Download Will “Velocity” Change the Conversation?

“Bringing you national and global economic trends for more than 25 years”
November 11, 2013
Will “Velocity” Change the Conversation?
Throughout this recovery, money velocity (the amount of nominal GDP created by each dollar of the
money supply) has mostly declined. Since the monetary “bang for the buck” has proved disappointingly
weak, the national conversation has persistently focused on what could be done to improve and sustain
the pace of economic growth. Chronically weakening velocity has also allowed the Fed to implement
and maintain a unique, massively stimulative monetary policy without facing significant criticism or
unacceptably boosting inflation concerns.
Could this change in 2014? Is money velocity finally poised to begin rising next year changing the national
economic conversation, forcing the Fed to significantly alter its monetary policy and perhaps creating the
first overheat/inflation scare of the recovery? Most importantly, how would the financial markets react?
Velocity Eventually Rises
Some believe the persistent decline in velocity during this recovery is highly irregular and reflects a
new-normal economy with lowered debt and spending propensities. They expect velocity to remain subpar
throughout this recovery and therefore suggest the Fed needs to maintain an uncommonly accommodative
posture in order to offset diminished spending proclivities and forestall deflationary possibilities.
Exhibit 1
Velocity of M2 Money Stock (M2V)
Shaded areas indicate U.S. recessions
Source: Federal Reserve Bank of St. Louis
Economic & Market Perspective Update
However, money velocity has risen in “every” recovery of the post-war era. Consequently, it seems
highly likely it will eventually improve in the current recovery. Exhibit 1 shows M2 money supply
velocity since 1960. As illustrated, the decline in velocity so far in the current recovery is not at all
uncommon. Only in the 1990s did velocity begin rising right at the start of the economic recovery. In
every other recovery, velocity declined for the first several years before eventually improving. The
current recovery is a little over four years old and so far velocity has declined longer than it did in the
last recovery and compared to the 1970’s recoveries. But during the 1960s and 1980s recoveries, money
velocity declined a bit longer than it has so far in this recovery.
In the current recovery, the velocity of money is not behaving oddly as many believe. Rather, as shown
in Exhibit 1, falling velocity characterizing the contemporary recovery has also been commonplace in
past recoveries. Moreover, and most importantly, should velocity continue to simulate past recovery
cycles, it should soon begin rising.
Indicators Suggesting Velocity Poised to Rise?
Several key indicators suggest the economic environment has recently turned more conducive to rising
monetary velocity. Exhibit 2 highlights the historic relationship between money velocity and four
important indicators—the level of consumer confidence, growth in the money supply, the bond yield
credit spread, and the slope of the yield curve.
In each chart, the solid line is detrended M2 money supply velocity. A decline (rise) illustrates periods
when velocity grows slower (faster) than its historic average. With only minor exceptions, velocity has
persistently grown more slowly than its historic average since the mid-1990s.
Chart 1 compares velocity to consumer confidence. Until about 1990, confidence and velocity tended to
be inversely related. That is, rising confidence was typically associated with weaker velocity growth and
when confidence declined, velocity usually strengthened. Since 1990, however, velocity and confidence
have been strongly positively correlated. Why did the relationship between confidence and velocity
change so abruptly? Our guess is this reflects a change in the cultural obsession. From the mid-1960s
until perhaps the late-1980s, inflation risk came to dominate the mindsets of companies, consumers,
investors, and policy officials. So, confidence often improved as inflation weakened. However, weaker
inflation also implied slower monetary velocity. Conversely, rising inflation tended to be associated with
strengthening velocity but also lower confidence. This cultural obsession with inflation risk began to
weaken by 1990 as Japan fell into a deflationary depression. Since, concerns surrounding inflation have
diminished while economic growth concerns (and deflation fears) have intensified. Consequently, since
1990, confidence and velocity have tended to move together. Evidence of stronger growth has tended
to boost confidence and improve velocity whereas fears of weaker real economic growth have lowered
confidence and slowed velocity. As shown in Chart 1, confidence has recently risen to its highest level in
five years and for the first time in this recovery suggests velocity may improve soon.
