Full Steam Ahead for the USS "Inflation"
Our forecast for the next 12-18 months is that the high rate of inflation (money supply growth) over the past 12 months will boost prices and that commodities will be the major beneficiaries of the inflation. As is usually the case when commodity prices are pushed higher by inflation, bonds will not fare well.
The above may seem like strange things to say with the CRB Index close to its lowest level of the past 20 years and the T-Bond price approaching its 1998 peak. However, last week's Treasury-engineered bond market rally actually solidifies our belief that large gains in commodity prices will be seen during 2002-2003. The reason for this is the tight relationship that exists between bonds and the money supply (M2) growth rate as depicted on the following chart. The chart compares the year-over-year M2 growth rate with the T-Bond yield (the bond yield scale is inverted so that a rising line represents a falling bond yield or a rising bond price).
It is clear from the above chart that the bond market has led the M2 growth rate with great consistency over the past 7 years. Every significant trend reversal in the bond market has been followed by a trend reversal in the money supply growth rate with the typical lead time being 3-4 months. The reason this relationship has worked so well for so long is probably because every sizeable reduction in long-term interest rates has precipitated new waves of home buying and mortgage re-financing. If it continues to work then money supply growth will continue at a fast pace into the early part of next year (at a minimum). That is, the recent surge in bond prices (plunge in long-term interest rates) goes a long way towards guaranteeing a higher future inflation rate and, eventually, higher commodity prices.
We are not the only ones who are aware of the link between the bond market and the money supply growth rate and last week's US Government manipulation of market interest rates was a blatant, and initially successful, attempt to bring this link into play. However, while all government attempts to manipulate the markets have adverse long-term consequences, this latest effort may backfire more quickly than usual. The problem for the manipulators is that the official reason given for eliminating all future sales of 30-year bonds - that long-term financing is no longer necessary because deficit-spending will soon be a thing of the past - is so implausible as to be laughable. As such, the knee-jerk rally was over within hours (see chart below) and the peak reached on the morning of November 1st will likely remain unchallenged for a very long time.
We would be quite willing to buy into the idea of a deflationary future if that was the direction in which the evidence pointed. After all, our only goal with these commentaries is to be as accurate as possible. However, the evidence at the present time points very decisively towards higher inflation. Note that when we talk about evidence we are not talking about the latest releases of backward-looking economic data or the news of the day. Our objective is to correctly anticipate the future, not get bogged down in the past or even the present (we are less interested in today's headlines than in what the headlines are going to be in 6-12 months time). An example of what we are talking about is the ability of the US financial establishment (the Treasury, the Fed, the major private banks and brokerages, the GSEs) to keep the money supply expanding at a rapid rate come what may. This ability has been clearly demonstrated on many occasions over the past few years, most recently in the wake of the terrorist attacks.
In the US the M2 money supply has increased by around 10% over the past 12 months, so the US inflation rate is 10%. End of story. As discussed in last week's commentary, defining the inflation rate as a change in prices causes insurmountable problems. This is because money is spent in different ways at different times, depending on investment cycles and external factors such as foreign exchange rates. At certain times commodity prices will be the major beneficiaries of inflation, whereas at other times financial assets will benefit the most.
Right now we have the ridiculous situation whereby no amount of money supply growth is seen to be a problem because the CPI is not increasing at a rapid pace and long-term interest rates are low. However, this year's massive increase in the money supply is going to have a huge effect on prices next year. The problem is, by the time the price indices start to reflect this inflation it will be too late to take any remedial action. That is, of course, assuming that all the excess money doesn't just go into stocks or real estate or get added to the trade deficit.
At some time in the future the US almost certainly will experience a period of severe and sustained deflation, but as far as the next 1-2 years are concerned the evidence is pointing in the opposite direction. One sign that deflationary forces are getting the upper hand will be that the relationship between money supply growth and long-term interest rates depicted in the above chart stops working. In particular, prior to the US experiencing true deflation we should see a period where falling interest rates do not lead to an increase in the money supply growth rate. When deflation starts to take hold, falling interest rates will not stimulate increased borrowing/lending. That is clearly not the case right now.
7 November 2001
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