Stuff about the mysterious global liquidity (dark matter).

http://www.mises.org/story/2518

 

The Yen and Monetary Liquidity

By Frank Shostak

Posted on 3/20/2007
[Subscribe at email services, tell others, or Digg this story.]

The Bank of Japan's zero interest rate policy since early 2001 has created an incentive to borrow in Japan at close to zero interest rates, and employ the borrowed money to buy high yielding assets such as US 10-year Treasury Notes.

For instance, an individual borrows ¥106,200  from a Japanese bank at 0.5% interest rate, which he then exchanges for US$900 (the exchange rate is ¥118  per US dollar). He then uses the $900 borrowed money together with his own $100 to invest in US Treasury Notes for a yield of 4.5%. After one year the $1000 becomes $1045, implying that after interest expenses of $4.5 our investor makes a profit of $40.5, which amounts to 40.5% return on his $100.

As long as the dollar stays stable or does not fall against the yen our investor is going to make a hefty return on his money.

However, the whole thing could reverse very rapidly should the US dollar depreciate against the yen. Let us say that the yen has appreciated against the US dollar and it is trading at the end of the year at ¥115 per US dollar. In this case, on the maturity date, one year after, our investor must repay $928 — this means that his profit falls to $17, or 17%. Obviously should the yen  appreciate much more — let us say to ¥112 — then his repayment to the Japanese bank in dollar terms will amount to $953 implying a loss of 8%.

So it is not surprising that most yen carry trade players have become very fearful of the recent appreciation in the yen against the US dollar. (On Thursday March 8 the price of US dollars in yen terms fell to below ¥116  against ¥118.44  at the end of February).

Most analysts maintain that the yen carry trade has boosted world liquidity and this in turn has given a boost to asset prices in all parts of the world. It is held that as a result of the strengthening in the yen an unwinding of the yen carry trade is likely to ensue, which in turn could lead to the decline in the world liquidity. A fall in world liquidity in turn could pose a serious threat to financial markets and to world economic activity, so it is held.

There is a problem with the whole notion of world liquidity. What is this term supposed to mean? Before attempting to tackle this issue we must establish what is meant by the term liquidity and what rising or falling liquidity means.

The meaning of monetary liquidity

The subject matter of liquidity emanates from the interplay between the supply and the demand for money. People demand money in order to facilitate trade. By means of money a product of one specialist is exchanged for the product of another specialist. The nub of what makes a particular thing money or a medium of exchange is that it offers to the holder of money a greater purchasing power than any other good.

In short, money (being the most marketable entity) enables an individual to secure a greater variety of goods than any other good could do, i.e., it has a much greater purchasing power than any other good.

People therefore don't want more money in their pockets as such but more purchasing power. According to Mises,

The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power.[1]

So when an increase in the demand for the medium of exchange, i.e., money, has taken place it means that people now want in their possession more purchasing power than before. With the greater purchasing power of money more goods and services can be now secured. Or we can also say that more goods and services can be now exchanged for money.

For instance, as a result of an increase in economic activity and the subsequent increase in the production of goods, an increase in demand for money emerges. Consequently, given an unchanged supply of money and a given purchasing power of money, the result is a shortage of money. So how is this shortage resolved? By what means will the increase in the demand for money be accommodated? (People now want more purchasing power than is available).

The emerging shortage of money can be labeled as a fall in monetary liquidity. This fall in liquidity sets in motion a process, which accommodates an increase in the demand for money. Since now more goods and services are going to be sold (exchanged) for an unchanged stock of money this means that prices of goods and services are going to fall, or the purchasing power of money is going to rise. (Remember that price is the amount of money per unit of a good). The increase in the purchasing power of money thus accommodates the previous increase in the demand for money for a given money supply. In short, the fall in prices eliminates the shortage of monetary liquidity.

An increase in the supply of money for a given demand for money and for a given purchasing power of money will result in a surplus of money or an increase in monetary liquidity. (There is now more money than what people require at a given demand for money and a given purchasing power of money). A given stock of goods will now be  exchanged for more money.

Consequently, this will lead to a fall in the purchasing power of money, i.e., rise in the prices of goods, the prices of assets, and the prices of services. The fall in purchasing power brings into balance the quantity of money supplied with the quantity of money demanded. In short, the rise in the prices of goods and services reduces the initial increase in monetary liquidity.

A change in monetary liquidity doesn't affect all goods and asset prices instantly — there is a time lag. As a rule the effect from a change in monetary liquidity tends to manifest first in financial asset markets before moving to the other markets.

For instance, an increase in monetary liquidity, after a short time lag, will lift the prices of financial assets (lowering financial asset yields). As time goes by, liquidity starts to enter other markets, which results in the rise of prices of goods in these markets. Consequently, as a result of the widening in the increase in prices, the surplus of liquidity dwindles.

Once the new money has filtered across most goods and services, the purchasing power of money falls in line with the demand for money — i.e., the surplus of liquidity disappears. Conversely a fall in the supply of money for a given demand will result in less money being exchanged, i.e., sold for financial assets — thereby depressing asset prices and raising their yields. A decline in monetary pumping after a time lag will hit other markets — i.e., less money will be exchanged for goods in these markets. The adjustment culminates once the purchasing power of money increases in line with the demand for money.

