Economy doing too well. Stocks slump.

On Monday night while everyone was peacefully sleeping (possibly on a mattress stuffed with money because they don’t trust the Bernanke fuelled financial system) the US markets did a peculiar thing. Good (or should I say improving) economic data from the United States has started to trickle out over the last eight months in the form of a slightly lower unemployment rate. The market marched steadily higher but then hit a roadblock. Then, on said Monday night, the inflation fairy Ben Bernanke commented on the frailty of this recovery in jobs, and the unchanged weak outlook for the US economy. Markets rallied. This is a prime example of the short term mindset of Wall Street traders driving prices.

The obvious question is why should stocks rally when the economic outlook is dire? The obvious answer is that there is no good, long term sustainable reason. However there is a short term, get rich quick, Ponzi scheme reason. And here it is. In The Wonderful Central Bank of Oz I outlined how Central banks like the RBA and the Federal Reserve manipulate interest rates by buying and selling bonds. In practise central banks only deal in government bonds when manipulating interest rates. However as interest rates on these bonds fall, holders find themselves less willing to hold them. They sell their government bonds and use the money to buy slightly riskier bonds. This higher demand for riskier bonds increases their price and lowers their interest rate. The price changes tend to ripple through all assets, until money flows into stocks, pushing up their price.

In theory this is how monetary policy spreads through the economy and affects interest rates, including the implied rate of return on stocks. As Ben Graham originally highlighted, this return is inversely related to price like all assets, but I digress. Traders and fund managers know this so as soon as they get a wiff of words like Quantitative easing they dive into the share market. A more realistic description of the same (monetary policy) process is that with interest rates at rock bottom levels traders can borrow money cheap and plow it into the stock market. Ben Bernanke wants this because it makes everyone feel richer. People who feel richer spend more, which will supposably kick start the economy. Ben Bernanke has promised the continuation of this cheap money until 2014. But what traders have been worried about up until Monday night is that if the economy improved too much, the proverbial punchbowl would be removed in the form of higher interest rates and less cheap money being printed. Traders are aware that without these low interest rates the market will fall and the economy wont be able to stand on its own two feet. However they will buy as long as the “hot” money is coming thick and fast and cheap from the "fed". They all think they’re smart enough to jump out before the drop. They can’t all be right. Bernanke’s less than stellar report on the economy has allayed their fears of stimulus withdrawal, and the market surges. Anyone who can’t get to sleep tonight click here for the same old scripted political drawl. This is classic short termism at its greediest, and the first sign of the “mal-investment” that begins every boom cycle. In the next article we’ll talk more about this term and see how we’re already stoking the next asset bubble before we’re even finished popping the last one.

What have China’s money supply and America’s money supply got in common?

At the end of What do Chinese economists and Rhianna’s feet have in common? we saw how China mops up extra money flowing into its country as the United States buys its goods. While this will reduce the money supply, we have learnt that it will also increase interest rates. Americans are currently getting around two percent on their saving deposits, but if they were to put it in a Chinese bank account they would get closer to seven or eight percent. Better yet, why not borrow money in America at rock bottom interest rates, exchange it to renminbi at a fixed unchanging rate, and put that money in a Chinese bank account. The continuation of this process will increase the money supply in China, and negate attempts by the Chinese government to reduce it. Up until recent years the Chinese have of course been wise to this “carry trade” (after all, this concept was foreseen by mundell and flemming in the 1970s) and have had tight “capital controls” over money flowing out of and into the country. However loosening of those controls means that as the Chinese central bank raises interest rates to "make way" for the American demand, "hot" investment money will flow in and interest rates will fall again, rendering null and void the attempt to curb inflation.

China’s economy is less than half the size of the United States as measured by income or GDP. However China’s money supply was measured in October to be a third larger than that of the United States in this article. As the US continues to depress its interest rates by printing money, the carry trade will flow into China and balloon their money supply, and the Chinese will have limited ability to contain the torrent.  This is the so called “impossible trinity” proposed as part of the Mundell –Flemming model. Of a fixed exchange rate, free capital flows, and control over the money supply, you can have any two, but you can’t have all three. And that’s why. An inflationary monetary policy in the US will translate to an inflationary monetary policy in China. So what have China’s money supply and America’s money supply got in common? Unfortunately for China’s money supply: Ben Bernanke.

What do Chinese economists and Rhianna’s feet have in common?

Trick question. Nothing.

Armed now with your newfound knowledge on interest rates and the money supply from The wonderful Central Bank of Oz it’s time to take it to the next level.

