Tag Archives: interest rate futures

Mechanically Profiting in Confounding Markets

There are times in any endeavor when the stars align and the proper course of action is as clear as a bell. We’ve all had our moments when even we knew we, “were on a roll.” However, most of life’s endeavors and their eventual successes come simply from the honest trudge of hard work and dedication to a specific task. This explains the late 2015 early 2016 success as many of the commodity market were displaying classic commercial trader group clues which we discussed frequently in our Commitment of Traders analysis. This led to catching several of the market rallies like the metals, energies and grains. However, as these moves have disconnected over the last month or so, the next set of predictions becomes much more difficult. This week, we’ll look at the issue of profitable trading via mechanical programs while using the interest rate sector as a barometer for the general markets’ confusion as the global rate picture remains one of the biggest variables.

Continue reading Mechanically Profiting in Confounding Markets

Interest Rate Futures Appear Set for Rare Occurrence

The interest rate sector has been going crazy trying to determine what to do since the Federal Reserve Board (FRB) chose not to raise rates at the September meeting. My email has been inundated by interest rate related mailings. The basic point of most them was, “Now that the Fed held steady, what corner have they backed themselves into?” Most of the boxing in is focused on the FRB’s historical actions. I went back through 45 years of data to determine the scarcity of an October or, December rate hike along with Presidential election cycle analysis which isn’t supposed to be linked to the FRB in any way, shape or, form (wink.) We’ll also move through the individual futures charts to determine what the big money is suggesting with respect to FRB action, history be damned.

Continue reading Interest Rate Futures Appear Set for Rare Occurrence

Interest Rate Futures – Confounded

There’s been no shortage of talk surrounding the interest rate complex. I believe the recent Federal Reserve Board’s meeting was the most highly anticipated since the economic collapse. Their decision to leave rates unchanged sent everyone back to their drawing boards. I’ve read tons analysis since then by people who really know the inner workings of the Fed, the economy and the interest rate markets. The general consensus among these people is as clear as mud. When the brightest of minds come down on opposite sides of an argument it leaves us mere mortals incapacitated in a head shaking way. Since we can’t count on the experts, we’ll go straight to the source, the markets themselves.

Continue reading Interest Rate Futures – Confounded

Cutting Through the Rhetoric

There are times when the markets tell us more about what’s going on than the people on TV. I think this is one of those times. The recent rhetoric has been a political budget argument over nickels and dimes when we they need to be talking about hundreds and thousands. The political blame and spin game is being played at its highest level. The reality is that we are quickly approaching the end of the second round of quantitative easing. The government’s balance sheet reached a record level of $2.63 trillion as of April 7th. This is evidence that the fed has been putting their purchasing power to work. The $600 billion that was enacted to keep interest rates low, provide loans to new businesses and help the economy regain its footing after the financial meltdown of ’08 may be coming to an early end. The markets suggest that the Fed’s next meeting on April 26th could put a kink in the free flow of dollars coming to the market.

There are arguments on both sides of this fence from the insignificant periphery right down to the board of governors itself. The quantifiable portion of this argument is that the commercial traders clearly expect a slowdown in inflation and the economy in the near term. The consensus and conviction of the commercial traders’ positions can be seen in multiple markets; corn, oil, heating oil, copper, bonds, 10 year notes, S&P 500 and Dow Jones futures, etc. Their shift in positions can best be described as, “defensive.”

Copper is typically referred to as the, “economist” of the metals markets. Its use in building construction has always been a fair barometer of the economy’s growth and contraction. Commercial traders in copper from the commitment of traders report have shed nearly 40% of their positions since late February. The combination of China’s successive rate hikes and tightening lending practices paint a clear picture that their fully stocked warehouses are in no danger of depletion.

The crude oil market has seen consistent selling by commercial traders above $100 per barrel. Fear, due to the unrest in Northern Africa has been the primary driver of crude oil prices. This market has remained oblivious to the fact that the storage wells in Cushing, Oklahoma are bumping along near record levels. The price of gasoline has disconnected from the price of crude due to refining issues, not supply issues.

Interest rate futures have seen a flush of commercial buying. The 10 year Treasury Notes have seen commercial positions increase by more than 20% while the 30 year bonds have seen commercial traders increase their net position from 70, 000 contracts at the end of February to more than 120,000 contracts currently. Their buying of U.S. interest rate futures is part technical, and part predictive of a flight to safety driving down Treasury yields.

