The central bank and your investments: Investment Implications

A tightening of monetary policy implies a decrease in liquidity in the system. During such times financial assets tend to perform poorly. Because of the lack of liquidity, business and consumers tend to sell financial assets and use the proceeds to invest in their businesses and to raise cash balances.

On the other hand, when the Federal Reserve is following an easy monetary policy, injecting liquidity in the system, this increased liquidity cannot be used right away by the real economy. It is placed temporarily in the financial markets waiting to be used. This is the main reason why stocks and bonds usually rise during these times of expansion in monetary aggregates.

Monetary policy impacts two main crucial economic variables; the growth of the money supply and the level of real interest rates. It is important to recognize the impact of these two variables on the economy, because as we mentioned in a previous chapter, a strong growth in the money supply causes the economy to expand rapidly, creating a high-risk environment for the stock and bond markets. The reason for this high risk is that a strong growth in the economy is followed by increases in short-term interest rates, and an increase in short-term interest rates has always had a negative impact on stock prices.

It is also true that a strong economy creates great business opportunities, and therefore, business tends to borrow aggressively, thus placing upward pressure on long-term interest rates, thus having a negative impact on bond prices. This is also a time when inflation increases, raising the inflation premium embedded in bond yields. On the other hand, a slow economy creates investment opportunities. As the economy slows below its long-term average growth rate, upward pressure on interest rates declines, thus allowing short-term interest rates to decline and provide a very favorable environment for the stock market. Also, weak economic conditions convince business to borrow less, therefore, creating downward pressure on long-term interest rates. This is also a time when inflationary pressures subside, reducing the inflation pressure embedded in bond yields. This situation typically creates a favorable environment for the stock and bond markets. >p>In order to keep abreast of the trends and position of financial cycles, investors need to follow the money supply, for that matter, all the measures of money: M1, M2, M3 and MZM because their growth tells you what will happen to the economy. If the money supply begins to accelerate, and this is typically favored by the Federal Reserve during a period of slow economic growth, the investor should look for a stronger economy - one to two years into the future. If the money supply grows very rapidly, let’s say close to fifteen percent, the economy should be expected to be very strong. The good news for investors is that stocks will be strong because liquidity is growing rapidly.

However, one should be aware that strong monetary growth is the seed that eventually will bring higher short-term interest rates and a weak stock market usually after two to two and a half years. The money supply is therefore a very crucial leading indicator for investors. Strong growth in the money supply is followed by strong growth in the economy and in industrial production, income, sales and employment which are the typical coincident indicators. Broad measures of money supply should be growing anywhere between 5-7%. Much higher growth rates than 5-7% create the conditions for strong economic activity. If the money supply grows too rapidly for too long, it will cause the lagging indicators: inflation, cost, commodities, and interest rates to rise.

As the price of money increases, it becomes more and more expensive to borrow. An increase in interest rates would gradually discourage businesses from making investments and expand capacity, thus reducing the demand for money. As a result, the money supply slows down. Only substantial weakness in the economy and lower interest rates will encourage businesses to start borrowing again. This is the time that costs (raw material, wages and interest rates) decline, thus improving margins. For this reason, following a decline in interest rates, the money supply starts accelerating again and a new financial cycle is under way.

What we are trying to emphasize here is the important interplay between money supply and interest rates. Their relationship is a typical relationship that exists between leading and lagging indicators. An increase in the growth of the money supply is followed by rising short-term and long-term interest rates after about two years the growth of the economy is rising. An increase in short-term and long-term interest rates is followed by a decline in the growth of money supply. A decline in money supply is followed by a decline in interest rates. The decline in interest rates is followed by more rapid growth in the money supply.

From the investor viewpoint, there cannot be a decline in interest rates without a substantial deceleration in the growth of the money supply. The reason is that a prolonged decline in the money supply is followed by a decline in the growth of the economy. Because of the slow growth in the economy, the demand for money subsides, thus allowing interest rates and commodities such as crude oil to decline (Fig. 6-4). On the other hand, strong acceleration of the money supply will eventually lead to higher interest rates. Strong growth in the money supply is followed by a strong economy, and because of the strong economy, business and consumers increase their borrowing activity, thus placing upward pressure on interest rates.