Is there such a thing as global liquidity?

When we talk about monetary liquidity we always refer to a surplus or a deficit with respect to a particular money like the US dollar or the Japanese yen or the European euro. Since we deal here with different moneys, obviously these moneys cannot be added up into a meaningful total. So by saying that there is an increase in world monetary liquidity, one implies that there is such a thing as total world money. As we have seen, however, such a total cannot be established.

Goods and assets in the world markets are not exchanged against non-existent world money but against specific moneys. For instance, in commodity markets most prices are quoted in US dollars. In the European stock markets prices are quoted in euros likewise in Japan the stocks are quoted in yen. Hence to ascertain the effect of liquidity on a particular market one must pay attention to the relevant money.

Since Japan doesn't print US dollars, it cannot determine the overall supply of dollars. Japan also, cannot alter the overall demand for dollars. From this we can infer that the increase in Japanese liquidity cannot have much effect on the American liquidity, all other things being equal. Consequently, Japan cannot have much say with regard to monetary liquidity of the United States or any other country.

Despite this conclusion, Japanese monetary policy has still given rise to a disruptive process in the allocation of scarce world resources. The zero-interest rate policy of the BOJ has caused a misallocation of resources by supporting various asset classes, which if not for the zero-interest rate would not have been considered. The unwinding of the yen carry trade is likely to undermine these assets.

What ultimately matters for stock markets in various countries is the state of monetary liquidity in a given country and the state of its pool of real funding. For instance, in the case of the United States, what will matter is the state of US dollar liquidity. So regardless of the yen carry trade, if the liquidity is going to be there, and the pool of real funding is still growing, then US financial markets will continue to hold their ground.

On this score, after falling to 1% in August last year the growth momentum of our US monetary measure AMS has struggled to form a rising trend. The yearly rate of growth after climbing to 2.1% in November eased to 1.3% in February. However, on account of a weakening in the growth momentum of economic activity, the growth momentum of our measure of liquidity has been in a visible rebound since August last year (see chart). This in turn should provide support for US financial markets regardless of the yen carry trade.

The unwinding of the yen carry trade cannot alter the other countries' liquidity, all other things being equal, but it can weaken Japan's liquidity. The unwinding of the yen carry trade could undermine Japanese liquidity only if Japanese banks do not replace the repaid loans from the unwinding of the carry trade with new lending. (We assume here that the loans were created out of "thin air.")

So in this case the unwinding of the yen carry trade could be negative for Japanese financial assets, all other things being equal. A similar effect on liquidity will also take place as a result of any credit contract (the loan was created out of "thin air") that has reached its maturity date and the loan is repaid and not replaced with a new loan.

For now, the growth momentum of Japanese monetary liquidity displays a visible strengthening. After falling to negative 10.3% in July last year, the yearly rate of growth of monetary liquidity jumped to negative 4.5% in February. The growth momentum of bank credit to the private sector has been in positive territory for the past thirteen months. The yearly rate of growth stood at 1.4% in February against 1.8%  the month before.

An important factor in the recent strengthening of the yen against the US dollar is a tighter interest rate stance of the BOJ. Since July last year the interbank call rate was pushed from zero to 0.5%. Consequently, the yield on the 3-month Treasury bill rose from 0.34% in July 2006 to 0.59% in February. We suspect that a visible fall in the growth momentum of the core price inflation might bring to a halt the present tighter interest rate stance. (The yearly rate of growth of the core CPI fell from 0.3% in August last year to zero in February.)

Additionally, the relative money growth differential between Japan and the United States has visibly moved in favor of the US dollar versus the yen. We suggest this could put a break on the fall in the US dollar against the yen in the months ahead.

To conclude then, as long as the pool of real funding available to Americans is still growing, and as long as the growth momentum of liquidity is heading up, US financial markets will remain well supported regardless of the yen carry trade.

http://www.hussmanfunds.com/wmc/wmc070312.htm

March 12, 2007

The "Money Flow" Myth and the "Liquidity" Trap

John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy

I'm pleased to note that, including reinvested distributions, the Strategic Growth Fund achieved record highs in each of the past two weeks – one while the market was declining, and one while the market was advancing. The Fund is intended to outperform the general market over the complete market cycle (bull market and bear market combined), with smaller periodic losses, on average. As detailed in the latest semi-annual report, I estimate that we would require a moderate correction in the area of 10% (though far less than a typical bear market) to put the Fund ahead of the S&P 500 for the largely uncorrected period from 2004 to the present. The market has run the second-longest stretch in history without a 10% correction. The Fund's performance record over longer periods, as well as its risk profile, does encompass a complete market cycle.

---

Wall Street seems to making excessively confident use of the past tense in discussions of the recent market pullback. It strikes me as a potentially dangerous mistake to interpret the warning shot of recent weeks as a starting gun. While it's certainly possible that the market will advance further, even a modest further advance will quickly re-establish the overextended conditions which ultimately forced the recent slide in the first place.

On the positive side, market internals did not deteriorate enough during the recent pullback to signal a change in investors' willingness to take risk. That allowed us to soften our hedge somewhat on the decline. For now, the evidence does suggest that investors remain willing to speculate (even if that speculation is of the “damn the torpedoes” variety). On the negative side, the market is a stone's throw from refreshing the overvalued, overbought, overbullish, yields-rising condition we've dubbed “ovoboby” (Investopedia chose that as their word of the day early last week, which was very funny).

