Money, Bonds, and a Mea Culpa

[Executive summary/TL;DR : A huge amount of cash was dumped into the economy with the 2020 COVID relief bill, which caused the burst in inflation.  We have not yet returned to equilibrium (and lower inflation) but may by the end of 2024]

An interesting recession we are having, isn't it?

Earlier this year I stated a recession is coming, fortunately ignoring to tell you when it would happen.  More than six months later there is no recession.

The Treasury bond market is not signaling a recession either as the entire yield curve continues marching higher.  Thirty year mortgage rates continue rising, now over 7.5%, with no let up.  

Source: Federal Reserve

The most recent GDP numbers came out and still no recession, with a real growth GDP above 2.5%

Source: Federal Reserve

So what happened?  

I think I found the reason, or perhaps, a reason.  The US economy is an incredibly complex entity and there is not just one factor which pushes it around.  I will be discussing just a few parts of it, so please keep that in mind.  Now, take yourself back to the early parts of the COVID lockdown and hysteria.  I know, a bad place to visit but sometimes finance blogging can be a scary place. In order to mitigate the lockdown, the COVID relief bill passed in early 2020 which dumped a massive amount of money into the economy, and when I mean massive, I mean unprecedented.  Just look at this graph. 

Source: Federal Reserve

On a year over year basis M2 expanded around 17%, the largest spike in the entire data series.

To define for those who may not know,  M2 is cash you have access to immediately.

Quoting the federal reserve:

M2 is a measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds. 

Source: Federal Reserve

[Addendum added 11/20/23 -  I should have included the massive increase in the Federal Reserve's balance sheet as another possible reason for the jump in M2.  The relative importance of each (Federal Government or Federal Reserve) is not important for for the scope of this post, just that both had a factor in the spike.  Looking at the graph below one can see just how massive the Federal Reserve expanded its balance sheet, roughly triple their response to the financial crisis of 2008/09.  Currently the Federal Reserve is contracting their balance sheet and this is most likely the cause of the current reduction in M2.

Source: Federal Reserve

Someone with more specialized knowledge regarding Federal Reserve balance sheet expansion and M2 wrote a detailed article regarding the interplay.  --End Addenum]

Now let us look at M2 as it compares to the US economy as a whole, expressed as GDP.  As the real economy grows over time a slow increase in M2 is also needed, as it is how one facilitates the transactions which make up our economy. Observe the ratio of M2 to GDP (Gross Domestic Product, the sum of goods and services consumed domestically)  Economist call the inverse of this 'monetary velocity'

Notice the massive spike in this fraction?  Again, unprecedented.

Source: Federal Reserve

The increase in M2/GDP is even more dramatic when looking at the annual change in this fraction.

Yes, that is a greater than 7 standard deviation move.  Something that hasn't ever happened in modern US history.

So where did all that excess money go? Everywhere.  Remember the AMC and Gamestop rip higher? Money from the sky, and bored people at home created that frenzy.  Rolex prices? Yeah, that too.  

Inflation hit soon after, the highest in decades.

Source: Federal Reserve

What gives me confidence to claim the rapid rise in M2 facilitated a rapid rise in inflation? Well, The Federal Reserve looked at this 30 years ago and noticed the causation.

https://www.richmondfed.org/-/media/RichmondFedOrg/publications/research/economic_review/1992/pdf/er780502.pdf

Quoting from the above paper:

Over the three periods shown [30 years], the trend rate of growth of nominal GDP matches fairly closely the trend rate of growth of M2. 

If velocity is stable, the rate of inflation will correspond over long periods of time to the excess of the rate of growth of money over output. To illustrate, over the three decades from 1960 through 1990, the excess of the annualized rate of growth of M2 (8.1 percent) over the annualized rate of growth of real GDP (3.0 percent) was 5.1 percent, while annualized inflation (measured by the implicit GDP price deflator) was 4.9 percent.

In short, the helicopter money shower in early 2020 resulted in a lot of the inflation we are seeing today. 

Long term interest rates responded; gradually and then suddenly.

