I’m hard-pressed to think of a time in my life, outside of my early childhood, where people have been more convinced that we are going to experience inflation. Little proof is needed from my early childhood because mortgage rates were 12%+ with a variable rate – some of you may remember those days. For all the talk and media hype about inflation, outside of asset prices, I’m struggling to find evidence to back these claims.
I understand the narrative – the recent tax cuts, the record government deficits and the proposed infrastructure bill should be inflationary, but they won’t be. Government transfers funded by increased deficits are deflationary, which can be proven by the last 35 years of data — as deficits and debts have risen, bond yields have fallen.
Some of the hype has to do with the better-than-average economic data posted in the latter part of 2017. However, keep in mind, there were two hurricanes in 2017 and a large California fire that boosted spending. In January, retail sales fell, car sales fell, and home sales fell. How that can be inflationary is beyond me! Maybe the American consumer is taking a breather before ramping up their spending; it’s hard to say, but given all the available economic data, there are more signs of a tapped-out consumer than a consumer who is ready to go spend.
It’s also unusual to see inflation when the growth rate in the money supply is falling (inflation is a function of either too much money in the system or too much demand). It’s clear there isn’t as much demand in the system, therefore less money in the system should lead to deflation. The Fed is actively reducing the money supply by hiking short-term interest rates and selling off their massive $4 trillion balance sheet. The Federal government is also reducing the money supply by borrowing a record amount of debt. Furthermore, the markets are reducing the money supply through higher interest rates. While the public believes inflation is coming, the data suggests otherwise.
I planned to write a piece on the money supply and velocity of money, and how that will lead to lower bond yields during the next recession. John Mauldin, one of our country’s top economists, recently posted a piece on his website titled, “The Fed Has Put Itself Out of Business, Where to Now?” In this piece, John interviews Dr. Lacy Hunt, an expert on interest rates and the money supply. If his name sounds familiar, it’s because I’ve referenced him in prior updates. John, with permission from Dr. Hunt, references Dr. Hunt’s charts and opinions on where interest rates are headed. Dr. Hunt, unlike the mainstream financial media, backs his claims up with historical evidence relating to the money supply, velocity of money and government debt. It’s a very educational read. John’s article is linked below.
Q&A with Steve – Your Questions Answered
- Why did the market surge on Wednesday, then reverse course and close down for the day?
The stock market was largely quiet until the 11 am when the Federal Reserve minutes from January were released. The initial response was that the Fed will let interest rates, and inflation, rise higher than expected which caused stocks to rise. A short while later, after bond yields rose, the markets changed their minds. This caused bonds to sell off, which then turned into a stock sell-off. The key is that higher bond yields are bearish for stocks.
- Shouldn’t the Treasury auctions push yields higher?
This is the biggest common misconception about bonds. Higher debts don’t necessarily lead to higher bond yields. When the government issues debt, which must be bought in its entirety, the new debt takes dollars out of the system and swaps them for bonds.
As dollars leave the money supply, there is less money in the system. Less money leads to less demand, which leads to lower bond yields. The main reason bond yields remain elevated is that Wall Street has convinced the public that they need to sell their bonds to buy stocks. As you know, Wall Street is heavily short bonds, so they are profiting on the publics ignorance. At some point, Wall Street will stop shorting bonds and yields will fall. This may happen sooner than later because demand is falling, which should cause bond yields to fall.
- Aren’t the tax cuts stimulative?
Only if they are met with an equal reduction in government spending, so no.
Many businesses will pay a lower tax rate, but remember, as spending falls, revenues fall, and so does taxable corporate incomes.
- What does it mean when stocks rise in the morning but fall near close?
The public buys the most in the morning and the big money sells near close. It’s a sign that liquidity is draining and that stocks are more likely to fall in the future then rise.
- Why is the public so bullish about stocks?
Mostly because they have their life savings tied up in stocks and few can afford another 2000-02 or 2008-09 event. I thought the recent 10-12% correction might be a wake-up call, but it wasn’t.
- Do you think Wednesday’s price reversal has anything to do with the Federal Reserve?
Yes. When the Fed buys or sells bonds is unknown, but it appears to affect their balance sheet on Wednesday’s. We can find out what the Fed did the prior week every Thursday, with the data being valid as of that Wednesday.
As of this Wednesday, the Fed sold off all the bonds it purchased the prior two weeks and continued on its path of selling. I’m amazed stock prices are holding against this liquidity drain.