The upshot is that we currently observe little upside to further speculation. Having lifted a portion of our hedges (using call options only) in the depths of the recent decline, we've benefited from the latest rebound. Still, I clipped off a small portion of that exposure on last week's advance. Despite rich valuations (on the basis of any measure other than the landmine of “forward operating earnings”), market action remains constructive enough to warrant a modest amount of “one-sided” market exposure using call options. Again however, there is not much remaining distance to the point where the market would again be overextended enough to sound a shrill warning.

The “money flow” myth

I am increasingly losing confidence that Wall Street operates on a well-defined base of knowledge. Instead, I am struck by the number of platitudes and false constructs that seem to dominate the investment management industry.

First, we should be very clear that there is no such thing as money going into or out of a secondary market. When stocks are issued in an IPO, or bonds are floated to investors, companies receive funds from investors and, in return, give investors pieces of paper called stocks and bonds, as evidence of the investors' claim on some future stream of cash. This is a “primary market” transaction.

Once those pieces of paper are issued, they are traded between investors in the “secondary market.” When we talk about the stock market, we're talking almost exclusively about the secondary market, because new issues make up a very small part of total activity.

Dear Wall Street analysts and financial reporters – when investors purchase a stock in the secondary market, the dollars that buyers bring “into” the market are immediately taken “out of” the market in the hands of the sellers. It is an exchange. This is why the place it happens is called a “stock exchange.” The stock market is not an air balloon into which money goes in or out and expands or contracts that balloon. Nor is it a water balloon that is expanded by pouring in “liquidity.” Prices are not driven by the amount of money that buyers “put in” or sellers “take out” (as those dollar amounts are identical). Prices are determined by the relative eagerness of the buyer versus the seller.

If a dentist in Poughkeepsie is willing to pay up 10 cents to buy a single share of General Electric, the total market value of General Electric increases by over $1 billion (GE has 10.28 billion shares outstanding - do the math). In this way, market capitalization can be created and destroyed out of thin air and on the smallest of trading volumes. So you'd better be sure that the there is a sound and fairly reliable stream of expected cash flows backing up the value of the securities you're buying.

Cash does not ever find a “home” in a secondary market. Every time you hear the phrase “investors are putting money into…” or “investors are taking money out of …” or “money is flowing out of … and into …,” it is a signal that the speaker is unable to distinguish a secondary market from a primary one.

As I used to teach my students, if Mickey sells his money market fund to buy stocks from Ricky, the money market fund has to sell some of its T-bills or commercial paper to Nicky, whose cash goes to Mickey, who uses the cash to buy stocks from Ricky. In the end, the cash that was held by Nicky is now held by Ricky, the money market securities that were held by Mickey are now held by Nicky, and the stock that was held by Ricky is now held by Mickey. There may have been some change in the relative prices between cash, money market securities and stocks, depending on which of the three was most eager, but there is precisely the same amount of “cash on the sidelines” after that set of transactions as there was before it.

The “liquidity” trap

I'm similarly convinced that Wall Street has no idea what it's talking about when it uses the word “liquidity.” While using the phrase “global liquidity” lends a further element of worldly sophistication, Wall Street still hasn't the slightest idea what it's talking about. The phenomenon that's being called “liquidity” is nothing more than a combination of fiscal irresponsibility and risk blindness, and will ultimately prove itself to be the time-bomb that it is when investors begin to “re-price” that risk.

Let's go back to basics. If the economy produces output valued at $100, we can classify that $100 as either consumption or investment. Let's say that $80 represents “consumption.” We define “savings” as the portion of output that wasn't consumed ($100-$80), which is $20. Not surprisingly, that's exactly the value of the stuff we classified as “investment.” It's an accounting identity that saving always equals investment (always – if the investment goods weren't sold, the income wasn't generated, and the saving didn't happen).

If we look at individual actors in the economy, it will generally be true that some of them want to save part of what they have, and some of them want to invest more than they have. So we need a way for savers to transfer their income to the people who want to use those savings. This is done by issuing securities. Money is transferred from the saver to the spender, and the spender issues a receipt which offers some hope of repayment in the future.

Here is the crucial point. Once a security is issued, that piece of paper thereafter represents savings that have already been deployed in order to purchase investment goods and services (factories, equipment, housing, computers, and so forth).

The security is simply a receipt. It means that at some point in the past, someone produced goods and services without consuming them, and someone consumed or invested in goods and services without producing them. That change of ownership was accomplished by issuing that stock, or bond, or IOU. Again, it represents money that has already been spent – goods and services that have already been deployed.

Now consider government and foreign trade. The U.S. is currently running massive federal deficits, and massive current account deficits. What's really happening here is that we are, in aggregate, consuming more than we produce, and foreigners are producing more than they consume. This difference requires the issuance of a huge volume of new securities to enact that transfer of purchasing power. The resulting mountain of issued securities does not represent newly created money looking for a home, or looking to be spent. It has already been spent! And we've spent it.

Specifically, the U.S. has issued huge volumes of Treasury securities that have been purchased, largely, by China and Japan . There's your global liquidity. It's a monstrous stock of Treasury debt that represents the claims of foreigners on our future production. That's in addition, of course, to the enormous inter-generational claims that we've promised via Social Security and Medicaid, which place further burdens on our future production.

