- The monetary policy followed by the US is like the one followed by Europe and Japan. It is likely to achieve the same results.
- The amount of debt issued will force the economy to grow slowly. Government dictated demand management will keep producing disappointing results.
- The sagging velocity of money re-enforces the cautious tone about the economic outlook.
- The outcome is yielding to fall to European levels below 1.0%.
Wall Street follows the wild gyrations of the economy after the 2020 lockdown and tries to rationalize the wildly fluctuating growth rates never seen in our history – an impossible task.
What we are experiencing is pure abnormality. What is normal are the main forces driving the market for the next several months: our long-term growth potential, the levels of debt, the business cycle, and the effects of misguided government/monetary policies.
The long-term growth of the US economy is about 2.5%. Recent growth rates of 10% or even 5% are temporary and have only one implication – economic growth rates will drop in a major way. This tendency will have a negative impact, capping yield levels.
Another important consideration is the role of debt. I have discussed in detail this subject here. C. M. Reinhart, V. R. Reinhart, and K. S. Rogoff studied extensively the historical implications of high debt on economic growth in many countries since 1800.
The bottom line is nations sporting debt well above 100% of GDP are bound to grow slowly. Their conclusions apply perfectly to what has been happening to Europe, and Japan. Italy is also a typical long-term example. They all suffered stagnation accompanied by negative, or close to zero percent, bond yields for several years.
Can the US be immune to this disease? It is doubtful. It is no coincidence the steadily increase in debt in the US has been accompanied by gradually and gradually slower economic growth. And steadily slower growth has been accompanied by steadily lower yields.
Another impact on yields is the business cycle. The downturn of the business cycle (Phases 3 & 4) reflects a significant slowdown in business activity. This is the time when portfolios should avoid cyclical sectors and be overweight defensive sectors and bonds.
The decline of the business cycle is anticipated by rise in commodities and inflation which undermine consumers’ purchasing power. The slowdown in demand is not recognized at first by business which remains mainly focused on replenishing inventories. The fear of losing sales forces business to ramp up production to meet sales.
Eventually inventories start rising faster than sales. The inventory to sales ratio rises and production needs to be cut to protect profits.
The reduction in production requires a cut in working hours. The cut in working hours is followed by layoffs, reduction in purchases of raw materials and borrowing to finance operations.
The forces unleashed by the inventory correction are visible in slower growth in manufacturing employment, declines in commodity prices, and lower yields.
The above chart shows our real-time business cycle indicator (lower panel) which is updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary subscription is available to the readers of this article. The yields on the 10-year Treasury bonds are shown in the upper panel.
Since 1910 there have been three completed business cycles. The most recent business cycle started in March 2020. The graphs show yields rise when the business cycle rises. They decline when the business cycle declines.
The trends in commodities and inflation and the gaining of relative strength in long-term Treasury bond prices (TLT) (discussed in the articles mentioned above) suggest we are close to the transition of the business cycle from Phase 2 to Phase 3.
The implication is yields are likely to move lower for the duration of the decline of the business cycle which could last about 2 years according to the historical norm.
There is another major force acting on yields and driving them lower. The velocity of money is a measurement of the rate at which money is exchanged in an economy. It is the number of times money moves from one entity to another. It reflects how much a unit of currency is used in each period. Simply put, it is the rate at which consumers and businesses in an economy collectively spend money.
The above chart shows the graph of the velocity of money measured as a ratio of gross domestic product to the money supply M1. The velocity of money is important for measuring the rate at which money in circulation is being used for purchasing goods and services. The second line is the yield on 10-year Treasury bonds.
M1 includes the most liquid portions of the money supply because it contains currency and assets that either are or can be quickly converted to cash.
There are two crucial patterns in the chart. Money velocity has been declining steadily since 2008. It reflects the idea the Fed is “pushing on a strong”. The liquidity is placed in circulation by the Fed does not stimulate economic transactions strongly enough to stimulate the economy. It is no coincidence the reserves at depositary institutions soared close to $4.0 trillion.
The point is there is a lot of liquidity in the system. This liquidity is not stimulating growth as reflected by a sagging velocity of money.
The above chart shows also bond yields have been following closely M1 money velocity in its decline. Yields are declining because Washington is attempting to solve the issues of the economy by giving people “stimulus money” rather than stimulating productive investments.
Demand management does not work, and my previous articles listed above have documented the long-term downward trends of the growth of the US economy.
The US, Europe and Japan have experienced massive debt creation with the illusion it would stimulate their economies. Exactly the opposite has happened. The outcome is after decades of monetary failure yields on government bonds have been stagnating close to zero percent for a long time in Europe and Japan.
What has been happening to Europe and Japan is what we should expect in the US. Yields will drop close to zero percent reflecting the failure of printing absurd quantity of money for the purpose of demand management. Decades of this experience show it has been a failure,
The recent sharp increase in inflation is creating a negative feedback on consumer spending. It is already happening to the housing sector. Eventually consumers recognize their spending power has being seriously curtailed. Declining purchasing power will trigger the transition of the business cycle from Phase 2 to Phase 3.
The bond market is perfectly aware of the inflation conundrum. Bonds are looking at the misguided economic policy which will create stagnation and much lower bond yields.
- The decline in the velocity of money and the slowdown in economic activity (decline of our business cycle indicator) will keep placing downward pressure on yields.
- The debt level will force the economy to grow slowly as already demonstrated by Europe and Japan. These economic blocs have clearly shown aggressive printing of money has resulted in a slow growth economy and historically low yields.
- The US is following the same path as Europe and Japan, and it is likely to achieve the same results.
- Yields are likely to decline to European levels below 1.0% for the next two years as the business cycle keeps heading lower.