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Atle Willems, CFA
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Atle Willems, CFA, is an equity investor with a long-term view investing in undervalued listed shares with solid operational track records and sensible balance sheets. He holds a master's degree in finance from Nottingham University Business School, a bachelor's degree in business... More
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Liabridge
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EcPoFi - Economics, Politics, Finance
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  • The Crank Report (29 March 2015)

    "What is prudence in the conduct of every private family can scarce be folly in

    that of a great kingdom", Adam Smith

    But who's issuing the newly created money?

    Last year a major change took place in the U.S. monetary system that seems to have gone largely unnoticed: the role of creating new money shifted from the Federal Reserve to the domestic commercial banks. This change is important for two major reasons. Firstly, money supply developments are important as changes in the money supply and its growth rate affect asset prices and economic developments. Secondly, understanding whether banks or the Federal Reserve are the key driver of the money supply is therefore important. Monitoring money supply developments during the 2008 to 2013 period was fairly straight forward: listen to Fed guidance. The banks weren't lending, so most of the growth in the money supply was generated through government deficit spending, the debt of which the Federal Reserve monetized, i.e. the Fed ended up buying most of the treasury securities issued by the U.S. government. As the Fed bought these securities with newly issued money created by a few touches on the key board, the amount of money in circulation increased. During 2014, the Fed spent every month "tapering" the amount of assets it bought, officially ending QE in October. One thing QE did achieve was to increase bank reserves. To the extent this increase in bank reserves was achieved through buying mortgage-backed securities and treasuries above market value (prices would have been lower if the Fed did not enter the market) this was a waste of Americans' resources. Nonetheless, it did make U.S. banks more liquid as treasuries and MBSs were replaced with cash. As cash forms part of bank reserves while MBSs and treasuries do not, QE 1, 2 and 3 greatly increased banks' ability not only to lend, but with it enabling banks to take over the role as the chief new money generator when the Fed finally ended QE. During the last year banks have increased lending by 7.8%, up from 1.8% at the end of 2013, with it creating almost $585 billion worth of new money. This represents almost 77% of the increase in the money supply during the last 52 weeks, with the rest coming from banks and the Fed buying securities from non-bank entities. But here's the thing: so far this year, the money supply has increased close to $190 billion (1.79%) while bank loans has only increased $49 billion. This leaves a $141 billion increase in the money supply that must have come from either banks or the Fed buying securities. Year to date, banks' securities holdings have increased less than $41 billion, part of which is due to a fall in interest rates (as a portion of the securities are marked-to-market). If we assume that all the increase in bank securities came from increased buying, this nonetheless leaves us with an unexplained increase in the money supply of about $100 billion year to date. As the Fed is not expanding its balance sheet anymore (for now) and as the money supply does not increase when the Fed buys securities owned by banks (which instead increases bank reserves and hence the monetary base), the $100 billion must have come from the Fed rolling over expired securities by way of buying securities owned by the non-bank public. The implication of this is that the Fed's open market operations still lead to increases in the money supply even though QE has officially ended. How can this be? As long as the non-bank public reduce the amount of government securities they own by selling them to the Fed (or banks), the money supply will increase as a result. This practise is however not a "sustainable" way for the Fed to contribute directly to money supply growth as the public will eventually likely reach a floor as to how little government securities they prefer to own. Therefore, as time pass and as long as the Fed does not announce QE4, ever more pressure will be put on banks to increase both lending and their holdings of government securities.

    ***

    Bank Capital: Déjà vu September 2008

    More than six and a half years have now passed since the U.S. banking system collapsed and Lehman Brothers filed for bankruptcy. QE was exclusively about saving banks from insolvency as both their capital and fractional reserves were inadequate when confidence evaporated swiftly in mid-September 2008. Just prior to the collapse, the average American bank had an equity to total asset ratio of 10.62% and a cash to total asset ratio of 2.85%. As of 11 March this year, these ratios now stand at 10.72% and 18.8%, respectively. Banks are therefore more liquid today, but remain just as poorly capitalised today as back then. As the Fed will usually buy securities from banks during downturns anyway, the improvement in the cash ratio only means the Fed needs to buy fewer securities next time around. For all practical purposes therefore, whether banks hold treasuries or cash is largely irrelevant as treasuries can quickly be converted to cash through the Fed when the need for more cash arrives.

