The Fed Is Growing the US Money Supply, So What?

As speculation grows surrounding the upcoming September 13th 2012 Fed meeting and whether or not there will be another round of quantitative easing to boost the economy, it is interesting to stop for a moment and examine how the M1 money supply has evolved over the past 30 years.

This chart provided by the St. Louis Fed gives a good glimpse at how the M1 money supply has evolved in the recent decades. It simply shows the money stock at the end of each month since August 20th 1982 in billions of dollars.

As they say, a picture is worth a thousand words and I thought it would be interesting to have a visual representation of how far we have come since the 2007 financial crisis. The last two rounds of quantitative easing have almost doubled the M1 money supply in as little as 4 years. One only has to wonder what will be the long term effect of going from 1.4 trillion to 2.4 trillion USD on the dollar. Even if it is currently the world reserve currency, it is obvious the US Dollar is bound loose value in the coming years. How is your portfolio positioned assuming such a scenario? Soon enough the world will notice that they are getting less and less value for their US Dallar holdings. Food for tought....

The Comeback of the US Dollar?

The following graph of the US Dollar Index tells a story that can be summed up in the following terms. There seems to be change in sentiment regarding the way people perceive their positions relative to the US Dollar. This is all translating into a major change in the way Forex traders are positioning themselves regarding the future of the US Dollar.

Recent economic news on each side of the Atlantic have heavily influenced the strength of the American currency. In the US, it is clear that talks by the Federal Reserve to end of quantitative easing, QE2 on time, and that there probably is no QE3 in sight. Economic data on employment is improving and recent speeches by Fed's Chairman Ben Bernanke lead to think that the US economy is getting stronger.

Expect for the specific cases of Germany and France, economic data for Europe is coming in short of expectations and the continued Greek sovereign crisis is weighting on the Euro. As long as the market has no certainty as to what will happen with Greece's debt, forex investors will keep expecting the worse as time passes by and will fly back to the US Dollar.

Looking at the chart at the beginning of this post, there a long term reversal is in place for a comeback of the US Dollar that should last many weeks. Shorting the Euro and getting long on the US Dollar will prove to be a winning trade as long as a bond crisis still looms over Greece.

Timothy Geithner’s Plan for the Financial System

Secretary of treasury Tim Geithner is absolutely the right person President Obama could have appointed to the job. He has been working for some time on a way to better regulate the financial system. It has taken form lately as a legislative proposal to congress. It will be a major step in overhauling the nation's financial regulatory system. It’s main characteristics is that it will allow better regulation of the derivatives market and, to investors, a better understanding of the impact of those products on financial markets.

New rules would discourage financial firms from taking excessive risk, prevent fraud and make sure that instruments called derivatives are marketed appropriately. Current legislation concerning derivatives, for the most part, excludes regulation of instruments that are not traded on the open market, those referred to as "over-the-counter" derivatives because they are traded privately.

I really wonder how the new tougher rules will affect hedge funds, those big, mostly unregulated pools of money that use intricate trading tactics to earn big returns for exclusive investors. The fact is that many hedge funds currently use derivatives contracts to offset risk on their other transactions. The need for improved regulation is really evident; the value of over-the-counter derivatives depends of another figure or commodity, which in turn makes verifying the real value of a derivative very complicated. The primary use of a derivative is to reduce the risk of loss from the underlying asset, not try to create huge amount of profits out of thin air. What worries me even more is that the global business world, at the end of 2008, held an overwhelming $600 trillion of such contracts; while the stock market capitalization, for all exchanges on the planet combined, was of $33 trillion at the same period.

The most well-known examples of derivatives are certainly credit-default swaps, some of them were sold by American International Group Inc (NYSE: AIG). AIG was selling the swaps to investors as a sort of insurance to protect against defaults on mortgage-backed securities, the CDOs that I talked about in a previous article. The rest is history...

Under Geithner's new plan, companies like AIG would have to prove they have a sufficient amount of reserved capital to support a continuing sale of derivatives, thus reducing the systemic risk of a company. I really hope such a plan passes because it will ensure more stability from financial companies that have the potential to impact the economy as a whole.

Full Disclosure: The author does not have a position in AIG.

The Great Housing Bubble

At the end of the 90’s, investing in the bull market was kind of a walk in the park for all the people hunting for a quick profit. The internet was promising to revolutionize how people buy what they need and many companies ending with .com flood the market with  IPOs. Thousands of speculators rush on them, certain to bet on the next IBM. Their illusions are quickly scattered when they notice that most of those companies burn more cash than they can get on the open market. Between 2000 and 2001, investors pull out of the market and many speculators follow them swiftly, causing one of the worst panics to hit the stock market since the Oil crisis. However, those events remained silent for most people because they were eclipsed by the horror of 9/11. 

Governments were quick to react, in most industrialised countries; they asked their central banks to reduce interest rates at levels so low to make credit inevitable. That spurred a takeoff in consumer spending, mostly financed by credit and avoided a recession in some countries. It also generated an explosion in the housing market and the mortgage market at the same time. That was a close call. Banks were able to offer really affordable mortgages to almost anybody who wanted to buy a house.

For those same banks, making money on those mortgages wasn’t enough, they had to make more; mostly on the lower quality mortgages that could easily default. Some investment banks, like Lehman Brothers (OTC: LEHMQ), started recycling those mortgages in investments vehicles of smaller size called collateralized debt obligations. They also got rating agencies to give those financial instruments a rating ranging from AAA to B depending of the seniority of those vehicles. To make sure they would be able to repay in case of default, they bought bond insurance, to companies like AIG (NYSE: AIG) on those CDOs to ensure payment on the holders, hence the AAA ratings, no matter the safety of the underlying investments. That system could have worked forever based on the assumption that home prices ALWAYS go up; since people could have refinanced their mortgages.

