Erosion in the M2:M1 Relationship and the Burgeoning Eurodollar Bubble 22 comments
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I had a discussion with a strategist at PIMCO last week. He quite animatedly emphasized that Dow 10,000 is not a rally. Dow 10,000, he said, is a correction. We overshot on the way down to 6500, and now you’re about to see the real rally. I counter that losses are amplified in a leveraged environment. Fear and illiquidity made small contributions to overshooting, but fundamentally Dow 6500 wasn’t an unhinged outlier.
What happened thenceforth (6500-10,000) was the displacement of levered losses by government stimulus and liquidity injections. So, I suppose I agree with the PIMCO strategist's first point. The problem henceforth (at Dow 10,000) is all that liquidity isn’t performing. It’s sitting in bank vaults as capital reserves. There’s no return on that capital. It’s not working its way into the real economy to promote growth. We know what the steep hike to Dow 10,000 looks like. Watch how it’s echoed by a steep hike in M2. Only thing is, we’re seeing a decoupling as M2 has started to tail off from its March highs:
click to enlarge
So there's all this stimulus out there, and it seems to me like it's met by diminishing returns. So I charted recent M2 against M1 to see what the relationship is looking like:
Looks like every $1 of M1 has reared an average of $2.83 M2 since October 2007. So I compared that to historical norms:
Since 1959, we've seen an average of $4.74 M2 reared from every $1 M1. But, the data are higher correlated in the near term.
Since 1985, that number (M2:M1) clocks in at $6.04.
Since 1993, it registers a whopping $9.29.
Compare those numbers to the past 3 years' at $2.83. Stunning. Now, we have to be fair and give monetary policy its 9-month grace period... but we've been easing since Sept 2007; we've been ZIRP since Dec 2008.
This is why it's so important for the Fed to report M3! All arrows are pointing to deflation, but we're still in this balance between de- and in-flation. How is that possible with the Money Supply's impotence and liquidity sitting in bank vaults? Simply put: the cheapened dollar has been funding the global carry trade. Speculators are borrowing USD at low rates, investing in foreign currencies at higher rates. There's a glut of eurodollars floating around the globe, under short-selling pressure and beyond the jurisdiction of the Fed. That's a variable that M2 doesn't account for, which is why someone better be tracking M3.
We've all heard this "carry-trade" chatter already. Most of us are waiting for the maturity these ST USD borrowings, because it should bring a rush of demand for USDs in short covering. I worry, however, that once the rush happens, a lot of unaccounted-for, external M3 will onboard in narrower classifications (M2/M1), and we could see serious hyperinflation.
I've noticed two powers at work during our zero-interest-rate-policy onset:
1. There are powerful domestic deflationary forces
2. Even more powerful USD hyperinflation is burgeoning outside our domestic economy
The wool is over our eyes because the Fed [has us believe] that it's ignoring M3. Regardless of whether they're tracking eurodollars or not, there's no infrastructure poised to suck excess USD out of the domestic economy if inflation were to hit suddenly. Using the reverse-repo system would be like sopping up a flood with a mop. What's really happened is much of the Fed easing has leaked out of the US (where there's really no y/y nominal GDP growth) to finance opportunities internationally.
That brings me around to my main point. The USD keeps getting skittish around its $73 support on the DXY. Every bump of that lower bound starts earnest talks of sweeping divestiture from USD. (It's like oil at $150 making people talk about Alternative Energy. The noise dissipates when oil retreats--and it really is just noise--but confidence and sentiment move markets nonetheless.) Now after decades of disinflation, a year of ZIRP, Quantitative Easing and sacrificing the dollar, the Fed has reached the bottom of its bag of tricks.
There's no more liquidity/stimulus coming to support revenue growth, which is the only impetus for sustainable profit growth now that firms have cost-cut their way to wider margins.
You can see in the graph below that, while earnings have ticked up slightly off lows, PE ratios have dropped precipitously--with 87% of S&P components having reported earnings to date:
S&P trailing EPS have more than doubled off lows... to a paltry $12.69. That will help gouge PE; even in the face of a market rally. We will see inventory rebuilding and another good quarter of earnings. That will reduce PE to an astronomical "new-normal" normal... relatively astronomical as long as there's government liquidity outstanding.
