Money Printing and Rising Prices

Today we will take a look at the markets, taking a snapshot of where things stand as the most massive bout of fiscal and monetary intervention in history comes ever closer to winding down. The old Wall Street adage of 'sell in May and go away' may well prove to be good advice again as the anniversary of the 'flash crash' approaches. In the wake of the extraordinary monetary stimulus provided by the Fed, the prices of all so-called 'risk assets' (stocks, commodities,  high-yield bonds) have increased to levels where they have once again become extremely risky to own.  Given that Ben Bernanke himself has stated that pushing up stock prices and lowering risk premia more generally in order to create the so-called 'wealth effect' was one of the policy's goals, some people argue that 'success' has been achieved. One person so arguing is none other than Paul Krugman, who now calls the rising stock market  the 'new monetary policy transmission mechanism', which is supposed to have 'replaced housing' as the 'transmission mechanism' of yore. Krugman wisely left a back door open by stating that he is unsure of the sustainability of the recovery. As one perceptive reader wrote in the comments section:


Since economies don’t have or need “traction”, your Krugmanite model is silly, worthless and misleading. We always know what the “transmission mechanism” for money dilution is: Theft of purchasing power from those holding the existing money and other Cantillon Effects. If the new spending was based on an increase in stock prices, no new “wealth” was created. Instead, the Fed’s manipulations merely shifted existing purchasing power to those purchasing or owning stocks. The rise in stock values did make the owners of those stocks richer in the short run vis-à-vis people who lost purchasing power and induced them to spend more than they would have without the artificial grant of stolen purchasing power.”


There is no doubt that when monetary pumping is underway, some prices will rise, but the central bank has no control over which ones. This is amply demonstrated by the fact that the US housing market remains firmly in the dumps, with prices falling back to their 2009 lows after the effect of the 'first time buyer' tax credit has waned. However, it is a good bet that the Fed was hoping to hold up prices in this market more than any other. If you wonder why we are asserting this, consider the chart below:



Real Estate loans at commercial banks – declining from the bubble highs due to write-offs, but still at a lofty level, to put it mildly. The fact that the market prices of the collateral behind these loans are still falling is probably of major concern to the Federal Reserve – click for higher resolution.



We can also be fairly certain that the Fed is unhappy to see commodity prices rise as strongly as they have – of course the Fed denies responsibility for this – as we have noted before, Fed chairman Bernanke has insisted in the past that rising commodity prices have little to do with the Fed's inflationary policy. The above linked NYT article mentions an exchange between Rep Paul D. Ryan and Bernanke:


“Mr. Ryan all but accused Mr. Bernanke of devaluing the dollar, saying, “There is nothing more insidious that a country can do to its citizens than debase its currency.”

Mr. Bernanke said the rise in commodity prices was mostly “a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply.” He did not mention China by name, but he has in the past.

He added that overall inflation was “still quite low” and that longer-term inflation expectations, which can influence short-term changes in prices, were stable.”


According to Bernanke 'inflation is low', but that requires redefining inflation as  just one of its effects (rising prices). Defined properly, as an increase in the supply of money, inflation has been and continues to be extraordinarily high:



US money supply TMS-2 ('broad' Austrian money supply, via Michael Pollaro) – inflation has been on a tear. According to Bernanke, there has been 'very little' of it. According to the money supply data, there's been plenty – click for higher resolution.



Back when Kartik Athrea wrote his jeremiad against unwashed economic bloggers, he mentioned Gregory Mankiw as 'one of the exceptions'. This was probably due to Mankiw's infamous NYT editorial of December 2007, which advised us that in order to 'avoid recession' we should 'let the Fed do its work' (that didn't quite work out, but what the heck…we shouldn't judge modern day macro-economists by the practical value of their theorizing and planning, right?). Mankiw closed his article by saying:


“The truth is that the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team as we are ever likely to see. They will make their share of mistakes, but it is too easy to find flaws when judging with the benefit of hindsight. The best Congress can do now is to let the Bernanke bunch do its job.”


