Money supply, bonds, property, equity and the Great Moderation

In this big post I try to pull together a theme to describe the last 20-30 years of investing.

One of the principle characteristics of this was the so-called 'great moderation' in inflation. This can be seen in the chart left since the early 1980s (courtesy of the US Cleverland Fed.)

In the next chart we see that inflation is reasonably reflected in in the US 10 yr Treasury yield. Notice how yield rose from 1960s lows to peak in the early 1980s then fall through to now. Note also the price of a notional 10 yr US Treasury bond works in reverse and we had large bond rises. In fact bonds, particularly zero-coupon long bonds have been a great investment.

We'll come to why at the end, but for now note in the chart below how bond prices have been rising as yields/inflation fall.
With inflation falling, shares increase in value. Why? Well a share price can be considered the current value (CV) of future cash flows from dividends over the long term. With falling inflation the discount rate (IR) falls, and the share CV becomes worth more. This is explained in 'What is NPV?' and the bond basics post. For now not that the S&P500 really took of when inflation started moderating as shown below:
Proof that much of the expansion in the S&P500 index was price to earning expansion is seen in the following long-term PE chart from Bob Bronson. Note Bob's forecast into 2012.
The next asset class is housing and this two has boomed relative to fundamentals (rents). The chart below shows US and Australian prices in real terms, in nominal the price gains are greater. Since 2006-7 we have seen house prices globally correct (US, UK, Spain, New Zealand, Ireland, Canada and now Australia).
The last major asset class is commodities. The chart below is from Martin Pring and shows commodity prices back to 1800. Martin suggests in a presentation that as of July 08, commodities are close to peaking (if not already).
So over the last 20 years we have had every major asset class (bonds, equities, housing and commodities) boom and peak (possibly for commodities). Why?

The answer seems to be an amalgam of reasons as listed below, followed by commentary on whether it is likely to continue.

1. Excess money supply (M0-M3). Not likely to continue with high inflation (M0) and commercial banks repairing balance sheets from massive credit losses (M1-M3). See posts on money here.
   
2. Further interest rate falls. Not likely as inflation rises and bond holders demand higher returns (discount rates) and bid lower prices for bonds.
3. Globalisation benefits. The growth of China Inc. was responsible lower prices everywhere on account of lower wages. However with China inflation rampant, and the Yuan appreciating against the US, China import prices are rising.
4. Low commodity prices. Commodities rose out of mid-80s lows to the current high levels. Whilst they may correct, it will take significant global demand destruction to do so (and this only occurs in a global recession/depression).
5. Inventory management gains. The smoothing of supply chains was responsible for reducing economic volatility. These gains have been made.
6. Reduced wage bargaining power. The late 80s and 90s where eras of conservative pro-business/anti-worker global governments in which workers lost bargaining power. The swing has been back to the worker so there are no more wage gains to be made.
   

In short, I believe the inflationary aspects of excess money supply where masked by items 2-6 above allowing the great moderation. However, that excess money supply found it's was sequentially into bonds (lower interest rates), equities (2000 peak), property (2006 peak), and now commodities (2008 peak).

Consumers everywhere are maxed out. In the developed world consumers borrow costs, access to credit and higher living costs are forcing a dramatic reduction in spending amist falling housing prices. In the developing world high commodities dramatically affect the cost of living which is the major purchase item, killing any discretionary spending that may have existed.

What can turn the global economy? BRIC nations (Brazil, Russia, India, China) spending on infrastructure as part of nation building? Maybe, but these nations export economies will suffer the in the global downturn so at best nation-building will offset this.

Be sure to check the SEI global review for more information as events unfold.

What is monetary and fiscal policy?

In this post we look at government monetary and fiscal policy and how that are related. Very interesting stuff when you follow the actions of governments (spending/taxes), and reserve banks (interest rates).

General Monetary Policy

The process by which central banks control 1) the supply of money, 2) the cost of money or interest rates, and 3) the availability of money. See 'What is money supply?'. Monetary policy can be expansionary which increases the supply of money in the economy (used to spur economic growth); or contractionary which does the reverse.

