Weekly Economic Update 08-25-2017

The Banks are Creating a Recession (Part 2)

As a continuation of the first part of this series, The Banks are Creating a Recession, I want to cover how the banking system, money supply, and Federal Reserve relate to creating inflation and deflation. This is an important topic because when credit or asset bubbles burst, they typically cause asset prices to fall by fifty percent or more. Perhaps even worse, these deflationary forces can persist for several decades after the bubble bursts. If this happens, it will have a direct impact on every Boomer’s retirement.

Before we get started, I want to briefly cover how money is created. Money is created by the banking system when banks create new loans. The money supply expands as long as an increasing demand for credit from consumers and businesses is met by banks who are willing to extend increasing amounts of credit. Our government can only create currency, so when our government needs money, they must borrow it from the banks. When our government borrows, money is not created because the proceeds from the loan come from the existing money supply.

If you ask most people what causes inflation, they might say rising prices. But it’s what causes prices to increase that matters. The Consumer Price Index’s (CPI) two biggest components are rents and the price of oil, meaning if those rise, prices throughout the economy should rise. That isn’t sustainable inflation. Let’s say the price of oil rose to $10,000 a barrel. As oil prices rose, consumers would demand non-oil based products and energy. After all, a gallon of gas would likely be several hundred dollars or more. Price shocks like that can be transitory.

Another answer people give when asked what causes inflation is the printing of too much money. When too much money is printed, or too much of anything is created, the value of it falls. When money loses value, it takes more of it to buy something. This is why a hamburger that once cost a nickel, today costs several dollars or more. The money lost its value, not the hamburger! To understand what really causes inflation or deflation, we must go back to the money supply.

If the money supply is halved, then the economy and prices also must drop by fifty percent. If the money supply is doubled, then the economy and prices must increase by one hundred percent. It’s the latter that scares retirees, and for good reason.

A perfect example of runaway inflation is the Weimar Republic in Germany. In 1918 a dozen eggs in the Weimar Republic cost half a Reichsmark. By 1923 a dozen eggs cost four billion Reichsmarks. Reichmarks became worthless. Workers were paid twice a day and spent their money as fast as they could.  Anyone on a fixed income during that time was wiped out. The take away from what happened in the Weimar Republic isn’t that they printed an enormous amount of money, which they did, it’s how fast the money they printed changed hands. When money changes hands rapidly, inflation is created.

The speed at which money changes hands is referred to as the Velocity of Money. The Velocity of M2 Money Stock, which includes money in cash, checking and savings accounts, is tracked by our government on a quarterly basis. The Velocity of M2 Money Stock is at the lowest point since the 1950’s.

Despite the velocity of money falling to a near seventy-year low, the Fed, or Federal Reserve, has tried to stoke inflation by printing money. I know I said the government can’t increase the money supply, which is true, but the Fed can. Once the Fed finished recapitalizing the banks after the Great Financial Crisis of 2007-08, they continued to buy government bonds on the open market. By doing that, they injected cash into the money supply in exchange for U.S. Treasuries. Their plan hasn’t worked; the money supply and the velocity of money are falling.

The Fed remains optimistic that the money they printed is going to show up in the economy, even though they don’t know where it went. I can tell you that some of it ended up in the stock market in the form of stock buy backs, and some of it was funneled into the pockets of the wealthiest Americans through executive bonus programs and dividends. This money won’t come out of hiding until the depths of the next recession. When all this money does come out of hiding, it’s not likely to create much inflation. The wealthy know that when credit bubbles burst, asset prices fall. That’s when they will go on a shopping spree to buy up real estate, stocks, and businesses at half price or less. Buying these assets will not increase the velocity of money. And during the next expansion, those assets will increase in value, which means they will get even richer. This gives meaning to the phrase Cash is King, because those with cash will be able to buy assets at steeply discounted prices.

The direction that the money supply and the velocity of money is moving will determine whether we are likely to experience inflation or deflation. When the money supply and velocity of money are increasing, inflation increases, just like it did in the Weimar Republic. When the money supply is increasing and the velocity of money is falling, like it did in 2016, there will be brief spurts of inflation followed by deflation. When both the money supply and the velocity of money are falling, as they are now, there will be deflation.

This comes back to the concept that I introduced in Part 1, that the money supply is made up of circulating money and hoarded money. Circulating money is money that continues to exchange hands, while hoarded money is money that finds itself in a bank account where it stays locked away. The economy only moves as money circulates, so when money gets hoarded, as evident by the velocity of money falling, the economy contracts.

This is why the economy is weakening despite the Fed printing trillions of dollars. While the Fed can’t figure out where this money went, what I can tell you is that it went into the hands of the wealthiest Americans. Central banks have been printing money in hopes to create economic prosperity for more than one hundred years. Along the way, the wealthiest figured out ways to capture large chunks of the money for themselves. So, any time a central bank starts printing, the wealthiest try to capture as much of it as possible and lock it away in their bank accounts.

