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Money, Money Everywhere (And Not A Drop Of Liquidity)

For the time being, the oscillations have resolved in favor of the bulls as stocks soared 4.6% today (and it was well more than 5% until profit-taking at the close shaved the gain). Liquidity, as it has been all week, was poor and that clearly is contributing to the severity of the swings.

The rally was not a response to news. That’s not really surprising; I cannot imagine what kind of news could be dropped into the current cycle to warrant a 5% move in equities. It certainly wasn’t Initial Claims, despite Bloomberg’s headline – on their TOP news page all day – that “Stocks in U.S. Rebound, Treasuries Fall on Decline in Unemployment Claims.” That’s just stupid. It is true that there was an improvement in Initial Claims (to 395k versus expectations for 405k), and it is true that stocks rallied, but there is no relationship between those two statements. I can state authoritatively that a 10k miss in Claims does not, and will never, cause a three-quarters-of-a-trillion-dollar rally in the stock market. If you have an equity fund manager who bought stocks up 4% “because Claims were better than expected,” change funds.

Now, as the chart below shows, Claims isn’t doing too badly. While 400k per week is not great, it’s also not a disaster (unless, after a multi-year recession, there aren’t many as many people to lay off).

Initial Claims are improving, modestly. Worth 5% on stocks? Probably not.

Employment lags the economy anyway, and there’s nothing in this chart that excites me about either expansion or recession. Move along.

The market moves are about European news or the lack of it. Today, that news is that the European Securities and Markets Authority is considering recommending a short-sale ban in Europe.  After all, the ban against selling financials short, and then an ever-widening list of stocks, worked so well in late 2008! There are many examples of this sort of nonsense, and they almost uniformly produce a rally (as short-sellers cover) followed by a decline which is sometimes made more precipitous since the longs who want out have no one to sell to now. Even given our own Administration’s penchant for over-regulation, it would surprise me to see such a ban instituted when we haven’t even seen stocks decline 20% from the highs yet – but traders know that if it’s instituted in Europe and European stocks rally 8% over a day or two as a result, our market will rally in sympathy. Late in the day, France, Spain, Belgium, and Italy instituted short-selling bans.

I suspect that is a big part of what is behind this rally, although there are also plenty of investors who simply think stocks are cheap and are buying so as to make sure they don’t miss the bottom. Volume was much worse than it has been for the last few days even though the point swing was huge, but volume was still far better than it has been for most of the year.

There may be some people who are buying because the situation in European sovereign debt appears to be improving, with Italian and Spanish yields dipping below 5% today. But what did it take to get them there? Authorities have shown repeatedly that they can produce the illusion of a solution with relative ease. The question is whether they can produce an actual solution, and I’ve not seen any sign of it yet. What will happen is that in a few short days or weeks, just as with Greece, natural sellers will unload Spanish and Italian bonds at the new, gift price, and prices will go back down. The only way the EU can keep that from happening is if they persuade the longs (not the shorts!) that the current price is fair, or even cheap, so that the owners of the bonds want to continue to hold them. I seriously doubt that any of the banks currently stuffed to the gills with sovereign paper are having meetings today saying “hey, I like our Italian bond exposure now. Let’s add to the position!”

In contrast to Italian and Spanish debt, U.S. bonds fell sharply today. TIPS yields jumped 20bps and the nominal 10y rose 22bps to 0.02% and 2.33% respectively. Dealers who bought the long bond at auction today are wearing losses, and those are big basis points. Inflation swaps were tighter in the short and middle part of the curve, and roughly unchanged at 10 years.

Commodities rallied sharply, with the exception of precious metals. Gold fell $32.80, for a change. The COMEX increased margin requirements for gold last night. When it did the same thing for silver a couple of months back, that contract was crushed; in this case, gold barely noticed. All of the other commodity complexes rallied. Crude oil rose back over $85. Grains were +2.8%, Livestock +1.6%, Softs +1.3%, and Industrial Metals +2.4%. All of this is with the dollar unchanged. I think commodities investors are thinking back to the Jackson Hole conference last year, and the blast-off that ensued when Chairman Bernanke pre-announced QE2.