In the meantime, the Fed's 'crack team of PhD economists' has come to Bernanke's assistance, with propaganda disguised as economic research. The latest coup of these taxpayer financed econometric magicians: a study that reveals that money printing (i.e., 'quantitative easing') not only is not responsible for rising commodity prices, but actually leads to falling commodity prices.  As Economic Policy informs us:


“Two economists at the Federal Reserve Bank of San Francisco, Reuven Glick and Sylvain Leduc have just reached the conclusion that Fed money printing doesn't cause price inflation. In fact they go one better, they claim that Federal Reserve asset purchases (which create money out of thin air) are deflationary.  I am not making this up. Here's the introduction to their argument:

Prices of commodities including metals, energy, and food have been rising at double-digit rates in recent months. Some critics argue that Federal Reserve purchases of long-term assets are fueling this rise by maintaining an excessively expansionary monetary stance. However, daily data indicate that Federal Reserve announcements of large-scale asset purchases tended to lower commodity prices even as long-term interest rates and the value of the dollar declined.

What makes them so sure about this price deflation? They start off by telling us this:

…commodity prices have surged since Chairman Bernanke’s Jackson Hole speech. The Goldman Sachs Commodity Index, a heavily traded broad index of spot commodity prices, rose 35% between the Jackson Hole speech and the end of February. The increase was widespread, spanning a range of commodity categories. Industrial metals rose nearly 30%, energy prices climbed 35%, and food prices rose close to 50% during the six-month period.

So how with these facts do they reach their conclusion. They argue this way:

The LSAP [Large Scale Asset Purchases] announcements about monetary policy may have signaled that the Fed perceived economic conditions to be weaker than previously thought. Alternatively, they may have increased market worries about risk and made Treasury securities more desirable as safe-haven investments. Thus, an announcement that makes investors feel that conditions are worse than originally perceived or that heightens risk concerns may lead investors to increase their demand for Treasuries, lowering their yields. These concerns also could reduce investor demand for other assets, such as commodities, resulting in lower prices.

They then go on to report on an absurd empirical study that they completed. There are methodological problems with empirical studies in the first place in the social sciences, but this study is over the top in its poor structure.”


You couldn't make this up. We will however continue to stick with economic logic and that tells us that when the supply of money increases markedly, numerous prices are likely to rise. It is no coincidence that the prices of commodities and titles to capital (which is what stocks represent) are rising very strongly.  An artificially low interest rate does after all tend to increase the prices of higher order or capital goods relative to those of lower order or consumption goods. This can be easily understood by picturing the temporal ordering of the production structure – the further away a good is from becoming a present good, the more influence the interest rate by which its present value is discounted will have on its market price.  One can look at the effect also from a different angle – a low interest rate would normally indicate that time preferences have become lower, i.e. that consumers are increasing their savings. An increase in savings in the here and now means that consumption is being deferred in favor of production with the aim of consuming more in the future. A low interest rate therefore signals that the pool of savings is sufficiently large to enable more time-consuming and hence more productive production processes than before. More investment will be drawn toward production of higher order goods as a consequence. Monetary pumping has the same effect, as it artificially lowers interest rates and the additional money created so to speak masquerades as actual savings.

We have previously noted that real estate can be regarded as a higher order good for analytical purposes – so why are real estate prices still under pressure? The answer is that during the last boom so much capital has been malinvested in this sector that the Fed's monetary pumping has so far failed to significantly arrest the process of liquidation that is still ongoing in housing. Since houses are especially long-lived goods, an oversupply problem in the sector is not easily or quickly resolved.

We would also note, Bernanke's assertion about emerging market demand for commodities is not entirely without merit. After all, the Fed is not the only central bank that has vastly increased the money supply. For instance, China's central bank in conjunction with the country's commercial banks has done exactly the same and the resulting building boom in China has greatly contributed to soaring demand for commodities. Lastly, commodity prices were immersed in a bear market from 1980 to 2000 following the boom of the 1960's and 1970's and it takes a long time for investment in the sector to turn around and increase supply. This is mostly due to the massive regulatory hurdles commodity producers have to contend with, but also a matter of the enormous capital investment involved. Producers have to be reasonably certain that prices will remain high enough to justify investment in new production capacity. It is e.g. estimated that from the discovery of an economically viable ore body to the commissioning of a new mine up to ten years or more can pass.

