Liquidity Game

“All present day governments are fanatically committed to an easy money policy.”  Ludwig von Mises.

This statement was taken from Mises’s masterpiece “Human Action”, which was first published in 1949. It has never been truer than it is today. Indeed it has become hard to find any currency where broad money supply has not been growing consistently above nominal GDP growth.

This excessive liquidity, credit expansion or money supply growth, call it what you will, is the most significant and defining characteristic in global markets today. It even reaches far beyond to economic developments, and more widely, to society in general. However, despite its key relevance it remains widely misunderstood.

Just analyzing the current market situation demonstrates the power of monetary policies today.

Current Market Situation

The stock market, defined for convenience as the S&P 500, is currently enjoying one of it’s longest ever periods of a sustained rally without even a correction of 10%. This suggests that we should be due at least some setback before long. Looking in more detail at individual factors, Jason Goepfert’s excellent sentiment analysis on www.sentimentrader.com shows that 21 of his best indicators are all signalling a bearish extreme. He has no indicators giving positive signals. So it is a legitimate question to ask “how can the market continue to rally given this disturbing and apparently fragile background?” Or indeed “how could it possibly have already reached such a significant extreme?”

The missing piece here is simply the power of monetary policy. The underlying signals from central banks are clear. We have already described the US situation in previous notes, but the US is not alone when it comes to monetary excess. Japan’s economy expanded at an annualized rate of 4.8% in Q4 2006, its eighth straight quarter of growth. Yet the Bank of Japan only tentatively managed a baby steps rate hike last July to 0.25%. The European Central Bank talks a tough game, but its actions don’t back up its rhetoric. The ECB has left its repo rate at 3.5%, knowing that the Euro M3 money supply was exploding at a 9.7% annual rate in December. In the UK, M4 broad money has been growing at 14%! You get the picture.

No wonder asset prices are doing so well, but what comes next? How can we monitor monetary developments simply and effectively?

 

 

Nominal growth versus interest rates is the key

It really is nominal growth in GDP that matters most. The money we earn and the bills we pay are all in nominal currency terms. It’s nominal growth that ultimately drives the rate of return on capital. So the relationship between current interest rate levels and nominal GDP grow is key to monetary developments. If interest rates are 0.25% and the economy is growing nearly 5%, for example, there is significant incentive to expand business, and no doubt money supply will grow. If on the other hand interest rates are higher than nominal GDP growth there is a negative incentive.  This is one of the key metrics central banks use to manipulate money supply.

For a good take on this have a good look at the latest insightful missives both from Bill Gross of PIMCO and Hoisington Asset Management, both readily found by searching the web. Indeed Merrill Lynch calculate that over the past 10 years, the correlation coefficient between annual changes in the 10-year note yield and comparable changes in year-on-year nominal growth has risen to 63%. The dance between interest rates and nominal GDP growth tells us a great deal about what is going on in the markets and the economy.

This being the case we need to recognise that interest rates are still well below nominal GDP grow in most key global economies. So it is no great surprise why markets have been performing so well and may well continue to do so.

Why are central banks so relaxed?

From a central bank perspective things are currently looking pretty good. The world seems to be growing strongly, and price indices seem overall to be well behaved. Indeed the market’s measure of the expected CPI can easily be measured by taking the difference between the yield on a 10 year Treasury Note and the yield on an Inflation-Protected 10 year Note.

The chart shows that this reading has been ranging between 2.25% and 2.7% for the last 3 years and if anything is currently threatening to break down through the low end of this range. The perception, rightly or wrongly, is that all is well as regards taming the growth in the consumer price index. Reinforcing this view the Federal Reserve forecasts, announced by Bernanke last week, suggested that nominal GDP growth in the US would likely be falling over the next few months. Whether or not their forecast turns out to be right this sets the tone for interest rate policy for the foreseeable future. So if anything the Federal Reserve has good “cover” to further support the markets with lower interest rates, or at least have no apparent necessity to raise them any further.

Summary

There is no doubt that there are many good reasons why the stock markets around the world could have a good sized correction before long. The duration of the current rally has been exceptionally long and many indicators are signaling a warning. That being said how concerned should we really be?

There are still some very powerful positives. The central banks remain extremely supportive of the markets and are highly likely to remain so. This is very apparent from a simple but effective analysis of the key relationship between nominal GDP growth and interest rates, the current development of price indices, and recent actions taken by the central banks themselves.

One of the most effective long term guides for the stock market is the “1-2-3 stock market model”, which we have discussed before in these notes. At the current time we have both momentum and Federal Reserve policy providing a following wind.

The bottom line is that although we may well have a correction at any time given the warning signs from a whole range of indicators, there does not seem to be any chance of a significant change in stance from the highly supportive central banks. For the time being, any setback is still most likely to be minor in nature. Monetary conditions are likely to remain highly supportive. There may be some short term downside trading opportunities, but longer term investors have rarely been successful betting against the central banks.

 

 

Notice

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