We began our series on QT in WILTW July 27, 2017, and it has sparked several months of robust discussion. So far, the data appear to support the original thesis. The central argument is based on the mathematical relationship between the velocity of the M2 money stock, NGDP and the M2 money supply. When the growth rate of the M2 money supply is shrinking (as shown by the blue line in the following chart), it influences M2 velocity in the opposite direction (as shown by the red line). The year-over-year change in M2 velocity crossed into positive territory in Q1 (+0.6%)—the first positive reading in almost eight years.
And historically, rising velocity has been associated with rising inflation. Since October 2016, when the growth rate of M2 peaked and commenced its long decline, the CPI growth rate has risen from 1.6% to 2.4%—a move that was contrary to the conventional wisdom at the time, which held that tighter monetary policy would be disinflationary.
Year-over-year growth of the M2 money supply (blue, lhs) vs. year-over-year change in the M2 velocity ratio (red, rhs)
Source: St. Louis Fed
Whether or not these trends continue remains an open question, but week-after-week, we have demonstrated that oil, oil-related equities and many commodity-related indicators have been advancing powerfully in spite of the relentless decline in M2 money supply growth and the very recent spike in the DXY (see section 1).
The following chart shows that TIPS are outpacing intermediate-term bonds—an indicator of growing inflationary pressures—while high-yield bonds are outpacing investment-grade corporate paper. This is important because junk bond ETFs (such as JNK and HYG) are heavily influenced by energy and other cyclical companies, and their fortunes tend to follow the trends in inflation and deflation.
That this is happening despite the widely-publicized EM currency crises in Turkey and Argentina—which is considered contractionary—leading one to believe that the underlying inflationary trends are indeed sustainable.
iShares TIPS Bond ETF (TIP) vs. iShares 7-10 Year Treasury Bond ETF (IEF) with SPDR Barclays High Yield Bond ETF (JNK) vs. iShares iBoxx Investment Grade Corporate Bond ETF (LQD)
We are often asked the following: if U.S. inflation causes the Fed to boost rates faster than expected—widening the spread between Treasuries and other sovereign paper, such as German bunds—why wouldn’t more global capital flow into the U.S. dollar? This is a good question and is a risk that always bears watching, especially if a wider currency crisis unfolds globally. At the same time, it is also worth pointing out that favorable spreads on USTs are not the only determinant of the dollar’s value.
Case in point: between September 2002 and May 2006, the UST 10-year spread over German bunds rose by 184 basis points, as denoted by the red circle in the top chart that follows. Based on conventional wisdom, this rising spread over bunds should have caused the U.S. dollar to get stronger. But in fact, the dollar weakened quite dramatically, with the trade-weighted broad-dollar index falling about 16%, as denoted by the red line in the bottom chart that follows. One of the reasons behind the fall was the sharp erosion in the federal budget balance, from a surplus of over $100 billion to a deficit of over $400 billion at its nadir, denoted by the blue line in the second chart that follows.
Source: The Wall Street Journal
Federal budget surplus/deficit in $MM (blue, lhs) vs. trade weighted broad dollar index (red, rhs)
Source: St. Louis Fed
This stands in stark contrast to the strong-dollar period that occurred after the “Tea Party” of the GOP effectively took over the U.S. Congress in 2010. While the Fed was distorting the yield curve with QE, the Federal budget deficit was cut by more than half in absolute terms between 2010 and 2016. In other words, an increasing amount of USTs was being absorbed by the Fed, thus raising their scarcity value, while Congress reduced the amount of new borrowing necessary to balance the budget each year. The environment for a dollar rally could not have been better, and the favorable UST/bund spread, from 2012 to 2016, only added to that attractiveness.
But, these underlying trends in fiscal and monetary policy have reversed (see WILTW March 8, 2018). In modern peacetime, there is no precedent for the Fed and Congress to be working in opposite directions—the former hitting the brakes on monetary policy while the latter is hitting the accelerator on fiscal policy— during the 10th year of an economic expansion. Could this mean that the dollar may follow a path similar to 2002-2006, when deficits exploded after two tax cuts, while oil and commodities were in a raging bull market driven by emerging-market demand?
Only time will tell, but it is worth noting that the last meaningful and sustained increase in M2 velocity occurred between mid-2003 and mid-2006, when the ratio rose 6% (see red oval below). If another sustained rise in velocity is beginning, the dollar bear market would resume and become even more pronounced. Bottom line: if global investors begin to fear that the U.S. currency will lose its purchasing power because of spiraling budget deficits, and bond yields rise to reflect that fear, would foreign investors necessarily want to hold more dollars? We doubt it.
M2 velocity ratio
Source: St. Louis Fed
Bloomberg carried an article this morning headlined “Yields at 3% Failed to Entice Some of the Biggest Treasuries Fans,” which underscores our argument. We quote: “Having booked a loss from U.S. debt holdings last year, the regional lender [Shizuoka Bank] is in no rush to load up again, even with a 10-year yield near the highest since 2011. The bank’s experience goes some way to show why Japan, once the biggest holder of Treasuries, still seems unwilling to embrace the American bond market.”
Shizuoka Bank President Hisashi Shibata, elaborated: “We need to be aware of the risk of yield inversion and avoid being stuck with valuation losses from foreign debt, and even if we do, we need to make sure we secure a spread so we can hold to maturity.”