So yes, enormous volumes of securities, primarily U.S. Treasuries and mortgage securities, have been issued in recent years. Foreigners hold a staggering quantity of the Treasury securities. Our own financial system holds direct and indirect claims on a lot of the toxic stuff like mortgage debt. Wall Street talks about all of this using the upbeat term “liquidity.” But what it really represents is a crushing pile of claims on our future production, as well as high risk junk, some of which (like sub-prime mortgage debt) is already starting to go belly-up. This is not money “looking for a home.” It is a pile of IOU's for money that has already been spent.

To understand the importance of this to the “money on the sidelines” mirage and the “liquidity sloshing around looking for a home” fallacy, notice that as the U.S. issues more Treasury debt, that debt simply must be held by someone. It is clear, then, that we must by necessity observe a rising stock of apparent “money on the sidelines” in the form of Treasuries on the balance sheets of foreign central banks, U.S. corporations, and individual investors. There is no other way. Again, these securities represent spending that our government has already done. It is not wealth (at least, not to the U.S. ) but a claim on future production. Nor it is money that “has to find a home.” It has already arrived, moved in, and in many cases, trashed the place. If somebody sells these bonds to buy stocks, somebody else has to buy the bonds and sell the stocks. In aggregate, no money goes into or out of either stocks or bonds by virtue of such transactions.

With regard to the “yen carry trade,” want to know who is the largest investor in that trade? Simple: the nation of Japan. It is the Japanese themselves who are most active in selling yen, buying dollars, and investing in U.S. Treasuries at higher yields. Japan has done this, as China has with its currency, in order to support the value of the U.S. dollar. But as their ownership of Treasury securities has grown, the potential cost of any realignment of exchange rates is becoming dangerously high, so both countries are beginning to diversify their central bank assets into other currencies such as the euro. Accumulating U.S. securities may have been fun while it lasted, but China and Japan are beginning to realize that the U.S. government has no plans to restrain its fiscal irresponsibility (largely because it lacks the capacity for constructive diplomacy).

This will end badly. “Global liquidity” is not a positive for U.S. markets. It is simply evidence of the existing claims of other nations against our future prosperity. There will be an increasing amount of apparent “money on the sidelines” in the years ahead, for the simple reason that the U.S. government will keep issuing securities and somebody will have to hold them.

Total return experiments

Near-term considerations for the stock market aside, I am sometimes asked what the prospects are for stock returns perhaps five years ahead. In general, a 10-year horizon is more reliable because speculative influences wash out to a greater extent, but some observations on this may be useful.

I've noted for some time that S&P 500 earnings are at the very top of their long-term 6% peak-to-peak growth trendline – a level of earnings that has typically been associated with an average price/earnings multiple of 10 (not the current 17). See last week's market comment for a review of these conditions. Meanwhile, the dividend yield on the S&P 500 is about 1.9%.

We can imagine a few reasonably optimistic outcomes. First, suppose that record profit margins are persistently maintained, so that earnings continue to grow along the very peak of their 6% growth trend. Rather than assuming the price/earnings multiple on these peak, record-margin earnings will fall to anywhere near 10, let's assume that 5 years from now, the multiple merely touches 15 (just two points lower than presently). Given that assumption, the 5-year S&P 500 total return would work out to be:

1.06(15/17)^(1/5) + .019(17/15+1)/2 – 1 = 5.41% annually.

Alternatively, we could assume that given extremely wide profit margins and rising unit labor costs, profit margins will normalize somewhat in the coming years. Assuming continued revenue growth at 6% annually, profit margins would still have to be above their historical norms 5 years from now just for earnings to remain at present levels. As it happens, we can identify many historical periods where earnings did not, in fact, grow over a 5-year period, and not surprisingly, those periods generally started when earnings were at the peak of their long-term 6% growth trend. But let's not be too dour. Let's also assume that the price/earnings ratio on the S&P 500 will increase to 19, which would still be a rich valuation on earnings at that point. Given those assumptions, the 5-year S&P 500 total return would be approximately:

(19/17)^(1/5) + .019(17/19+1)/2 – 1 = 4.05% annually.

Neither of these cases require particularly negative or bearish assumptions, but they imply quite unsatisfactory long term returns, which underscores the point that rich valuations rarely deliver pleasant long-term results.

In order for the S&P 500 to achieve a “normal” annual return of about 11% over the coming 5 years, we have to assume a maintenance of record margins, sustained top-of-channel earnings growth (which has never before been sustained for such a period), and an expansion of valuations to a multiple of 20 times peak earnings (the same multiple as at the 1929 and 1987 peaks, which is double the average historical multiple on top-of-channel earnings). Investors should think now about whether these assumptions are plausible, because they may find themselves wondering later why they ever did.

My impression is that the probable expectation for total returns on the S&P 500 over the coming 5-years is below 5% annually, in a likely interval that includes zero. It takes implausibly optimistic assumptions to move substantially above that range.