• Expansionary policy. Total money supply can be increased by printing more money (increasing M0), lowering the cost of money (interest rates) and making easier to 'borrow' it into existence, and by lowering reserve and capital requirements on banks (allowing them to lend more). The US Federal Reserve has added an additional measure allowing banks to swap risky assets (code for assets that have lost most/all of their value, but the banks can't afford to admit it) for quality US Treasuries. This impacts their balance sheet and thus capital ratios by being able to account for the assets differently.
  
• Contractionary policy. Reducing total money supply by printing less (or taking money out of circulation), raise the cost of money (interest rates), and raising reserve requirements.

Monetary Policy Targets

Governments control or direct different policy objectives with monetary policy. These include:

1. Inflation targeting. Targeting a CPI rate of change, say 2-3% yoy, through changes to the overnight interest rate.
   
2. Price level targeting. A specific CPI number, through changes to the overnight interest rate.
   
3. Monetary aggregates. Targeting a CPI rate of change, say 2-3% yoy, by changing money supply (M0).
4. Mixed policy. Targeting low (full) unemployment and low CPI change (low inflation).
5. Gold standard. Targeting low inflation as measured by gold price by changing the fixed gold - currency rate.

Difficulties arise in monetary policy due to globalisation. With globalisation investment capital, and commodity prices are free to move across borders resulting in exchange rate fluctuations, whilst monetary policy is nation dependent. As of July 2008, we have the following quick summaries of monetary policy:

• US. Expansionary - The Fed is stuck between inflation and a failing economy, as it has dual mandates of price stability (low inflation - stability in prices) and employment (sound economy).
• China. Contractionary - Rampant inflation is being addressed with high and rising interest rates and increasing bank reserve requirements. However money supply is increasing (M0) as the Yuan is pegged to the USD, requiring China money printing and sales to artifically depress the Yuan.
• EU. Contractionary - The EU Fed mandate is price stability (low inflation) and is raising interest rates to contract the EU economy in response to high CPI. The EU economy is believed to be close to stalling point.
• Australia. The Reserve Bank is raising interest rates to slow a booming economy (based on the resources sector & government spending). Mandate is inflation targeting with yoy CPI 2-3%.

Fiscal Policy

Fiscal policy relates entirely to government spending. Like monetary policy, fiscal policy can expansionary or contractionary. Fiscal policy is expansionary when government spending exceeds income (money added to the economy), and contractionary when taxes exceed spending (money taken from the economy).

Governments spend of things like social programs, military/police, healthcare and education, as well as infrastructure like roads, airports and ports. Government spending can be funded through:

1. Taxation. Or taxes, surcharges, fees, levies, co-contributions, fines and other language that means taxes.
2. Sale of assets. Such as airports, highways, power plants, radio spectrum.
3. Draw-down of previous surpluses.
4. Borrowing money from capital markets. By selling government bonds.

Are monetary policy and fiscal policy independent?

John Hussman summarises best though this is a more advanced concept (albeit in a US environment. Swap Federal Reserve for your local central bank, and Congress for your local Government).

There is a simple way to think about the relationship between fiscal policy (government spending, taxes) and monetary policy (money supply, interest rates). It is what economists call the Government Budget Constraint

Government Spending = Tax Revenues + Change in Bonds held by Public + Change in Bonds held by Federal Reserve

What this says is that there are literally only 3 ways to finance government spending.

1. Increase tax revenues. Note that this is not necessarily accomplished best by raising tax rates. Regardless of how high the government has set top tax rates, government revenues have consistently hovered between 19% and 19.5% of GDP. The high deficits of the recent past are due to growth in the government share of GDP from about 19% in the 1960's to nearly 23% currently. This growth has been due primarily to an increase in Social Services expenditures such as Medicaid and Social Security. The share of GDP allocated to infrastructure (highways, telecommunications) as well as basic research has actually declined.