The flight to safety is predicted from commercial traders selling stock index futures. Commercial traders were buyers on the mid March stock market correction. However, their buying was light and their selling since has pushed their net momentum to negative levels. They may view the extended period of low volatility in the VIX index combined with testing the markets’ February highs as reasonable long liquidation levels or, low risk short selling opportunities.

This combination of moves is certainly bearish. I believe it is predicated by the theory that QE2 may be brought to an early end. If this is the case, the short term reaction would be a stronger U.S. Dollar. This would obviously be a short term negative for commodity markets in general like copper, oil, grains, cotton, etc. However, this would do nothing to alter the global change in demographics. There will be no fewer people to feed and this will not impact the growing global purchasing power that has fueled much of the commodity rally. Therefore, the macro trends will remain intact. This will simply force out many of the weaker hands that have been riding the coat tails of the rallies on the way up.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Buy Bonds – Price Appreciates What Yield Gives Up

Buy Bonds – Price Appreciates What Yield Gives Up

Japan’s official interest rate policy hasn’t been above 2% since 1993. In fact, since 1996, it hasn’t been over .5% and has bounced along at zero for much of that time. Furthermore, Japan has actively increased its balance sheet through the direct purchase of corporate debt as well as absorbing numerous bad loans. In spite of this historically loose monetary policy, Japan’s major fight for over a decade has been deflation. Our own Federal Reserve Board’s decision on August 10th to leave rates steady and purchase long term notes is a strong push towards zero interest rates here in our own country and is a clear statement that the major concern here is also, deflation.

When we view the recent actions by our own Federal Reserve Board within a global context, we see the following picture emerge – Global Deflation. The largest economies in the world, U.S., Japan, England, Germany, Spain, France, etc. are all in recession and facing debt crises. In fact, the G7 as a whole is currently carrying a debt to gross domestic product ratio upwards of 110%. This means that the seven largest free economies currently are borrowing 10% more than they produce in a given year. How long could any of us run our houses or businesses like that?

China, while not in recession, is slamming on the growth brakes in an attempt to prolong their prosperity and avoid the boom and bust cycle. The combined global action is an attempt to borrow our way out of debt. The simple version is that governments lend money to be put to work creating jobs, goods and services in anticipation that each job, good or service will generate revenue in excess of the principal plus interest loaned. However, the money being loaned is not being put into the creation of infrastructure or small businesses, both of which would have lasting payoffs.

Thanks for bearing with me through the setup of the macro economic trade that’s taking place. Commodities as a whole have risen throughout the period of loose fiscal policy with gold and silver leading the way. The more money the global governments pump into the system, the more people want to place their inevitable inflation trades. These fall into three categories, buying metals, selling interest rates and selling the U.S. Dollar. The emotion attached to these trades is the “Homerun Trade.” Talk to your buddies. I’m sure that one third of them fall into this category. Listen for phrases like, “The Dollar is worthless.” “Gold is going to $5,000 dollars an ounce and I’m going to catch it all.” Finally, “Stay away from bonds. These historically low rates can’t last forever with all the money we’re printing.”

It’s been my experience in trading that the day -to -day task of trading the markets profitably has never been about catching a generational shift in market behavior. Making money in the markets on a consistent basis requires following the major players and the moves they create. This requires the ability to set aside personal feelings of any given market and fall in line with those who are collectively smarter than we are.

The most dynamic setup is in the interest rate complex. People have been reluctant to buy bonds since late 2007. The operating thesis was that the government is going to flood the system with liquidity, which can only lead to inflation. In normal times, I would agree with that statement and so would the markets. However, after a brief dive in June of ’07 bond prices have increased by 50% while yields are correspondingly lower. At these prices, most of the calls I get are from people either afraid to buy bonds or, people who can’t wait to sell them.

Currently, U.S. interest rate futures show the yield to maturity on long bond futures is around 3.375%. This equals a long bond futures price around 133.  The long bond had been consolidating for nearly a year as investors expected the yield curve to steepen as the recovery got underway. The general action in the market was to buy short- term debt and sell long- term. However, as the recovery has failed to find its legs and the global governments prepare for a lengthy slow down, we’ve seen a substantial build in commercial trader’s acquisition of long -term debt. As much as people dislike the idea of 3.375% interest rate, there is the opportunity to gain some price appreciation in the interest rate complex.

