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More details on the US money creation process

Here is the next -- and hopefully final, for a while -- installment in our on-going effort to clarify how the Fed's QE boosts the money supply.

One of the most important points to understand is that for every dollar of asset monetisation carried out by the Fed, one dollar gets added to bank reserves (NOT counted in the money supply) AND one dollar gets added to commercial bank deposits (part of the money supply). Another way of saying this is that the Fed's QE increases the economy's money supply dollar for dollar, with each new dollar being 100% backed by reserves.

Delving deeper into the mechanics of the process, what happens is that the Fed conducts its asset purchases via Primary Dealers, the current list of which is found at http://www.newyorkfed.org/markets/pridealers_current.html. Details of how the Fed interacts with Primary Dealers to expand the money supply are contained under the heading "Bank Deposits - How They Expand or Contract" on page 6 of the Federal Reserve document archived HERE*. For ease of reference, here is a relevant excerpt from this document:

"One way the central bank can initiate...an expansion [of the money supply] is through purchases of securities in the open market. Payment for the securities adds to bank reserves. Such purchases (and sales) are called "open market operations." How do open market purchases add to bank reserves and deposits? Suppose the Federal Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in U. S. government securities. In today's world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an "electronic" check drawn on itself. Via its "Fedwire" transfer network, the Federal Reserve notifies the dealer's designated bank (Bank A) that payment for the securities should be credited to (deposited in) the dealer's account at Bank A. At the same time, Bank A's reserve account at the Federal Reserve is credited for the amount of the securities purchase. The Federal Reserve System has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances. These reserves on Bank A's books are matched by $10,000 of the dealer's deposits that did not exist before."

And:

"If the dealer immediately writes checks for $10,000 and all of them are deposited in other banks, Bank A loses both deposits and reserves and shows no net change as a result of the System's open market purchase. However, other banks have received them. Most likely, a part of the initial deposit will remain with Bank A, and a part will be shifted to other banks as the dealer's checks clear. It does not really matter where this money is at any given time. The important fact is that these deposits do not disappear. They are in some deposit accounts at all times. All banks together have $10,000 of deposits and reserves that they did not have before." [Emphasis added]

The above-referenced Fed document appears to have been prepared in 1992 and in some respects is out of date. In particular, it doesn't incorporate the regulatory changes of the early-1990s that, via a process called "sweeping", effectively make the traditional "money multiplier" irrelevant by enabling any amount of reserves to support any amount of deposits. However, the description of how the Fed's asset monetisation expands the amount of money within the economy (not just the amount of money held in reserve) is still accurate.

Now, the effect on the economy of the Fed's asset monetisation will depend on what the Primary Dealers do with the new money credited to their bank deposits. They aren't going to leave the money in uninsured deposits earning roughly 0% interest. They are going to invest the money somehow. Some of the new money will likely be directed towards the purchase of bills, notes and bonds from the US Treasury, thus making the federal government one of the first receivers of the new money. The government will then spend the money on whatever the government spends money on (defense contractors, salaries of government workers, welfare payments, etc.). Some of the new money could also be invested in equities and corporate bonds, in which case the sellers of these equities and corporate bonds will end up being among the first receivers of the new money. They will then use the money to buy something else, and so on.

Some of the effects on the US economy of the large money-supply increase brought about by the Fed** are readily apparent. For example, the new nominal all-time high for the stock market is an obvious effect. In general terms, however, the most obvious effect has been to maintain the long-term downward trend in the US dollar's purchasing power. Following the bursting of the real estate and mortgage-financing bubbles in 2006-2007, the US economy should have experienced a great deflation. That the great inflation has continued with only a 1-year interruption is due to the Fed-engineered increase in the money supply.

    *Thanks to Mike Pollaro for the link to the Fed document.
    **The US money supply increased by about $3.7T from the start of the Fed's first QE program in September of 2008 through to March of 2013. About two-thirds of this money-supply increase was directly due to QE.

More of the same from the Fed

The Stock Market

At a superficial level the following two charts have nothing to do with the stock market, but if we look beneath the surface we find some relevance.

The first chart shows the gold/GYX ratio. Gold is a counter-cyclical investment, whereas the industrial metals tend to do best when global economic growth is on an up-swing. The gold/GYX ratio will therefore typically trend upward during periods of weak or slowing growth and downward during periods of strong or improving growth.

Gold/GYX began to trend upward in February, but at the beginning of April it abruptly reversed course and during 12th-15th April it plunged to a multi-year low. If the breakdown had been sustained it would have been a good omen for the stock market, a growth-oriented investment. However, the breakdown proved to be fleeting. The gold/GYX ratio has now retraced the bulk of its April-2013 plunge and is up on a year-to-date basis.



The rapid rebound in the gold/GYX ratio is partly due to gold's upward reversal and partly due to continuing weakness in the pro-cyclical industrial metals. As illustrated by the following chart, the Industrial Metals Index (GYX) has just dropped to its lowest level since July of 2009.



