Wednesday, May 19, 2010

A Sea of Liquidity or A Mirage?

I have received more emails this week with questions surrounding the state of the money supply and liquidity in the system than at any other time since publishing EPJ. It is the correct question to focus on. That said, it is the most difficult period I have ever experienced to get a true hold on exactly what is going on with the money supply.

A look at the numbers themselves indicate, up to this point, that there has been no money supply growth for many months either here in the U.S. or in the EU. Yet, we know that this may change since the Fed has relaunched it's currency swap program, and the ECB has announced that it would support the EU bond market.

Last week, the Fed announced that it conducted just over $9 billion in swaps. The ECB announced that last week they spent €16.5 billion to support EU markets. $9 billion and €16.5 billion in and of themselves won't create a massive wave of inflation, but if this trend continues, then certainly a problem would develop, let's make that a major problem. However, this analysis has one more factor to take into account, that is, central bank monetary sterilizations. If the ECB pumps €16.5 billion, but then drains €16.5 billion, it 's impact will be non-inflationary, though it will distort the economy in favor of the areas where the money is being pumped, i.e., the land of the banksters, and it will bedrained from the rest of us. It won't be inflationary pain but, none-the-less, pain for the non-banksters in the world.

The ECB has announced it will inflict such sterilization pain. The Fed has also given indications that they may sterilize their currency swaps.

There is just one more kink. The ECB sterilization could be phony. BofA’s Jeffrey Rosenberg explains.

We believe undermining the Euros valuation vs. the dollar stands the threat of indirect debt monetization of Greek and other periphery debt. Despite its claims to the contrary, today’s ECB announcement on operational details of its Securities Markets Programme of direct secondary market purchases of sovereign debt suggests the possibility the ECB could end up effectively sterilizing its own sterilization. This occurs as the term deposits used for sterilizing the EUR16.5bn of purchases last week itself are eligible as collateral against ECB repo liquidity. To us that means that the liquidity drain of collecting deposits from banks could be effectively unwound in the scenario whereby the bank used those term deposits as collateral against ECB repo lending, a possibility explicitly permitted in today’s announcement. While we believe such a scenario is highly unlikely, the perception it creates of debt monetization nevertheless is the larger issue to the near term outlook for the Euro, in our view.
So there you have it. Money printing that really isn't money printing because of sterilization. And, sterilization that may not really be sterilization.

If there ever was a time to think, as G.L.S. Shackle suggests we do, in terms "of a skein of potentiae, and to ask..., not what will be its course, but what that course is capable of being in case of the ascendancy of this or that ambition entertained by this or that interest," it is now.

The possibilities, in the short tern, could lead to quite rapid inflation, if there is rapid money printing, or if the sterilization does take hold, pretty much the opposite, slow inflation.

To prepare for such diametrically opposed scenarios is obviously difficult. There is one trade that does stand out though. Under either scenario, the U.S. bond market is doomed. Short sales of long term bonds make the most sense. If the Fed stays tight, then the government debt problems will only escalate and rates will climb as the Treasury desperately attempts to fund the deficit. If the Fed inflates to battle the debt crisis, then the inflation will cause higher rates.

The stock market is a fairly clear play. Inflation will push the market higher (provided there is enough inflation) and slow money growth will mean a declining stock market.

This is pretty much the case with gold [During inflation goldwill go  up, with slowed money growth, gold goes down] although I'm sure my goldbug friends will don the thinking caps of the broke former real estate flippers and think that gold only goes up in price. I hasten to add here that everyone should have gold coins tucked away because the ultimate likelihood is a huge inflation at some point, but if the Fed stays tight, gold is likely to decline short term. The current spike in gold , I believe can be attributed to panic buying in Germany. With the ECB possibly limiting euro printing, the German buying is likely to subside (although, I won't stake my life on it).

Thus, with this skein of potentia before us, it is time to think in terms of investments.Clearly, short selling the bond market is the best option, betting on volatility is another solid option, buying gold for the long term is also a good option, but as far as that sea of liquidity in front of us, it is a mirage. There may be a sea of liquidity around the next narrow, but this one isn't real. Thus, for the short term, one has to operate with the thinking that the stock market and gold are headed lower.  I could change my mind on this with little or no notice, if I see money growth. But at present when it comes to liquidity, I'm from Missouri, you have to show me the money supply growth before I believe it is anything more than a mirage.


  1. By money growth , do you mean M2 or MZM?

  2. M2. Since some people use money market funds to pay bills, I consider money market funds part of the money supply.