Weekly Economic Update 05-11-2018

Using High School Math to Forecast Major Economic Problems

Recently, the Congressional Budget Office announced the United States economy will continue to expand for the next ten years before experiencing a recession. A panel of experts recently stated that the next recession will not occur until late 2019 or 2020 and the American public now believes the Federal Reserve has permanently eliminated recessions. Evidence of an impending economic boom is obvious, as nearly every investor has rushed to the front of the line to buy stocks in advance of the next big Bull market in stocks. But what if everyone is wrong? Based on the Fed’s plans and simple high school algebra, it is easy to demonstrate there is a high probability the economy will be in a recession, or at least experience major problems by year’s end.

According to the National Bureau of Economic Research, the institution which identifies expansions and recessions, a recession is a decline in economic activity lasting several months or more. Economic downturns can be mild when the economy catches a cold, and they can be severe, like during the Great Financial Crisis when the economy experienced a heart attack.

In the late 1800’s to early 1900’s, economic expansions were short, lasting on average no more than four years. Recessions were equally short, lasting six to nine months, and were rather mild compared to modern-day recessions. With the intervention of the Federal Reserve, economic expansions now last about eight years on average and contractions one-and-a-half to two-years in length.

Prior to the Industrial Revolution, economies did not experience the boom-bust cycles we experience today. Central banks themselves, who are the great protectors of the economy, are the real source of recessions. Central banks implement easy money policies which lead to the creation of non-wealth generating, or profitless activities. Non-wealth generating activities, or businesses, are often early recipients of the newly printed money and would not exist if central banks did not engage in easy money policies. When the central banks tighten monetary policy, the non-wealth generating activities are forced to survive on less money, which usually causes them to fail. It is the liquidation of these profitless businesses that causes a recession.

The reason prior recessions were not as severe as modern-day recessions, is due to the length of the expansions. The longer a central bank maintains a loose-monetary policy, the more non-wealth generating activities that can be created. The Federal Reserve maintained an easy-money policy in the 1990’s that caused the dot-com bubble, in the early 2000’s that caused the mortgage bubble and in the 2010’s that have led to the largest multi-asset bubble in history.

Starting in 2016 the Federal Reserve decided it was an appropriate time to begin reducing the growth rate of the M2 money supply. Per Investopedia, the “M2” money supply includes cash, checking and savings deposits, money market securities, mutual funds, and other time deposits. The M2 money supply was algebraically defined in the 1960’s by economists Karl Brunner (1916-1989) and Allan Meltzer (1928-2017): M2 Money Supply = Monetary Base (MB) times the money multiplier (m).

The Monetary Base (MB) consists of all currency and commercial bank reserves held on deposit with the Federal Reserve, or simply, all the money in our country. The money multiplier (m) is the amount of money banks generate for each dollar held in reserve. The Federal Reserve only provides data for the “M1” money multiplier, which excludes savings deposits, money market securities, mutual funds and other time deposits, but the Fed does provide weekly data on the Monetary Base (MB) and the M2 Money Supply which can be used to calculate and graph the M2 money multiplier (m). [m = M2 / MB]

The reason the growth rate of the M2 money supply is important is because the growth rate of the M2 money supply decelerated prior to 17 of the last 21 recessions, dating back to the early 1900’s. Approximately 81% of all recessions are led by a deceleration in the money supply. The year-over-year growth rate of the M2 money supply peaked in October 2016 and has since fallen to 3.71% Historically, the growth rate of the money supply has only been this low about 14% of the time and each time the year-over-year growth rate falls below 3.70%, our economy eventually lapses into a recession or worse, depression.

The Fed reduced the monetary base by $30 billion in the last quarter of 2017, $60 billion in the first quarter of 2018 and is planning to reduce the monetary base by $90 billion this quarter, $120 billion in the third quarter of 2018 and $150 billion in the fourth quarter of 2018. The Fed plans to continue reducing the monetary base by $600 billion per year starting in 2019 and expects to continue at that pace until their balance sheet is “normalized.” This doesn’t count the Fed’s plan to further raise the Federal Funds rate three more times this year, and three-to-four times next year, which decreases the monetary base by approximately $60 billion each time they hike.

