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VIDEOThe Velocity of Money
How it works.
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But let's go back to our equation, P=MV. If velocity slows by 10% (which it well should) then money supply (M) would have to rise by 10% just to maintain a static economy. But that assumes you don't have 1% population growth, 2% (or thereabouts) productivity growth, a target inflation of 2%, which means M (money supply) needs to grow about 5% a year even if V was constant. And that's not particularly stimulative, given that we're in recession.
Bottom line? Expect money supply growth well north of 7% annually for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow arm chair economists (and that's most of us) to sit back and Monday morning quarterback for many years.
A Slowdown in Velocity
Now, why is the velocity of money slowing down? Notice the real rise in V from 1990 through about 1997. Growth in M2 (see the above chart) was falling during most of that period, yet the economy was growing. That means that velocity had to rise faster than normal. Why? Primarily because of the financial innovations introduced in the early 90's like securitizations, CDOs, etc. It's financial innovation that spurs above trend growth in velocity.
And now we're watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in and Wall Street began to game the system. End of game.
What drove velocity to new highs is no longer part of the equation. Its absence is slowing things down. If the money supply did not rise significantly to offset that slowdown in velocity the economy would already be in a much deeper recession.
While the Fed does not have control over M2, when it lowers interest rates, it's supposed to make us want to take on more risk, borrow money and boost the economy. So, the Fed has an indirect influence.
I expect the Fed to cut another 25 basis points this week, and to give us a statement that will look neutral, with a nod toward difficult economic conditions. The latest Beige Book from the Fed was simply dreadful, so you can bet the governors will have a deteriorating economy in mind. Given the 25 plus year low in consumer confidence, they have little choice.
But the difference another 50 basis point cut (over the next few meetings) would make is not all that much. A 2% rate is already low. That would make the real rate (after inflation) negative. In one sense, 2% today is lower in real (inflation adjusted) terms than the 1% that Greenspan took it to. Back then inflation was just above 1%. We'll have a negative real interest rate after this next cut. Depending upon which inflation measure you use (and there are a few with some wide differences), it could be as much as 2% negative. Now that is real stimulus.
And since we're on asides, let me predict that the official GDP for the first quarter will not be negative. You watch and see if the PCE deflator is below 3%. Call me cynical, but it would not surprise me, even as CPI is over 4%. Also, watch GDP get revised to negative next year.
If You Are in a Hole, Stop Digging
I often listen to financial radio when I'm driving to work (if I'm not on the phone). I'm amazed how often I hear (or read) about the bottom of the housing market. Often we hear that the stock market is predicting the bottom. I wonder if any of these cheerleaders actually looks at the relevant statistics. Again, let's do some basic arithmetic so that even an analyst can understand.
Last week we found out that new home sales are running at an annual rate of 526,000, the lowest number in almost two decades. The supply of new homes, in terms of the amount of time it would take to work through the inventory available for sale was 8.4 months last October. It's now an even 11 months. (Source for data: www.weldononline.com.)
How many homes did the home building industry start building last month? Housing starts were running at an annual rate of 947,000. Permits for new homes was 927,000. That means the industry is building over 400,000 more homes than they're selling. Add in a million or so foreclosures. Kill the subprime market. Really make it hard to get a loan securitized for anything but government backed mortgages.
Home construction is going to drop precipitously before the inventory of new homes is worked through. Those who are predicting a rebound this quarter are simply not paying attention to the basic math. New home prices are down 13.3% year over year. They're going much lower. Margins are going to get squeezed. Now maybe the market is pricing all this in. But I think there are better places to gamble than the home builders.
And More Write-offs to Come
And speaking of gambling, a few quick thoughts on the write-offs that we're seeing in the banking industry. We have just seen the beginning of woes. We're nowhere near close to the end, for three reasons. First, the estimated amount of write-offs from the subprime crisis is now approaching $1 trillion (courtesy of the IMF). We have seen (maybe) write-offs of about $250 billion. Where is the other $750 billion?
Now, some of it – maybe even most of it - is in insurance companies, pension funds and sovereign wealth funds. It'll be years before we can even estimate how much. There will be no press releases from the Central Bank of China saying they are writing off $15 billion. Which pension fund investment committee will announce their losses? We'll only "see" it in lower performance numbers.
But a lot is still in the banking system, having yet to be downgraded by the rating agencies.
Secondly, the problems are spreading from subprime. Bill King called my attention to this note from www.Housingwire.com. Here is the quote (emphasis mine):
"Moody's Investors Service issued more Alt-A downgrades on Thursday morning, this time taking a heavy hand to 32 different Aaa-rated tranches from 10 different Alt-A deals. Many of the downgrades even pushed former Aaa's into non-investment grade categories - a stunning descent for top-rated Alt-A mortgage bonds that underscores two key points.
First, defaults are obviously accelerating. Second, many Alt-A deals were issued with less in the way of overcollateralization - which, in plain English, means that these deals will start to see downgrades sooner, compared to the relative stress that a typical subprime RMBS deal can withstand before the hits start coming at the Aaa level.
The rating agency placed an additional 254 Aaa-rated Alt-A classes on negative ratings watch Wednesday."
Clearly the default disease is moving up into Alt-A loans. Do you think any bank has written these loans off yet? There are more write-offs coming from the mortgage space. It is not unrealistic that we could see as much (in total) as we've already seen.
Third, we're in a recession. That means all sorts of business loans, commercial real estate, credit cards, student loans, car loans and so on are yet to default. Defaults on such loans are a lagging indicator. Those write-offs occur closer to the end of the recession than the beginning and we haven't seen much of them yet. We will. Expect banks to continue to post ever larger reserves for losses.
All in all, we're nowhere close to the bottom of the credit crisis. The cycle of large write-downs and then going to the market for more capital is going to continue for some time, perhaps longer than a year. Anyone who is putting money in the financial stocks is gambling, not investing.
South Africa, La Jolla, Toronto and Maine
Next Saturday I leave for South Africa. I'm not looking forward to a 14 hour flight in coach, but I always enjoy South Africa. (South African Airways executives take note: I will be glad to testify to the comforts of first class for an upgrade!) I'm there about ten days and then head back to La Jolla for a quick trip to meet with my partners at Altegris and Thomas Fischer of Jyske Bank.
Tiffani committed me to a speech in Toronto mid-June and in late July I'll go to Maine to go fishing with my youngest son at David Kotok's annual fishing fest - sometimes called the Shadow Fed.
Then the big event. Tiffani is getting married on 08-08-08. It's going to be quite the production. Every table is its own work of art. The cake will look like an old sculpture with vines all around it. Of course, everything has its own significance. And the photography that has already been done is way over the top.
As noted above, I am flabbergasted at the cost of flowers. And fireworks? In downtown Dallas? I have three other daughters, who I am sure will all be watching and taking notes. Guess it is good I have no plans to retire in the next 20 years. It seems Dad is going to be working and traveling for a long time.
The twins are coming down this weekend, so all seven kids will be around. I'm looking forward to it. And the Rangers are playing outside my window, trying to keep from losing eight straight. They've already set the team record for worst April, and there are six games to go. And the Mavericks are down to New Orleans. Isn't it time for some Dallas Cowboy football?
Have a great week and remember, times with family and friends go by fast, so enjoy all that velocity while you can.
Your 'watching the velocity of life pick up speed' analyst,
John Mauldin
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