Chart 2 examines the relationship between growth in the money supply and velocity. Not surprisingly,
slower money growth is associated with faster velocity growth. Indeed, one reason velocity has
remained weak in this recovery is because the Fed has continued to aggressively prime the pump and
keep monetary growth at a rapid pace. This may be nearing an end. Fed taper talk has increased and it
now appears likely the Fed will soon begin to scale back its quantitative easing program. This should
slow money supply growth and help improve velocity. Already, as shown in Chart 2, the money supply
indicator has slowed in the last year (the dotted line has risen), perhaps implying stronger velocity in the
coming year?
|2|
November 11, 2013
Chart 3 relates velocity and the credit yield spread (i.e., the difference in yield between low quality
corporate bonds and Treasury bonds). As expected, improved economic credit quality (a tighter yield
spread or a rise in the dotted line in Chart 3) has historically led to faster velocity growth. Once balance
sheets are restored (reflected by tighter credit yield spreads) spending and borrowing propensities
often strengthen. As shown in Chart 3, yield spreads have improved in the last year pointing to quicker
velocity trends in the coming year.
Finally, Chart 4 illustrates that a flattening Treasury yield curve has typically preceded an improvement
in monetary velocity. The yield curve has actually steepened this year as bond yields have risen while the
Fed continues to anchor short-term interest rates. Consequently, as we head into 2014, the yield curve
is not currently supportive of improved velocity. Next year, however, should the Fed begin tapering, the
Fed funds rate may also be increased initiating the process of flattening the yield curve and helping to
boost velocity trends.
Exhibit 2
Chart 1
Money Velocity* vs. Confidence Indicator**
Chart 3
Money Velocity* vs. Yield Spread Indicator**
Chart 2
Money Velocity* vs. Money Supply Indicator**
Chart 4
Money Velocity* vs. Yield Curve Indicator**
*The level of M2 money velocity as a ratio of its trend line level.
**Each volatility indicator variable (dotted line in each chart) were transformed into standard normal variables.
|3|
Economic & Market Perspective Update
Overall, Indicators Point to Improved Velocity Trends?
Exhibit 3 combines the four variables discussed above into a single velocity indicator. Although far from
perfect, this overall indicator has historically had a good record of suggesting upcoming movements in
velocity. Note, the indicator (dotted line) has persistently “led” movements in velocity.
Currently, the rise in this indicator during the last year suggests velocity in 2014 is perhaps poised to
improve for the first time since 2009. Are policy officials prepared for a surprising rise in velocity? Are
the financial markets? Are you?
Exhibit 3
Money Velocity* vs. Indicator**
An Overheat/Inflation Scare???
After years of worrying over sluggish economic growth, potential problematic deflation and a recovery
speed which has been chronically disappointing, it is hard to imagine a cultural mindset worried
about inflation or overheated conditions. However, the first upturn in monetary velocity in a recovery
characterized by an unprecedented and massively stimulative monetary policy is likely to be met with
some trepidation. Investors should consider what may happen should rising velocity next year at least
temporarily significantly alter mindsets.
We enter 2014 with an incoming Fed chair widely perceived as dovish. The U.S. dollar has been very
weak in recent months, short-term interest rates remain near zero, long-term yields are still close to record
lows, the unemployment rate will soon have a six-handle, annual wage inflation is near its highest rate
of the recovery, capacity utilization is nearing the 80% level, most commodity indexes bottomed earlier
this year, the Baltic freight rate index has jumped upward in recent months, the growth rate in the M2
money supply has recently accelerated, the U.S. economic recovery is firing on more cylinders then ever
(e.g., for the first time this recovery is being boosted by both housing and manufacturing activities), a
consensus expects U.S. real GDP growth to accelerate in 2014 to about 3% and real economic growth
is simultaneously positive and rising in the U.S., Europe, Japan, and in the emerging world. Such an
environment is not that remarkable with a consensus focused on weak economic growth and deflationary
forces. However, the same circumstances could quickly take on a whole new connotation should monetary
velocity surprisingly turn higher for the first time in this recovery. How would an about face in velocity
impact inflation expectations? The U.S. dollar? Commodity prices? The price of gold? How much would it
change the conversation both inside and outside of the Federal Reserve? How would the bond market react
to almost $4 trillion in excess bank reserves should velocity suddenly jump? Finally, would rising velocity
prove good (faster economic and earnings growth) or bad (higher bond yields and heightened inflationary
expectations) for the stock market?
|4|
November 11, 2013
Do not misunderstand. We are not suggesting the economy faces a significant inflation risk next year
should velocity increase. Nor are we suggesting real economic growth is set to explode. Currently, we
expect real U.S. GDP growth to reach about 3 percent in 2014. While the inflation rate could rise some
in 2014 as global growth and velocity increase, a serious imminent inflation problem within the U.S.
or about the globe is not very likely. However, given the increased probability monetary velocity may
soon begin rising, the chance of a serious “fear of inflation” next year is worthy of consideration. As
history has often demonstrated, an actual inflation problem is not required (simply a change in inflation
expectations) to cause considerable fluctuations in the financial markets.
