by Rom Badilla, CFA – Bondsquawk.com
May 27, 2010
Milton Friedman must be turning in his grave as the Daily Telegraph reports that despite all of the federal stimulus, the U.S. Money Supply, M3 is contracting at an accelerated rate that matches the decline last seen since the Great Depression.
The M3 figures – which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance – began shrinking last summer. The pace has since quickened.
The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.
“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.
Lawrence Summers, the White House economic advisor said that the U.S. needs to continue to support the economic recovery via another stimulus bill to the tune of $200 billion. Addressing job growth and boosting output first before addressing the issue of the growing budget deficit should be the concern of U.S. lawmakers. According to the article, Summers stated, “”We are nearly 8m jobs short of normal employment. For millions of Americans the economic emergency grinds on.”
The White House request is a tacit admission that the economy is already losing thrust and may stall later this year as stimulus from the original $800bn package starts to fade.
Recent data have been mixed. Durable goods orders jumped 2.9pc in April but house prices have been falling for several months and mortgage applications have dropped to a 13-year low. The ECRI leading index of US economic activity has been sliding continuously since its peak in October, suffering the steepest one-week drop ever recorded in mid-May.
Mr Summers acknowledged in a speech this week that the eurozone crisis had shone a spotlight on the dangers of spiralling public debt. He said deficit spending delays the day of reckoning and leaves the US at the mercy of foreign creditors. Ultimately, “failure begets failure” in fiscal policy as the logic of compound interest does its worst.
However, Mr Summers said it would be “pennywise and pound foolish” to skimp just as the kindling wood of recovery starts to catch fire. He said fiscal policy comes into its own at at time when the economy “faces a liquidity trap” and the Fed is constrained by zero interest rates.
If the U.S. is unable to spark significant job growth through future fiscal policies, an economic recovery may never get off the ground. Stagnant growth coupled with downward pressures in price levels could result in the U.S. following the path of the Japanese who have been mired in the “Lost Decade” for close to 20 years now. Japan who has attempted to use fiscal measures as way to ignite growth now has a debt-to-GDP ratio of nearly 200 percent, tops in the world.
“Fiscal policy does not work. The US has just tried the biggest fiscal experiment in history and it has failed. What matters is the quantity of money and in extremis that can be increased easily by quantititave easing. If the Fed doesn’t act, a double-dip recession is a virtual certainty,” he [Mr Congdon] said.
Mr Congdon said the dominant voices in US policy-making – Nobel laureates Paul Krugman and Joe Stiglitz, as well as Mr Summers and Fed chair Ben Bernanke – are all Keynesians of different stripes who “despise traditional monetary theory and have a religious aversion to any mention of the quantity of money”. The great opus by Milton Friedman and Anna Schwartz – The Monetary History of the United States – has been left to gather dust.
Mr Bernanke no longer pays attention to the M3 data. The bank stopped publishing the data five years ago, deeming it too erratic to be of much use.
This may have been a serious error since double-digit growth of M3 during the US housing bubble gave clear warnings that the boom was out of control. The sudden slowdown in M3 in early to mid-2008 – just as the Fed raised rates – gave a second warning that the economy was about to go into a nosedive.
Mr Bernanke built his academic reputation on the study of the credit mechanism. This model offers a radically different theory for how the financial system works. While so-called “creditism” has become the new orthodoxy in US central banking, it has not yet been tested over time and may yet prove to be a misadventure.
With the collapse in the money supply, the threat of deflation as we have mentioned here on Bondsquawk a number of times is real and closer than most people think. Core CPI is dangerously low with little buffer and will continue to decline as prices decline in face of light demand from consumers who are dealing with job uncertainty. Furthermore, commodity prices are dropping along with markets that support it such as China and Australia.
The Daily Telegraph article warned against the mechanical interpretation of the M3 measure of money supply. Specifically, M3 could be declining due to people going out and purchasing stocks, bonds, properties, and other assets.
While possible, the data as suggested by Lipper is telling us that the money isn’t being spent on stocks or bonds. The most recent data, which can serve as a general indication, shows that a total of $25.5 billion of outflows occurred in the week ending May 19 of which, $27.1 billion came from Money Market Funds. Bond Funds received a light inflow of $1.9 billion while Stock Funds had an outflow of $0.3 billion.
The decline in the money supply probably isn’t headed to the real estate market as very few are predicting a run up in real estate for a very long time. While the recent data on housing has been decent at best, much of the improvement in activity comes from federal tax incentives that expired recently. Furthermore, both residential and commerical real estate pricesare showing some signs of weakness as of late which implies weak demand as evident by the recently released Moody’s and Case-Shiller data.
If we can rule out the aforementioned three assets, where did the money go exactly? An unconventional answer is to present another question. In this case, David Rosenberg, chief economist for Gluskin Sheff asked a bunch in his daily report, “Breakfast with Dave.”
After an 18-month period of unprecedented fiscal, monetary and bailout stimulus, it is completely legitimate to pose the question: why is the yield on the 5-year T-note sitting below 2%? (Not to mention a record low 0.769% two-year note yield at yesterday’s auction.) Is that consistent with a V-shaped reflationary recovery? And, wasn’t the Fed so convinced just a few months ago that the recovery was going to be entrenched enough to allow the central bank to start to shrink its pregnant balance sheet? If so, then why is it that since March, the Fed’s balance sheet has expanded a further $50 billion, and all with extra mortgage backed securities?
The answer to all of our questions is that the money supply is dropping for a reason. The “recovery” isn’t real. The deflationary spiral may already be upon us. If not, it soon will.
Posted by Rom on 
Bond Market Recap – May 27, 2010
U.S. Treasuries tumbled today after China, in response to yesterday’s Financial Times report, said it will continue to support investments in the European region. Treasuries reveresed its flight-to-quality course as yields soared, leg higher by the long end. The yield on the 10-Year spiked 17 basis points to 3.36 percent while the Long Bond reached a yield of 4.25 percent, a rise of 16 basis points. The 5-Year, which underperformed the rest of the maturity stack, increased 18 basis points to end today’s session at 2.20 percent. The yield on the 2-Year finished at 0.88 percent, an increase of 6 basis points.
10-Year Treasury Yield Intraday Chart
The spread on 2-Year interest rate swaps reversed course from earlier this week by declining 7 basis points to 40. The spread or yield differential between the yield on the fixed coupon component of interest rate swap contracts and U.S. Treasuries now matches levels seen late last week, offsetting the rise where spreads reached a recent high of 60 basis points. By this measure, counterparty risk is subsiding for now.
2-Year Interest Rate Swap Spreads - Historical Chart
The LIBOR-OIS spread was again unchanged on the day at 31 basis points.
Along with equities, corporate credit performed well as spreads tightened across the board. The BofA Merrill Lynch U.S. Corporate Master Index which contain over four thousand investment grade issues declined 2 basis points to a spread of 202 over comparable maturity Treasuries. The High Yield Master Index closed at a spread of 688 basis points, a drop of 19.
Equities advanced and is displaying the “all-clear” sign as we head into the holiday weekend for the US. The S&P gained 3.3 percent to 1103.06 while the NASDAQ increased to 2277.68, a jump of 3.7 percent. The VIX dropped 15 percent to 29.68.
The Dollar Index dropped 1.0 percent to 86.232. The Euro rallied back again from the recent lows to 1.2362, a gain of 1.5 percent from the prior close. The British Pound increased 1.4 percent to 1.4582.