(As I’m proof reading this, Professor Jeremy Siegel of the Wharton School of Economics is on CNBC arguing that the current yield on government bonds do NOT represent a good investment for most portfolios. My argument is for price appreciation in the futures market, not yield accrual in the cash market.)

The scenario is this. The 30 yr. T-Bond futures have a margin requirement of $3,375. The contract is a 6% coupon with a face value of $100,000 dollars. This market is currently trading at a price of 133 with a 3.375% yield. The consensus is that the bond market will continue to climb in price, which means lower and lower yields ahead. We stated earlier that Japan has gone through deflation and their government operated at 0% interest for years. In spite of the governments 0% stimulation plan, Japanese Government Bonds never traded below a yield of .5%. If we are to assume that our situation is going to take longer to sort itself out than we first expected, then it is safe to say that we will edge closer to the 0% rate that our Federal Reserve Board is already defending. If 30yr. T-Bond futures were to drop to 2% yield to maturity, that equal a futures price of 165.59 or, approximately a $30,000 gain on the contracts $100,000 face value. A futures price of 190.03 which corresponds to a 1% yield to maturity would equal a gain of $57,000 per contract. Finally, to match the Japanese Government Bond’s all time low yield of .5%, 30yr. T-Bond futures would have to trade, in price, up to 204.53. This would equal a cash gain of approximately $90,000 on the $100,000 face value.

Bonds should remain a part of one’s portfolio. Through the use of the 30yr. Bond futures, the market’s price gain can be captured as yields continue to fall without having to commit a large portion of available cash. The $3,375 initial margin requirement to control $100,000 face value Treasury bond contract helps illustrate the beauty of the commodity markets. Since it is extremely rare for a trader to be instantly right the market, a sufficient cash cushion should be kept to absorb day to day price fluctuations.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Customer’s Question