As for 10-year returns, for which the historical evidence has typically allowed tighter confidence intervals, the following chart updates the study that appeared in the February 22, 2005 market comment (“The Likely Range of Market Returns in the Coming Decade”) using the same methodology. Note that actual market returns moved outside of the typical range only during the late 1990's bubble, and that the most recent 10-year return of about 7.6% since 1997 has been at the top of the expected range precisely because current valuations are at the top of historical norms.

Currently, the likely range for S&P 500 returns over the coming decade is between a -3% annual loss and a 5% annual return, centering in the low single digits. That range will seem preposterous to some investors, but remember that it took the late 1990's market bubble to move actual returns even 5% outside of this set of bands. Unless investors anticipate a repeated excursion into similar valuation extremes, it would be a good idea for them to recognize now, rather than later, that stocks are unlikely to produce satisfactory long-term returns from current valuations.

On the bright side, there is nothing that prevents us from hedging risk during portions the coming years when valuations and market action are unfavorable, and accepting risk during the many likely periods when one or both of those factors are favorable. Nor does it prevent us from constructing portfolios of stocks which appear more favorably valued than the major indices. A buy-and-hold approach on the S&P 500 has produced a total return of about zero since 2000, but that has not prevented our more flexible investment strategy from achieving very satisfactory returns at contained risk.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and modestly favorable market action. There is not much room between current levels and a level that would represent overextended market conditions (from which stocks have typically produced average returns below Treasury bill yields). A 2-4% further advance would remove the basis for even modest speculation – our current exposure uses a limited position in call options only. A 4-6% further advance would most likely re-establish extreme overvalued, overbought, overbullish, yields-rising condition that has typically resulted in hostile declines. We need not actually revisit those conditions to be concerned, even here, about the potential for a much deeper correction. Suffice it to say that while we're willing to accept a limited exposure to market fluctuations using call options, even a moderate further advance will probably remove that willingness. Meanwhile, our essential downside protection remains largely in place.

In bonds, the Market Climate was characterized last week by moderately unfavorable valuations and relatively neutral market action. Unit labor costs increased at a 6.6% rate (quarterly, annualized) in the latest report (note that these already adjust for productivity growth), and the highest year-over-year rate in 6 years. Labor costs have been pushing higher both in financial and non-financial sectors, so the argument that the increase was due to Wall Street bonuses is a canard.

While the bond market seems trapped between upward inflation surprises and downward economic surprises, the larger picture is one of relatively low long-term yields, inflation slightly but persistently above comfortable levels, and an inverted yield curve. Keep in mind that it would take 7 or 8 quarter point reductions in short-term interest rates to minimally normalize the yield curve, even holding long-term interest rates constant. Accordingly, the prevailing structure of yields provides little basis for a long-duration investment position in Treasury bonds. With the emerging weakness in sub-prime mortgage debt, credit spreads are waking up slightly, but we still don't observe the sort of spike that would convey pressing recession risks or deflationary pressures. That doesn't rule out such risks from emerging over the months ahead – only that we're not observing them in the indicators that typically provide red flags.

For now, both stocks and bonds appear priced to deliver relatively unsatisfactory long-term returns for the risks involved. Stock market investors are still expressing a preference to speculate, at least on the basis of price/volume behavior, but we are not far from the point where stocks could again be characterized as overextended.

In the Strategic Growth Fund, current investment conditions allow us to accept modest speculative exposure (our investment position looks essentially like a fully hedged stance plus a reasonable number of in-the-money call options). If the market encounters further downward pressure, our investment position will look increasingly like a full hedge, without requiring us to manage risk by selling into a decline.

In the Strategic Total Return Fund, we continue to hold a short-duration investment stance, mostly in Treasury Inflation Protected Securities. The Fund also holds about 20% of assets in precious metals shares. It's worth noting that the fairly simple but generally useful Gold/XAU ratio is now pushing close to 5.0, though it has not breached that level.

To reiterate my remarks on the Gold/XAU ratio from the May 2, 2005 comment:

“To put some historical context on this measure, since 1974, the Gold/XAU ratio has been greater than 5.0 about 15% of the time. When the ratio has been this high, the XAU has followed with annualized gains of 89.6%, on average – a figure that remains high even if the data is split into multiple samples. When the ratio has been greater than 4.0, the XAU has followed with average annualized gains of 27.4% (though the finer profile of returns has been sensitive to other conditions such as interest rates, economic trends, and inflation). In contrast, when the ratio has been less than 3.0 (meaning that the gold stocks are very elevated relative to the actual metal), the XAU has declined at an annualized rate of -36.6%, on average.

“Importantly, the return/risk profile for precious metals shares is strengthened further if the economy is experiencing weakness. For example, when the Gold/XAU ratio has been greater than 5.0 and the ISM Purchasing Managers Index has been less than 50 (indicating a contracting U.S. manufacturing sector), gold shares have appreciated at an average annualized rate of 125.6%. In contrast, when the Gold/XAU ratio has been less than 3.0 and the Purchasing Managers Index has been greater than 50, precious metals shares have plunged at an average annualized rate of -49.9%.”

Such strong periods for gold are also generally associated with weakness in the U.S. dollar. Something to think about as the economic picture evolves in the months ahead.

Well worth the time to look at these charts. Take a look at Chart 3 in  particular. Is it any wonder that the markets are climbing with the FED pumping away through the repo market?

Now the question is: Who can fight the FED? And when will they run out of ammo (because I sure am!).