(Although it's not crucial to my argument, I expect that the premium on stocks will start withering into a secular PE downturn as earnings stabilize, much like we saw 2002-03. Businesses are enjoying wide margins after cost-cutting; plus there's a lot of stimulus in the system to aid balance sheets, top lines, and bottom lines. I'll talk more about this later, but there's no more liquidity coming... there's just liquidity recycling. Thin profit growth can only come from margins that are wider still= more unemployment. The premium will certainly wither.)
The USD has established a new, low range in the 70s on DXY. More volatility in the world's reserve currency is too unsavory for the world's other economies to digest. Unleashing additional stimulus in the domestic economy is also too politically unfeasible. The Fed can't tease inflation more than it already is. Adding more liquidity could break that camel's back, for which the remedy is tightening via rate hikes. With a historic debt roll and option-ARM reset nearing, rates can't run too high.
Mortgages are underwater and debtors are suffering cash flow shortfalls, rates have to stay pinned. Otherwise, interest rate increases would exacerbate defaults/foreclosures. Don't forget that rates are artificially low. Even with that intervention, creditors aren't seeing loan growth. There's no correlated growth in corporate revenues or household income to service higher interest payments. If rates were to go up, there's a shark for the economy to jump while liquidity vacuums out of a system that has yet to rear growth. That's what's scary about M2 dropping despite all the easing.
The absence of loan growth is already a harbinger of the remedy: Deleveraging. It will happen in earnest now that balance sheets have had a chance to mend in the broad asset rally since March. If economic growth is slow and steady, it can happen in an orderly fashion: credit facility aversion, debt retirings, debt maturities without subsequent debt rolls. Or, it can be a shockwave: loan modifications, defaults, and foreclosures. For reasons discussed above, Americans just have to recognize the inevitability of a slow-growth environment through 2012/13.
Check out these updated digits, courtesy of the HS Dent November forecast and DebtDeflation.com:
- Financial Sector Debt: 120% of US GDP
- Non-financial Debt: 180% GDP
- Total Private Debt: 300% GDP
- Total Consumer Debt: 100% GDP
- Total Government Debt: 100% GDP (Federal= 85%, State/Local= 15%)
- Corporate Debt: 80% GDP
GDP isn't swelling. We have to start saving.
Disclosure: None
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This article has 22 comments:
My response is, "why should average U.S. Joe save money and stick it in a savings account at a bank when the bank pays an interest rate of about 1% ? "
-Matt
note(1): Meaning in a money market, not stuffed into your mattress or sitting in an untrustworthy bank.
-Matt
I like your comments here... good level headed, pragmatic stuff.
On Nov 10 01:04 PM MattZN wrote:
> Yah, people in general don't like the idea of throwing money into
> a savings account paying only 1% (and money markets aren't doing
> much better). On the flip side, with the dollar this low holding
> cash (note 1) could reap dividends in the future. If/when the Fed
> raises interest rates both equities and bond funds will pull back,
> the dollar will strengthen vs other currencies, and the guy holding
> the cash will be the guy able to buy into them at a lower price.
>
>
> note(1): Meaning in a money market, not stuffed into your mattress
> or sitting in an untrustworthy bank.
>
> -Matt
Thanks for your article. Do you discredit the two entity's which now chart M3 or why do you not mention them?
I wrote this recently:
seekingalpha.com/artic....
I'd be curious to hear your comments.
A lot of people has to save money to pay back their mountain of debts and reduce their interest liability, not to save into a bank.
On Nov 10 12:40 PM ryanclarke wrote:
> The author wrote ,"GDP isn't swelling. We have to start saving."
>
>
> My response is, "why should average U.S. Joe save money and stick
> it in a savings account at a bank when the bank pays an interest
> rate of about 1% ? "
Does anyone have a theory on why/how this can be happening?