The stock market is driven more by monetary conditions, inflation expectations and sentiment than by economic growth, but our impression is that the complacency now evident in the stock market is based to a large extent on the view that the economy will avoid a recession. Evidence that challenges this view could therefore create a problem.

The following chart compares the Russell2000 Small-Cap Index (RUT) with the RUT/SPX ratio. The RUT has performed well since October of 2011 and hasn't yet signaled that its upward trend has ended, but notice that the RUT/SPX ratio has dropped sharply over the past six weeks. It did something similar in the early stages of general shifts away from risk in 2010, 2011 and 2012.



The RUT/SPX ratio, the gold/GYX ratio and the modest widening of credit spreads over the past two months all suggest that the financial world is moving into "risk off" mode.

Gold and the Dollar

Gold

Supply versus demand and physical versus paper

Changes in the demand for gold cannot be measured independently of price. In fact, the only reliable way to determine whether gold demand is rising or falling relative to gold supply is by looking at the change in price. If the price is falling then we know, with 100% certainty, that demand is falling relative to supply, and if the price is rising then we know, with 100% certainty, that demand is rising relative to supply. It's that simple.

But what about the artificial creation of supply via the paper markets? Couldn't the price of gold fall due to a large increase in the supply of "paper gold" even while the demand for physical gold were rising relative to the supply of physical gold?

We don't see how, because demand for physical gold cannot be satisfied by paper gold. In any case, even if we make the tenuous assumption that an increase in the demand for physical gold could somehow be satisfied by an increase in the supply of "paper gold", evidence that something along these lines was taking place would appear in the differences between the spot price and future prices and in the differences between the near and the more distant futures contracts. Specifically, there would be pronounced rises in the spot price relative to the price of the nearest futures contract and in the nearby futures relative to the more distant contracts. This evidence was conspicuous by its absence during the April-2013 plunge in the gold (and the silver) price.

The wrongheaded idea that the total demand for physical gold was surging relative to the total supply of physical gold during the gold-price plunge of 10th-16th April, reflecting some sort of disconnect between the physical and paper markets, was based on evidence that the general public in many countries was rushing out to buy gold coins and small gold bars. The sudden increase in the public's demand for physical gold in certain forms naturally led to temporary shortages of gold in these forms at establishments that specialise in serving the retail crowd, but it's important to understand that these types of sales constitute only a small part of the global market for physical gold. To provide some context we point out that gold coin sales by the US Mint totaled 502,000 ounces over the first four months of this year and that about 40-times this amount of physical gold changes ownership in an average trading DAY on the LBMA. We also point out that the reduction in the amount of physical gold held by the SPDR Gold Trust (GLD) since the beginning of this year is about 17-times the total amount of physical gold in coin form minted in the US over the same period.

Current Market Situation

Based on the gold market's price action we can be sure that gold demand fell relative to gold supply from 10th through to 15th of April. We can also be sure that the sudden price reduction stimulated a sufficient increase in total demand, either in the form of bargain hunters entering the market or short-sellers closing out their positions, to temporarily cause demand to exceed supply, because the price subsequently rose relentlessly from a low in the $1320s on 15th-16th April to the $1480s late last week. The price has pulled back from last week's high, but at this stage the magnitude of the pullback is too small to be interpreted as anything more than a random fluctuation.

It's very unlikely that the gold price will trade significantly lower than the April-2013 crash low within the next two months, but a continuing pullback to the mid-$1300s to test the crash low remains a realistic possibility.



Gold Stocks

Despite the volatility caused by traders first anticipating and then reacting to the latest FOMC statement, Wednesday 1st May was an "inside day" for the HUI. In other words, on Wednesday the HUI traded within the preceding day's price range.

Regardless of whether or not the gold sector is still immersed in a cyclical bear market, a 2-4 month rally probably either began in April or will begin this month after a spike to a new low. The tendency of the gold sector to reach an intermediate-term extreme during the month of May suggests that the HUI will spike below its April low before commencing a multi-month rally, but the fact that the April low was accompanied by the most 'oversold' readings of the past 13 years means that an intermediate-term extreme might already be in place.

If the HUI closes above 300 before trading below its April low then we will assume that an intermediate-term bottom was put in place last month.



Currency Market Update

The Dollar Index has just fallen for six days in a row and has reached support at 81.0-81.5. The most important support, however, lies at 79. A break below 79 would indicate that our currency market outlook was probably wrong.



Sentiment indicators such as the COT data and Market Vane's survey suggest that the Dollar Index's short-term downward correction has further to go, either immediately or after pausing for a few days. However, much will depend on what happens to stock markets in general and European bank stocks in particular. There's a good chance that stock market weakness and heightened concerns about the safety of Europe's banking industry will eventually fuel a sizeable rally in the US$ relative to the euro. From our perspective the main unknown is whether this happens over the next few months or later this year.

Due to the sentiment situation and our uncertainty regarding the timing of the next episode of European bank-related drama, we remain short-term "neutral" on the Dollar Index. Our intermediate-term US$ outlook has shifted to "bullish" (from "neutral"), though, because the drama is likely to begin within the next 6 months.

Update on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html