Weekly Market Insights

1. Weekly Market Insights Dow Jones:14712 YTD 13.12% ‌ │ S&P 500: 1582 YTD 11.65% │ NASDAQ: 3279 YTD 8.95% April 29, 2013 A Brief Diversion into Money On a quarterly basis, we review monetary policy in an attempt to explain what has or hasn’t happened in the real economy and what we might expect in the future. We want to know if there is anything within the monetary framework that might inhibit economic growth or cause inflation. Also, if monetary policy is expanding, why isn’t the economy growing faster? M2, the broadest definition of the money supply, has been growing at a healthy rate since the beginning of 1990 (see Chart A). It is instructive to look at the composition of M2 from early 2010. Fear was the dominant emotion in financial markets. In an attempt to start the economic engine and restore confidence, the Fed poured money into the system, most of which found its way into demand accounts which are highly liquid. In October 2008 the FDIC increased the deposit insurance to $1 million, which means the most liquid financial vehicle became the safest. This is a very compelling case in a time of fear. The questions then are: If there is plenty of money in the system and interest rates are low, why isn’t it flowing into the economy? Why is economic growth anemic? The answer is twofold, and both are very rational. First, banks are the transmission mechanism to project monetary policy into the real economy. Lending had just gone through a devastating period of loan failures and were below capital standards. Approbation had been heaped upon them for lax credit standards and balance sheets had to be rebuilt. Also, the Fed started to pay interest rates on bank reserves at the Fed. Rational bankers looked at this as a risk-free alternative to making loans. Since the interest on loans was/is very low, many bankers chose the risk-free CHART A alternative. This becomes very obvious when comparing the growth of money supply and the growth of adjusted reserves. Compare Chart A with Chart B. At the moment, the transmission mechanism that moves excess money into the real economy isn’t working very well. The availability of a risk-free arbitrage has kept funds from entering the economy in the form of loans. This arbitrage is truly risk free since the Fed is the borrower. There is no credit risk, and the reserves are overnight maturity. There is no time risk. 1

2. Weekly Market Insights Dow Jones:14712 YTD 13.12% ‌ │ S&P 500: 1582 YTD 11.65% │ NASDAQ: 3279 YTD 8.95% April 29, 2013 Another way to see how the monetary system has not behaved as one would expect is to look at a chart of the velocity of money (Chart C). Velocity is M2 divided into GDP— the more it turns over, the more active the economy. This chart clearly shows rather than turnover increasing, it has slowed. Without velocity increasing, the economy will not be very strong. This does not imply that monetary policy has been a failure. On the contrary, it may very well have kept the U.S. and the world out of a recession. It just did not do all we hoped. Why has it stopped being an engine of growth? CHART B CHART C The views expressed are subject to change. Any data cited have been obtained from sources believed to be reliable. The accuracy and completeness of data cannot be guaranteed. Past performance is no guarantee of future results. • The Week Ahead: • MONDAY: Germany Consumer Price Index (m/m) expected at -0.20%, US Pending Home Sales (m/m) expected at 0.90%, Japan Industrial Production (m/m) expected at 0.40% • TUESDAY: France Producer Prices (m/m) expected at -0.20%, Germany Unemployment Rate (s.a.) expected at 6.90%, Euro-Zone Unemployment Rate expected at 12.10% • WEDNESDAY: US Construction Spending (m/m) expected at 0.60%, US FOMC Rate Decision expected at 0.25%, US Domestic Vehicle Sales expected at 12.00M • THURSDAY: US Trade Balance expected at -$42.2B, US Nonfarm Productivity expected at 1.40%, US Initial Jobless Claims expected at 346K, US Continuing Claims expected at 3028K • FRIDAY: EC Euro-Zone PPI (m/m) expected at -0.20%, US Unemployment Rate expected at 7.60%, US Factory Orders expected at -2.50% 2