As a result of all these factors, commodities are nowadays a favorite target for speculative investment as investors desperately seek to preserve the purchasing power of their savings in the face of enormously profligate monetary and fiscal policies.


The Echo Bubble Becomes Very Stretched

Lately the financial markets are once again giving us subtle signals indicating that risk has become very high relative to the potential reward. We mentioned on Thursday that a number of stock market related sentiment indicators are once again at extreme levels. To this it should be noted that sentiment indicators are always to some extent a function of the price action of the recent past. They are most valuable as actionable signals when they diverge from the price action. However, when they go to rare extremes one must be on guard as well. What makes the current period interesting is that we detect extremes in speculator positioning in futures and options across the breadth of markets that can be said to be 'money printing beneficiaries'. The idea that what one could call the 'Bernanke put' will continue to support ever higher prices is certainly well established in the minds of traders.

As regards market-immanent signals, one can not state that they are 'unequivocal' – some of the indicators we are watching are giving us strong warning signs, others still seem to be in 'all clear' mode. If that were not the case, market timing would be easy. We are in fact not engaging in an exercise in short term market timing. Rather we are taking the aforementioned snapshot of conditions and conclude that risk remains uncommonly high.

There is an important fundamental reason why this uncommonly high risk may  soon find expression in an increase in market volatility. Due to the rise in financial asset and commodity prices and the recovery in some economic statistics, central banks are beginning to become more stingy with their monetary accommodation. Some central bankers are – unlike Ben Bernanke and Mervyn King – worried by the increasingly obvious effect their policies have on prices. Others are increasingly feeling the political backlash that these rising prices have produced. Thus the Federal Reserve's policy making arm is these days split between 'hawks' and 'doves' and a pause in the inflationary policy is  to be expected. However, when looking at credit market data, we can see that the commercial banks have as of yet not 'taken the baton' from the Fed and begun to increase their lending. Hence a discontinuation of the quantitative easing policy is likely to lead to a sharp slowdown in money supply growth – with the attendant effects on real economic activity. Normally these effects will be felt with a considerable lag, but we suspect that such lags will be much shorter nowadays on account of the  visible lack of private sector credit demand (more on this further below).

We will first look at the stock market. Apart from the growing list of sentiment extremes, we note that lately the normally leading technology sector has begun to noticeably lag. This may just be a temporary hiccup, but the growing gap has definitely caught our attention:



SPX (candles) vs.  NDX (solid black line) – up until the top made on February 18 (an options expiration, incidentally), the NDX has led the advance. In the rebound following the sell-off inspired by the earthquake in Japan, it has begun to lag – click for higher resolution.



One of the reasons for the somewhat weaker relative performance of the NDX can be found by looking at the stock that has the biggest weight in the index, Apple (AAPL). What is remarkable about the recent soggy performance of AAPL the stock is that the company is 'firing on all cylinders' in terms of its fundamentals. It has after all just introduced the inedible, but cheap, 'iPad 2' tablet computer (see William Dudley's comments) that is by all accounts  eating the competition's lunch, so to speak. If that is not enough to enthuse more buyers to want to pay up for the stock, what will? Note here that AAPL is one of the most widely held stocks among hedge funds (195 funds hold the stock as of late March). We would therefore watch closely how the stock handles the approaching lateral support level – since most fund managers are bound to sell first and ask questions later should it break.



AAPL, daily. Momentum is waning and the stock has produced a second lower high. There is a layer of lateral support between roughly the $320 and $328 level that needs to hold on pullbacks – click for higher resolution.



Another measure we are watching to gauge risk appetite is the ratio of the S&P 500 to WalMart.  WalMart is the quintessential 'place to hide' for long-only fund managers, due to its perceived status as a recession-resistant 'stodgy' stock. It has markedly lagged the rally in stocks to date, a sign that risk appetite has been on the rise. However, we note there is a subtle indication that this may be about to change:



The SPX-WMT ratio vs. the SPX (solid black line) – it looks like the ratio may be bottoming here. If so, then risk aversion will be on the rise again. We recommend keeping an eye on this – click for higher resolution.