Closer to us, in 2007, the first wave of mortgage try to get some refinancing. But there is a big problem; since 2002, interest rates have almost doubled, affecting mortgage rates and at the same time doubling mortgage payments. Millions of homeowners in the US could not afford their new payment and since home prices were not going up; in some cases, they were going down! This led to an increase in the number of bankruptcies, forcing many financial institutions to write-down many of those mortgages, which in turn caused most of the sophisticated investors who had acquired CDOs to write-down their assets. What we have here a good example of systemic risk.

This is the chain of events that caused the current recession. It has been many years in the making and many rational investors saw it coming. The good thing with the current financial environment is that it will force most companies to deleverage, making them safer and reducing their systemic impact in the process. Those events also showed the need to regulate the market of derivative contracts that are still selling over the counter because their current value is now a staggering 600 trillion dollars.

Warren Buffett and Taxes

Every year, in the month of April, Forbes magazine comes with the list of the billionaires of the planet ranked by wealth in UDS. Warren Buffett came number one in 2008, but for 2009 his friend Bill Gates came back to claim his number one spot of the past 13 years before 2008. It has always amazed me that even for the amount of wealth those two persons own, they are the most avid fighter for an equal distribution of wealth in society, starting with the fairness of the tax system.

Warren Buffett and Bill Gates are known for the more liberal opinions, and it surprised me for a while, since I would expect the richest guys on the planet to be conservatives and protective of their money. I fell on an interview of Buffett explaining his stance on taxes and comparing the lack of fairness between his own tax rate and, for example, the tax rate paid by his secretary.

I also saw a video from the senate finance committee hearing on November 14th 2007 when Warren Buffet showed up to share some of his impressions of about the current tax system and his proposition on what could be change to make taxation more equal.

From these videos, it is good thing to have such a successful and socially responsible investor as Warren Buffett representing value investing. He certainly gives capitalism a good name.

Chrysler should have been avoided by investors a long time ago!

The news of the bankruptcy of Chrysler or the financial difficulties of GM (NYSE: GM) or Ford (NYSE: F) never came to me as a surprise in any shape or form. Companies in the conventional automotive industry or even worse in the airlines industry have failed to show a consistent pattern of profitability over long periods of time.

So let’s take a look at General Motor’s most recent publicly available annual financial statements, it is astonishing to notice that the last time their balance sheet was carrying a positive number in the retained earnings section was back in 2006, fame thing for Ford. At the end of 2008, the accumulated deficit had reached 70 billion dollars... and 16 billion for Ford. That’s steep value destruction!

Ford seems to be in a better condition than its competitors, but looking at the respective market share of each of those companies; but it is pretty obvious that GM (NYSE: GM) and Ford (NYSE: F) are in a much better shape than the third counterpart of Detroit’s Big Three. Considering those facts, value investors must have fled Chrysler a long time ago. I know for sure I wouldn’t have invested in those companies, no matter the buzz in the financial community.

Full disclosure: the author has no position in GM, F or Chrysler

Yearly Returns of The Caisse de Dépot et Placements du Québec

Year	Total Return
1966	6.4%
1967	-1.2%
1968	4.4%
1969	-4.4%
1970	12.8%
1971	14.1%
1972	10.8%
1973	3.4%
1974	-5.6%
1975	12.5%
1976	18.3%
1977	10.9%
1978	9.9%
1979	7.2%
1980	9.9%
1981	-1.9%
1982	32.8%
1983	17.0%
1984	10.1%
1985	24.0%
1986	13.5%
1987	4.7%
1988	10.5%
1989	16.9%
1990	5.0%
1991	17.2%
1992	4.5%
1993	19.4%
1994	-2.1%
1995	18.2%
1996	15.6%
1997	13.0%
1998	10.2%
1999	16.5%
2000	6.2%
2001	-5.0%
2002	-9.6%
2003	15.2%
2004	12.2%
2005	14.7%
2006	14.6%
2007	5.6%
2008	-25.0%

Quebec’s “bas de laine”

The 2008 results of the Caisse de depot et de Placement du Québec have been the worst in its whole history. Contrary to the general upheaval that has taken place in the public opinion, it remains important to take one step back to get a broader sense of the role of the Caisse and the utmost important role it has been playing in the economic landscape of the province to create more wealth for its inhabitants.

First, it is important to clarify that the Caisse one of about 25 sovereign wealth funds in all the countries on earth, meaning it is an entity that put public money to work for the good of the nation’s population. Measure its size by assets, the Caisse de depot et Placements du Québec, comes 6th, even after accounting for the catastrophic results of 2008.

Assets under management amount for a staggering 220,5 billion dollars as of December 31st, 2008. That represents about 28000$ Canadian Dollars for each resident of the province. In Canada, only Alberta has a fund of similar purpose, but it is still a lot smaller and younger. If you count the Alaska Permanent Fund, it becomes pretty clear that there are only three funds of that type in North America.

Looking a little further into the future, Quebec has to be on a smart path to create collective wealth, if we think of the magnitude of the Abu Dhabi Investment Authority. That entity of gigantic proportions manages assets of about 875 billion US dollars... yes billions with a B. Dividing by the number of residents of that kingdom, you get a collective wealth of about 2 million US dollars per person!

That funds managed by the Caisse do not come from a source as lucrative as oil, but with the deposits made to it by numerous provincial pension funds, the Caisse will be a very valuable instrument for the creation of wealth in Quebec. It was a bold proposition from, then Prime Minister Jean Lesage, but it seems that very few people appreciate it and are fast to get angry when things get sour...