This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

I received the following email from one of my more erudite customers. I think, between us, we raised more questions than we answered. You will see my response below. Andy, I sent that same article (Swiss Bank say “goodbye to US”) to a European friend that I frequently have global economic discussions with.  He excused it as the “Swiss being the Swiss”.  He said they have been complaining for years as almost all of the European countries have demanded the same transparency from them. He feels that their historic dependence on secrecy and neutrality has been crumbling as the world gets smaller and hasn’t seen them as “playing ball”.  This is the sound of a “baby crying because its not getting its way”.  They used to command respect in international finance, but are becoming far less significant or impactful.  Excuse it.  Ignore it, he said.  It signals desperation, as to lash out against the US is an old European ploy to garner support from there brothers on “the continent”, in a “we stand together” approach.  He reminded me that their list of complaints about the US government approach to the economy and the private sector is, 1) well know , and, 2) the same complaints that you hear in the US itself.  “Who needs them to remind us of the obvious?  Its just rubbish!  Throw it away.”  Interesting …………… As I constantly try to summarize and update my outlook, her are my latest random thoughts……. Although a double dip recession is theoretically possible, what are the realistic chances when money is being printed around the world and interest rates are so low?? As our major companies have globalized over previous decades, and that pace continues to accelerate, is the statistical relevance of the US economic indicators disconnecting from our own stock market?  So many of our prognosticators and experts base there predictions and interpretations on models built from another era.   The rest of the world’s indicators are showing a bottom in place and a standard upturn based upon overprinting of currency and low interest rates – full steam ahead.  The fact is that we have the same, but our banks are holding onto money to protect themselves from the government changing the rules, and the housing glut is feeding the negative impact on household wealth perceptions.  So, our government policy nightmare could feed domestic fears of deflation, economic slowdown, and continued unemployment, while the rest of the world is full steam ahead.  They may worry about potential inflation, fed by the voices of the gold bugs and their own fears based upon many a small country’s own history.  But as you rightly pointed out, it will not be based upon scarcity of labor, material, or capital.  But those three factors usually only come into play at the end of the cycle.  Inflation is prompted by too much cheap money  funding speculation, which fuels growth, expansion, hyper growth and eventually scarcity of labor or material (usually not capital, as what politician in his/her right mind would shut off the spigot which provides their power?)  And since in a globally developing world with 2/3 of the population at poverty levels, and global companies able to readily locate or relocate production to cheaper labor markets – labor inflation will not be a problem.  This leaves only material, raw or manufactured, as the instrument of limited supply – too much money chasing limited supply. And those with true needs for production, will be punished by speculators crowding into their space. Gold is a monetary option, not an inflation indicator.  It is a currency equalizer.  It has risen in response to the drop in the USD, which is in response to our government’s unclear policies.  Gold should drop when these become clearer (the rules of the game) and the game restarts. Although the floor has risen as all currencies are being devalued. Also, has the education of the US investors expanded sufficiently that global investing differentiation has reached the level whereby their personal wealth could be positively impacted by successful investment returns from emerging or global markets, such that they spark retail here?  Or will they focus on reinvesting to rebuild wealth (having been burned recently) and link consumption directly to job security and taxes? We are seeing the condensed cycles we discussed previously.  Easy money has only been around for a year and already everyone’s worried about inflation. So where does that leave me?  With the intention of getting in early and out on time ….. Short term (start of cycle) opportunities would appear to be:  Emerging market stocks, and US stocks of global companies, or banks, small companies with a global labor supply or consumer market but little exposure to materials with potential price spikes or limited supply (SHIT !!!!!! Just realized I’m in the wrong business !!!!)  Perhaps some real estate. Middle term (mid cycle) opportunities would appear to be:  Global stocks and US stocks of global companies, raw materials with limited supply or long windows of new supply coming on stream Long term (late cycle) opportunities would appear to be: Start looking for tops:  to short all stocks, to sell commodity futures, End of cycle opportunities:   Short everything, buy bonds (as interest rates will need to be lowered in the next recession), hold cash (to start buying at the beginning of the next cycle). What should I do today?   Looks like commodities should have a floor, due to cheap money and economic recovery world wide.  So I should stop shorting against minor pullbacks.  Perhaps the only fear of a double dip is domestically?  Although global growth is recovering, it is no where near levels to spark commodity demand – just speculation due to cheap money, and limited alternatives.  Commodities may stay in a range for some time. (When gold retreats, so will many other commodities) Play USD recovery when policies become clearer. Invest in merging markets. Drink wine…. My response: There’s an awful lot to go on here. PhD’s  are working overtime to generate responses to each of your individual questions and you expect me to digest it, whole? I do have a couple of thoughts on some of your points. I’ve read it three times now, and I think I’m starting to wrap my head around it.     1)    Double dip recession – I think it’s very likely if the tax plans go through. It seems to me that taxes will rise and this will hurt our economy both by slowing new employment and, in turn, undercutting federal estimates of planned tax collection. Furthermore, these taxes will provide no long term benefits whatsoever to our infrastructure, our individuals or, our corporations. As you and I have discussed, profits have come through cost cutting and one time stimulus injections. We’re generating zero domestic demand and our exports are increasing, primarily, through the effect of the declining Dollar and its effect on the agricultural markets. Finally, on the inflation/deflation debate of the double dip, I think I’ve gotten my head around to the following argument for deflation as our primary focus. We’ve already had the excess land and labor argument and I think deleveraging has put a damper on capital demand. Throughout the financial crisis, we have g
lobal deleveraging on an unprecedented scale. In addition, the money that the governments are printing is going into a banking system where it is being used by the to fix their own balance sheets. Therefore, the newly printed money is not being lent out, has no velocity and is generating less inflation than would historically be the case.     2)    I tend to think that models have a finite lifespan. Through my experiences in programming them, I have separated quite a bit of wheat from the chaff. There are technical indicators showing our bottom in place like the major divergences in negative momentum from the March lows. There are fundamental indicators like the explosion in jobless claims two months ago or, so followed by declining claims that tends to serve as a predictive indicator. There are the earnings reports, particularly in the financials, that all would indicate the worst is behind us. Remember when the LIBOR (see U.S. Interest Rate Futures) had its own 24 hour window on CNBC through the crisis? I think that globalization has put the U.S. markets in a basket of “tradeable markets.” It’s no different than U.S. investors placing money overseas. Any investor is simply looking for return on investment. As long there are sectors or, markets as a whole, people will design new trading strategies to increase their risk to reward ratios and, in doing so, become less concerned with a market’s internals as the day’s closing price will be the only meaningful metric. This WILL continue to create bubble after global bubble. We will ALWAYS seek out our own financial best interest. The education of U.S. investors is to ride the wave until it crashes then, look for the next one. Ignorance is bliss the whole way into the beach.     3)    Where do we stand in the cycle? The simple version is to invest anywhere there is a growing middle class  with an historically high savings rate, both in population and demographic. That description does not exist domestically.

