It is hard to believe that over a month ago investors were celebrating stock prices making new all-time highs, and at the time of writing, the Dow Jones Industrial Average has shed ten thousand points or 35% in five weeks. The fastest stock market decline in history. Sadly, most investors and professionals did not believe anything could rattle the markets, let alone the economy, so they have held on hoping the fears of the Coronavirus will pass and stocks will once again reach new highs.
The Coronavirus was not the problem, but the catalyst which has exposed an overleveraged and debt-laden economy hidden beneath the shiny veneer of rising stock prices. Also, the world was already massively short dollars due to the contraction in World Dollar Liquidity that started back in December 2015 when the Federal Reserve began raising the Federal Funds Rate.
Between the Fed’s tightening monetary tightening, and a series of events over the years following, this contraction in World Dollar Liquidity has been the largest and longest in the history of the dollar being the world’s reserve currency. World Dollar Liquidity is significant since the number of dollars in the global economy is used to facilitate global trade. The expansion of dollars in the global economy is what leads to rising asset prices and increased wealth.
Until the Coronavirus arrived, the contraction in World Dollar Liquidity was barely even noticeable as rising stock prices and the Fed’s short-term dollar loan program were able to mask the true problem underneath. While I have been predicting the next recession would be the worst in our lifetimes, due to the severe contraction in World Dollar Liquidity, the speed at which this is happening is because of the economic effects of the Coronavirus.
Unlike other professionals, I do not share the rosy optimism that the economy and the stock market will quickly rebound once a cure is found. Even if the Coronavirus were to disappear tomorrow, the global economy still must deal with the largest shortage of dollars in history. Those dollars do not magically reappear even if every worker and factory return to full production tomorrow.
Even absent the Coronavirus, the economy would have eventually started contracting down to the level of dollars available in the global economy. With the global pool of dollars being destroyed faster than they are being created, the economy is going to continue contracting until the flow of global trade is restored. How far and how much the economy needs to contract before it stops is unknown, but it can be estimated.
Based on my data, World Dollar Liquidity needs to grow at a compounded rate of 10.5% per year to maintain the standard of life most Americans have come to know and love. Due to the Fed tightening monetary policy out of fears of inflation, World Dollar Liquidity has been growing at a rate of 9.25%, or about $8 trillion short of where it needs to be. To come into parity with the number of dollars, the global economy would need to shrink to 2014 levels.
There is only one solution to the World Dollar Liquidity problem. The Fed needs to monetize at least $8 trillion in debt, if not more due to the unforeseen economic damage caused by the Coronavirus. The faster the Fed chooses to monetize debt, the quicker they can restore stability to the global financial system. The notion of monetizing debt has many investors fearful of inflation, but they are completely wrong. Monetization leads to deflation, not inflation.
Many charts are circulating among financial professionals that show interest rates rising during periods of Quantitative Easing. They are somewhat misleading since yields rise due to lending demand following lower interest rates, which is why the charts show yields rising during periods of Quantitative Easing. The entire purpose of easing financial conditions is to lower interest rates, not raise them.
When the Fed lowers the Federal Funds Rate, it does so by purchasing approximately $60-70 billion of Treasury Bills. When the Fed engages in Quantitative Easing, they buy Treasury Bills, Notes and Bonds, which have the same effect as lowering the Federal Funds Rate. Yet, investors continue to get Quantitative Easing wrong, even though the two involve the Fed buying Treasury securities.
Few investors and professionals are even aware of the Money Multiplier. The Money Multiplier is algebraically defined as the M2 Money Stock divided by the Monetary Base. When the Fed engages in Quantitative Easing by buying Treasury securities, it has a direct influence on the Monetary Base. The Monetary Base rises in a nearly one-to-one ratio as the Fed purchases Treasury securities.
When the denominator of the Money Multiplier rises faster than the numerator, the Money Multiplier falls. When the Money Multiplier falls, so does inflation. The Money Multiplier is how many times money exchanges hands before it dies when it is applied to the principal value of a loan. When money dies at a faster rate, it is not inflationary.
During the Great Financial Crisis, the Money Multiplier crashed when the Fed slashed the Federal Funds Rate to 0% and engaged in the first of three rounds of Quantitative Easing. Treasury yields did not rise when the Money Multiplier crashed, they fell. Treasury yields only began rising once yields were low enough to incite lending demand.
Since most investors and professionals have not studied our monetary system or the effects of Quantitative Easing beyond a simple chart, they are still selling or shorting the Treasury bond market as they believe stock prices rise when the Fed eases. This will be the biggest mistake of their financial lives or financial careers, as stock prices and Treasury yields fall when the Fed eases. It is algebraically proven!
One of the reasons large commercial banks, the “Smart Money”, began buying large quantities of Treasury securities three years ago is they knew yields would fall when the Fed eases. They also knew the Fed would buy these bonds for a premium, giving the large commercial banks a profitable exit strategy. Anyone who had the foresight to buy Treasury securities while the rest of the world was buying stocks, is likely to realize equity-like returns in the short term as the Fed is now buying more Treasury securities in a day than they did per month following the Great Financial Crisis.
Many investors and professionals held on to their stocks believing the economy will rapidly rebound from the Coronavirus sending stock prices to new all-time highs. The belief stock prices will soon rally to new all-time highs is a fantasy built on the fact that investors and money managers failed to prepare for an economic downturn and instead loaded up on stocks without any downside protection. Their exit strategy is built on hope and a false premise.
Since 2009, according to a report by Bank of American Merrill Lynch Global Investment Strategy, corporations purchased $3.6 trillion of U.S. stocks and foreign investors purchased $200 billion of U.S. stocks. Sellers over the same period were households, to the tune of $400 billion and, insurance and pension funds who sold $1.5 trillion, to pay benefits to retired Baby Boomers. The largest buyer of stocks were corporations buying their shares back.
Corporate share buybacks peaked between 2018 and 2019 but have fallen off a cliff in 2020 due to the Coronavirus. According to a recent report by J.P. Morgan U.S. Equity Strategy and Quantitative Research, announced corporate share buybacks are $80 billion, their lowest level since 1998, and down from their peak purchase of $833 billion. Investors and professionals fail to realize that corporations buying their stock back were the reason stock prices rose since there were more buyers than sellers.
Without corporations buying their stock back, Baby Boomers, pension funds, and insurance companies will continue to sell to meet their financial needs in retirement. Stocks are more likely to fall as redemptions outpace purchases. For those who have invested in Treasury securities rather than stocks, they will soon be presented with the investment opportunity of their lifetimes.
Contrarian investors who bought Treasuries are going to have the opportunity to buy stock prices at rock bottom prices due to the global economy shutting down from the Coronavirus. Companies who are forced to take bailouts and slash dividends, perhaps even to zero, will see their stock prices fall to levels not seen for more than a decade. This will truly be the investment opportunity of a lifetime created by the biggest economic event of our life for those who choose to buy bonds instead of stocks.
Word Dollar Liquidity – The circular flow of dollars through the global economy and global trade cycle. Steven Van Metre
Monetary Base – A monetary base is the total amount of a currency that is either in general circulation in the hands of the public or in the commercial bank deposits held in the central bank’s reserves. Investopedia
M2 Money Stock – M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money. M2 is a broader measure of the money supply that M1, which just include cash and checking deposits. Investopedia
Money Multiplier – The money multiplier is the amount of money that banks generate with each dollar of reserves. Study.com Or the number of times money exchanges hands before it dies; a measure of inflation. Steven Van Metre
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