Changes in the Dollar's Value Reflect Changes in Money Velocity

I've posted these charts numerous times this year because the enduring relationship between equities, the value of the dollar, and implied volatility has been so fascinating.

The first chart isn't so hard to understand: it basically says that equities do better as fear and uncertainty decline. That makes perfect sense—how could any asset market prosper if the future became less certain and more variable? In the past several months there have been several equity selloffs, each one accompanied by a spike in the Vix index, which is a proxy for the market's fears, doubt, and uncertainty. Since these selloffs have been driven by "panic," rather than by any change in the fundamentals, they have proved to be only temporary. I pointed this out most recently in this post.

The second chart is more difficult to understand. In fact, it's counter intuitive, since it suggests that a falling dollar is good for the stock market. For a supply-sider, that goes against all common sense. Supply-siders would normally view a strong currency as a necessary condition for a strong economy, since it reflects confidence, a willingness to invest, and a low-inflation outlook. So how can 8 months of a falling dollar (the dollar is down 15% against other major currencies and down 19% against gold) coincide with a 60% rise in the stock market?

The answer that ties everything together is that the big changes in the dollar's value since early last year have been a reflection of big changes in money velocity. The economic collapse of last year was largely driven by a huge and relatively sudden collapse in money velocity. Consumers and businesses alike were panic-stricken by fears of a collapse of the global banking system, so everyone stopped spending money and tried desperately to increase their holdings of money, by selling other assets and by paying down debt. Then we had the big collapse in the equity market that hit bottom in early March, and that collapse was driven by fears of a looming fiscal train wreck in the U.S. Once again fear drove investors to stock up on cash. The dollar ended up being the chief beneficiary of the world's desperate desire for safety and liquidity.

What we have seen since March is therefore the gradual return of confidence and the unwinding of flight-to-safety trades. Dollar cash is no longer so desperately desired, and we see evidence of this in a huge decline in the growth rate of dollar currency and M2 since March. This next chart documents the big slowdown in money growth which began at the same time as the equity market started to turn up last March. Note also the huge increase in M2 growth which started in Sept. '08, around the time of the Lehman bankruptcy.

Equities have turned up because the economy has been recovering from shell-shock. Cash is being spent again, and the economy is gradually recovering the ground that it lost last year. In economic terms, we are enjoying a rising velocity of money; in a sense, money that had been "stuffed under mattresses" is now being spent, and that is powering a rise in economic activity. Contrary to what many pundits are suggesting, I think equities are far from signaling a bubble—they are rising because the market is experiencing the equivalent of a big sigh of relief. In early March, markets were braced for a super-double depression and deflation. Now that it is clear that we are not going to fall into an economic black hole, risky asset prices are slowly returning to levels that, in my estimation, reflect the expectation of a run-of-the-mill recession.

Comments

[Dave Wrixon:]

The only increase in the velocity of Money is the speed at which it is fleeing the US.

Nov 10 04:14 AM

[aussiereader4:]

so much opinion, so little data. M2 appears to be re-balancing; does that mean we are in for a correction?

Nov 10 04:47 AM

[Gary A:]

M1 is still tanking. This is from the St Louis Fed. Where did the author get the idea that money velocity is increasing? research.stlouisfed.or...

Nov 10 02:12 PM

[Gary A:]

And I want to add, how can velocity decline and money supply decline cause the dollar to decline? Maybe the author could take a stab at answering this.

Nov 10 02:26 PM

[Robert Mart...:]

Calafia:

I agree that velocity is recovering as the "flight to safety trades unwind," the economy recovers from "shell shock," and people spend money that "had been stuffed under mattresses." So I agree that these factors are helping monetary velocity to recovery.
These are natural and healthy developments, and occur in every business cycle recovery.
Unfortunately, I also see two headwinds to a full recovery in velocity during THIS economic cycle.
First, I believe that the drop in velocity since 2008 reflects the deleveraging of the American economy.We got drunk on debt, the Fed has given us another drink while we sober up. Private deleveraging by consumers and financial institutions is a long, slow process, and a stiff headwind for the economy.

