Verizon and Velocity
What is the significance of the fact that Verizon on Wednesday managed to sell $49bln in bonds without any kind of hiccup?
Obviously, it means that the corporate market is doing okay, that investors who are starved for good spreads like the attractive spread the bonds were priced at, and that there is reasonable confidence in the marketplace that Verizon can succeed even as a much more-leveraged company. All are good things.
But here is another thing to think about. My friend Peter Tchir, who writes the excellent T-Report, noted this morning that “Investors weren’t selling other bonds to buy Verizon.” That is, a fair amount of the money may well have been coming out of cash to go into the Verizon bonds.
Why does this matter? Remember that the velocity of money is the inverse of the demand for real cash balances. That is, when everyone is holding cash, the velocity of money is low; when no one wants to hold cash, the velocity of money is high. I have shown the chart below (source: Enduring Investments) before and argued that higher interest rates will tend to increase velocity by decreasing the demand for real cash balances. At least, that usually is what happens.
What would a turn higher in velocity look like? Well, I think it may well look something like this. “I no longer have to reach as much for yield and take all the risk I had to in March to get a 3% yield. So it’s time to invest some of this cash.”
Now, the ultimate flows get a little confusing, because cash is neither created nor destroyed in this transaction. Cash is transferred to Verizon from investors; Verizon then transfers that to Vodafone investors, who perhaps put it back in the bank for no net change. But if those investors in turn say “I don’t want those cash balances, either,” and then go invest or lend it or spend it, then you’re starting to see how money velocity is increasing. The money essentially becomes a kind of financial “hot potato” now, moving more rapidly from investor to investor, from consumer to vendor, and so on. The volume of transactions rises, which increases prices and output as explained by the MV≡PQ monetarist credo.
And that is how higher rates can produce more inflation.
We are seeing other strange things, too, that could be consistent with this explanation. Another great blog, “Sober Look,” observed last week that 30-year jumbo mortgage loan rates have fallen below conforming mortgage loan rates. Their explanation of the phenomenon is worth reading, but note this part: “Flush with deposits, banks have access to extraordinarily cheap capital and are seeking to earn more interest income.” Yet this has been true for some time. What has changed is that interest rates are now higher, increasing the opportunity cost of cash in both nominal and real terms.
This doesn’t automatically mean that money velocity is increasing; it may just be an interesting bond sale and unusual market activity in jumbo mortgages. But it is worth thinking about, because as I note in that article linked to above, even a modest rise in money velocity could produce an aggressive response from inflation.
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I take your general point, and probably agree with it. But the very things you say in the paragraph that starts “Now, the ultimate…”, undermine the idea that today’s transaction alone could be evidence of increasing velocity.
This, by itself, makes no sense:
“Investors weren’t selling other bonds to buy Verizon.” That is, a fair amount of the money may well have been coming out of cash to go into the Verizon bonds.
Money can’t “come out of cash.” (This is, of course, what you say yourself later on). What’s true by definition is that cash went from some investors to Verizon. What’s unknown, and what’s relevant here, is what you talk about in the “now” paragraph: what happened to that cash next? How many more transactions did it participate in in quick succession? The fact that the transaction itself happened may very illustrate a phenomenon if you have other reason to believe that phenomenon is happening, but it can’t itself be evidence of the phenomenon.
Fair enough. This is the problem with working things out while I’m writing! I suppose what I mean is that the mindset that leads to investors falling all over themselves for a massive bond issue, and using cash to do it, suggests that many investors are looking for ways to decrease their cash holdings. It’s that mindset that the transaction might be evidence of…and that mindset, if it is symptomatic of a general mindset throughout the economy, is what will be reflected in higher velocity. I definitely could have been clearer on that line of reasoning! Thanks for calling me on it.
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It just happens to be a pet peeve of mine that so much financial journalism and blogging talks about things like “lots of cash on the sidelines,” “money moving from bonds into stocks,” etc. I started composing my comment in my head when I read the first few paragraphs and couldn’t manage to hold my tongue even after I found you making the point much better further down. I certainly think its plausible that people are looking to get rid of cash as yields start looking more enticing. One other piece of evidence for this is how much discussion there has been, in the last two months, of Mreits on seeking alpha.
No, that’s a pet peave of mine as well although for a different reason. It is common practice for a mutual fund that invests in equities to hold some cash to meet redemptions but to maintain a beta equal to 100% by holding futures. So the amount of cash has really less to do with the degree of general bullishness or bearishness of investors than most techies think, at least at low levels of cash. You could be 100% bullish but hold 100% cash, just by holding futures also. However, the higher the cash holdings go the more likelyit is to indicate that investors think there is a dearth of investing opportunities or too much risk for the potential reward available. It’s just an overused phrase. None of that observation of course has anything to do with the amount of cash held generally by all investors…just the funds. But I also dislike the phrase.
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Sorry for the double post—but one other thing I wonder: to the extent that the velocity increase is taking the form of investor buying bonds so that one company can acquire another, won’t the velocity produce financial asset inflation (of which we arguably have already had plenty!) more than consumer price inflation. If that’s true, then is it possible that accelerating financial asset inflation provides a release valve for monetary velocity? And would that mean that CPI would remain (relatively contained) precisely up until investors decide (for whatever reason) to shed their risk appetites?
I have wondered this for a while too, whether financial asset inflation acts as a pressure vessel that holds inflationary pressures for later release into the system. However, when I buy a bond from you at an elevated price, you get more money to spend. (On the other hand, as the chart shows – higher bond prices imply lower velocity). I wrote something a year ago, though http://mikeashton.wordpress.com/2012/08/28/regime-change-economist-style/ illustrating that higher equity market valuations are coincident with higher velocity. So I am not sure the sponge theory/pressure vessel idea works.
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