Interest rates are the fever chart of any economy. The higher they go above 5-6%, the more a country suffers major imbalances and rising inflation. The lower interest rates go below 5-6%, the more pronounced the imbalances become as deflation raises its ugly head.

This process can also be formalized in terms of leading, coincident, and lagging indicators. We have seen that the money supply is a leading indicator. What we call the economy, which is reflected by what happens to employment, production, income, and sales, is a coincident indicator. Interest rates are a lagging indicator. The interaction between these parameters can be visualized as follows:
• A trough in the growth of the money supply is followed by a trough in the growth of the economy.
• The trough in the growth of the economy is followed by rising interest rates.
• Troughs in interest rates are followed by a peak in the growth of the money supply.
• A peak in the growth of the money supply is followed by a peak in the growth of the economy.
• A peak in the growth of the economy is followed by a peak in interest rates.
• Which is almost immediately followed by an increase in the growth of the money supply.
And the cycle starts all over again.

How does the Fed fit in this process? The Fed cannot substantially change the trend in interest rates because they have been determined by how fast the money supply expanded, by the strength of the economy, and borrowing activity. The Fed can have an impact on the growth of the money supply through the level of interest rates relative to inflation. That is the other variable of monetary policy, real interest rates. They are impacted in a profound way by the Federal Reserve, because the Federal Reserve manages the rise in interest rates so that their increase or decrease does not become disruptive for the economy and the financial markets. What is important, crucial to remember for investors, is that the growth of the money supply, the amplitude and length of its cycle that determines business cycle conditions and trends in the financial market.

Real interest rates, as we have seen in a previous chapter, have a fundamental impact on inflation expectation and overall inflation. Changes in real interest rates affect the demand for goods and services because they impact borrowing costs, the availability of bank loans and foreign exchange rates. For this reason, real interest rates are an important tool of monetary policy. While real interest rates represent the difference between short-term interest rates and inflation, nominal interest rates are the level shown without adjustments for inflation.

In 1978, nominal short-term interest rates averaged about 8% and the rate of inflation was 9%. Even though nominal interest rates were high, monetary policy was stimulating demand with negative real short-term interest rates of –1%. Real short-term interest rates were very low. Money, as a result, was very cheap and monetary policy was very easy. That was the main reason inflation soared in those years.

In contrast, in 1998, nominal short-term interest rates were close to 5%. The inflation rate was about 2% and the positive 3% in real short-term interest rates reflected a fairly tight monetary policy. The point is that nominal interest rates don’t provide, per se, a true indication of monetary policy. The nominal funds rate of 8% in 1978 was much more stimulative than the 5% rate in early 1998. The reason is that in 1978 inflation was above 8%, thus making real interest rates very low and very simulative because the price of money in real terms was actually negative. On the other hand, in 1998 when interest rates were 5% and inflation was close to 2%, real interest rates were much higher, in relative terms, than in 1978 with nominal interest rates about twice the level of inflation. Thus, the high level of real interest rates in 1998 was one of the main reasons inflation was low.

A decrease in real interest rates lowers the cost of borrowing and leads to increases in business investments, consumer spending, and household purchases of durable goods, such as autos and new homes. This has inflationary implications because demand for goods and services increase considerably when the cost of money in real terms, that is after inflation, is low. This extra demand is what produces inflationary pressures.

When real interest rates rise at high levels, the reverse is true. The cost of borrowing increases and only those businesses that have projects with a very high return can make the investment, due to the high real cost of borrowing. What is the impact of real interest rates on the economy? Declining real interest rates is a sign money is becoming less expensive, and therefore, consumers and businesses tend to borrow aggressively during such times, causing the economy to grow rapidly, stimulating inflationary forces.