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    ***

    The Austrian True Money Supply Weekly - 19 years of inflationary policies

    The money supply continues to expand relentlessly in the U.S. In fact, the last time it declined on a year on year (y/y) basis was in February 1996. The U.S. economy has therefore consistently lived with inflationary policies for more than 19 years. The average y/y growth rate on a weekly basis ever since is 8.39%. This week, the growth rate came in at 7.52%, down from 7.60% the previous week. The growth rate has been fairly stable during the last fifteen months or so hovering between 6.52% and 8.45% with an average of 7.65%. This average his however substantially lower than the 8.29% average since 1980 and substantially lower than the prior peak of more than 16% back in August 2011.

    The 5-year annualised growth rate in the money supply ended the week on 10.16%. This was substantially higher than the 7.59% longer term average, but the growth rate has slowed substantially since peaking at 12.39% in October 2013. The growth rate continues to decline as the current growth rate is lower than it was both 26 weeks and 52 weeks ago. The growth rate has now declined compared to a year ago for 68 consecutive weeks.

    In summary, the shorter term trend (1-year) in the money supply is flat to down while the longer term trend (5-year) is still one of contraction in the growth rate. Both signal a less inflationary environment which is not good news for equities.

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    ***

    The U.S. Stock Market - Catch me if you can

    The inflationary policies highlighted above have certainly helped fuel a range of asset bubbles. The Fed combined with the banks have during the last 19 years managed to create no fewer than three major stock market bubbles; 2000, 2007 and the current one. Why blame this on the Fed and the banking system? For one simple reason: if it wasn't for the inflationary policies the overall stock market growth would have been restricted to the slow accumulation of savings, much of which would be channeled into real investments as opposed to stock market speculation. As Fritz Machlup, the economist, explained in 1940:

    "A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply [money supply]" (The Stock Market, Credit, and Capital Formation).

    One would expect stock market prices to reflect the future prospects of the listed companies, which again reflects the prospects of the economy. If the overall economy is doing poorly, it would be folly to expect companies to do well. Over the longer term, bar shorter term speculation, one would expect the stock market and the economy to track closely. Not so these days. Especially during the last year, most major U.S. stock market indices have completely dislocated from a range of economic aggregates (here's a selection from December last year, all of which are even more extreme today). Every week the Economic Cycle Research Institute (ECRI) publishes its leading economic indicator for the U.S. economy. This indicator started showing y/y declines towards the end of last year and has been in decline on that basis ever since. The stock market on the other hand relentlessly pushes in the opposite direction. As a result, the ratio between the Wilshire 4500 Total Market Index and the ECRI leading indicator has hit record highs, dwarfing the previous record from October 2007 by a whopping 92.5%. Yes, there have been plenty of good reasons to invest in the stock market in recent years as artificially low treasury yields and interest on savings accounts have raced towards zero. But the stock market has gone too far in its quest for relative yields and has dug its own grave. At these levels, and with earnings actually expected to contract during the first half of this year and Fed interest rate hikes looming (personally, I expect the Fed to raise interest rates only incrementally, if at all), future equity returns will be dismal, at best. Also, stock market participants tend to ignore the quality of earnings during stock market peaks, which become only too apparent when big-bath accounting practises rule during stock market troughs. Like an elastic rubber band, the stock market can contract substantially quicker than it can expand. Only continued monetary expansion and low interest rates can maintain elevated stock prices at this stage. This is but one reason to follow money supply developments closely.

    ***

    When the Monetary Crank Gets His Will - Take-off for Eurozone Monetary Base and Money Supply