An Interesting Case for Bonds


This is from John Mauldin’s “Outside the Box.” and provides an interesting perspective on U.S. interest rate futures.This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk in investing in futures.

Quarterly Review
and Outlook – First Quarter 2009

by Van Hoisington
and Dr. Lacy Hunt



Over the next decade, the critical element in any investment portfolio
will be the correct call regarding inflation or its antipode, deflation.
Despite near term deflation risks, the overwhelming consensus view is that
“sooner or later” inflation will inevitably return, probably with
great momentum. This inflationist view of the world seems to rely on two
general propositions. First, the unprecedented increases in the Fed’s
balance sheet are, by definition, inflationary. The Fed has to print money
to restore health to the economy, but ultimately this process will result
in a substantially higher general price level. Second, an unparalleled
surge in federal government spending and massive deficits will stimulate
economic activity. This will serve to reinforce the reflationary efforts of
the Fed and lead to inflation.

These propositions are intuitively attractive. However, they are
beguiling and do not stand the test of history or economic theory. As a
consequence, betting on inflation as a portfolio strategy will be as bad a
bet in the next decade as it has been over the disinflationary period of
the past twenty years when Treasury bonds produced a higher total return
than common stocks. This is a reminder that both stock and Treasury bond
returns are sensitive to inflation, albeit with inverse results.

Economic Theory

If inflation and interest rates were to rise in this recession, or in
the early stages of a recovery, the expansion would be cut short and the
economy would either remain in, or relapse into recession. In late stages
of economic downturns, substantial amounts of unutilized labor and other
resources exist. Thus, both factory utilization and unemployment rates lag
other economic indicators. For instance, reflecting this severe recession,
unused labor and other productive resources have increased sharply. The
yearly percentage decline in household employment is the largest since
current data series began in 1949. In March the unemployment rate stood at
8.5%, up from a cyclical low of 4.4%. This is the highest level since the
early 1980s. The labor department’s broader U6 unemployment rate includes
those less active in the labor markets and working part time because full
time work is not available. The U6 rate of 15.6% in March was the highest
in the 15 year history of the series and up from its cyclical low of 7.9%.
The operating rate for all industries and manufacturing both fell to their
lowest levels on record in March. Manufacturing capacity was around 15%
below the sixty year average (Chart 1). Given these conditions, let’s
assume for the moment that inflation rises immediately. With unemployment
widespread, wages would seriously lag inflation. Thus, real household
income would decline and truncate any potential gain in consumer spending.

Manufacturing Capacity Utilization - Monthly

A technically superior and more complete method of capturing the concept
of excess labor and capacity is the Aggregate Supply and Demand Curve
(Chart 2). Inflation will not commence until the Aggregate Demand (AD)
Curve shifts outward sufficiently to reach the part of the Aggregate Supply
(AS) curve that is upward sloping. The AS curve is perfectly elastic or
horizontal when substantial excess capacity exists. Excess capacity causes
firms to cut staff, wages and other costs. Since wage and benefit costs comprise
about 70% of the cost of production, the AS curve will shift outward,
meaning that prices will be lower at every level of AD. Therefore, multiple
outward shifts in the Aggregate Demand curve will be required before the
economy encounters an upward sloping Aggregate Supply Curve thus creating
higher price levels. In our opinion such a process will take well over a

An Illustration of the Aggregate Supply Curve during a Period of Substantial Unutilized Resources

Expansion of the Fed’s Balance Sheet and M2

In the past year, the Fed’s balance sheet, as measured by the monetary
base, has nearly doubled from $826 billion last March to $1.64 trillion,
and potentially larger increases are indicated for the future. The
increases already posted are far above the range of historical experience.
Many observers believe that this is the equivalent to printing money, and
that it is only a matter of time until significant inflation erupts. They
recall Milton Friedman’s famous quote that “inflation is always and
everywhere a monetary phenomenon.”

These gigantic increases in the monetary base (or the Fed’s balance
sheet) and M2, however, have not led to the creation of fresh credit or
economic growth. The reason is that M2 is not determined by the monetary
base alone, and GDP is not solely determined by M2. M2 is also determined
by factors the Fed does not control. These include the public’s preference
for checking accounts versus their preference for holding currency or time
and saving deposits and the bank’s needs for excess reserves. These
factors, beyond the Fed’s control, determine what is known as the money
multiplier. M2 is equal to the base times the money multiplier. Over the
past year total reserves, now 50% of the monetary base, increased by about
$736 billion, but excess reserves went up by nearly as much, or about $722
billion, causing the money multiplier to fall (Chart 3). Thus, only $14
billion, or a paltry 1.9% of the massive increase of total reserves, was
available to make loans and investments. Not surprisingly, from December to
March, bank loans fell 5.4% annualized. Moreover, in the three months ended
March, bank credit plus commercial paper posted a record decline.