This is why in the past several decades that the wealthiest have gotten wealthier. There’s a huge income gap between the top 10% and the bottom 90%, like what it was during the 1920’s before the depression. It’s the lack of wage growth for the bottom 90% that ultimately leads to asset bubbles bursting. Central bankers have desperately tried to create wage growth and have failed repeatedly, but it hasn’t stopped them from trying. They have created the biggest asset bubble in history, with the biggest amount of debt to build it, and the bottom 90% can’t continue to pay these higher prices without wage increases. The result will be what it has been throughout history: the bubble will burst, deflation will ensue and asset prices will fall until people can afford them again.

Let’s look at various ways deflation can occur:

Bank Lending: Banks create money by lending and when more money is lent out than the prior year, the money supply expands. When payments are made against debt, money dies. Right now, there is an all-time high amount of debt and the rate-of-loan growth is contracting at the largest rate outside of a recession. Retirees also tend to pay off their debt and minimize borrowing. With the Boomer’s heading into retirement and planning to pay off their debts, this could keep the money supply at depressed levels for a couple of decades.

Loan Defaults: When borrowers default on a loan, the entire amount of the loan is removed from the money supply. While this isn’t a problem now, it will be when the recession is in full swing.

Fed Policies: The Federal Reserve can decrease the money supply by raising the Federal Fund interest rate, which they have been, and by phasing out their bond purchase program, which they are planning to do.

Rising US Dollar: When the US Dollar appreciates, people tend to hold on to it, which contracts the velocity of money. The dollar index has been falling since January. The consensus view is that the dollar will continue to fall, but it tends to rise during times of economic uncertainty.

Hoarding Money: During recessions people hoard money. Retirees, as they age, also hoard money. This could keep the velocity of money at depressed levels for a couple of decades.

Unfunded Liabilities: If there’s any one thing nobody wants to talk about, it’s all the unfunded liabilities in Social Security, public pensions and private pensions. The number to fix them all is in the tens of trillions of dollars, which is more money than we have. How or if this will be resolved remains unknown, but it will become a crisis in the next recession due to the heavy reliance on equities by both public and private pensions. If people have less income, then the money supply will fall.

Bear Market for Stocks: the typical Bear markets means that stocks are likely to fall at least fifty percent during the next recession. With the average Boomer heavily invested in stocks, this means they will have less money to spend when the equity market goes bust. A stock market crash will contract the money supply as all the leverage and speculative loans get unwound.

If any of this sounds like a good idea, it’s far from it. In December 1990, Japan’s economy and stock market peaked. Twenty-seven years later, they’ve had four recessions, the government has run about twenty-five fiscal stimulus programs and they’ve been fighting deflation the entire time. Interest rates there are at 0%. Their stock market is down about 50% from the peak set in 1990. Their central bank is the largest purchaser of sovereign debt in the world and nothing they do can fix the problem of an aging population. The reason I mention Japan, is because our central bank is headed down the same policy path as theirs and our population is aging as theirs is.

Yet today people believe that central banks can prop up economies and stock markets indefinitely. History suggests otherwise.

Video Topic of the Week

Brief discussion on Janet Yellen’s comments on algorithmic traders providing liquidity in the markets and her concern that they may not provide liquidity if there is a selloff in stocks.

Chart of the Week – Philly Fed Signals Recession

The Philadelphia Fed’s Coincident Index (1-month) is flagging that a recession is coming soon. This index has been very accurate at calling recessions.

Portfolio Shield™ Update

Next Friday will see a new allocation for the portfolio. My prediction is that the Russell 2000 will be replaced with the Treasury fund in the model.

Weekly Sector Commentary

US Equities

Not much going on in the US equity market this week. The S&P 500 made several attempts to close over its 50-day moving average after bouncing off its 100-day moving average on Monday. Sentiment is at 43% and is in a declining trend. This suggests a larger drop is coming.

US Treasuries

Ten-year Treasury yields dropped this week and are pushing back to their 6-month low at 2.1%. A break below 2.1% should send bond yields falling, which is bullish for bond prices. When the budget is passed and the Treasury can raise funds, I expect yields to fall. Until that time, I don’t expect yields to fall below 2.1%, but they might. Bond sentiment is at 58% and rising, which is becoming bullish.

Commodity Producers

Both gold and silver miners are trading inversely to bond yields again, meaning a break on the 10-year Treasury of 2.1% could kick off a rally in the miners. Looking for gold futures to break the $1,300/oz. Looking for a break that will signal us to buy and build upon those trades as the bull market in miners resumes.

Agricultural Commodities

Commodity prices found a bottom and have started to move up. They are oversold, meaning I expect buyers to see opportunity here. There has been buying despite prices falling. I am looking to sell once prices get back in the low $20’s unless there’s a break out to the upside.