Enjoy!

Graham

http://www.nowandfutures.com/fed_watch.html

 

Federal Reserve forecasting and watching

Warning, complex economics below (also see our intervention page)

Repos, comm'l & Fed

Securities Lending

Monetary base

SOMA

Reserves

Credit

ESF

Money supply

Program trading

GSDS

All Fed actions

Velocity

On all charts, pay particular attention to the direction and trend of the rate of changes line(s).

Also, the Fed is not omnipotent and neither are we - the charts below are intended as guides and not guarantees.

What does the Fed want the US stock markets to do?

The first chart shows repos and their almost immediate effects from changes in outstanding repo balances. The 2nd one assumes an approximate 41 week time lag until another effect is created on the Dow. The relationships have been fairly stable since 2002.

The 3rd one also shows how relatively fast or slow that repos are being created since its not always clear in the 1st one. Stock market support in late 2002 and early 2003 is particularly visible.

The basic theory behind its workability is that the large banks use the repo loans to buy & sell stocks.

Definition         Source        

Click here for the repo and Dow picture since 1980.

---

What does the Fed want to happen to interest rates?

There is a strong parallel or correlation between what interest rates do and how the rate of change of Securities Lending moves. As of April/May 2006, it appears that interest rates are not doing what the Fed seems to desire.

Definition         Source <!--         SecLend & bonds -->

---

How much is the Fed concerned about U.S. inflation and/or deflation (and doing something about it)?

We see here that the Fed was concerned about inflation in 2000, moved to lower it, then likely judged they went too far and moved back up in 2001. There was also a large spike starting 9/11/2001.
Since then and up to early 2006, it has gradually been lowering the rate of money creation as measured by the monetary base.

Definition        Source

How strongly do other central banks feel about the US dollar?
How much are other central banks helping to monetize US debt?

Definition         Source

Agencies only chart (chart above is total custodials)

Starting in roughly August of 2004, the interest of foreign central banks in the US dollar as measured by custodials has been declining.

Here is another view of confidence of other central banks in the dollar It shows how much of their reserves are placed in dollars over the last few years, and their relative lack of confidence since 2002 and up to when this was written in early 2006.

How much is the Fed supporting US Treasury Bonds and/or monetizing some of the debt?

Definition         Source

How easy is the Fed making money to borrow?

Definition         Source 1 Source 2

Notice that there has been plenty of reserves available at the banks for borrowing by the public during the entire period of the chart, regardless of the level of interest rates. Here's the same data going back to 1970.

Definition         Source

Notice that, as of mid 2006 and in spite of interest rates having gone up significantly, Fed credit is still growing at about a 5% rate and has sped up since late 2005. Also notice that large drops in Fed credit have a correlation, after a lag of a few months, with drops in the U.S. stock market.

---

All major Fed operations plus custodials, showing the running total

Please see the glossary for all definitions          Source

Same data, going back to mid 1996     

---

Where is the value of the dollar going, per the Exchange Stabilization Fund?

Source

Same data, from 1998 through currently available data, showing major & likely tradable trend changes.
As of the mid 2006 data, it appears that the dollar trend will be down.

---

How fast is money moving through the U.S. economy?

The actual money of money and credit being created is only part of the picture. Velocity must also be factored in since it affects the amount of total money in an economic system. Velocity is low in a depression and high in a hyperinflation.

Definition         Source: Fed & BEA
(Note: the huge jump in M1 / Base in 1984 was due to a definition change in base)

---

Various recent credit and money supply data, rates of changes

Definition         Source

Money supply, 1950-2005      Money supply, 1879-2006      Money supply, 1920-1940      Money supply, 1980-

---

Program trading

Definition         Source

Program trading, 1999-2006     

---

How easy are credit standards?

Five-year Loan Officer Survey
(percent tightening standards for loans)
from BullAndBearWise.com

---

<!--



-->

GSDS - Government Securities Dealer Statistics - totalGSDS - Government Securities Dealer Statistics - componentsGSDS - Government Securities Dealer Statistics - component, changes rateDefinition         Source

---

A historical perspection on the Federal Reserve's Monetary Aggregates: Definition, construction and targeting

---

Fed Chairman Ben Bernanke on Inflation Targeting

"First, making inflation targeting explicit would serve the important goal of ensuring continuity in monetary policy, or at least of increasing the likelihood that future policy would take the same general approach as recent policy has taken. In particular, if the inflation- targeting regime were made explicit, the transition from the current chairman to the next one would create less anxiety in financial markets and for the economy than otherwise. Second, transparency enhances the stabilizing properties of forward-looking policies. In particular, in the simulations reported in this paper we implicitly assumed transparency of policy, in that private-sector actors were assumed to know the policy rule. The results might be very different if, for example, we assumed that private agents thought the central bank was following the accommodative rule when, in fact, it was following the more aggressive inflation- targeting policy. Likewise, much of the stabilizing effect of our recommended policy arises because investors expect the central bank to raise interest rates when rising asset prices threaten to overheat the economy, and vice versa if declining asset prices threaten to induce an economic contraction. From the standpoint of maintaining both macroeconomic and financial stability in the future, the desirability of increased transparency in U.S. monetary policymaking is a topic deserving of close attention in the Fed's planning."