- Isn’t the economy strong?
I hear this all the time, but a rising stock market is not an indication of a strong economy. In Trump’s first year as President, the economy grew at a rate of 2.3%, which is exactly the same rate of growth Obama saw in his first year.
On an annualized rate, looking at January from the 4th quarter of 2017, existing home sales are down double digits, single-family home starts are down, retail sales are down, inflation-adjusted weekly earnings are down, hours worked are down and manufacturing output is up slightly. Those are not signs of a robust economy.
- But the stock market is strong and it can pull the economy forward!
Maybe… but keep in mind, three stocks have accounted for half of this year’s gains – Amazon, Microsoft, and Netflix. A healthy market is where most stocks participate in the growth, not a few.
- What’s the word on entering the gold/silver miners?
This week the miners gave back their post-correction surge and have fallen below a key trendline that we’ve been following. It appears, just as they did in 2008, that the miners are still affected by any liquidity drain.
Compared to other defensive sectors, gold and silver miners have held up rather well. I expect prices to drop to their longer-term support line set back in late 2016. If prices hold there, that will signal an entry. Failure there and who knows how far they may fall.
What is different this time is that the Treasury balance at Federal Reserve banks is rising, which has been bullish for gold. Gold prices have lagged a rising Treasury balance in the past, but it’s hard to say this time what that lag will be. We do know that correlation is strong and that our government’s debt is playing a role in the markets.
I still like the opportunity because when the global economy runs into a wall and global stock markets tumble, global central banks will be forced to print an insane amount of money to fix the global economy. There are few assets that hold their value against money printing and precious metals are one of them.
For the moment we remain on hold but ready to move in once the trend changes.
- Are you sure interest rates are going to fall?
Yes, unless supply and demand dynamics have changed. So far we have seen consumers reject higher interest rates, so demand is falling. And the US Treasury is pulling money out of the economy and putting that cash into the Federal Reserve banks, which adds supply. Increasing supply with falling demand should lead to lower interest rates.
- Won’t inflation push yields higher?
How do you get inflation when demand is falling and the Fed is contracting the money supply? What we are seeing is inflation due to rising short-term interest rates. Those costs are being passed onto consumers, which so far, appear to be rejecting them.
The Fed raising rates and contracting the money supply will cause short-term bond yields to rise which will create an inflationary effect of rising prices. But inflation isn’t just rising prices; it’s a rising money supply.
Long-term bond yields are a function of supply and demand. Due to falling demand, long-term bond yields should fall.
Video Topic of the Week – The Powell Put
This week I discuss the “Powell Put,” liquidity, bond yields and momentum.
Chart of the Week – Treasury Deposits at Federal Reserve Banks
Treasury Deposits at Federal Reserve Banks affect many different asset classes. As our debt and deficits rise, the U.S. Treasury has started to affect the stock market. This week I go through how several major asset classes should perform going forward.
Portfolio Shield™ Update
Work has continued on the “new” algorithm which is nothing more than a price-trend following formula using moving averages. A couple weeks ago I shared with you a prototype that worked well, except for one potential flaw.
Moving averages always lag price. If prices are rising, a moving average will also rise, but it will be delayed. This creates a problem for writing a formula the follows a moving average.
The problem is that I can either write the formula to exit a market peak later than I’d want it to, but reenter the market early, or vice versa. There appears to be no way to exit near the top and reenter near the bottom. This is where a pure momentum strategy would be superior because momentum catches the trend before prices react. This is important because when I back-tested the moving average formula against the market bottom in 2003, it would miss the bottom by six months. A momentum formula finds the bottom three months earlier, which is an 18% difference in lost returns. Now you see the advantage of momentum over price!
The other problem with a moving average based formula is that it doesn’t work well with volatile securities. The reason that happens is due to the lag associated with a moving average. That delay would have the strategy buying as prices are falling and selling as prices are rising. Momentum doesn’t have that problem.
But as you may know, I ran into problems creating pure momentum formula and I gave up. Until this week when I revisited my old friend. The reason I went back to it was that the solution to the moving average formula just so happens to be the same solution for a momentum-based formula. The other benefit to a momentum strategy is that it can be readily adaptable to a wide variety of investments.
As it turns out I just needed to add another condition to the formula. Hopefully it will work and hopefully, I will have a back-test on the S&P 500 for you next week.