    A few months ago, "Bumble-bee" Draghi finally got what he so desperately wanted, namely the opportunity to once again expand the monetary base. And that's what the ECB is doing. In January and February, the monetary base increased for the first time in two years on a y/y basis. Will this help the eurozone economy? Of course not, buying debt that never should have been sold in the first place and with it, either directly or indirectly, creating more money can only help those selling the assets at the expense of all others and the economy as a whole over the longer term. Just as QE never worked in Japan or the U.S. it will not work for the eurozone either. Savings and investments as determined in a free market and increased purchasing power in the hands of people are what create economic growth. Though QE might frequently lead to an increase in investments, frequently in the wrong areas or the areas favoured by politicians (e.g. housing, construction and government spending), it will be at the expense of savers and people's purchasing power. May the rapid depreciation of the euro in recent months serve as but one witness to the depreciated purchasing power. Another sinister outcome of QE is that it brings about less pressure on banks and politicians to undertake real reform that could truly lead to put the eurozone back on track to a more prosperous future. As that is not happening, QE is a last desperate and futile attempt to solve economic problems that cannot be solved through creating yet more money. It seems that the causes of the eurozone crisis, too much debt and too much bureaucracy, is long forgotten. As money is created as debt, it remains a mystery as to how more of what created the problems in the first place can cure the problems caused by it. In true style, Draghi has of course already pointed out how money printing is helping the economy. Actually, he steps right into a core problem with low manipulated interest rates when he states "as bank lending rates are being reduced, new investment projects, previously considered unprofitable, become attractive". Probably unaware of the consequences of his statement, which by the way is completely correct, Draghi fails to attend to what is sustainable over the long term. The day the ECB and eurozone banking system fail to keep interest rates artificially low, the investments that were projected to be profitable with low interest rates will fail when interest rates move up. In the classical sense, that's how the boom and bust cycle is created. It's therefore fitting to remind Draghi than in the four years leading up to the September 2008 debt and banking crisis, that the M1, M2 and M3 money supply measures increased on average by 9.0%, 9.4% and 9.5% every year. Little thought by the ECB appears to have been centered on the damages such tremendous monetary inflation created in its wake. Goodbye common sense and one day goodbye to the eurozone which likely have cemented its eventual downfall with yet more economic distortions that will bring the eurozone to its knees.

    Far from being close to deflation, the growth in the money supply measures for the eurozone has not really ever come close to zero. The M3 did however come close to deflation after hitting 0.5% growth on a y/y basis in December 2013, but the M1 and M2 has expanded on average 5.8% and 3.0% a year since January 2010. As of February this year, these two measures are up 11.3% and 5.2% on last year, while the M3 is up 5.4%. These growth rates have surged during the last year as they stood at 6.2%, 2.4% and 1.1% in February last year. With QE now again in place, there are good reasons to expect money supply growth rates in the eurozone to climb further up in the months to come. This is good news for asset prices and poor news for the economy in the eurozone. It is also good news for eurozone exporters, but bad news for the importers, the savers and the owners of euros who involuntarily subsidise them. There is no "free lunch", never has and never will be. With monetary expansion there is a looser for every winner. This is in stark contrast to savings-fuelled growth which is a win-win situation, at least ex ante, for the saver and the investor. A further divide, perhaps U.S. style as discussed earlier, between the real economy and the stock market casino is in the making.

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    ***

    U.S. Economy: Say No to Thrift!

    The latest savings stats for the U.S. have just been released for Q4 2014 by the BEA. Gross saving expanded at a seasonally adjusted annual pace of just under 3.9%. With a negative growth rate in six out of the last seven quarters, this was welcomed news. Unfortunately, the money supply, in this case measured as the M2 money supply, expanded 5.7% during the same period, vastly outpacing savings growth. Why does this matter? As money supply growth creates financial instability and as savings, i.e. thrift, promote stability, the ratio between the two indicates the extent to which an economy is stable or unstable. Specifically, an increase in the ratio of the money supply to savings indicates increased artificial growth and with it increased future economic instability. As F.A. Hayk once put it,

    "...saving at a continuously high rate is an important safeguard of stability" and that a high rate of saving would also "...tend to mitigate disturbances arising from fluctuations in credit" (Profits, Interest and Investment)

    Currently this ratio stands at 3.33, the second highest ever reported based on data since 1959, beaten only by the 3.39 ratio from Q1 last year. Previous peaks in the ratio include Q2 1987, Q4 2000 and Q4 2001, and Q4 2007, all periods experiencing significant stock market drops and economic turmoil. The ratio therefore currently flashes red which historically, and in theory, is very bad news for asset prices and the economy.

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    *****

    Mar 29 9:08 PM | Link | Comment!
  • "Austrian" True Money Supply Weekly (9 Mar 2015)

    The short version of the "Austrian" True Money Supply for the U.S. increased 0.32% on last week for the week ending 9 March 2015. At $10.7919 trillion, a new high, the money supply is now up $189.7 billion, or 1.79%, year to date.

