Saturday, 3 August 2013

U.S. Money, Credit & Treasuries Review (as of 24 July 2013)

The monetary base continues to expand rapidly on a bi-weekly basis. According to the latest statement from the FOMC issued on 31st July it is likely to increase on a monthly pace of about $85 billion for a while yet going forward,
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative. 
The money supply on the other hand is expanding considerably less than the monetary base as the banks are not granting bank credit to the extent they theoretically could. This has lead to a massive build up of excess reserves for U.S. banks. Currently more than $2 trillion in excess reserves are parked at the Fed, on which the banks earn 0.25% p.a. in interest. Whatever the reason for banks not putting this money to work, being it due to limited projects or opportunities to extend credit, the tightening of reserve requirements related to Basel III or a simple lack of demand from borrowers, the result can now clearly be seen as a considerably drop in the growth rate of bank credit. Towards the end of last year, the year on year (YoY) growth rate in bank credit was 6.0%. This has now dropped to 2.8%. At the same time, the annualised growth rate during the most recent six week period (three bi-weekly periods) is now 4.5 percentage points lower than the current YoY growth rate (see table below).

The growth rate in the M2 money supply is also slowing down and has done so for a while as pointed out in this report many times before. Although the YoY growth rate has been fairly stable around the 7.0% mark since mid April this year, the six week annualised growth rate is currently only 3.3%. So far this year M2 has only increased by 1.5%, which is very low compared to historical figures. Looking at the longer term growth rate, the 12 month smoothed YoY growth rate in M2 has fallen from 8.8% in mid June to the current 7.6%. In conclusion, both the shorter- and longer-term growth rates in the M2 have dropped significantly.

The 10-year treasury yield pulled back by 2 basis points on two weeks ago, following five consecutive bi-weekly periods of increases (increasing from 1.71% on 1st May to 2.58% as of 10th July). Compared to one year ago, the 10-year yield has increased by 78 basis points. The 1-year treasury yield decreased 3 basis points on two weeks ago and the current nominal yield of 0.11%, slightly above the 0.10% record low in November 2011.

A note to readers: The Austrian Business Cycle Theory is the reason why EcPoFi creates this bi-weekly report
Avid readers of this bi-weekly report know that we closely follow monetary and credit developments as they are key components in the Austrian Business Cycle Theory (do a search on "Austrian Economics" or "Austrian Business Cycle Theory" on this website if you are not familiar with the subject).

In very broad and simplistic terms, the theory shows us how a credit induced boom will turn to bust once credit stop expanding (a mere slowdown in the growth rate can actually lead to a bust). The extent of the boom and bust naturally depend on to what extent credit is created and then ended.

When credit (e.g. a loan) is created, a deposit is created as well. This deposit is classified as money which is why we monitor developments in money supply in tandem with credit. As money becomes more plentiful, this has a tendency to push actual interest rates below the "natural rate of interest" leading to malinvestments. The boom and the bust created by credit expansion not backed by a commensurate increase in savings naturally affects the economy, corporate profits and various asset classes, such as the stock market. In essence, this is the reason why we monitor and report on money and credit developments on a bi-weekly basis.

Stock market investors should read this report together with the monthly "10-year Average Earnings- and Dividend Yields for the S&P 500 index" report (see here). In general, and all other things remaining the same, a slowing down in the growth rate of money supply and bank credit when the stock market is highly priced is a dangerous combination which could lead to very poor future returns. The U.S. appears to be in that territory now.

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