Using basic high school math and the Fed’s plan to unwind their balance sheet, the future value of the M2 money supply can be algebraically solved. We know the Monetary Base (MB) will continue to fall as long as the Fed holds to their proposed plan to continue unwinding their balance sheet. Assuming the money multiplier remains constant, the M2 money supply will achieve a zero- or possibly a negative-growth rate by the end of 2018. If not, then the growth rate will likely turn negative in the first quarter of 2019. The Fed is betting heavily the money multiplier will rise, but the banks will need to increase lending to make the money multiplier rise.

Historically, the M2 money supply has not been negative since 1930, but it has been zero or briefly negative three times between the late-1930’s and the mid-1950’s. Since the mid-1950’s, the growth rate of the M2 money supply has not been allowed to get too close to zero percent. Every time the M2 money supply approaches a zero-percent-growth rate, the Fed intervenes to stop a recession! The growth rate of the M2 money supply doesn’t need to reach zero percent to trigger a recession, but when it does, there has always been a recession.

The Fed is embarking down this undesirable path because they are following a flawed economic theory which states an economy will experience an inflationary boom when the unemployment rate reaches an artificially low level. To the Fed’s credit, there is some logic behind this theory.

As more people enter the workforce, the demand for goods and services will increase. Those newly employed workers will borrow money to buy goods and services knowing the loan payments can easily be made. As new loans are made, the money multiplier starts to increase along with the velocity of money, or how many times money exchanges hands in a year. As the money multiplier and the velocity of money increase, so does inflation.

The Fed is betting everything on their plan working. After all, they have convinced most investors their stock investments are now safe. If the Fed prevails, then they will have successfully eradicated the business cycle forever. The economy would grow indefinitely, interest rates would normalize, and the Fed could then safely remove the emergency monetary life support that has been propping up the economy for the past nine years.

In order for the Fed’s plans to work, the velocity of money would need to increase substantially, which is highly improbable. The velocity of money is simply the number of times money exchanges hands in a year. In a highly indebted economy such as ours, as money changes hands, the probabilities are high the next person in line will use the money to pay a debt. Currently, the velocity of money is at 1.43, its lowest level since 1949, and has briefly turned higher due to the insurance company payouts from the three natural disasters last year. Given the increasing amount of debt in our society, the velocity of money should continue its downtrend.

Knowing the velocity of money is unlikely to surge higher, the hope for an economic rebound is placed squarely on the shoulders of the money multiplier (m). The money multiplier works by multiplying monetary injections into the banking system by the Federal Reserve. Let’s say the Fed injects $1 billion into a bank, who can then lend $900 million, or 90%, against their newly printed reserves. The $900 million arrives at the next bank, who lends out 90% against $900 million, or $810 million. The $810 million finds its way to another bank where the process of money multiplication continues. If the money multiplier is 10, then the initial $1 billion injection by the Fed can turn into a $10 billion indirect injection into the economy. This is exactly what the Fed was hoping to accomplish from Quantitative Easing’s 1-3.

I’ve tried to find explanations of why the money multiplier is so low and what needs to happen for it to rise, but nobody seems to know. It occurred to me that the key driver of the money multiplier is money being borrowed from one bank, deposited in another bank, and borrowed again. In the aftermath of the Great Financial Crisis, there was talk about breaking up the big banks, but the Federal Reserve stated it was easier to regulate a small number of large banks rather than a large number of small banks. I know the number of banks has fallen over the years, but could the answer be that obvious?

Fortunately, the St. Louis branch of the Federal Reserve has data available on the number of Commercial banks. At the peak, in the mid-1980’s, there were 14,000 Commercial banks. Today there are 4,888, which is a 66% reduction in commercial banks. The M2 money multiplier peaked at approximately 12 in the mid-1980’s and is currently at 3.7, a 69% reduction. The fact these two are so tightly correlated is astounding! I even charted the number of Commercial banks against the M2 money multiplier and the money multiplier does follow the number of Commercial banks!