In the technology sector we are also puzzled by the deterioration in the world's premier networking stock, which has become a habitual victim of 'gap down' action right after reporting earnings. This is likely company specific, as the AMEX Networking Index ($NWX) looks fairly strong, but we bring it as an example of a former market darling that has fallen on hard times – it is a reminder that there is no such thing as an 'invincible stock' (this is something fans of today's 'market darling' stocks should keep firmly in mind; it is often best to jump ship when things look the brightest).



Stair-stepping down – no, this is not the dollar, it's Cisco. The high-volume gaps are the reactions to earnings reports and/or warnings – click for higher resolution.



A weekly chart of the VIX also gives us pause. Sometimes the VIX will move due to short term quirks (e.g. it often decreases sharply close to option expiration as the front month options lose their time premium and increases again right thereafter), but it seems that it has found a long term support level in recent months and following the recent rebound in stocks it has produced a slightly higher low:



The VIX, weekly with the SPX (solid black line) in the background. The 15 – 16 level appears to be a longer term support zone now. Note the tendency of weekly MACD to make higher lows over the past year – click for higher resolution.



We have previously mentioned that OEX option traders are considered to represent 'smart money' and that therefore a rising OEX put-call volume ratio is generally reason for concern. Below we look at a related indicator, the OEX put-call open interest ratio. This ratio has more inertia than the volume ratio and its signals are thus not as frequent. It is currently indicating that OEX option traders are increasingly worried about the stock market. If they are worried, everybody should be, but as usual the opposite is actually the case, i.e. everybody else is rather complacent. For instance, the mutual fund cash to assets ratio remains stuck at 3.5%, a mere 10 basis points above an all time low. In any case, the OEX put-call open interest ratio is giving off the first major warning signals since the 2007 topping period:



Traders in OEX options become ever more worried – this is the third foray of the put-call open interest ratio into 'sell' territory in recent months. Note the previous spikes that occurred in 2007. Chart from J. Goepfert's excellent service – click for higher resolution.



Another noteworthy development is the steady decline in the NYSE short interest ratio since its 1997 highs. This indicates that short sellers are increasingly intimidated by the stock market's 'Teflon' qualities.  This is incidentally going hand in hand with NYSE margin borrowings reaching their highest level since 2007.



The NYSE short interest ratio has plunged to a mere 2.1 – this is to say, it would take an average of 2.1 days worth of trading volume to cover all outstanding short positions. The market is thus losing an important prop of support on declines, which are often softened by short covering – click for higher resolution.



One stock market that is not surprisingly still lagging the rebound that has been observed elsewhere in the world is Japan's Nikkei, which has only recovered about half the ground lost after the earthquake and is currently bumping against resistance provided by the 200 day moving average. The recently weakening yen no doubt has lent some support to the Nikkei, but it remains to be seen whether the yen can be relied upon to remain weak (small speculators hold their largest net short exposure in yen futures in a year). The Japanese stock market is one of the few in the developed world that deserve to be called 'cheap' on fundamental grounds.



The Nikkei has regained about half of its tsunami-induced losses amid a weakening of the yen – click for higher resolution.



Let us look at commodities next. Speculation in commodities has become quite astonishing, to say the least. In many cases one feels reminded of a beginning 'crack-up boom', where money increasingly flees into hard assets to avert the loss of purchasing power associated with an inflationary policy. As such the rise in commodity prices is quite logical, but we suspect that it is becoming too stretched in the short term in view of the upcoming end of 'QE2'. We would remind however that just as is the case with stocks, commodities do not tend to top out all at once. There will be leads and lags within the group and the terminal advances of the commodities the market is fixated upon can become much bigger than anyone thinks possible (good examples for this are the Minneapolis Spring Wheat contract in early 2008, which went from an already elevated $10/bushel to $24/bushel in the space of two months, or the relentless advance in crude oil into its summer 2008 high at almost $150).



Hard Red Spring Wheat, March 2008 contract. It was 'overbought' at $10 and then it went to $24 – click for higher resolution.



As can be seen by the example above, blow-off moves in commodities can become very big and often huge advances are accomplished in a matter of weeks and even days, with the price increases becoming more pronounced as panicked shorts begin to cover. It is always a good idea to watch open  interest during these moves – as soon as it is declining, one knows the advance has become a function of forced short covering and is thus in its final stretch.

