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Does M3 Matter Anymore?

When Bernanke took office, he deemed M3 to be irrelevant and the Fed stopped releasing the data. The data is still available from other market participants, and I have continued to highlight M3 and credit growth over the past 18 months. I have been watching it soaring off the charts, with M3 growing in the 18% annualized range. Credit growth is soaring as well. Below you will find a chart courtesy of www.nowandfutures.com highlighting the point that credit and M3 are growing exponentially. Even with all of this extra money and credit, the economy is not growing? This is Zero Hour defined. With all of the debt service consuming new money and new credit, we have reached the financial ‘Day of Reckoning’ when money and credit growth no longer stimulate growth.

Combined M3 and Credit Market Debt Growth

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Since I have been highlighting M3 and credit growth for years, you may ask yourself why I am no longer focused on it. It’s not that it isn’t important, just less relevant than derivatives which have grown so large that any major ‘event’ in the derivatives market could tear the financial system apart at the seams. According to the Bank for International Settlements (B.I.S.) there are now more than half a quadrillion dollars of derivatives outstanding, even growing now at 25% quarter-over-quarter.

Note that the chart I have attached, courtesy of Ned Davis Research, ends on June 30th 2007 and doesn’t include the latest data. Note not only the size of the market, but the trajectory of the growth. Again, it is parabolic. But if something goes awry in this market, what will the impact be? I have a fairly lame response—I don’t know. Last year, I highlighted this during a presentation in New York as one of my fears for the future and someone asked me ‘surely the risks are hedged away, no’? Again, my answer is that I doubt it, but truly, I don’t know.

Derivatives by Sector Ending June 30th 2007

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I read an article here the other day that highlighted just how large the derivatives market was in comparison to the rest of the ‘capital structure’ worldwide. The chart is staggering and can be found below.

The World’s Capital Structure-Total Liquidity

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A Few Quotes from Warren Buffett

• “Risk comes from not knowing what you're doing.”
• “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
• “If past history was all there was to the game, the richest people would be librarians”
• “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
• “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Warren Buffett is known as one of the best investors of all time and he only buys things that he understands and that can be held for extremely long periods of time. Forget for a moment that he is sitting on a gigantic cash hoard. Just look at the last quote. I would bet that if you asked him whether counterparty risks were developing between financial institutions, and what he thought would happen to the markets, the answer would likely be either ‘There is no way to know,’ or ‘I don’t know.’ Those are my answers.

This leads me to the very interesting possibility that banks no longer trust each other as counterparties. LIBOR is the rate that banks charge each other around the globe. For many years 1 month LIBOR traded virtually even with the effective Federal Funds rate. But this is no longer the case. No matter how much the ECB and Fed inject into the system, the spread is now very wide, a sign of market stress. Could it get wider? Yes. What would be the implications? Likely, an ‘event’ would occur in the credit/credit derivatives market. What impact will this have on the economy as a whole? Probably not a very pretty impact, which is why I continue nearly void of credit risk. But the honest to goodness answer is ‘Mr. Hand, I don’t know’. I only know to be cautious.

Spread Between 1 Month LIBOR and the Effective Federal Funds Rate

Click here to enlarge.

Happy Holidays to you and yours.

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