China has had its currency fixed to the US dollar more or less since 2004. The low value at which the renminbi is set makes renminbi cheap to buy for Americans, and hence Chinese goods are cheap to buy. A currency is said to be relatively cheap if you dont haveto part with much of your currency in order to get one unit of another. If the renminbi price of a Chinese good stays the same, then the less of your currency that you haveto give to get one unit of renminbi, the cheaper a good becomes. This process is described in slightly more in detail in Is the Australian economy “diseased?” This creates a large demand for Chinese goods from America. If this demand becomes great enough, it outstrips the Chinese manufacturing sector’s ability to produce (or supply) the goods, and prices begin to rise. This is the same effect described in Is gold a good hedge against inflation? except that the demand pull comes not from the domestic government printing money and spending it, but from Americans taking advantage of relatively cheap goods. As described in Is the Australian economy diseased? if the currency were floating and not fixed, the value of the renminbi would tend to rise as Americans scrambled to get their hands on it to buy cheap Chinese goods. The more expensive renminbi would make Chinese goods more expensive and the American demand would subside.

With the fixed exchange rate however, Americans can keep enjoying cheap goods indefinitely. But to stop the increased demand for renminbi from raising its price (and maintain the fixed "peg") the government must raise its supply. They print renminbi to give to Americans, which as we know results in inflation. But we also know the government can mop up this extra liquidity (cash) by selling bonds as we saw in The wonderful Central Bank of Oz , which is equivalent to raising interest rates. The other side of the "interest rate money supply coin" is that the Chinese are raising interest rates, to curb demand by the Chinese, to "make way" for the extra demand from Americans (who are not directly affected by the interest rate increase). But this works fine only while China has capital controls in place to stop money flowing into the country. The reduction in capital controls announced greatly dilutes China’s ability to reduce its money supply as we’ll see in the next article.

The wonderful Central Bank of Oz

Back in October 2011 I wrote about China’s rising inflation. Further news about China easing its capital controls here provides a prime opportunity to illustrate one of the most elegant and forward thinking economic ideas of all time.

But first a little information on the link between interest rates and the money supply is in order. In The evil, ever present, value eroding effect of inflation on… Gameshows I talked about the Reserve Bank of Australia, Australia’s central bank, manipulating interest rates. Here is a brief a brief example of how they do it.

The best way to understand the connection between interest rates and the money supply is just to apply it to yourself. If the central bank were to print lots of money, all else being equal, people would find themselves with more money than they required. And what do we do with extra money that we don’t need. We put it in the bank. Even if you decided to spend the extra money, in that case the business owner who you bought goods from would now find himself with the extra money, and it would eventually find its way into a bank. Those banks that we love to hate then find that people are more willing to deposit money and realise that they can lower interest rates they pay on your deposit. If the banks are paying lower interest rates to get money from depositors, in theory they can charge lower interest rates on their loans. This is the basic link between interest rates and the money supply, and basically all you need to know for the next article. However, for those who want a more in depth explanation of the mechanics of how the central bank does this, read on.

A lot of money is borrowed today with the issuance of bonds. A bond is just an IOU. If Woolworths wants to borrow some money it simply stipulates how much it wants to borrow, when it will pay this amount back, and how much money (interest) it will pay you each period. A bond is even simpler than an ordinary loan in the sense that the amount that is borrowed at the start is not slowly paid back over the life of the loan like your home loan, it is paid back as a lump sum at the end. The dollar value of the interest paid each month is fixed and doesn’t change.

If Woolworths wanted to borrow $5000, and said it would pay you $50 interest every year, you would be receiving $50/$5000=1% interest every year. Now imagine for a moment that someone wanted to buy the bond for $10000. What interest rate are they receiving? The actual dollar value of the interest doesn’t change, it’s still $50. But now the interest rate is $50/$10000=0.5%. this is the critical inverse relationship between interest rates and bond prices. As former rises the latter falls and vice versa. So all that the RBA has to do is change the price of bonds and interest rates will change. They do this using the universal law of supply and demand. They can increase the demand for bonds by buying massive amounts, increasing the price. Of course they buy these massive amounts of bonds with massive amounts of money (the RBA is of course the only entity legally allowed to print money) and this is what brings about the increase in the money supply we talked about earlier.

This is a short run outcome. The RBA cannot in the long run affect the real price of anything. Money printing in the long run can only cause inflation, which has the opposite effect on interest rates. For a run down on the effects of inflation on interest rates, check out  So what’s the best way to hedge against inflation?

This is the RBA's primary inflation fighting tool, alluded to in So what’s the best way to hedge against inflation? In ­­Is gold a good hedge against inflation? excess demand caused by money printing (which in Australia can be done only by the RBA) was described as causing inflation (and we now know this would cause an increase in interest rates). Of course the RBA could reduce the money supply and alleviate the excess demand, causing interest rates to rise again.

This can be thought of in another way. If the RBA lowers interest rates (by increasing the money supply) it makes it cheaper for businesses to borrow and increase investment demand, and consumers with mortgages have lower repayments and hence more money to spend in the economy. If this were to get out of hand and inflation took hold, the RBA can raise interest rates, which will reduce business spending, and create that familiar tightening feeling in all home owners throats, alleviating inflation pressures. This demonstrates again how the money supply and interst rates are two sides of the same coin, even as a tool of the RBA.