Pedro the Impaler

Anatomy of a Meltdown
Ben Bernanke's Washington tell-all says too little, too late
Pedro Nicolaci Da Costa

Former Federal Reserve chairman Ben Bernanke’s new book feels more like the first of many acts than an authoritative memoir. And the main body of the narrative remains, so far as financial history is concerned, very much a work in progress.

Still, notwithstanding its provisional character, there’s no denying that The Courage to Act is a useful document. Bernanke was arguably the most powerful economic official in the world during the worst global financial crisis since the Great Depression. His direct account of that event, staid though it can be, is invaluable—both for the official record and for understanding how his thinking shifted during an eventful eight-year tenure atop the Fed.

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Itching For Another War

From Eric Margolis:

ANOTHER BIG STEP TO A MAJOR WAR

Turn to page 214 in the book “War-making for Dummies.” You will find: “plan air operations right on your neighbor’s border, zig in and zag out, make rude gestures at enemy pilots, and shoot them down if you can.”

On Tuesday this week, the inevitable air clash occurred on the Syrian-Turkish border west of Aleppo. From what we know so far, two Russian SU-24 bombers that had been pounding anti-Damascus forces on the border briefly intruded on Turkish airspace for all of 17 seconds.

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Why do the Central Banks want inflation?

Without inflation, the existing debt would crush the system.  The existing debt could be paid off and major defaults would follow.  This would reset the deck and would be a wonderful development over the long term, but very painful over the short term.  This option is always available, but who is going to be the one to bring down the current economic system?  Certainly, no one voluntarily.

Keep 'Em Guessing

For inflation to work, a central bank must have key market participants believe they will inflate, while having the masses believe the prices will remain about the same as recent past.  The moment the majority of the public believes that prices will move higher over the longer term, they will bid general prices significantly higher.  This will cause the central bank to tighten monetary policy and push the economy into a recession.

To prevent price spikes, the central bank must keep most participants guessing.  To see through all the central bank double talk, the following rule should be used when analyzing future central bank decisions: The central bank must ensure money supply is increasing.  The only exception to this rule: Except when money supply contracts. 

The exception to the rule may sound odd at first, but a contracting money supply usually follows a boom. The banks themselves are likely to be in financial trouble at this point in the cycle, which is why the money supply is contracting.  The central bank could step in to increase the money supply, but it is very difficult for a central bank to increase the money supply (i.e. Q.E.) when the boom is in progress.  Not only would a Q.E. program be politically difficult, but market participants would bid prices much higher.  So a central bank must wait for the bust to surface to provide cover for future money supply growth.  Then the first rule takes effect and the business cycle unfolds.   

Can markets be manipulated over the long term?

The short answer is yes.  Although most market participants believe the markets are susceptible to short term manipulation, many feel market manipulation over the long term is not possible.  Although there are times when the market may get away from the authorities like the Fed, most of the time, the Fed can strongly influence or outright control markets.

As an analogy, most all government action is compulsory with the threat of punishment for non compliance.  The government need only to take a small group of people and make an example out of them for the rest to see.  For example, riots get a lot of play in the media.  But once the government has had enough, they make an example out of specific groups (i.e. beatings and arrests) for all to see.  This is typically enough to send most rioters packing and keep those watching at home.

The same analogy holds true for the Fed and why the old adage of "Don't fight the Fed" has endured for many years.  The Fed will overwhelm any group of market participants because of their printing press.  So most, but not all, jump on the side of the Fed. 

To conclude, the Fed can manipulate markets over the long term.  

Murray Rothbard on Milton Friedman

Milton Friedman was a great economist, but fell short of the high standards that Austrian Economics imposes.  Studying the differences among Mises, Rothbard and Friedman (and yes, even Bernanke) provides an excellent overview between the two worlds that we live in: the one that should be (Austrian view) and the one that is (Keynesian view) - at least for now.

At the end of the day, the Austrians' will have the final say.  Rothbard's critique of Friedman is outlined in this five part video series:

Morning with Murray

Perhaps the most important book on economics behind Mises' Human Action is Murray Rothbard's the Mystery of Banking.  Murray breaks down how central banks and commercial banks produce inflation.  A wonderful read, deeply insightful and full of knowledge that only a select few - unfortunately - in our society will be lucky enough to access.

Murray Rothbard on Economic Recessions

US Money Supply Continues to Slow

M1 continues to decline from its peak.  This is the likely cause of the economic slowdown we are currently experiencing.  Will this lead to a recession?  It's possible, but the signs are not there at this time.  

Austrian economic theory suggests that a slowdown in money growth is enough to push the economy into a recession.  But there have been times when the money supply has slowed, but the economy did not enter a recession.  