Source: Monetary Policy and Asset Price Volatility Bernanke 1999 (pdf)

Fed Chairman Ben Bernanke, etc. on Fed actions

"There is some evidence that central bank communications can help to shape public expectations of future policy actions and that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset."

Source: Monetary Policy Alternatives at the Zero Bound

Is the Fed really "pumping money"?

By Michael Shedlock

 

I had a very interesting email exchange with three Minyanville professors about whether or not the Fed is "pumping money". The three professors are Fil Zucchi, John Succo, and Scott Reamer.

The discussion started off with an email to Fil Zucchi so let's start there.

Mish to Professor Zucchi

 

Fil, I would like to discuss a comment you made about the “Fed pumping money”. I am not trying to nitpick but "pumping money" doesn't seem to be the best description of what is really happening. Here is how I look at things:

This Fed has chosen to defend an interest rate target. The Fed must supply all demand for credit at that target. If the Fed failed to do so the interest rate target would not be hit and interest rates would either rise or drop accordingly.

Now I am a big fan of abolishing the Fed and letting the market set rates, but as long as the Fed has an interest rate target (as opposed to a money supply target) the Fed is not pumping money per se, the Fed is defending an arbitrary target that it has established, no more no less. Thus it is not the Fed initiating anything, the Fed is merely meeting demand for money at the arbitrary target they set.

Now if the Fed instead set money supply targets instead of interest rate targets then interest rates would float day to day and money supply policy would be known. Yet every day I hear the same comments every day “The Fed is pumping to save housing” or “The Fed is pumping to save the stock market” or “The Fed is pumping the PPT”. All of this kind of talk seems ass backwards to me. The Fed is meeting money supply demands at its target. Period. Typically the Fed has been meeting demand for money with repos. Repos are short term loans, not part of permanent money supply.

But people take these ideas about “pumping” as well as conspiracy theories about M3 and draw still more inaccurate conclusions as to what is going on. I can and will make a case that looking at M3 in isolation is missing the big picture (at least from an Austrian perspective) as to what is really going on with money supply. But that is another issue for Friday or early next week in my blog.

Right now, it’s time to clear up this “pumping money” issue. Claims that the “Fed is pumping money” is putting the cart before the horse because by defending an interest rate target instead of a money supply target the Fed does NOT have a choice as to what the demand for money will be at its designated (and arbitrary) target currently set at 5.25%.

In essence I feel that "pumping money" statements only serve to reinforce various conspiracy theories that are now running rampant. If I am mistaken then perhaps you or John Succo or Scott Reamer can clear up my misconceptions and I welcome the opportunity to learn.

 

Response from Professor Zucchi

 

HI Mish – great points and I understand what your saying, but I am not sure I agree entirely with it. A response will require me to wear my thinking cap for a while, but I’ll certainly post one. Meanwhile I’m gonna send this on to Succo, Reamer and Sedacca as I imagine they may wanna give a crack at it as well. Hear u soon, Fil

Response from Professor Succo

Both are right…we are picking over semantics.

The Fed has set an artificially low interest rate. The market wants higher rates because it sees the problems these low rates are causing: that money is getting into speculation and very low grade credit. The Fed must supply enough new credit (repo) in order to keep rates from rising. The recent steepening of the yield curve is telling us that this is hard to do: they are doing too many repos trying to keep rates low.

If the Fed wants to stop pumping money they would admit that rates are too low and would raise them.

In fact the recent steepening is very alarming. It is due to defaults/foreclosures/ where lenders are saying they cannot continue to pass on to speculators/low quality borrowers all that new credit the fed is trying to force into the market.

An inverted yield curve normally predicts a recession. That recession comes home to roost when the yield curve suddenly steepens our of that inversion: the market is tightening out of necessity just as the fed is trying to make it not to.

 

 

Response from Professor Reamer

 

There is another operational element here that very few folks appreciate and it is this: In setting the fed funds target rate and defending it, the Fed’s open market operations take the form of either pumping liquidity into or out of the banking system (via Fed Funds) in an effort to keep the target rate at (for now) 5.25%.

Let’s say that economic activity is heating up; there is more manufacturing activity, more employment, more lending by banks and as a result of all of those, more demand for short term monies by commercial banks. Bank lending activity goes up and their demand for short term money (the cost of which is set by the Fed) increases commensurate with their need to keep capital/coverage ratios at whatever bare minimum regulations demand they be. So, net/net greater economic activity implies more money demand by commercial banks. If money demand by commercial banks increased, in the absence of the Fed, we would see the ‘cost’ of the money (the interest rate) do what?

Like all goods, when the demand for something goes up, the price increases in the short run. So in the case of short term (Fed) funds, increased economic activity generates greater demand for short term funds by commercial banks and that increases the cost of those monies – increases the interest rate of these monies. But the rate – cost – of Fed Funds is 5.25% and the good boys at the NY Fed have pledged that it will defend the FOMC’s Fed Funds target – neither letting it rise nor fall. But if increased economic activity is driving up the Fed Funds rate, then the Fed must increase the supply of credit in an attempt to keep the rate at 5.25%. This is of course a basic law of economics: in the face of increased demand, prices rise. The only thing that can keep prices the SAME would be an immediate increase in supply. And that is what the NY Fed does when economic activity increases – they increase the supply of monies in the system (via repos and other means) in order to defend that Fed Funds target.