Copper is the one base metal we always keep an eye on. It is supported by a 'good story' – namely that mine supply is insufficient to meet projected demand (see recent comments by Chile's biggest producer, Codelco) – and it is subject to a lot of speculative buying and hoarding (scroll down to 'Coppery Shenanigans' in this post). Clearly copper is one of the metals most reflective of the combination of monetary pumping and the waxing of economic confidence. Its chart has recently looked a bit wobbly, but over the past several trading sessions it has regained quite a bit of lost ground, overcoming the 50 day moving average again that has briefly offered resistance on a previous rally attempt:



Copper, continuous contract chart, daily –  it looks bullish again – for now, anyway. The $4.10/lb. level is important short term support, and price is now back at the zone of resistance between $4.50 and $4.60 – click for higher resolution.



Crude oil has broken out to the upside after essentially moving sideways for many months. We have previously commented (in mid October 2010 , before there was any unrest in the Middle East) on crude oil's consolidation with the words 'this type of consolidation more often than not resolves with an upside breakout' and this has obviously occurred. The question is 'how much further can it go'. To this we would note that crude oil is traditionally a 'late mover' (it was e.g. one of the last commodities to top out in 2008) and that it continues to be supported by the imponderabilities attending the situation in the Middle East (for instance, the bulk of Libya's oil remains off-line and it is unknowable when that will change). Nothing in the chart suggest as of yet that the move is over. In fact, a breakout from such a long-lasting sideways consolidation usually tends to lead to a big move.

We would however note that the if prices remain this high or go even higher  – and remember that Brent crude continues to trade at a considerable premium to WTI crude, so the average world oil price is actually higher than the WTI chart would indicate – then this will create a considerable headwind for the economies of the net oil consuming countries. In fact we can not recall a similar advance in crude oil's price that was not eventually followed by a recession in the industrialized nations.



Crude oil (West Texas Intermediate, continuous contract) and the SPX (solid line) – rising essentially in tandem, but crude is now quickly closing the gap that previously obtained between the two – click for higher resolution.



The CCI index (continuous commodity index, i.e. the equal-weighted CRB) keeps streaking higher, with numerous components recently reaching new highs for the move – click for higher resolution.



The CCI keeps moving higher – note how it made higher lows relative to the SPX in the summer 2010 correction. A similar divergence may become evident near the next major high.



A weekly chart of the CCI with WTI crude (black solid line) in the background. The CCI is in the meantime trading well above its 2008 pre-crash high. Commodities have overall strongly outperformed stocks in the 2009-2011 rally – click for higher resolution.



One of the sectors in the commodities space that is doing extremely well lately are precious metals, especially silver. In fact, silver's chart is liable to make one dizzy. It has just reached a new 31 year high and now remains only $9 below the blow-off top made in the 1979-1980 Hunt brothers silver corner rally. Believe it or not, on a very long term chart one can glean a potential target that lies even higher than this old high. This is not a prediction we hasten to point out. We are rather worried by the current enthusiasm in silver, since one can infer per experience that gold's more subdued advance will likely only continue if silver remains firm.  On the other hand, the interplay between silver and gold will likely be useful in gauging the timing of the rally's end.  Clearly this is not a good time for complacency.



Silver, continuous contract, daily. Going from overbought to more overbought in an accelerating move – click for higher resolution.



Silver weekly – it is overbought in this time frame as well, but recall our introductory comments on commodity blow-offs – it is difficult to tell where such a freight train comes to a stop – click for higher resolution.



A very long term chart of silver showing the potential target in the $55 region after the recent break of trendline resistance. We'd be surprised if it gets that far in this move, but who knows …  – click for higher resolution.


Gold has ended last week at a new all time high and its advance still looks fairly steady. In fact it appears likely that some sort of accelerated move will be in evidence before the next intermediate term high is put in, but this will likely depend on how soon the move in silver exhausts. Note also that gold in terms of the euro has not broken out to a new high yet, but the chart looks constructive as well.



