Originally published on Jul 20, 2014.
Further stock market gains are facing heavy headwinds in the U.S. as earnings growth is slowing and the Fed is indeed tapering (for now). The reach for yields driven by artificially low interest rates have rocketed many asset prices upwards to new all-time highs, some reaching spectacular highs (though some have slipped back a little in recent weeks). Where to put your savings at work is an all too crucial question as interest on ordinary bank savings and deposits often doesn't even cover consumer price inflation and is significantly outpaced by money supply growth, spanning from the U.S. to Norway and beyond. This has no doubt played a role in the current dire situation faced by many savers and investors: equity prices have reached such a bloated level any decent gambler with a knack for probabilities would stay way clear of making major bets on further outrageous gains, or even gains covering price inflation, the 10-year U.S. treasury yield has once again plummeted following an increase in the yield in the aftermath of Bernanke uttering the possibility of Fed tapering in May last year, and junk bonds credit spreads are plunging towards the insane levels seen in 2007.
As of 18 July 2014
What are investors to do in such an environment? Buy gold, allegedly endlessly battled by governments and central bankers in coordinated efforts to keep its value down with the lurking risk of outright confiscation? Jump back into all housing related ventures only to be left with empty pockets when people once again realise prices don't always just go up? Or invest in a real businesses and employ staff at artificially expensive salaries deemed reasonable by the high lords in their ivory towers, businesses soon to be choked by another credit and debt crisis? These are truly difficult times by most standards. Luckily enough, it's just as simple these days to make money from falling asset prices as from rising ones. Just better hope the corporations running the various ETFs and other instruments remain solvent to pay out any potential gains made by investors.
With all the above having been built on a base of ever increasing government debt and quantity of money, it's a true struggle finding positives about the U.S. economy at this stage. If anything, it's substantially worse than back in those grueling, but inevitable, days in September 2008. Yes, U.S. commercial banks hold substantially more cash now, but their capital to asset ratios are broadly unchanged and far from adequate to survive a substantial storm without the help of the Fed (read: tax payers). As is the case with the EU and the Euro Zone (and countless other countries suffering from and utter lack of prudence), unless the fundamental flaws of the economic policies are rectified and put right by our dearly beloved highly paid bureaucrats which the rest of us feed through high income taxes, VAT and all else evil (abandon all hope of a general awakening of the electorate at large), true economic progress in the U.S. and elsewhere simply cannot be achieved. More free market policies, less rules and regulations, including a substantially smaller government, and a complete end to all government bailouts orchestrated by the Fed and other central banks are what is necessary - administration and overheads do not create prosperity, they reduce it. No bank or other company has ever been too big to fail (if it truly was, investors would line up to take it over). Nor should it ever be going forward.
Without bank credit expansion, supply and demand tend to be equilibrated through the free price system, and no cumulative booms or busts can then develop. But then government through its central bank stimulates bank credit expansion by expanding central bank liabilities and therefore the cash reserves of all the nation's commercial banks. The banks then proceed to expand credit and hence the nation's money supply in the form of check deposits. As the Ricardians saw; this expansion of bank money drives up the prices of goods and hence causes inflation. But, Mises showed, it does something else, and something even more sinister. Bank credit expansion, by pouring new loan funds into the business world, artificially lowers the rate of interest in the economy below its free market level.
Murray N. Rothbard
This is pretty much what is happening in the U.S. now. The Fed has assisted the banks in piling up tremendous amounts of regulatory excess reserves (through granting loans and virtually now costs, by buying assets from banks and paying interest on reserves) which means the banks are in a position to create, for all practical purposes, limitless amounts of credit. It's therefore perhaps not without reason the Fed monthly asset purchases have been reduced to US$35 billion this month (from US$85 billion a month last year). And the Fed is doing so presumably with a firm expectation that banks will expand credit to make up for these reduced purchases With government debt expanding at a slower pace, regular readers of this bi-weekly report were notified months ago of the increasing importance commercial banks now play in ensuring the money supply continues to grow at a significant pace. More money in circulation cannot improve on real economic growth. All it can do is alter who receives the new money first, redistribute wealth and create unsustainable classes of consumers of resources (e.g. government employees in excess of what is sustainable). An increasing money supply can do one more thing however: as most economic indicators are measured in money terms, an inflating money supply will show a gradual increase in many nominal indicators of so-called "economic growth" and fool politicians, businesses and consumers alike that the economy is progressing when in fact it is not. An increased money supply hence can conceal, temporarily, that the economy is not improving or maybe even deteriorating. This becomes apparent, for all to see, when the money supply growth slows down and all the cards are finally revealed. In light of the Fed taper, what banks do going forward is hence of crucial importance for all and an important reason why it is monitored in this report.
And banks are no doubt currently driving money supply growth (also see article from two weeks ago). In fact, lending to commercial and industrial ventures are booming in the U.S. as it has increased by more than 10% compared to last year for the last seven bi-weekly periods in a row, most recently by 11.5%, the highest since January last year. As explained two weeks ago, what is happening now in the U.S. economy is a text book example of the classic trade cycle theory which explains how a portion of easy credit and newly created money ends up being malinvested resulting in a false boom followed by a very real bust (e.g. here). How long it continues and to what extent remains to be seen.
According to some reports, a portion of this borrowing by companies is used to lever up balance sheets (e.g. here). During the last twelve months, increases in Commercial & Industrial Loans (CIL) made up 44.3% of the overall growth in Loans & Leases, of which CIL is a sub category. This increase in CIL has again helped fuel Bank Credit and money supply growth. Bank Credit increased 5.4% for the bi-weekly period ending 9 July 2014, the highest since January last year and nearly five times higher than the 1.1% reported at the end of last year. The M2 money supply growth came in at 6.5% for the week, slightly down from the 6.8% reported two weeks ago, but slightly higher than the 52 week moving average.
The 1-year treasury yield was unchanged from two weeks ago while the 10-year declined by one basis point. Compared to the end of last year, the two have declined by 2 and 46 basis points, respectively, but are virtually unchanged compared to the same period last year. The yield on both remain of course substantially lower than the long term averages since 1984, while the spread between the two is 91 basis points higher than average.
Key U.S. monetary statistics and charts as of 9 July 2014 (treasury yields as of 18 July 2014):
Disclosure: The author is short MYY.