More interesting than that is what happens when economic decreases. The opposite situation arrives: when economic activity decreases the demand from commercial banks for short term funds decreases and thus the price (rate) falls. In order to maintain and defend that fed funds target in a scenario where economic activity is decreasing and lending activity is slowing, the Fed has to decrease the supply of monies available to the system. Thus, the Fed will be taking money from the system once economic activity decreases unless and until they change the Fed Funds rate target.

That period of time between a slowdown in economic activity and an eventual decrease in the Fed Funds rate can take months or quarters. If the size and severity of the misallocation of investments in the economy are significant, that period where the NY Fed open market desk is defending the FOMC’s rate by decreasing monies in the system, need not be lengthy at all to create the kind of tightening of monies that is so anathema to a credit-driven, asset-based economy. A few months of taking money out of the system in order to defend a Fed funds target is all that is theoretically needed to create the type of tail event that we believe it highly probable in the credit and stock markets, not to mention the real economy.

The conditions of decreasing economic activity are present; the malinvestments are both huge and pervasive; the Fed could easily start to take money out of the system to keep the Fed Funds rate at 5.25%; and commercial bank lending declined last week more than it has at any time since February 1960. Those are the conditions – sufficient but perhaps necessary – for a credit-based contagion event. And few times in history have markets been implying the odds of this are so low.

I took the liberty of passing on Professor Succo's comments to my Austrian minded friend who goes by the name of Trotsky.

Trotsky Chimes In

• You are right - Since the Fed has abandoned 'money supply targeting' it merely supplies WHATEVER the market demands at the prevailing set target. Note however, that lately, the Fed has supplied funds quite often well BELOW target, so the idea that it is busy 'pumping' right here and now is not totally off the wall. Nonetheless I agree with the general thrust of your argument.
• Succo is also right - When the curve begins to steepen out of an inversion, the recession alarm bells go off. This is due to the nature of the whole thing - Why is the curve inverted? It is not because the Fed has deliberately inverted it - After all, in setting the FF rate, the Fed actually tends to follow rather than lead the short term market interest rate. In other words there is a feedback loop - when the market expects them to tighten, it will raise t-bill yields before they actually tighten, and vice-versa. So what creates inversions? It is mostly enormous demand for short term speculative credit.
• The previous episode of money pumping (examine money supply growth charts for 2001-2002 when they dropped rates to 1%, and you will see they went off the charts) begins to percolate through the markets setting off asset bubbles (stocks, housing, commodities - what have you), that produce returns that far exceed the rate charged by the Fed. Consequently, demand for credit based speculation heats up, as the bulk of traders, hedge funds, etc. are simply trend followers. This eventually inverts the curve. Thus, when the curve begins to steepen out of an inversion, it signals a growing loss of liquidity, as speculative demand for credit wanes (for whatever reason - it could well be that lenders become reluctant to supply more credit, such as is the case in housing now).
• The 'market is tightening out of necessity' just as Succo has put it. Since the boom was entirely artificial and credit driven, the sudden loss of credit intermediation support shows up as a steepening curve and morphs into a recession/bear market.
• The Fed IS or HAS BEEN pumping in the sense that the rate it has set is still lower than the one the market would have set if rates were completely free in the face of such overwhelming demand for credit. In short, the housing bubble would have been stopped in its tracks much sooner in a truly free market, as the demand for mortgage credit would have pressured rates higher much earlier. Of course, in a truly free market, the entire rate term structure would look different - there would be scant difference between short and long rates most of the time, and rates overall would be far lower in an honest money system.

Discussion Points

• As Professor Reamer points out the big risk is for a "credit-based contagion event" especially if the Fed artificially tries to hold the Fed Funds Rate higher than where the market thinks rates should on the way back down. Such actions would require various monetary draining operations by the Fed that perhaps the market is not prepared for.
• If the Fed has indeed been supplying money at rates below the Fed Funds Rate as Trotsky pointed out, then the word "pumping" in and of itself seems appropriate.
• If the Fed was targeting money supply instead of defending an arbitrary interest rate target it would be easier to defend claims one way or another whether or not the Fed was "pumping money".
• In a free market economy where the market set interest rates instead of the Fed, the housing bubble never would have gotten as big as it did because interest rates would have been driven higher faster and may not have gotten as low as they did in the first place.

Outside of the Fed supplying money below their targeted rate, this may be a debate over semantics as Professor Succo suggests. Nonetheless I am sticking with my cart/horse scenario simply because defending an interest rate target while claiming to be fighting inflation (as the Fed is doing now) is putting the cart before the horse.

When it comes to inflation fighting discussions, talk about the CPI, PPI, capacity utilization, as well as the price of oil, copper and cotton is in reality nothing but a sideshow. Inflation starts with an expansion of money and credit. It is striking (as well as absurd) that we have a monetary policy where the Fed discusses everything but money.

By arbitrarily defending interest rates targets that the market never would have set, the Fed put itself in a box and started chasing its own tail inside that box. The Fed is now wondering what to do next when there simply is no right solution at this point other than to abolish the Fed and let the market fix the problem over time. Since that is not about to happen any time soon, the best we can do is watch for conditions that might signal the beginning of a "credit-based contagion event".

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com