What we know is the Fed is going to continue reducing the Monetary Base (MB) and we know the velocity of money is unlikely to substantially rise due to the massive amount of debt in the economy. The money multiplier (m) should fall below 3 based during the next recession on its correlation with Commercial banks. Given the equation M2 money supply = Monetary Base (MB) * money multiplier (m), we can easily forecast the M2 money supply will continue to fall until it turns negative because the Monetary Base should continue to fall.

The implications of my research are staggering. It tells us the Fed is once again going to tighten the money supply until the economy recesses, which should happen by year’s end. The only problem this time is there are bubbles in more sectors of the economy than ever before and the majority of investors money is positioned in risk assets.

Q&A with Steve – Your Questions Answered

  1. Did you find out how many jobs were created by the Birth-Death model?

The Birth-Death model is a fictitious number made up by the Bureau of Labor Statistics to estimate the number of workers who joined the ranks of the self-employed each month. For April, the number was 45,000. Bringing the actual number of jobs created in April down to approximately 120,000, which takes some of the shine off last month’s job report.

  1. What happened to the stock market on Monday?

Traders are saying this is the most important week for stocks, as the Bulls and the Bears are in a showdown to see who is going to control the markets. The Bulls drove the market early, but on extremely low volume. By close, volume was marginally higher on the S&P 500 than it is on a day the market closes early. About an hour before close the Bears stepped in a without much effort started pushing back.

The challenge for the Bulls is they are fighting against a liquidity drain. The Bears have been patient but are stepping in at lower and lower levels. By the end of the week, one side should stand out. My guess is the Bears win out since the smart money has been selling equities since January.

In the meantime, the 200-day moving average has been the where the Bulls are buying. Keep in mind, the sign of a weak market is how high the rallies go. As the rallies off the S&P 500’s 200-DMA become weaker, it’s a sign the Bulls are getting exhausted.

Treasury yields barely moved and I don’t expect them to move much in the next day or two. Later this week there is a 10 and 30-year Treasury auction, which will indicate if demand for bonds is rising. The smart money has been buying bonds, so the big players expect interest rates to fall.

  1. What happened to the stock market on Tuesday?

The showdown between the Bulls and Bears continue. The S&P 500 tagged its 50-day moving average in early trading before the Bears stepped in, who continued to defend 2,672 level for the second day. Traders and market participants are buzzing about the recent price action, which is an indication the equity markets are “coiling” in advance of a larger move. When markets coil or oscillated up and down in an ever-tighter trading range, prices tend to burst upward or downward.

Bulls are hoping for a move upward due to their extreme leveraged positions. Bears are looking to break prices below the 200-day moving average and force the Bulls to sell. According to a recent piece by Goldman Sachs, who carefully monitors hedge fund positioning, they believe Hedge Funds will start heavily selling if the bottom of the recent support range doesn’t hold. Who’s likely to win… well, if you understand liquidity, the Bears are likely to win out. If not in the short-term, the lack of liquidity will force asset prices down.

Yields rose in early trading but fell after President Trump announced we are pulling out of the Iran deal. Tomorrow’s big 10-year Treasury auction should shed some light on foreign interest in U.S. Treasuries. Regardless of how the auction goes, it will continue to act as a liquidity drain, which puts downward pressure on equities and upward pressure on bonds.

The U.S. Dollar is in a strong zone where sellers have dominated. Most of the traders I follow who track the dollar are expecting another move down to confirm the upward trend before the real rally begins.

  1. What happened to the stock market on Wednesday?

In an effort to push the markets higher, the computer algorithms traded S&P 500 futures over its 50-day moving average in overnight trading. This brought in buyers, who on very low volume bought the FANG stocks in effort to revisit the S&P 500’s 100-day moving average. The 100-DMA earlier this year was an area of support that prices traded above. Now it’s an area of resistance where prices are trading below. Based on today’s price action, traders are signaling for new all-time highs. But weak trading volumes aren’t how rallies begin.

