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Financial markets have become increasingly obviously highly dependent on central bank policies. In a follow-up to Incrementum’s previous chartbook, Stoerferle and Valek unveil the following 50 slide pack of 25 incredible charts to crucially enable prudent investors to grasp the consequences of the interplay between monetary inflation and deflation. They introduce the term “monetary tectonics’ to describe the ‘tug of war’ raging between parabolically rising monetary base M0 driven by extreme easy monetary policy and shrinking monetary aggregate M2 and M3 due to credit deleveraging. Critically, Incrementum explains how this applies to gold buying decisions as they introduce their “inflation signal” indicator.
GoldSilverWorlds.com has done a great job of summarizing the key aspects (and the full chartbook is below)…
The authors introduce the term “monetary tectonics” as a metaphor for this war. Similar to tectonic plates under a volcano, monetary inflation and deflation is currently working against each other:
- Monetary inflation is the result of a parabolically rising monetary base M0 driven by the central bank monetary easing policy.
- Monetary deflation is the result of shrinking monetary aggregates M2 and M3 because of credit deleveraging.
The following chart clearly shows that 2013 was a pivot year in which the monetary base M0 grew exponentially while net M2 (expressed on the chart line as M2 minus M0) declined significantly.
The chartbook shows several trend which confirm the deflationary monetary pressure:
- Total credit market debt as a % of US GDP has been shrinking since 2007 (“debt deleveraging”).
- US bank credit of all commercial banks is stagnating (close to negative growth), similar to the period 2007/2008. See first chart below.
- Money supply growth in the US and the Eurozone is trending lower. See second chart below.
- Personal consumption expenditures are exhibiting disinflation .
- The gold/silver-Ratio is declining. Gold tends to outperform silver during disinflationary and/or deflationary periods.
- The gold to Treasury ratio is declining. See third chart below.
- The Continuous Commodity Index (CCI) has been in a steep decline since the fall of 2011.
On the other hand, inflationary pressure is present through the following trends:
- An explosion of the monetary base M0. See first chart below.
- US households show signs of stopped deleveraging. See second chart below.
- The currency in circulation keeps on expanding.
- Commercial banks have piled up an enormous amount of excess reserves which, in case of a rate hike by central planners, could flood the market through lending in the fractional banking system. See thrid chart below.
How is gold impacted in this inflation vs deflation war? The key conclusion of the research is that, due to the fractional reserve banking system and the dynamics of the ‘monetary tectonics’, inflationary and deflationary phases will alternate in the foreseeable future. Gold, being a monetary asset in the view of Austrian economics, tends to rise in inflationary periods and decline during times of disinflation.
The key take-away for investors is to position themselves accordingly and consider price declines as buying opportunities for the coming inflationary period. How comes one can be so sure that inflation is coming? Consider that the government must avoid deflation; it is a horror scenario for the following reasons:
- Price deflation results in a real increase in the value of debt and a nominal decline in asset values. Debt can no longer be serviced.
- Price deflation would lead to massive tax revenue declines for the government due to a declining taxable base.
- Deflation would have fatal consequences for large parts of the banking system.
- Central banks also have the mandate to ensure ‘financial market stability‘
Interesting to know, Stoeferle and Valk developed the “Incrementum Inflation Signal,” an indicator of how much monetary inflation reaches the real economy based on market and monetary indicators. According to the signal, investors should take positions according to the the rising, neutral or falling inflation trends.
A recent piece in the Financial Post titled “How many times can economists cry wolf about interest rates” caught my interest because I – like many economists in Canada – have been expecting interest rates to eventually start to rise and yet they do not. So when will Canadian interest rates start to go up? My knowledge of money and banking and monetary economics is pretty rudimentary but I’m feeling adventurous in the New Year.
However, money supply growth needs to be considered in the context of the growth of the economy and money demand. Figure 2 presents a more interesting picture by taking the ratio of M2 to GDP for the period 1871 to 2013. From a ratio of just under 0.2 in 1871, the M2 to GDP ratio has grown over time. Recent years have seen it grow to the highest it has ever been. Of course, the period from 1870 to 1930 reflects the growth and development of the modern Canadian financial intermediary sector and monetary sector and the rise in the ratio reflects this. However, the period since 1935 represents the “modern Canadian banking era” in that the Bank of Canada has been in existence during that period.
Figure 3 presents a graph of the trend setting Bank of Canada interest rate and it shows a hump shaped pattern with the lowest interest rates in the period from 1935 to the mid 1950s and since 2009 and the highest rates in the period from the mid 1970s to the early 1990s. On the other hand, since the Second World War, the M2/GDP ratio has shown an approximately u-shaped pattern with lowest M2/GDP ratios in the mid to late 1960s. If the two are juxtaposed as in Figure 3a and taking into account that there is probably a lag between a drop in M2/GDP and the subsequent rise in interest rates, it appears that the peak in interest rates occurs after the low point in the m2/GDP ratio in the late 1960s. If you take the first differences of the M2/GDP ratio and the Bank of Canada rate over the period 1935 to 2013 and plot them against each other (as in Figure 4) and fit a linear trend, you do get a slight inverse relationship. That is, a higher money supply to GDP ratio is correlated with lower interest rates. However, I admit this is a pretty noisy picture. Moreover, this discussion focuses just on Canada and international economic and monetary conditions play a role in the Canadian economy. It would be interesting to see how the performance of Canada’s M2 to GDP ratio over time compares to other countries.
We have been expecting interest rates to rise for several years now because GDP has recovered somewhat from the 2009 financial crisis and the Canadian economy is growing. As a result, one might expect a growing demand for money and credit to fuel rising interest rates. However, money supply – as measured in this case by M2 – is still growing faster than GDP. I think we will see interest rates start to increase provided first that GDP continues to expand and then the M2/GDP ratio starts to drop. However, its not enough that this happens just in Canada – it would also need to happen on a global scale. I don’t think that is going to happen anytime soon. For example, look at Japan.