Source: Stockcharts

This is where I plead Mea Culpa to my clients.  The standard signs where there; inverted yield curve, rising continuing claims, prices appeared to have bottomed (in late 2022), etc. so I started buying long duration Treasuries.  I didn't think to look at the M2 growth, because it never changes too much.  Until 2020. Whoops. Fortunately I only started nibbling on long term treasuries in late 2022, so the pain does not compare to someone who held them as a permanent part of their portfolio.  Even now I am underweight my target bond allocation.

So what now?  Considering my irrational desire to predict the future I posit the following; we are almost through this M2 money spike, we just don't know it yet.

Before the helicopter money drop the M2/GDP ratio was at ~0.70 and as of Q32023 ratio is at 0.75. The median absolute annual change in the ratio is 0.012 so as of today we are close (0.736 vs 0.75)  to being back within the range of a 'normal' ratio.  (Source at Federal Reserve) A combination of  M2 reduction, economic growth, and inflation will most likely bring the ratio to within the normal range of variation by year end 2024. 

So, we are mostly through the money storm now? Right?  Well, maybe.  Markets and economies have a tendency to swing well past their equilibrium points as they veer from one extreme to another.  Considering just how much else is going on with the world I'm hesitant to make too many predictions with confidence. For now I've been building up my position in 90 day treasury bills instead of the long part of the bond market. When to buy more, well I don't quite know yet.

Ours is still a highly leveraged economy and the massive rise in funding costs for everyone in America as well as the inverted yield curve will eventually bite into economic growth.   Right now we have two powerful forces pulling us in opposite directions; an excessive amount of money (M2) still sloshing around the economy versus a decelerating economy due to a massive increase in funding costs.

Additionally I believe this spike in M2/ GDP may have caused multiple active allocation strategies to fail as well.  Some of these switch between equity market and Treasury bonds, but with the relentless inflation and subsequent bond market thrashing they have performed poorly.  The M2 spike we've recently experienced hasn't ever happened before, so how do you model it?   This is a facet of current finance, the impossible seems to keep happening with disturbing regularity.

additional reading:

https://www.stlouisfed.org/publications/regional-economist/2022/jul/was-paycheck-protection-program-effective

https://twitter.com/steveanastasiou/status/1651059292089499649

So when will the Chinese debt bubble burst?

So when will the Chinese debt bubble burst?

I've yammered on about this for a long long time. Highlighting empty cities to nowhere, excessive debt buildup, etc. Obviously the Chinese government's ability to extend this bubble is greater than my FinTwit credibility.

Are we hitting another decision point? Will the next US recession finally detonate the bubble? Honestly I don't know, but now ever Peter Zeihan is commenting on this.

https://www.youtube.com/watch?v=PVMlEiewyT4

The more China blows the debt bubble the larger the explosion when it pops and right now they are working on exceeding the Japanese bubble from decades ago.

Source: Federal Reserve

No one wants to be blamed for ending the party but eventually it does.  I can't tell you when it will go off, but be careful when it does.

Recession is Coming

 

Recession is coming. No one likes to hear it but a storm is brewing. The Federal Reserve wants inflation below 2% and it's going to get it by forcing the US economy into a recession. (How we got here? That's for another email.) By consistently raising short term interest rates in an attempt to bring down inflation the Fed has inverted the yield curve. (Where short term rates are above longer term rates.) If you notice below, a 2 year rate higher than the 10 year has preceded every recession throughout the entire data series.     Source: Federal Reserve It can take a while for pressure from an inverted yield curve to work its way through the economy but there are already a few signs. Temporary help is already negative on a year over year basis and it leads full time employment.     Source: Federal Reserve Continuing claims for unemployment have also turned up on a year over year basis. Like the employment data it's not screaming Recession just yet, but the direction higher coupled with continued yield inversion will send more people to the unemployment office. The COVID lockdowns broke the graph, so here is the data before, after, and with COVID.         Source: Federal Reserve   So, how can you prepare yourself for the upcoming financial storm? Raise Cash: I've been slowly reducing the risk of client portfolios. I suggest you do the same in both your investment accounts and personal financial profile. Liquidity: This is not the same as cash; do you have excess buying power on your credit cards, lines of credit, etc.? Untapped debt you can access during a recession can help one get through the rough patches or capitalize on the dislocation. Shopping list: I'm already building one for assets to purchase during the upcoming financial storm. This doesn't have to be stocks, bonds or market related items. Are you planning on a vacation? Consider deferring the decision until prices drop. Counterparty Risk: How will a recession affect those you do business with? This could be an employer or a business partner. Do you have any loans or financial commitments coming up in the next two years? Now would be the time to consider how a recession would affect those relationships. Opportunities arise during the chaos of a recession, which can counterbalance the inevitable disruption which occurs during an economic downdraft. Don your metaphorical financial rain coat and get ready.