Many analysts are thinking that past may be prologue and that Bernanke may kick off QE3 with a speech at Jackson Hole again. I am not one of those analysts, but I understand the thought.

However, I think the Fed has done about all that it plans to do for a while. And I’ve come up with another way to think about the “Fed Pledge” that gives the Fed a little more credit (though not much). I think it’s plain that the Fed would be content with a little bit of inflation. That’s probably been the case since 2009. Many of the problems we have would be easier to tackle if the economy produced 3-4% inflation for a few years instead of 1-2%. Well, it is easy for a central bank to create inflation: just multiply the money supply by 10x and you will get inflation. The problem is that it is very difficult to create responsible inflation. And more than that, the Fed can’t tacitly let inflation rise without response, lest it lose credibility for abandoning the inflation part of the mandate.

And this is the generous interpretation of the Fed Pledge. By tying their hands, they allow higher inflation to happen without being duty-bound to fight it. The Committee clearly doesn’t believe that there is any chance of a long tail in inflation. They believe – as every FOMC has always believed – that they can rein in inflation whenever they want. So they’re willing to take the risk that inflation rises to 3-4% over the next two years. They’d actually like that, in a way.

I am uncomfortable attributing great cleverness (as distinct from intelligence) to the current Fed Chairman. It may simply be a colossal blunder from the Fed. But if he is clever, then this could be the reason the Fed chose to beat its sword into a plowshare.

This might turn out, cleverness or not, to be a bad idea. Today’s money supply numbers were jaw-dropping. M1 was up $100bln on increases in demand deposits. M2 was up an incredible $159bln. In addition to the rise in M1, savings deposits at commercial banks rose $59bln. As the chart below shows, this takes the annual, semiannual, and quarterly rates of change up to levels last seen near the very peak of the response to the 2008 crisis.

Holy smokes! Transactional money is growing at the fastest rate since 2008.

Now, I am sure someone is going to tell me why I shouldn’t worry about all that money heading into savings accounts and checking accounts. And yet, I do worry. I insist on it. That money is eventually going to be spent on something. It is in the system. In a week, in a single week, a dollar sitting in a checking account became 1.7% less rare. I know the economy didn’t grow 1.7% last week, so there is 1.7% more money to buy the same amount of goods and services. That’s how prices rise.

I think stocks are setting up here for another leg lower, but I will change that view if the S&P can reach 1200. Some people will interpret the surge in M2 as good for stocks. I don’t, but I know that if stocks get to that level I won’t be buying stocks – I will be selling bonds.

Tomorrow’s Retail Sales (Consensus: +0.5%/+0.3% ex-auto) and August Michigan Confidence figures (Consensus: 62.5 from 63.7) are unlikely to have much impact on the market. The question for me is what markets do heading into the weekend. I assume there will be some element of ‘risk on’ if there are no big headlines tomorrow, since it will have been a couple of days since something bad happened. But I wouldn’t bank on it.


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  1. August 11, 2011 at 6:22 pm

    that looks like a staggering jump in M2.

    Q. Why wouldn’t this raise inflation expectation, i.e. expand the TIPS/treasury spread?

    • August 11, 2011 at 6:27 pm

      It ought to! The only reason it may not is that there are still a lot of people who think you can’t have inflation without growth, despite the copious contrary evidence.

      • Paul Michalk
        August 13, 2011 at 5:59 am

        Can you provide me with some of the “copious contrary evidence”? “Stagflation” of the 70’s can be traced to an oil boycott. You state “Many of the problems we have would be easier to tackle if the economy produced 3-4% inflation for a few years instead of 1-2%.” Why should this not be the goal of the Fed in this economy? I believe the lack of inflation is causing/allowing large pools of wealth to remain dormant (zero velocity). How can this be good for the economy?

      • August 13, 2011 at 8:14 am

        Well, the inflation of the 1970s was not caused by the two oil embargoes, nor wage and price controls. Each of those lasted only a short period of time. The inflation of the 1970s was caused by a number of Fed errors that led to very fast money growth. There’s also the circumstance of Zimbabwe, that has no growth and great inflation, and the US of the last few years where all of the popular models (especially the ‘augmented Phillips Curve’) would expect us to be in a serious deflation!