The following chart is M1 Money Supply on a year of year basis:

Defining Buffett's Economic Moat

Warren Buffett focuses on companies that have an economic moat.  Intuitively, we know what this means, but defining what an economic moat is not so simple.  Fortunately, Bruce Greenwald has done that for us.

In his article, "All Strategy is Local," Greenwald outlines the three types of competitive advantages:

1. Customer captivity
2. Proprietary technology
3. Economies of scale

I highly encourage anyone to read "All Strategy is Local" for both investing and better understanding your own business and industry.

Has oil bottomed?

Oil has likely found a bottom. Although possible for prices to move lower, the odds favor higher prices over the next year.  The following demonstrates the dramatic decline in rig counts:

The rig count will likely further decline.  A number of reports are starting to surface concerning the bankruptcy of many small oil companies.  Should this happen, it may be a good time to buy high quality energy companies.  

One company that I am following is Atwood Oceanics (ATW).  ATW is a high quality drilling and exploration company.  I have initiated a position in ATW.  

Why is China in recession?

Because money supply significantly contracted.  The following chart is a year-over-year change in M1 through June 1, 2015:

However, recent data suggests that M1 is starting to expand at a rapid pace - 12% on a year-over-year basis.

What is inflation and where does it come from?

What are traders thinking about a December hike?

From the CME's Fed Watch Tool:

FedWatch Tool

Based on CME Group 30-Day Fed Fund futures prices, which have long been used to express the market’s views on the likelihood of changes in U.S. monetary policy, the CME Group FedWatch tool allows market participants to view the probability of an upcoming Fed Rate hike.

This is the most bullish traders have been in some time.  So despite the consistent Fed statements and inconsistent Open Mouth Policy, the market has given a high probability (77.5%) to an increase.  However, there remains a 22.5% chance that the Fed may not raise rates.  

The reality is the increase is very unlikely to make a difference in economic activity.  So why all the fuss?  The Fed needs to keep interest rates low for a long time to reduce debt.  In order to reduce debt, the Fed needs inflation.  It also needs to keep market participants guessing about the future.  If not and most market participates concluded that the Fed was going to keep rates low for a very long time, then expectations can get away from the Fed.  This would likely unleash a significant boom and the Fed would have to put on the breaks.  This, from a debt perspective, would be disastrous.  

To conclude, a lot of time and drama has been spent on what would be a 25BP increase.  The Fed has certainly achieved its goal maintaining very low interest rates and tempered expectations about the future, whether interest rates increase or not.  

Will the Fed raise interest rates?

Here is a summary of the Fed's statements since 2009.  If one were to focus on these statements and nothing else, a reasonable conclusion would be that the Fed is not going to increase rates. Alternatively, if the Fed does increase rates, then I suspect a sizable number of market participants will be surprised.  This is why the Fed has used their "open mouth policy" to guide market participants.  We'll look at the market probabilities of a Fed hike next:

Release Date: August 12, 2009

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Release Date: August 10, 2010

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Release Date August 9, 2011

“The Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

Release Date: August 1, 2012

“The Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

Release Date: July 31, 2013

“The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

Release Date: July 30, 2014

“In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.”

Release Date: July 29, 2015

“The Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation."

Release Date: September 28, 2015

“The Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.”

Release Date: October 28, 2015

“The Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.” 

Stocks expected to boom due to global money supply

From Ambrose Evans-Pritchard at The Telegraph:

Barclays has advised clients to jump into world stock markets with both feet, citing the fastest growth in the global money supply in over thirty years and an accelerating recovery in China

Ian Scott, the bank’s global equity strategist, said the sheer force of liquidity will overwhelm the first interest rate rises by the US Federal Reserve, expected to kick off next month.

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Milton Friedman on Inflation and Money Supply

Can M1 project S&P 500 prices?

S&P 500 compared to M1
What is the relationship between M1 and the S&P 500?  Although time lags exist, the relationship between M1 and the S&P 500 is very tight.  So tight, that the correlation is .92.  Although Austrian and Monetary economic theory stats that general prices are determined by the growth in money supply, to see a correlation of this magnitude is truly astounding.  The period under study is from 1969 to 2014:

Summary
Average Ratio	1.3
Correlation	0.92
Min	0.56
Max	2.92
Current Ratio	1.49
Current Percentile	69%

The Average Ratio is the difference between the S&P 500 divided M1.  Correlation measures the fit between the S&P 500 and M1.  The Current Percentile stats where were are today as compared to history.  For example, the 69% suggests that the S&P 500 is over valued, but not to extremes.  

A detailed review of this study will be shared in subsequent posts.

Conclusion

Equity prices as measured by the S&P 500 to M1 can move much higher.

Introduction

This site is dedicated to the relationship between money supply, markets and liberty.  Money supply is used as a relative baseline to value asset classes, project price inflation and determine the current location of the business cycle.