2. Sell bonds to the public. This borrowing from the public is the primary means of financing the government deficit. Other things being equal, if the government issues more bonds, the price of those bonds tends to decline, meaning that interest rates tend to rise. This does not mean that a government deficit raises interest rates (there is no statistical evidence to support this notion). The true burden of government is not how much it borrows, but how much it spends. If the government decides to raise taxes rather than borrow from the bond market, it is true that investors will need to buy fewer bonds, but only because they also will have less to invest (due to the higher taxes, which almost always fall on those individuals with the highest savings rate). Raising taxes to cut the deficit therefore does nothing to increase the supply of funds available to other borrowers, and therefore nothing to reduce the level of interest rates. A cut in government spending does increase the supply of funds available to private borrowers. This is particularly true if the tax and regulatory environment is friendly to investment, which can then offset the cut in government spending without a decline in GDP.

3. Sell bonds to the Federal Reserve. This is another way of saying print money.

In short, the Federal Reserve is not nearly as independent as it may appear. The Fed has the choice of whether government liabilities take the form of bonds held by the public, or money held by the public. The Federal Reserve can alter the mix of government liabilities (bonds held by the public vs. money held by the public), but the total amount of these liabilities is determined by fiscal policy, not monetary policy. The Fed can affect whether excessive government spending results in tight bank credit or high inflation, but it cannot prevent both unless Congress controls the growth of government spending itself.

Bonds, inflation and the economy

In 'What is net present value?' and 'What are bonds, treasuries and corporate debt?' we looked at bond basics and bond fundamentals. Here we look at more advanced types of bonds and how they are influenced by the economy and inflation.

Let's be clear about how bonds work. Bonds are purchased for the current value (CV) of their future cash flow values (FV). For short term bonds such as overnight, 13 weeks or 1 year instruments this isn't hard to calculate. But when you work with long bonds such as a 30 year bond you need to be highly accurate with one variable...the discount rate. To show consider a special type of bond called a zero coupon bond. This bond pays no annual interest, instead returning the nominal principal amount at a date in the future. Let's consider a 30 year $1 billion zero coupon bond, with a discount rate of 4.22% and 5.30%. How much would you pay for this particular bond?

CV = $1B/(1+0.0422)^30 = $212.4 million (or a 79% discount to nominal)
CV = $1B/(1+0.0530)^30 = $289.4 million (or a 71% discount to nominal)

So for a 1.08% difference in the discount rate, this bond gained or lost 8% or $77.0 million. If you think this is not likely, look at the chart below (www.yahoo.com). This shows the implied yield (discount rate) on a 30yr US treasury.
As you can see the market is uncertain about the discount assumptions to make for such a long period of time. To see how these discount rate uncertainties translate into bond prices, let's look at two long bond ETFs (Vanguard - TLV, and SPDR Lehman - TLO). As you can see bonds can be a volatile investment, particularly at the long end of the yield curve.
The level of bond yields (discount rates) at different timeframes tells you a lot about the economy. Consider the following chart from Mike 'Mish' Shedlock, one of my favourite bloggers.
Looking at the 3 and 5yr US treasuries, we can see how bond market traders in late 2000 switched from worrying about inflation (high discount rate) to worrying about a recession. This is because the bond discount rate is basically made up of the markets opinion about inflation and economic activity. Shown below is the 'yield curve' for July 2008. This shows the forward yield estimates (discount rate) for different treasuries at different timeframes. Click here to go to this site which also shows a dynamic yield curve corresponding to the S&P500 over the last 6 or so years. A great feature.
The bond punch line... finally.
The reason bonds are so important is that there are trillions of dollars in bonds outstanding. Bonds are used to fund government debt (huge for the US and EU), corporate debt (huge for financial companies) and private debt (home loans, credit card debt, student loans). The bond market is at the heart of the credit crisis because bond holder demand higher returns (interest rates) when inflation or uncertainty rises. This raises the cost of borrowing for EVERYONE and why the mandate of central banks is price stability which by default means low and steady bond yields.

Next the great moderation and peak-credit. Peak oil is an insect bite compared to peak-credit!

What is net present value?

Would you prefer $50 now, or $100 in 12 months time? If you live in the US or Australia, you'd prefer the latter. If you live in Zimbabwe or 1920's Germany, you'd much prefer the former. Why the difference?