10-year Treasury yields were pushed up to 3% in overnight trading and spent most of the day in a very tight range. The last time the 10-year traded this high was in 2013 where markets rejected higher yields. So far markets are, despite nearly every investor being overly convinced inflation is coming.

  1. What happened to the stock market on Thursday?

Thursday was largely a repeat of Wednesday. On no major overnight news, the computer algorithms pushed the S&P 500 futures right below its 100-day moving average and then bought at open on the news that consumer price inflation slowed, and wage growth remained flat. Trading volume was again very low.

Bonds rose after the results of today’s strong 30-year Treasury auction. Momentum is starting to build steam, suggesting a long-awaited bond rally could be coming soon. The general pulse of the markets is inflation is coming in a big way. Unless something structurally changes, the deceleration in the growth rate of the money supply says otherwise.

  1. What happened to the stock market on Friday?

Very little. Stocks barely moved on the lowest trading volume of the week. Bonds rose a little.

  1. How are the big players in gold positioned?

The Speculators are long gold but have been backing off their positions. The Commercials, or the Smart Money, are positioned for gold to fall. The Smart Money is likely trying to push the Speculators out, so they can buy more gold at a lower point before driving prices higher. If it is true the Speculators should continue to exit their positions, which will drive prices down on the gold and silver miners, giving us an excellent opportunity to buy.

  1. Where are your targets on gold?

Gold (physical) is stuck between its 100- and 200-day moving averages, which is a dead zone. If prices can break above ~$1,355/oz, it would signal a buying opportunity for the miners. I think the more likely scenario at the moment is gold fall to approximately $1,260/oz, where it would also signal a buy for the miners. I think the downside move is more probable as the Speculators have been backing off their long gold futures contracts.

  1. Any news on Agricultural Commodities?

On Tuesday I watched an in-depth interview with a former agricultural commodities trader who recommended the same fund we are invested in with an upside price target of +10% from where we bought. She said plantings are down and any disruption could send prices higher. She also liked the “golden cross” in the moving averages, which is when the 50-day moving average crosses upwards through the 200-day moving average. She said the golden cross will act as price support. If summer is hotter than expected, she said that would be a strong catalyst for a rise in agriculture prices.

  1. How did the 3-Year Treasury auction go on Tuesday?

The results were mediocre at best, with foreign investors showing a lack of interest. As the Fed raises short-term interest rates, this should cause short-term bond yields to rise. The 10 and 30-year Treasury auctions on Wednesday and Thursday will be more interesting. In the meantime, weak foreign demand means the public must absorb this bond offering. As the public takes in more bonds, it drains liquidity away from stocks.

  1. How did the 10-Year Treasury auction go on Wednesday?

The auction went well with foreign buyers showing up at a level consistent with prior auction averages. The yield was below 3%, despite the secondary market thinking otherwise. As I expected, in overnight trading yields are falling. The market makers are making it clear that yields aren’t going higher.

  1. How did the 30-Year Treasury auction go on Wednesday?

The largest long-bond auction in history was strong, with foreign bidders taking 63% of the offer. The median yield was 3.1%, which is lower than the secondary market is trading. Increasing foreign demand should put the Speculators, who are short bonds, on notice.

  1. Lucky Number 7

What’s driving the stock market higher? Just seven stocks.

  1. Why does the market keep rising on low volume?

Volume is the number of shares traded per day. When volumes are rising, it is an indication of demand. Prices should rise on strong demand. When prices rise on low demand, it indicates there are few buyers. Normally market tops, in the short- or long-term occur when volume weakens.

The securities dealers have been legally selling trade information, such as where stop losses are at. Automated computer trading programs purchase this information, then buy or sell to flush out these positions. This is new to the most recent market cycle. As a result, short sellers have largely left the market and cash positions have dwindled to their lowest level in trading history.

The current market is devoid of buyers and sellers, but with far fewer sellers, these automated trading programs can move the market without much effort.

Video Topic of the Week –

Looking at the economy through Professor Milton Friedman’s interest rate theory.

Chart of the Week –

The money multiplier (m) vs Commercial Banks in the U.S.