        I think that the goal of 3-4% inflation, helping debtors to recover painlessly, would ordinarily be a bad one but in this case is probably our only chance to get out of this disaster without massive displacement. However, there is no evidence that the Fed can target inflation that they want. Creating inflation in a 3-4% band is much harder than creating it in a 1-2% band because there’s a natural resistance to deflation and so you have a wall on one side. At 3-4% you have loosed the bonds of earth and individuals have difficulty distinguishing between 3-4% and 5-6%. That is, inflation is both higher at 3-4% and also less stable. So it’s a risky move. I think it’s worth a try, but my fear is that the Fed has far too much confidence that it will be easy.

  2. Jim H.
    August 11, 2011 at 7:28 pm

    From the Fed’s H6 report: …………………………. M1 growth ……… M2 growth

    3 Months from Apr. 2011 TO July 2011 22.7 15.6
    6 Months from Jan. 2011 TO July 2011 16.8 10.7
    12 Months from July 2010 TO July 2011 16.2 8.2

    Shades of 1979! Too bad money market funds aren’t paying 19% any more.

    • August 11, 2011 at 7:53 pm

      Yes, those are monthly average numbers, so it actually blunts the effect a little. I’m doing 13-week changes (8/1 week vs 5/2 week, times 4), 26-week, and 52-week.

  3. Andy
    August 12, 2011 at 9:11 am

    My concern is that we have become so overtly political in the management of the economy (if you can actually call what we do management), that the narrative of fomenting inflation is not allowed to be discussed because it is counter to the thesis that if we just add more liquidity and stimulus, things will get better.
    Unfortunately, I believe we have not felt enough pain yet in this financial crisis. All the attempts to prevent bad things from happening have not allowed markets to clear, and so the pain drags on much longer than it otherwise would. Inflation is merely a symptom of this mindset, and so will only be addressed when headline is 4% or higher.

  4. Lee
    August 12, 2011 at 2:51 pm

    The down-leg in the S&P hasn’t even started to project yet. So unless things are really really really different this time, there’s awhile to go until a sustainable move higher.

    August 12, 2011 at 3:30 pm

    Michael, could you kindly explain how this WALL of cash feeds into inflation, if it just sits idle on the bank accounts, as if withdrawn from the economic cycle (which it is, effectively)?

  6. August 12, 2011 at 8:50 pm

    This is a great question because the answer is so fundamental to understanding how money works!

    What happens when you take out money from the bank deposit and spend it? You pay the baker, who pays his employees, who then put the money back in the bank. Notice what has happened with the money!

    The stock of deposits doesn’t change in that transaction, but there has been economic activity. We call the number of times that dollar makes a round trip in a year the velocity of money. If you take the stock of money, times that velocity, you get total nominal activity. It’s an identity: the amount that is spent equals the amount of output. MV=PQ.

    So the only way that increased deposits will NOT result in more PQ is if somehow these new deposits have a lower inherent VELOCITY than the previous deposits. Is there some reason to think that this money will sit in the bank more than the money that was there before?

    That’s a tough call…I think that money in the bank tends to be spent (and end up back in the bank)…but I guess “we will see.” The Fed needs to hope that velocity declines.

  7. Frank R
    August 13, 2011 at 5:00 pm

    I seem to remember several discussions about IOER. I get the impressions that eliminating IOER would entice the banks to actually loan money, which should (?) increase V. Given the growing size of M2, I suspect that this could lead to inflation. How much o wise guru?

    • August 13, 2011 at 8:36 pm

      Well, it wouldn’t increase V (I don’t think), but it would increase M. Right now, that’s probably the last thing that the Fed really wants to do because it looks like money is getting into M2 all on its own – lowering IOER would accelerate the growth in M2, and you’re right: dangerous repercussions.

  8. Nicolas
    August 15, 2011 at 1:00 pm

    Hi Michael,
    The rise in M1 comes mainly from the Reserve Balances (+58% YoY) and not from the Ccy (+9.3% YoY). As long as those Reserves balances don’t pass through the economy, there is no risk of inflation. The rise in M2 does not bode well for the next GDP figures. According to me, a rise in M2 means that households are increasing their saving and not their spending.

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