    The 1-year growth rate for the week came in at 7.60%, down from 7.82% last week and 31 basis points lower than for the same week last year.

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    The 5-year annualised growth rate was 10.00% for the week, the lowest reported for 13 weeks and 80 basis points lower than one year ago. This was the 67th week in a row with a declining growth rate compared to a year ago.

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    The dramatic monetary expansion in the US since the 2008/9 banking crisis becomes more readily apparent when looking at the longer term growth rates. Since bottoming at 5.57% in January 2007, the 20-year annualised growth rate has since climbed to the current 8.17% and is closing in on the 8.20% record from September 2002.

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    *****

    Price inflation expectations in the US has dropped significantly since August last year. Back then, the 10-year break even inflation rate (the difference between the 10-year treasury yield and 10-year TIPS) stood at 2.28% compared to 1.73% as of week ending 13 March.

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    The "money relation", which measures the relationship between the demand for and the supply of money, also confirms there has been significantly less inflationary pressures during the last year compared to 2013. The current reading signals no immediate "financial crisis", but the fact that the relation has been in negative territory for 13 consecutive months serves as a warning that economic troubles could be looming. Remember that banks and the stock market both thrive when the money supply expands and people demand less money to hold, i.e. an increase in the spending/savings ratio. Conversely, a decline in the money supply growth rate and an increase in the demand for money to hold, i.e. a decrease in the spending/savings ratio, will have the opposite effect on banks, the stock market and prices in general, including stock prices.

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    Meanwhile, the aggregate money supply growth for the US, eurozone and the UK, measured in US$, has tanked during the last 12 months. Though this to a significant extent has been driven by a strengthening of the US$ compared to the euro, the drop in the growth rate does signal less inflationary pressure. In fact, there has been deflationary pressures for the three economies since October last year as the growth rate has plunged below zero.

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    As US bank credit growth continues to expand at a rampant speed and as the ECB has once again started to expand its balance sheet (QE), the growth rate might very well soon climb above zero once again. Investors oblivious to the long term better hope it does.

    Visit the "Austrian" True Money Supply archive here.

    Mar 20 11:31 AM | Link | Comment!
  • "Austrian" True Money Supply Weekly (12 Jan 2015)

    The short version of the "Austrian" True Money Supply for the U.S., the measure of the money supply applied in this weekly report, decreased 0.24% on last week for the week ending 12 January 2015. At $10.6120 trillion, the money supply is now up $10.0 billion, or 0.09%, year to date.

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    The 1-year growth rate jumped to 7.39% for the week, the highest for 16 weeks (22 Sep 2014). Though it remains lower than both the long term- and 52 week averages, the growth rate was once again higher than the same week last year for the fifth consecutive week.

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    The 5-year annualised growth rate is still stuck in a downward trend as the growth rate declined for the 59th consecutive week compared to same week last year. The growth rate is however falling less than was the case especially during the nine week period covering 20 October to 15 December last year. It should be highlighted that the current growth rate of 10.26% is 213 basis points, or 17.19%, lower than the 12.39% peak from 21 October 2013.

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    In summary, the overall growth rate in the money supply is still slowing down, but some of the growth rates are now flattening or even increasing.

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    *****

    The growth rate in Federal Reserve assets plus the Austrian True Money supply, a measure of the overall monetary stimuli, remains in a downward slide. Since peaking at 15.09% on 27 November 2013, the growth rate has since dropped to the current 8.19%, the lowest reported since 26 December 2012.

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    The repercussions of this slide in the growth rate is yet to play out. It is blatantly obvious however that CPI inflation expectations have been falling sharply since August last year when the Fed was nearing the end of QE3.

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    For an economy run on inflationary policies instead of low government spending, low taxes and a high level of savings and investments, this drop in CPI expectations could very well be a harbinger of an economic correction. Many indicators are certainly pointing in that direction. To the extent that a steepening yield curve signals a strong economy, the current yield curve signals no such thing as it has flattened greatly during the last year.

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    Visit the "Austrian" True Money Supply Weekly archive here.

    Related:

    Welcome to A Very Dislocated 2015

     

    Recap 2014: The Short Version of the "Austrian" True Money Supply (NYSE:TMS)
    Jan 26 7:31 AM | Link | Comment!
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