Let's pretend your an investor who only invests in term (certificate) deposits, and the current interest rate is 10%. So $100 invested now will be worth $110 in 1 year. The future value (FV) is a function of current value (CV) and interest rate (IR) as follows:

FV = CV*(1+IR)
$110 = $100*(1+0.10)

Let's reverse the equation and find out what the CV of $100 in 1 years time is.

CV = FV/(1+IR)
CV = $100/(1+0.10)
CV = $91

This makes sense. If we put $91 in a term deposit at 10% for 1 year, we'd have $100 at the end.

We can also look out past 1 year by modifying the equation. Suppose we were promised $100 in five years time when the interest rate is 10%. How much is this worth?

CV = $100/[(1+IR)*(1+IR)*(1+IR)*(1+IR)*(1+IR)]
CV = $100/(1+0.10)^5
CV = $100/1.61
CV = $62.09

What this says is that if I took $62.09 and invested it for 5 years at 10% I would have $100 (the promised amount). But the really interesting thing is changes in CV as a result of IR. Suppose we look at an IR of 2% and 20% over 5 years with an FV again of $100.

CV = $100/(1+0.02)^5 = $90.57
CV = $100/(1+0.10)^5 = $62.09
CV = $100/(1+0.20)^5 = $40.19

The CV changes are dramatic, from -9% nominal, to -60%. The graph below shows the CV of a promised $100 in 5 and 10 years at different interest rates.
What is significant is just how quickly high interest rates reduce the current value of future money. This simple financial fact is one of the most important in finance. It helps us value bonds, shares and compare different investment opportunities. Check the articles index for more.

What are bonds, treasuries or corporate debt?

In what are bonds, treasuries or corporate debt we look at bonds, bond pricing and how they are affected by expected returns.

A bond is simply a loan. Bonds, treasuries and corporate debt are all loans from savers (who have money), to debtors (who need money) such as governments (treasuries), or companies (corporate debt). Although the loan comes in many types, the loan is usually an interest only loan for the duration, with the principle (in nominal terms) returned at the end of the loan. In normal finance, a borrower borrows money from a lender and pays an interest rate. In bond language, the issuer borrows money from the bond holder and pays interest at the coupon rate.

Little people/companies borrow money from banks who in turn get their funds from the bond market. Big companies or governments bypass the banks and borrow (raise) their money by selling bonds direct to investors. These bonds can then be traded between borrows just as shares are traded on indexes.

Let's say a government is selling $1 billion in 10 year government treasuries (bonds) with a coupon rate of 10%. Investors buy the bonds from the government (buy handing over $1B), and the government agrees to pay the investor 10% of $1B every year ($100M) for 10 years, and then return the original $1B.

Given that bond holder receives his payback over time, we need to understand net present value in order to value the bond. Suppose we consider a government that needs to raise money to give away to taxpayers to prop up a failing economy. Suppose the bonds it intends to sell at 5 year treasuries with a 10% coupon rate and nominal price of $100 billion. The prevailing interest rate is 5%. This means the government will give the bond holder $10 billion every year for 5 years and then return the original $100 billion. Since we know what NPV is we can calculate the current value of that as follows:

• Year 1. $9.52B = $10B/(1+0.05)^1
• Year 2. $9.07B = $10B/(1+0.05)^2
• Year 3. $8.64B = $10B/(1+0.05)^3
• Year 4. $8.23B = $10B/(1+0.05)^4
• Year 5. $7.83B = $10B/(1+0.05)^5
• Year 5. $78.35B = $100B/(1+0.05)^5

So adding up the CV of each element we derive a bond CV of $121.6 billion. We mentioned before that bonds (future cash flows from borrows) can be traded like shares. Suppose 1 day after this bond commenced trading we had an inflation spike (caused by a falling currency and rising commodities prices) and the bond interest rate went up to 8%. Sparing you the maths (just replace '0.05' above with '0.08') the current price of the now 1 day old bond is...

$108.0 billion. The original owner of this bond just lost $13.66B or 11%. If you haven't worked it out yet, bonds are really important and you can make or lose a lot of money. In 'How are bonds and inflation related?' we look in more detail at the importance of bonds in the economy. In 'How much money did Asia and the middle-East just lose?' we look at global bond trading.