Monday, January 27, 2014

Flirting With Recession

Investment Thesis: Treasury yields will fall further due to Fed tightening and sub-target inflation. Stocks will exhibit weakness until the decline in money growth is decisively reversed.

The Fed has been tightening for the past 18 months, since July of 2012. Money growth has declined from 10% in mid-2011 to 5% today. As a consequence, both inflation and nominal growth have also declined. Inflation has dropped from the targeted 2% to the current 1%, while nominal growth has declined from 5% to the current 3.4%. The economy has been slowing down in reaction to the Fed’s steady closing of the monetary spigot.

This slowdown has most recently manifested itself in the weak December jobs report, and will become visible in the 4Q13 growth numbers. (The strong 3Q13 growth numbers were a statistical anomaly; I expect the 4Q numbers to be much lower.) Until the slowdown is reversed by the Fed, the economy will flirt with recession. This will change the market’s psychology from “accelerating recovery” to “another slump”. The goldilocks scenario of continued recovery  will be discredited, which will be good for bond prices and bad for stock prices.

As readers of the FOMC’s emissions know, the Fed does not acknowledge that it has been tightening and insists that it has been providing “extraordinary monetary accommodation”. I don’t know why they say this when their own numbers say otherwise.

My opinion, as I’ve said before, is that the Fed has lost control of M2 and doesn’t want to admit it. Hence they only talk about what they can control, namely their own balance sheet. The fact that there is no observable relationship between the Fed’s balance sheet and the money supply is an embarrassing fact best left unmentioned. As QE had no impact, neither will the tapering of QE.

Given that Yellen does not wish to see the economy flirting with recession, I expect her to propose new policies to reverse the decline in money growth. These could include a money-growth target, a price-level target, or a reduction in the interest rate paid on excess reserves. She is very unlikely to do nothing, and she knows that her power will never be greater than it is on Day One. If she wants to be a success, she will have to act now.

Frankly, I don’t care what new policies the FOMC adopts. I’ve had it with new policy rabbits coming out of hats. All I care about is money growth, inflation and nominal growth. Theological discussions can go hang; it’s results that I’m looking for. I was disappointed in Bernanke’s failure, and I do not want to be disappointed again.

Investment Conclusion: Until current monetary trends are reversed by the Fed, bond yields will fall and stocks will be weak. Watch M2 growth and nominal growth. If they accelerate soon, all will be well. Otherwise, recession looms.

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