuously outpace supply. Regardless if it is real estate or stock prices, as long as there is strong organic demand, prices can rise. When higher asset prices come from currency-printing schemes, such as Quantitative Easing, once demand dries up, asset prices plummet. Asset prices eventually find equilibrium with the money supply, which is the price level where many consumers can afford to buy.

The recent price action of crude oil is an excellent example of an asset trying to find equilibrium. In October 2018, crude oil prices peaked around $75 per barrel, then crashed down to $43 per barrel, a price level where speculators thought oil prices were too low. As it turns out, they are not too low. The weekly crude oil inventory reports are posting large crude oil builds instead of draws, which would have validated the speculator’s view.

There are lags in the oil industry as well. When the call is made to cut production, it does not stop overnight. It can take up six months before production is dialed back, and by then, the economy still has to work through the existing inventory. Even though crude oil prices have risen, they have not fallen enough to find equilibrium.

The same happened with stock prices during the last two recessions. Stock prices needed to fall more than 40% to find a price level where many investors could buy. The same is true for real estate prices after the mortgage bubble and every other asset that got inflated due to the Fed’s easy-money policies.

There are even lags in World Dollar Liquidity (WDL), which shows the growth rate of U.S. dollars available for international trade. Rising WDL is critical to grease the wheels of global economic trade. As WDL decelerates, or contracts as it is now, stock prices and U.S. Treasury bond yields eventually follow it lower.

As the Fed tightens monetary policy and reduces the growth rate of the money supply as a byproduct, there is less money being created to make payments against all the debt. The long monetary lags slowly reduce the creation of new money, which is the purpose of tighter monetary policy, which means those who are financially marginal, slowly reach a point where their debt burden is impossible to pay.

Monetary decelerations usually led to deflation, which is why informed investors look to gold and U.S. Treasury bonds as a store of value to protect their investments. The other advantage of protecting one’s investments against deflation is the opportunity to buy risk assets after prices have significantly fallen.

This recent Fed tightening cycle is one of the longest, if not the longest in history, which suggests the monetary lags are going to affect the economy for a long time. The monetary lags indicate that stock prices, real estate prices, and Treasury yields are poised to fall. The economic data being released in March for the prior months is reflecting the beginning of an economic slowdown, which will likely lead to one of the worst global recessions in history.

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