M2 Money Multiplier and Excess Reserves - monthly

If this all sounds complicated you are right, it is. The bottom line,
however, is that it is totally incorrect to assume that the massive
expansion in reserves created by the Fed is inflationary. Economic activity
cannot move forward unless credit expansion follows reserves expansion.
That is not happening. Too much and poorly financed debt has rendered
monetary policy ineffective.

What about the
M2 Surge?

M2 has increased by over a 14% annual rate over the past six months,
which is in the vicinity of past record growth rates. Liquidity creation or
destruction, in the broadest sense, has two components. The first is
influenced by the Fed and its allies in the banking system, and the second
is outside the banking system in what is often referred to as the shadow
banking system. The equation of exchange (GDP equals M2 multiplied by the
velocity of money or V) captures this relationship. The statement that all
the Fed has to do is print money in order to restore prosperity is not
substantiated by history or theory. An increase in the stock of money will
only lead to a higher GDP if V, or velocity, is stable. V should be thought
of conceptually rather than mechanically. If the stock of money is $1
trillion and total spending is $2 trillion, then V is 2. If spending rises
to $3 trillion and M2 is unchanged, velocity then jumps to 3. While V
cannot be observed without utilizing GDP and M, this does not mean that the
properties of V cannot be understood and analyzed.

The historical record indicates that V may be likened to a symbiotic
relationship of two variables. One is financial innovation and the other is
the degree of leverage in the economy. Financial innovation and greater
leverage go hand in hand, and during those times velocity is generally
above its long-term average of 1.67 (Chart 4). Velocity was generally below
this average when there was a reversal of failed financial innovation and
deleveraging occurred. When innovation and increased leveraging transpired
early in the 20th century, velocity was generally above the long-term
average. After 1928 velocity collapsed, and remained below the average
until the early 1950s as the economy deleveraged. From the early 1950s
through 1980 velocity was relatively stable and never far from 1.67 since
leverage was generally stable in an environment of tight financial
regulation. Since 1980, velocity was well above 1.67, reflecting rapid
financial innovation and substantially greater leverage. With those
innovations having failed miserably, and with the burdensome side of
leverage (i.e. falling asset prices and income streams, but debt remaining)
so apparent, velocity is likely to fall well below 1.67 in the years to
come, compared with a still high 1.77 in the fourth quarter of 2008. Thus,
as the shadow banking system continues to collapse, velocity should move
well below its mean, greatly impairing the efficacy of monetary policy.
This means that M2 growth will not necessarily be transferred into higher
GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded
by 15.7%. The same pattern appears likely in Q1 of this year.

Velocity of Money 1900-2008

The highly ingenious monetary policy devices developed by the Bernanke
Fed may prevent the calamitous events associated with the debt deflation of
the Great Depression, but they do not restore the economy to health quickly
or easily. The problem for the Fed is that it does not control velocity or
the money created outside the banking system.

Washington policy makers are now moving to increase regulation of the
banks and nonbank entities as well. This is seen as necessary as a result
of the excessive and unwise innovations of the past ten or more years.
Thus, the lesson of history offers a perverse twist to the conventional
wisdom. Regulation should be the tightest when leverage is increasing
rapidly, but lax in the face of deleveraging.

Are Massive
Budget Deficits Inflationary?

Based on the calculations of the Congressional Budget Office, U.S.
Government Debt will jump to almost 72% of GDP in just four fiscal years.
As such, this debt ratio would advance to the highest level since 1950 (Chart
5). The conventional wisdom is that this will restore prosperity and higher
inflation will return. Contrarily, the historical record indicates that
massive increases in government debt will weaken the private economy,
thereby hindering rather than speeding an economic recovery. This does not
mean that a recovery will not occur, but time rather than government action
will be the curative factor.