Gold, daily. A breakout to new all time high ground in dollar terms. A new MACD 'buy signal' has just occurred. The blue dotted lines indicate the zone of near term lateral support – click for higher resolution.



Gold, weekly. A steady, slow advance that has covered a lot of ground since the 2008 low. In this time frame we also have an MACD buy signal – click for higher resolution.




The silver-gold ratio has become extremely overbought as well – just as it became extremely oversold in 2008. This is a measure of the waxing and waning of economic confidence, due to silver's dual role as precious and industrial metal. This ratio could be useful in timing the eventual top of the rally in precious metals – click for higher resolution.




A very long term chart of the inverse of the above ratio, the gold-silver ratio. It is approaching a level of long term support indicated by the straight line. If this should break, a move to the all-time low will become likely – click for higher resolution.



The daily chart of the HUI index of unhedged gold stocks has just broken out to a new high as well, belatedly confirming the rally in the precious metals. These days the index is 'dragged up' by the metals, instead of leading them, which shows that there is a measure of disbelief in the market that current metal prices are going to stick – click for higher resolution.



A weekly chart of the HUI index with the longer term lateral support level indicated by the dotted blue line (same as the lowest lateral support line on the daily chart above) – click for higher resolution.



The HUI-gold ratio shows that the index has largely 'shadowed' the gold price over the past two years, but recently it has begun to slightly outperform. A decisive breakout in this ratio over its 2009 high would indicate a more extended period of outperformance of gold stocks vs. gold. We will see if it happens this time – note that in the very long term, gold stocks are in a downtrend vs. gold since at least the late 1960's – click for higher resolution.



The one precious metal that has closely mimicked silver's strong performance is palladium. The palladium market is very small and as such prone to exaggerated moves – especially as it is still expected to be in a primary deficit this year, which means that dwindling stock piles will have to be drawn down further.



Palladium, weekly. This metal's rally has rivaled silver's advance – note however, there is now a weekly MACD sell signal in force. Palladium's old high in futures contract terms about 10 years ago was $1,100. If a supply-demand shortage persists, it may revisit that level in the longer term – click for higher resolution.



We don't know how much higher the various commodities can go – certainly speculators continue to hold vast net long exposure in the futures markets, but this has so far not been an obstacle to the rally.  As we noted above, such rallies can easily become 'parabolic' in their final stages. All we know for certain is that risk in commodities is just as high if not higher than in the stock market. We are partial to precious metals as insurance against fiscal and monetary profligacy, but the blow-off character of silver's rally suggests to us that the next correction in the sector is likely to be a major one. Caution is definitely advisable.


The Other Side of The Coin

Now we will take a look at the things that speculators tend to shun when the 'risk on' trade is in full bloom – namely the widely hated US dollar and the just as widely despised bond market. We are also going to look at the indicators that tell us that the commercial banking system is still unlikely to be prepared to inflate credit and money once the Fed pauses with quantitative easing. This in turn should put a brake on all sorts of bubble activities (i.e., economic activities that would not be undertaken without the support from monetary pumping). We are therefore quite confident that there will eventually be a 'QE3' – at least as long Ben Bernanke and his allies are manning the board of governors at the Fed.



The US dollar index, daily. The Fed has certainly succeeded in devaluing the dollar, but we note a growing divergence between lower price lows and higher MACD lows. Such divergences often precede (but don't guarantee) a trend reversal – click for higher resolution.



A weekly chart of the US dollar index shows it is once again approaching an important area of support that has marked a low in 2009. If this support breaks, the 2008 low will come into view. The 2008 low represents the final bastion of chart support – click for higher resolution.



The treasury bond market meanwhile acts similar to how it has acted in previous consolidation periods – it is a 'messy' trendless chart, but it remains firmly within the confines of a long term trading range. As such it is not yet truly 'confirming' the economic recovery and also seems to harbor doubts about the currently widespread inflation fears (this is to say, fears that CPI will rise faster than hitherto). What continues to be favorable to the treasury bond market is the fact that it is truly hated with a passion by just about everyone. While one of these days a funding crisis for the US government seems at least in the realm of the possible – in fact, given the large scale foreign participation in the treasury market and the government's vast unfunded liabilities it appears highly probable – this is unlikely to be a near to medium term concern just yet. We suspect that in the near to medium term, treasuries will continue to be driven largely by the interplay between growing risk appetite and growing risk aversion. In short, whenever stock and commodities sell off, treasuries are likely to strengthen and vice versa.