I'm buying TIPS again

In my last post lamenting the paucity of options available to low risk investors I highlighted the guaranteed negative return one would receive investing in Inflation Protected Bonds from the US Treasury.

Oh my, how the world can change in a few short months.

Source: Federal Reserve

What was once guaranteed punishment has flipped dramatically.  My mental buy price was a real 1% on the 10 year TIP rate.  We recently passed that and thus I will started buying these once again at auction for my clients in certain situations.  For those of you who don't wish to purchase individual bonds or deal with the tax headaches (I do this for some clients as well) you can mimic the return by buying the etf TIPS

Considering the parabolic move in yield (and converse decline in price) be careful. Remember I'm holding these individual bonds to maturity so I would prefer it (at least for this part of the portfolio mix) if the yield continues to rise.  How high the yield may rise is something I cannot answer but at least one is no longer punished for saving right now.

The Lament of a low risk investor

 The Lament of a low risk investor

10 year TIPS rate

source: Federal Reserve

One of the challenges in managing a portfolio during the distribution phase is balancing the conflicting desires of certainty and return.  This is the classic risk versus return debate.   Higher risk should be rewarded by higher return, with the opposite also true.  When you accept a lower risk your return will be lower as well.  

When a portfolio shifts to one providing income for the owner, return of principal becomes more important than return on principal. One of the ways I used to provide certainty was the purchase of inflation protected securities from the US government.   They provide a guaranteed return over the inflation rate.  Well they used to, but please read on.

Some of you are already considering not reading further. I'm a stock jockey Greg!  I only care and invest in stocks, equities, risky stuff. Why should I care about the ramblings of a manager trying to eke out a return for some grandma?   Please endure for a little while, my dilemma affects you as well.

As the chart above shows, nearly two decades ago one was rewarded for giving your funds to the US Treasury for 10 years with a low return of  around two percent above inflation.  That's not much, but remember, we are looking for the money to be there when it matures; security first, return second.

Some of you may reply the official inflation numbers are incorrect, and I would say you may be correct in this assertion.  Inflation for a person in their 20's is very different than one in their 80's.  The mix of products and services required of a retiree are very different from that of a young adult. Furthermore there is debate if the basket of products is properly measured at all.  I don't wish to make this article a discussion about the accuracy of government statistics so for those disagreeing please concede to me that this is the measurement I have, and these securities' returns are based upon that measurement.  It's the best we have right now.

Around the great recession of 2008 I started purchasing these 10 year securities at auction, slowly building up a small laddered position for those in the distribution phase of life. The goal was to have a laddered portfolio of these maturing every six months. I grumbled at the returns but knew their utility, a safe but low return security that would form the foundation of  a clients' portfolio.  (There is an ETF doing effectively the same. The symbol is TIPX)

Notice on the graph above how real yields dropped to below zero around 2012.  While I was willing to accept a low real return, a negative real return was not acceptable.  

Now consider this please, dear reader.  Why would you voluntarily hand the US government your funds for 10 years with the guarantee of a loss after inflation? (and taxes if you don't place them in a Roth IRA)   Yes, traders may want to buy them in order to profit from the price changing day to day, but I am holding these to maturity.  

I paused the purchases during this negative period and restarted when rates were again positive.