Gross Federal Debt Held by Public as a % of GDP

By weakening the private economy, government borrowing is not an
inflationary threat. Much light on this matter can be shed by examining
Japan from 1988 to the 2008 and the U.S. from 1929 to 1941. In the case of
Japan government debt to GDP ratio surged from 50% to almost 170%. So, if
large increases in government debt were the key to economic prosperity,
Japan would be in the greatest boom of all time. Instead, their economy is
in shambles. After two decades of repeated disappointments, Japan is in the
midst of its worst recession since the end of World War II. In the fourth
quarter, their GDP declined almost twice as fast as that of the U.S. or the
EU. The huge increase in Japanese government debt was created when it
provided funds to salvage failing banks, insurance and other companies,
plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225
average was 77% lower than in 1989, and the yield on long Japanese
Government Bonds was less than 1.5% (Chart 6). As the Government Debt to
GDP ratio surged, interest rates and stock prices fell, reflecting the
negative consequences of the transfer of financial resources from the
private to the public sector (Chart 7). Thus, the fiscal largesse did not
restore Japan to prosperity. The deprivation of private sector funds
suggested that these policy actions served to impede, rather than
facilitate, economic activity.

Japan: Gevernment Debt as a % of GDP and Nikkei Stock Average

Japan: Government Debt as a % of GDP and Long Term Government Rates

This recent Japanese experience mirrors U.S. history from 1929 to 1941
when the ratio of U.S. government debt to GDP almost tripled from 16% to
near 50%. As the U.S. debt ratio rose, long Treasury yields moved lower,
indicating that the private sector was hurt, not helped, by the government’s
efforts. The yearly low in long Treasury yields occurred at 1.95% in 1941,
the last year before full WWII mobilization. In 1941, the S&P 500,
despite some massive rallies in the 1930s, was 62% lower than in 1929, and
had been falling since 1936. Thus, two distinct periods separated by
country and considerable time indicate that stock prices respond
unfavorably to massive government deficit spending and bond yields decline.

The U.S. economy finally recovered during WWII. Some attribute this recovery
to a further increase in Federal debt which peaked at almost 109% of GDP.
However, the dynamics during the War were much different than from those of
1929 through 1941 and today. The U.S. ran huge trade surpluses as we
supplied military and other goods to allies, which served to lift the U.S.
economy through a massive multiplier effect. Additionally, 10% of our
population, or 12 million persons, were moved into military services. This
is equivalent to 30 million people today. Also, mandatory rationing of
goods was instituted and people were essentially forced to use an
unprecedented portion of their income to buy U.S. bonds or other saving
instruments. This unparalleled saving permitted the U.S. economy to recover
from the massive debt acquired prior to 1929.

Bonds Still an
Exceptional Value

Since the 1870s, three extended deflations have occurred–two in the
U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to
2008. All these deflations occurred in the aftermath of an extended period
of “extreme over indebtedness,” a term originally used by Irving
Fisher in his famous 1933 article, “The Debt-Deflation Theory of Great
Depressions.” Fisher argued that debt deflation controlled all, or
nearly all, other economic variables. Although not mentioned by Fisher, the
historical record indicates that the risk premium (the difference between
the total return on stocks and Treasury bonds) is also apparently
controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per
annum more than Treasury bonds, but in deflations the risk premium was
negative. In the U.S. from 1874-94 and 1928-41, Treasury bonds returned
0.9% and 7% per annum, respectively, more than common stocks. In Japan’s
recession from 1988-2008, Treasury bond returns exceeded those on common
stocks by an even greater 8.4%. Thus, historically, risk taking has not
been rewarded in deflation. The premier investment asset has been the long
government bond (Table 1).

Risk Premium During Debt Deflations

This table also speaks to the impact of massive government deficit
spending on stock and bond returns. In the U.S. from 1874-94, no
significant fiscal policy response occurred. The negative consequences of
the extreme over indebtedness were allowed to simply burn out over time.
Discretionary monetary policy did not exist then since the U.S. was on the
Gold Standard. The risk premium was not nearly as negative in the late 19th
century as it was in the U.S. from 1928-41 and in Japan from 1988-2008 when
the government debt to GDP ratio more than tripled in both cases. In the
U.S. 1874-94, at least stocks had a positive return of 4.4%. In the U.S.
1928-41 and in Japan in the past twenty years, stocks posted compound
annual returns of negative 2.4% and 2.3%, respectively. Therefore on a
historical basis, U.S. Treasury bonds should maintain its position as the
premier asset class as the U.S. economy struggles with declining asset
prices, overindebtedness, declining income flows and slow growth.

Van R. Hoisington
Lacy H. Hunt, Ph.D.