How do real interest rates and money supply impact the financial markets? High real interest rates help to keep inflation under control. This is a long-term determining factor for the stock and bond markets. From a business cycle viewpoint, the money supply has a more immediate impact for investors. When interest rates decline due to slow growth in the economy, credit expands because business and consumers borrow more aggressively due to the lower cost of money. As a result, the money supply grows more rapidly, positively affecting stock prices. An example of this situation occurred in 1995 when the money supply accelerated sharply as interest rates declined. This configuration was followed by strong economic conditions in 1998-2000 accompanied by sharply rising stock prices in the years from 1995 to 1999.

After a protracted period of strong growth in the money supply, the economy strengthens, the demand for money increases, placing upward pressure on interest rates. This is the time when investors have to be more cautious about the outlook of stock prices. When interest rates rise, the demand for money eventually declines and the money supply slows down. The stock market, which reflects trends in liquidity, cannot perform well under conditions of slower growth in the money supply. A good rule of thumb is to expect slow growth in the money supply, and therefore, poor market conditions after approximately two months of rising interest rates.

The investor has to keep in mind that only a slowdown of money supply of one to two years, followed by slower growth in the economy and lower interest rates, creates the conditions for the next bull market. From an investor viewpoint, it is important to be convinced that there is a close relationship between money supply and stock prices. And, since the level and trend of interest rates affect the growth of the money supply, they do have an impact on the stock market. The stock market is affected indirectly by the rise in interest rates, contrary to what is generally believed. It is quite typical for headlines to say interest rates are rising, therefore, the stock market is in a high-risk territory. That is indirectly true. The real impact on stock prices is actually due to the decline in the growth of the money supply, which is caused by the increase in the cost of money, which discourages borrowing, and therefore, reduces the amount of liquidity in the system.

An increase in short-term interest rates is followed by a decline in the growth of the money supply almost immediately and in stock prices after about two months. A decline in stock prices and in the growth of the money supply is followed by a decline in interest rates after about one year after the economy begins to slow down. A decline in short-term interest rates is followed by an increase of the growth of the money supply and in stock prices almost immediately.

These relationships are very important in determining the dynamics of risk, as far as investing in the stock market. In order to formalize this relationship, it is important to recognize that growth in the money supply and stock prices are leading indicators, the economy is a coincident indicator, and interest rates are a lagging indicator. Because of the relationship between leading, coincident and lagging indicators, the following occurs:
• A trough in the growth of the money supply or stock prices is followed by a trough in the economy, which is followed by
• A trough in interest rates, which is followed by
• A trough in interest rates is followed by a peak in the money supply and stock prices, which is followed by
• A peak in the growth in the economy, which is followed by
• A peak in interest rates, which is followed by
• A trough in the money supply and stock prices

The relationship between financial markets and money supply can also be formalized in terms of phases of the financial cycles.

In phase one of a financial cycle:
• Liquidity or growth of the money supply increases.
• The stock market rises.
• The economy is still slowing down.
• Commodities are declining.
• Interest rates are declining.
• Inflation is declining.
• The dollar is strengthening.

In phase two of the financial cycle it is quite common to see:
• Liquidity is increasing.
• The stock market is increasing.
• The growth of the economy is bottoming and then rising.
• Commodities are bottoming and then rising.
• Interest rates are bottoming and then rising.
• Inflation is bottoming and then rising.
• The dollar continues to strengthen.

In phase three of the financial cycle:
• Liquidity begins to decline.
• The stock market declines.
• The economy remains strong.
• Commodities continue to rise.
• Interest rates continue to rise.
• Inflation remains in an upward trend.
• The dollar weakens.

In phase four of the financial cycle it is typical to have the following:
• Liquidity, or growth in the money supply, declines.
• The stock market declines.
• The economy weakens.
• Commodities decline.
• Interest rates decline.
• Inflation declines.
• The dollar continues to weaken.

The decline in interest rates in phase four triggers the series of events which characterizes phase one.

(From Chapter 6 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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