Which brings us up to today.  10 year TIPS rates are quite negative and have been so since the COVID scare of early 2020.  As you may guess, I have stopped buying TIPS of any sort.  

I doubt the US government has noticed the lack of my purchases, but I'm not the only one who has noticed you are handing your money away for 10 years of punishment.

Why do I bring this up? Because other purchasers with a low risk mandate will have come to the same conclusion.  Why should I buy something that guarantees me a loss? Those buyers, like myself, will start to look elsewhere for returns.  

Are there alternatives for the low risk investor? Well not really.

There are I Bond savings bonds from the US Treasury.  The purchase of which is somewhat involved and are currently offered at a rate of 0, which means you will receive the inflation rate.  It's not a positive return, but at least it's not negative like the current 10 year tip rate.  There are exit fees if you redeem them early however.   Please read up and consider the negatives before you purchase them.

How about longer term US Treasury bonds? Well, same problem.  Negative real return, on top of adding quite a bit of duration risk

Source: Federal Reserve

Hmm. Perhaps high yield bonds? Switch from duration risk to credit risk? Same issue, return is negative on a real yield basis.

Source: Federal Reserve

So you can hopefully see the quandary.  There is no place to squirrel money away and not get punished for it.  This should violate the risk / return idea I highlighted at the beginning. I am willing to part with some funds for 10 years but right now I'm punished if I do so.  So what to do....

That comes later, but for now realize the situation we are in and realize individuals and institutions are responding.

As for the stock jockeys who managed to continue reading, realize the negative real rates affects your stock returns.  As the discount rate falls to a negative number this naturally inflates the value of stocks. Why is the CAPE ratio in the stratosphere?  Earnings are being discounted by a much lower number, raising their present value.   The movement of US Treasury interest rates affect the value of your assets as well so it behooves you to watch them.

Get ready to refinance. Again.

Get ready to refinance. Again.

At least there is one positive aspect to the COVID-19 crisis, the drop in interest rates.  And notice I said get ready.  It appears it would be better to wait to refinance. If you can.

Source: Federal Reserve

The Green line in the image above is the difference between the 10 year Treasury bond rate and 30 year mortgage rates.  If you notice, during the 2008 and current recessions the difference between those two rates expanded dramatically before eventually closing.

I downloaded the data from the graph above.  The average difference is 1.76% with a standard deviation of 0.29%.  Right now we are at a ~1.65 standard deviation event, which is very unusual.  To put it another way, if mortgage rates were 'average', right now they would be 2.44%

Yes, a sub 2.5% 30 year mortgage.

Now, we may not get there.  10 year Treasury rates could rise before the mortgage market normalizes, or they could go down.  I'm not going to make a prediction on interest rate movements in this post.  But if nothing happens with longer term Treasury rates we could see a sub 2.5% 30 year mortgage rate in the future.

Refinancing your house is only an option if you can, and for quite a bit of America this unfortunately is impossible due to business or job dislocation. But if you are able, go to the link above and watch it weekly. I sure am.  

Predictions are hard, especially about the Future

One of my favorite books ever is the book Dune by Frank Herbert.  He built a universe with a complex religious, economic and political framework that transports you to a completely different world.  It is not a dry technical read about an alternate reality but a compelling and rich story with an amazing tapestry behind it. 

I will stop gushing over the man, but I want you to watch this video and remember the respect I have for this man and his capabilities.  It's short at around 4 minutes.  He explains his natural curiosity and his broad skill set that created the situation for him to write the book series.  However even Mr. Herbert gets the end of fossil fuel prediction VERY wrong. 

When you extrapolate out the current state too far into the future one will come up with very wrong results.  The world is extremely dynamic.  Humans are very clever.  New technologies and innovations which were too expensive drop in price enough to totally transform the dynamics of a system, rendering your prediction invalid.

In this 1977 interview he states we will run out of fossil fuels in 40 years.  We are 3 years past that deadline.  Even brilliant people can be wrong on occasion.

Another attempt at a Dune movie is near release. I hope it's better than the last one.