In addition, part of the recovery in velocity is government induced, via loose monetary and fiscal policy. This boost to velocity is enormous, completely artificial, and does not reflect fundamental improvement in the economy. Unfortunately, quant easing must eventually come to an end.
Therefore, I continue to believe that we are in a reflationary bubble.

The best case outcome is a painfully slow recovery followed by a long period of stubbornly high inflation. This is better than depression, but I think we must acknowledge that the U.S. economy has deeply rooted problems that are undermining confidence in our currency.

Nevertheless, I always respect the other side of the trade. You may be right, and our country will be better off.

Thanks,
Rob

Nov 10 03:09 PM

[Gary A:]

Money multipliers are collapsing everywhere. What kind of a recovery is that? seekingalpha.com/artic...

Nov 10 03:15 PM

[Econ 1:]

Wow! You should go out for head cheerleader at CNBC! Your inverse charts are misleading and unnecessary.

This market is propped up by 0% interest and the dollar carry trades--ANY rally in the dollar for whatever reason and this house of cards Ben(ee) and the Jets has built comes crashing down.

How are you measuring velocity? Where do you see lenders loosening up? Savings have dropped a little but outstanding balances are still coming down as people pay off debt.

Look at the Corporate Tax Revenue--Down over 45% year over year-- Earnings are from cost-cutting (firing) not revenue growth and it ain't getting better-- lastly, $500 Trillion + Dollars worth of overhanging derivatives and a helluva lot of new social engineering to pay for--Gosh I'm sorry but your little happy equity bubble is just pissing me off.

Nov 10 04:21 PM

[Gary A:]

I wonder if he is fudging the truth here. Based on the St Louis Fed the velocity of money continues to DECLINE.

I be he won't be back to answer that fact!

Nov 10 05:23 PM

[Liz:]

Is this how we are to judge the world's economies? By seeing how many people can spend themselves into oblivion?

Nov 11 02:24 AM

[Charlie J:]

"Now that it is clear that we are not going to fall into an economic black hole..."

Glad to hear that everything is OK now. I'll be sure to tell that to the bookkeeper in our small business who is getting cut to halftime this month (you have to have sales to need a bookkeeper to keep track of those sales).

Nov 11 01:07 PM

[BioGuy:]

I don't think cash is being spent again.

But I do think money velocity is over looked as a problem in the economy. Everyone gets caught up in fancy terminology and they forget that money is a unit of labor. How can one expect an economy to function in a useful way when the concentration of wealth destroys money velocity and any meaningful definition of our currency?

Minimum wage is around $8. That means, an individual with 10 million dollars can command 651 years of labor. Or 65 years of work from someone making $150,000/year. That's the most idiotic and screwed up concept ever, making the dollar useless. **No one is worth that.** If a person were as smart as Einstein, as funny as Seinfeld and as good looking as Scarlett Johansson, she would not be worth 651 years worth of someone's labor. It's a stupid idea. But our USD is an idea, and it states just that. We wonder why it doesn't work?!?!?!? Go play monopoly with your kid, but give him $10 MIL, you take $5K, see how that game goes for you.

I despise empty complaining, so I owe some ideas.

1) Get ourselves out of this currency system- remove zero bound or move to demurrage currency.
www.sciencedirect.com/...

People say banks would hoard cash under negative interest conditions.... that would different the current situation in what way?? Hmmm.
krugman.blogs.nytimes..../

Demurrage easier said then done? Not compared to the stupid things we do now. Here is a good article on implementation by Mike Mezzadri;
seekingalpha.com/insta...

The average person is ignorant of economics, easily fooled and manipulated. It's a vague concept, people do not have time for it, they work. But people tend to get very savvy very fast when they are hungry or otherwise stressed, especially when they are being wronged. Which is quite obvious;
www.huffingtonpost.com...

Do I think social collapse or revolt is possible? No- but watch out for those voting booths if America gets hungry. Ron Paul will be in high demand due to his financial reformation platform- or someone like him. Whomever it would be, the wealthy will not like it one bit and wish they had behaved. Everyone is ignorant in one way or another.

Nov 13 07:06 PM