The US 10 year note, weekly. Maybe it is building a long term top as some say, but the fact is that it remains for now in the trading range it has inhabited for the past several years – click for higher resolution.




A measure of how 'hated' the bond market is – the Rydex bond ratio stands at 8.44. This means that the amount of money that is invested in the Rydex inverse government bond fund (that is shorting bonds) is 8.44 times larger than the amount of money in the Rydex long bond strategy fund. As can be seen, this ratio tends to be volatile, but has briefly even exceeded the 15 level this year. This is astonishing, as the very long term uptrend in the bond market remains unbroken to date. Since this ratio has been very high for many years, it is an example of sentiment diverging from price action – click for higher resolution.




It has been noted recently that China has become less enamored of buying US treasury bonds and that the absence of the Federal Reserve as a big buyer once 'QE2' concludes could therefore be construed as a negative for the bond market. We don't believe so. In fact, looking at both 'QE1' and 'QE2', these debt monetization programs were mostly successful in raising inflation expectations (rightly so) and therefore proved to be a net negative for the bond market. One must not forget the sheer size of this market in terms of daily trading volumes. Even a big buyer such as the Fed is unable to truly influence prices. Inflation expectations are the far more important factor in the price discovery process in the government bond market. In addition, the US commercial banking system has emerged as a major buyer of treasury bonds. This is in stark contrast to bank lending to the private sector, which continues to be largely conspicuous by declining.



Holdings of treasury securities at US commercial banks are  exploding into the blue yonder – seemingly right in line with the budget deficit – click for higher resolution.



The Fed's quantitative easing program, part 2, has further goosed the monetary base, but a large part of this has once again flown into 'excess reserves' – essentially the 'cash assets' of the banking system that remain sequestered with the Fed and have yet to enter the economy via an increase in bank lending. Since the Fed keeps insisting that it 'will take QE back', the banks have no incentive to let go of these excess reserves. As we will see further below, there is also not a lot of private sector credit demand. The private sector clearly remains in deleveraging mode. It must be noted however that concurrently, currency in circulation has also exploded higher. This forms part of the vast increase in the true money supply the Fed has managed to engender in concert with the government's deficit spending, essentially shifting the 'job of inflating' from the private to the public sector.



Base money to the moon. This forms the bulk of the liabilities side of the Fed's balance sheet, i.e., currency in circulation (including 'vault cash') plus bank reserves parked at the Fed – click for higher resolution.



Excess reserves of the banking system held at the Fed, which pays 25 basis point in interest on this mountain of digital money. As long as these reserves are not used to pyramid new loans on them they remain outside of the economy and are thus only 'potentially inflationary'. As can be seen on this chart, in pre-crisis times, the banks held practically no excess reserves at all with the Fed. In fact, the level of 'required reserves' plunged throughout the 1990's, and remained largely flat through the 2000ds, in spite of bank credit inflation accelerating throughout the entire period. This was due to banks using 'sweeps' that allowed them to let demand deposits masquerade as savings deposits (or more precisely 'MMDA's', or money market deposit accounts) and later the hiving off of certain types of consumer credit from bank balance sheets. The return of about $360 billion of such off balance sheet loans to their balance sheets in 2010 (the only tighter rule FASB has been able to impose on the banking system) has imparted a one time boost of about $20 billion to required reserves – click for higher resolution.



Currency in circulation – the part of the monetary base that is most definitely part of the money supply inflation we have observed. 'Only' up by about 20% in a little over two years, but fear not, the increase in deposit money dwarfs it by a large margin. As can be seen currency has roughly doubled since 1999. This must be compared with the concomitant increase in TMS-2 by roughly 150% over the same span. No inflation? – click for higher resolution.



Total loans and leases at the commercial banking system – by contrast to its treasury bond holdings – continue to decline.



