Published March 10, 2023
Though interest rates get all the headlines, changes in the supply of money can have substantial impacts on the economy and asset prices. Below is Delta’s analysis of changes in the supply of money and how that might impact inflation.
“The January money supply declined by 1.7% versus a year ago. Money supply (M2) is a measure of money including coins, currency, check and savings deposits, travelers checks and money market deposit accounts. This is both the biggest yearly decline and the first time ever it has contracted in consecutive months. The monthly rate of change has been falling consistently since mid-2021 when it peaked at a 27% growth rate.
An expanding money supply can stimulate consumption which is inflationary. A declining money supply does the opposite. With the money supply contracting rapidly, we should expect to see materially lower inflation later this year. Below is a graph showing how the Consumer Product Index (CPI) follows the year-over-year change in the money supply with about a 16-month lag.
If the current pace of money supply contraction keeps up for a few more months, overall money supply will be right back on its long-term average growth trend line of 6% year-over-year. It is somewhat surprising that the extraordinary build in money supply because of Covid is approaching normalization so quickly. Normalization of the money supply will remove one more Covid financial distortion and may provide support for the emergence of a sustained bull market.
The graph below shows how “extra” savings created by Covid stimulus money is expected to fully dissipate this year. The enthusiastic spending of extra savings has contributed to high inflation. With the money spent, we should begin to see lower inflation in coming months. Again, another source of Covid financial distortion removed from the system.
This week, the 10-year treasury rate is back up above 4% from a low of 3.3% a month ago. Recent inflation readings have been higher than expected and Fed Rate expectations are rising once again. Although the S&P 500 has a positive gain year-to-date and has remained resilient in the face of rising rate expectations in the past several weeks, it is technically showing increased risk in the intermediate term.”
Market Update
A string of solid economic reports had investors eyeing this week’s testimony by Fed Chair Powell and the monthly jobs report for clues as to the path of interest rates. After opening higher, Monday’s stock market session saw gains evaporate as investors grew cautious. Powell’s first day of testimony splashed cold water on investor hopes for an easier Fed tone, sending stocks lower by -1.5%. Powell noted that recent inflation reports have been stubbornly high suggesting higher for longer interest rates. Rising rates have been a strong headwind for stocks over the past year. Powell’s second day of testimony saw little movement while the 2-year U.S. Treasury note held above 5% with investors now thinking the Fed will raise short-term rates by a full 0.5% in their upcoming meeting this month. Investors reacted Thursday to a report that Silicon Valley Bank (SIVB) was having to raise equity capital to meet regulator capital requirements. The move was a shocking development indicative of the risks the bank had taken during the period of “cheap” zero interest rate money, a period which led to a boom in startup investing in 2021. The market’s banking sector ETF plunged -8% in Thursday’s trading with the Silicon Valley Bank losing -60% of its value as reports surfaced of a run on the bank. That news quickly shifted to word Friday that the FDIC had taken the bank over, the first major U.S. bank to fail since the 2008 Financial Crisis. Bank stocks continued their selloff, dragging down the broad stock market -1.8% on Thursday and another -1.4% Friday. The monthly jobs report almost got lost in the bank news as it offered mixed inputs. Hiring remained strong, though slowing from prior months, while wages, a key inflation driver, came in a bit cooler than expected. However, interest rates fell sharply Friday as investors fled stocks for bonds in a move to safer assets amidst the bank turmoil.
The abrupt failure of Silicon Valley Bank highlights one of the negative impacts of the sharp rise in interest rates driven by the Federal Reserve. Banks hold a huge amount of U.S. Treasury bonds which have lost value, on paper at least, as rates have risen. Some of those losses are ignored as banks will hold most of the bonds to maturity. BUT, if the bank is forced to sell those bonds before maturity, the losses must be taken and the bank’s financial condition sours. We are certain the situation for the banks is vastly more complex than just that. Nonetheless, the sharp rise in rates has had an impact on the value of bank bond portfolios, which could be a significant risk if the bank’s deposits drop quickly, as Silicon Valley’s did.
After delivering their first positive week in a month last week, stocks resumed their pullback this week with the S&P 500 (SPY) tumbling -4.52%. The Nasdaq 100 (QQQ) fell -3.71%. Smallcaps (IWM) suffered much worse with an -8.00% slide wiping out the year’s gains.
Warm wishes and until next week.