An M3 calculation requires a compilation of a LOT of data. I wouldn't hang my hat on SGS's having privy to enough information to come up with accurate numbers on a timely basis. That being said, it's a wonderful website that I turn to often for personal knowledge... and I suppose it's as credible as the actual government's data.
On Nov 10 02:55 PM Kalpa wrote:
> Romeo
> Thanks for your article. Do you discredit the two entity's which
> now chart M3 or why do you not mention them?
> I wrote this recently:
> seekingalpha.com/artic.... <br/>I'd
> be curious to hear your comments.
The average Joe will save money at 1% because the average Joe hasn't had (and can't forsee) a pay increase. Either that, or he's one of 17.5% of Americans that are unemployed according to "real unemployment," which counts those discouraged from job-seeking as unemployed... unlike the official gov't data. The average Joe has a mortgage that's underwater on top of that. There's no suitable alternative for the average Joe, because as far as his world is concerned, there's deflation all around.
When the risk-free return (T-bills) are yielding under 10bps, the average Joe's savings account suffers the consequence while a dirty bank borrows from the discount window at 50 bps or borrows from Joe's savings account at 100 bps, then can get a risk free return on 2yr treasuries yielding 143 bps. Why would you lend if you're a bank? Leverage up for that 43 bp risk free spread.
Not everyone's comfortable with investment risk. The alternative to a 1% savings account is cash under the mattress. That gets no yield and it's literally all your eggs in one basket--imagine a fire taking your net worth to zero?!
On Nov 10 12:40 PM ryanclarke wrote:
> The author wrote ,"GDP isn't swelling. We have to start saving."
>
>
> My response is, "why should average U.S. Joe save money and stick
> it in a savings account at a bank when the bank pays an interest
> rate of about 1% ? "
If you're simply asking why the spread mechanically widened, 3mo TBills went from 14bp yields in Sept to 5bps of recently.
On Nov 10 06:01 PM TucsonSpike wrote:
> Related to this the TED spread reversed course and started rising
> middle of September, while the LIBOR has stayed flat or even dropped
> a little.
>
> Does anyone have a theory on why/how this can be happening?
The number of times a dollar changes hands in the normal commerce of a healthy free market is very high, whereas these carry trades just work infinitesimal fringes going in slow circles.
Inflation will start to occur when the G20 agreements break loose early in 2010 and the "less developed" half of G20 is released from the suicide pact of zero interest stimulus. February might be very "interesting".
It may be you are biting off too much here. The conflict between inflation and deflation get into more than just how to accurately quantify M3. There is simultaneous asset price destruction and raw material perceived (and real) shortages. For example, how do you reconcile a severe national drop in housing stock prices, with the banks' perceived insufficient collateral? The answer is you really can't.
You run into cash flow measures of security values and asset price measures of value in conflict with each other. Until defaults (and perceived default risk stabilize, both consumer and business), you won't have an accurate picture of how deep is contraction. What is occurring is a suspicion of both borrowing and lending due to the uncertainty of who will be able to navigate our (the US economy) circumstance. In short, while you may get an idea about the whole structure (lots of liquidity chasing suspect opportunities) you can't track M3 anywhere accurately until you see the winners and losers of this downturn. And frankly, once you can, it won't do you much good, but to confirm what you will have already just witnessed.
Thanks for the nice article ... it's clear the depths to which we'll all fall if the people at the switches pull us off our morphine drip (cheap $) too quickly but also how sick the "patient" really is! And if they wait too long to reduce the dosage or overdose the "patient" (maybe we're already there?!) ....!!!
If I take a $1million of treasury bond and use it as collateral for overnight borrowing, I haven't increased my leverage.
As I understood the Japanese Carry Trade, a hedge fund would BORROW at 35 to1, AND THEN take the money and use it as collateral to borrow in Japanese Yen and Japanese interest rates.
Without the initial leverage, the transaction doesn't make much sense to me.
The question I have, then, is who is lending to the hedge fund at 35 to 1?
Or do I have this wrong?
Nice article. You mentioned above that there are powerful forces creating domestic deflation and global inflation. What forces are you referring to? China on US deflation, resources on global inflation...are there more?