Total loans and leases of commercial banks. Note that the brief spike higher in early 2010 is a bit misleading, as this came about due to the aforementioned one-off move of existing off-balance sheet consumer loans back onto bank balance sheets. Absent this $360 bn. spike, the total would be plumbing new post crisis lows – click for higher resolution.



Business loans at commercial banks. A tiny blip upward has been registered. The biggest decline in bank lending is in real estate lending and revolving credit, both of which keep falling to new lows – click for higher resolution.



Demand for small business loans has as of yet not recovered back into positive territory. Note that this measure registers consistently negative 'growth' since about 2006 – incidentally the year in which the real estate bubble topped out in terms of prices – click for higher resolution.



In browsing various data we also came across the following curious fact. While lending standards have been loosened in every area, credit demand has remained weak in all areas but one (leaving aside margin borrowing for stocks, which has exploded). This one area that sees rising credit demand is also the only one in which credit standards are still tightening.  Guess which one it is – sub-prime mortgages!



Demand for sub-prime mortgages is strongly rising – incredibly, one might say….only the prospective deadbeats apparently really want more credit – click for higher resolution.



Alas, sub-prime mortgages are still making the banks nervous. 50% of loan officers report that their lending standards for sub-prime are once again tightening – click for higher resolution.



Meanwhile, consumer confidence continues to flounder – no doubt a mixture of apprehension due to the still high rate of unemployment (if we count those that have 'fallen out of the statistics' for one reason or another, the reported mild decline in unemployment is in any event not very believable), the continued decline in home prices and rising prices for necessities, such as food and energy, i.e. the things the prices of which the Fed regards as less important than those of e.g. iPads, but which apparently bother the average consumer somewhat. The dichotomy between sharply rising stock prices and consumer confidence that remains mired close to the lows seen in several previous recessions provides what Robert Prechter refers to as the 'depressionary undertones to the party'.



Consumer confidence remains in the dumps. It has been mired in a downtrend since 2000, the time when the stock market mania made its 'orthodox' top with the blow-off in technology stocks – click for higher resolution.



Lastly here is a reminder that the  age of credit and money supply inflation really took off with the abandonment of the 'gold anchor' by Richard Nixon in 1971 (let's not forget to thank Paul Volcker also, who was one of the advisers in this particular tragedy) – a long term chart of total credit market debt. Remarkably, in spite of the decline in private sector borrowing, this data series has already reversed its post crisis downward blip as a result of the public deficit going gangbusters.



The total credit market debt parabola – recovering from its unintended small blip already. One of these days, someone will pay it all…..just kidding! – click for higher resolution.



Until any of these things matter again – party on!


Charts by: Bloomberg,,, Michael Pollaro, Federal Reserve of St. Louis




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4 Responses to “Risk Is Growing Like A Weed”

  • rojasrod:

    thank you for this amazing post

  • Joe Bloggs:

    So basically, although most of the new money ends up back with the Fed as excess reserves, the remainder goes to non-banks, and the Fed Govt (via purchases of govt bond). This money is measured as growth in the TM2 and rising commodity prices.

  • Joe Bloggs:

    You say that the Fed’s monetary policies are responsible for rising commodity prices, yet you also show that most of the money injected by the Fed is held in excess reserves. None of the charts show conclusively that the rise in commodity prices is due to substantial increases in the money supply.

    Also, you mention an explosion in the growth of margin borrowing for stocks. I would be interested in seeing the data on that.

    • Look again the chart of money TMS-2 provided early on in the article. The money supply has risen sharply, in spite of the fact that a lot of the QE money has been added to excess reserves. Since August of 2008, the true money supply in the US economy has risen by some 33%. The Fed buys bonds not only from commercial banks, but also from non-banks, which increases the amount of deposit money directly while adding to excess reserves at the same time. Moreover, the banks do not simply hoard every cent they receive in POMOs as excess reserves. As shown above, they have in fact increased their holdings of treasury bonds sharply. Thus money created via QE does ultimately find its way into government’s hands, and government spends the money. These two factors explain why the money supply has risen so sharply. That rising prices – including commodity prices – are an effect of the inflation of the money supply is a matter of economic logic.
      For a really detailed explanation I refer you to an earlier article on the mechanics of QE:
      I will add a chart of margin borrowings to the next post.

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