The Liquidity Trend
The following are slightly-modified extracts from recent commentary that appeared at The Speculative Investor web site.
How important is the Fed?
Over the past 4 months the various measures of US money supply have grown at exceptionally-high rates, prompting much discussion of how the Fed is aggressively printing money in an attempt to re-liquefy the system. Such talk, however, misrepresents the true situation.
The Fed sets a target for a short-term interest rate (the Fed Funds Rate - FFR) and then, via its Open Market Operations, adds or removes reserves from the banks in order to keep the FFR near that target. Over the past year the Fed has needed to make a net addition of around $20 billion to banks' reserves to keep the FFR near the targeted rate. Over the same period of time the GSEs (the Government Sponsored Enterprises that operate in the secondary mortgage market) and the financial sector have added several hundred billion dollars to the money supply. The point is that with or without the Fed's additions to bank reserves the US financial sector has the means to dramatically expand the money supply.
So, what stops the GSEs and the financial sector from expanding the money supply ad infinitum? Since the liquidity growth rate goes through periods of expansion and contraction what force, if not the Fed, regulates these changes in liquidity? The answer: the bond market.
Below is a chart comparing the year-over-year percentage change in M2 with the yield on the 30-yr T-Bond. The scale for the bond yield has been reversed so that a rising line indicates a falling yield. The chart, as shown, therefore reflects the movement of bond prices rather than bond yields.
The above chart begins in early 1995 - the point at which the major trend in the year-over-year M2 growth rate reversed from down to up. Note that the major turning points for M2 growth were preceded, in every case during this period, by a major turn in the bond market. Peaks in bonds have led peaks in the M2 growth rate by around 3 months and troughs in bonds have led troughs in M2 growth by 3-6 months. For example, the major peak in the bond price occurred in October 1998 while the major peak in the M2 growth rate occurred in December 1998. Similarly, bonds bottomed in January 2000 whereas the M2 growth rate bottomed in July 2000. This means that a) the bond market began 'easing' when the Fed was only half way into its tightening cycle, and b) rising bond prices led to an upward reversal in the M2 growth rate 6 months prior to the Fed's first interest rate cut. Note also that the liquidity growth rate moved higher over a 5-month period (July-November 2000) during which the Fed's stated bias was towards tightening.
As far as the future is concerned, this chart suggests that:
The bottom line is that under normal market conditions the bond market, not the Fed, controls the liquidity trend. The Fed simply bumbles along in the wake of the bond market, reacting to historical data and adding to market volatility. The Fed can, however, exert substantial control as far as financial system liquidity is concerned if it decides to make full use of its extraordinary powers as outlined in previous commentary (such as the unlimited power to 'monetise' private sector debt).
The A$-Bond Relationship
We've previously discussed the relationship between the Australian Dollar and the US T-Bond. In summary, the A$ and the yield on US T-Bonds move with each other with remarkable consistency. Furthermore, every significant turn in the US bond market over the past 15 years has either occurred in parallel with a turn in the A$ or has lagged a turn in the A$ by up to 3 months. The following chart shows the current situation.
We have, up until now, been working on the basis that the US T-Bond futures peaked on Jan-03. We also mentioned that if they were ever going to exceed the Jan-03 peak, the present time frame would provide the best opportunity for them to do so. T-Bonds have been very strong over the past 2 weeks, although they have still been unable to close above their Jan-03 intra-day high. However, based on last week's decisive break to new lows by the A$ there is now a high probability that bonds will break-out to the upside during the next 2 months (probably after a pullback over the next 2 weeks). Note that the above chart shows the yield on the cash bond, which moves in the opposite direction to the bond futures price and does not correlate exactly with the futures price.
We will retain our short-term bearish view on bonds for the moment since we expect a quick-fire correction (perhaps beginning in parallel with the next cut in official interest rates) prior to the final surge. After the A$ turns higher, something we expect to happen by the end of this month, bonds are likely to experience a further 6-8 weeks of strength. It is during this period (the period between the bottom for the A$ and the peak for T-Bond futures) that we expect a sharp rally in the gold price.
Liquidity Growth – 1998 vs. 2001
As discussed earlier, a) the Fed does not control the liquidity-growth trend - the bond market does, and b) it now seems highly likely that bond prices are headed higher over the coming 2 months. This means that the liquidity growth trend, which is already positive, should remain positive over the next 3-6 months (since M2 growth usually continues to improve for about 3 months after bonds have peaked and turned lower).
Liquidity growth has not yet reached the heights seen in the final quarter of 1998, but it is getting there fast. If bonds continue to strengthen and the Fed 'chips in' with a couple more official rate cuts, we could well approach 1998's peak liquidity-growth rate within the next 3 months.
There are some major differences between the present situation and the situation during the 1998 financial crisis. In particular, the US economy is nowhere near as strong as it was in 1998, corporate and consumer debt levels are higher, the oil price is much higher and, on this occasion, the US is at the epicenter of the brewing financial crisis rather than being just an interested bystander. However, as they did in 1998, US Treasuries and the US$ are benefiting from a flight to safety. Also, in similar fashion to 1998 bonds are driving higher as stocks drive lower and the liquidity-growth trend is positive. The differences almost guarantee that the US economy and the US Dollar will not come out of this crisis mostly unscathed, as they did in 1998, while the similarities (especially the positive liquidity trend) create the distinct prospect of a 'V' bottom for both the economy and the stock market during the next few months.
Money tends to gravitate towards the investments that are already rising in price. Therefore, if such a 'V' bottom does occur then the darlings of the previous speculative boom, which have been cheapening at a fast pace for many months, will not be the primary focus of investment during the next boom (although they will benefit to some extent). We expect the leaders of the next boom to be in the resource sector. However, before we get too excited about the next boom the current downtrend must come to an end. We see little chance of that happening until after the 'hot money' parked in US$ assets and the short-sellers of gold have capitulated.
Steve Saville
Hong Kong
21 March 2001
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