Investment Implications?
The possible combination of accelerating U.S. economic growth, broadening evidence of a global
synchronization in economic activity and a surprising upturn in monetary velocity could significantly
alter the national economic conversation in 2014. Investors should also consider how much the financial
markets may be impacted by this sudden change in conventional focus.
Foremost, discussions surrounding the Federal Reserve would shift quickly from target unemployment
rates to how fast and how effectively could the Fed drain almost $4 trillion in excess bank reserves
before they leak into lending channels. The prominent fear of recent years that the Fed was simply
pushing on a string would swiftly be replaced by angst over how the Fed overstayed its unprecedented
and massive easing campaign.
Rising apprehension that the multiplier (money velocity) on quantitative easing was strengthening much
sooner and faster than the Fed had anticipated would also likely force the U.S. dollar lower producing
upward pressure on commodity prices. A weak dollar and a renewed rise in commodity prices would
only exacerbate inflationary fears.
The first inflation/overheat anxieties of this recovery would undoubtedly not be friendly to the bond
market. On average, as shown in Exhibit 4, the 10-year bond yield has historically traded about 2% to
4% above the annual rate of core consumer price inflation. Since the core rate of inflation is currently
1.7%, to reach a reasonable historic valuation, the 10-year treasury bond yield would need to near 4%.
In our view, the 10-year yield is likely to reach this level next year should velocity surprisingly rise and
inflation concerns become elevated.
Exhibit 4
Real 10-Year Treasury Bond Yield*
*10-Year Bond Yield Less Core CPI Inflation Rate.
|5|
Economic & Market Perspective Update
Rising Velocity & the Stock Market?
The impact of rising velocity has traditionally been much less predictable for the stock market. Initially,
evidence of rising velocity has tended to boost stock prices as investors sense a quickening in the pace of
economic growth. Ultimately, however, once inflation fears intensify, bond yields adjust higher and the
Fed moves to reverse its policy, the stock market has frequently struggled.
Exhibit 5 illustrates three recovery cycles in the post-war era, which like today, saw monetary velocity
decline during the first several years of the recovery before finally and surprisingly improving. In
each chart, the solid line is M2 money velocity and the dotted line is the S&P 500 stock price index.
In all three recoveries, the stock market typically did well in the months leading up to the bottom in
velocity but often struggled once velocity actually began rising. Is this pattern playing out again in the
contemporary recovery?
Exhibit 5
Chart 1
U.S. Stock Market vs. Money Supply Velocity
1964 to 1967
Chart 2
U.S. Stock Market vs. Money Supply Velocity
1986 to 1988
Chart 3
U.S. Stock Market vs. Money Supply Velocity
2003 to 2005
|6|
November 11, 2013
In the 1960s recovery (Chart 1), velocity finally bottomed at the start of 1965. The stock market surged
in 1964 (anticipating a bottom in velocity?) but would peak by the spring of 1965 experiencing about a
10% correction. Although it did recover reaching a marginal new high in early 1966, it suffered a more
significant collapse later that year. Essentially, stock prices did well in the 1960s “leading up to” the
bottom in velocity. However, once it became clear velocity had finally turned, the stock market struggled
and in 1966 suffered a significant setback.
The record-setting single day stock market collapse on Black Monday October 19, 1987, was part of the
“velocity bottoming cycle” of the 1980s economic recovery. As illustrated in Chart 2, the stock market
did well in early 1986 when velocity appeared to be bottoming early in the year. However, as velocity
resumed falling later in the year, the stock market entered a trading range. In early 1987, however, as
velocity again showed signs of bottoming, the stock market soared. Indeed, by the spring, velocity
turned higher for the first time in the economic recovery and the S&P 500 rose about 40% in the first
nine months of the year. However, like the 1960s recovery, once it became obvious velocity was turning
higher the stock market peaked and collapsed.
Chart 3 shows the stock market had a similar but less dramatic response when velocity finally bottomed
in the early-2000s economic recovery. The stock market bottomed in early 2003 and rallied significantly
ahead of the eventual bottom in velocity later that year. However, by early 2004 when it was clear
velocity had finally turned higher, the stock market experienced a 10% correction and entered a trading
range which lasted until early-2005.
As monetary velocity begins bottoming, it helps improve economic momentum which initially causes the
stock market to rise. Improved real economic growth without inflation/overheat fears, without troublesome
higher yields, and while monetary conditions remain accommodative produces a bullish backdrop for the
stock market. Once it becomes obvious velocity has finally turned higher, however, both investors and
the Fed begin to worry over potential inflationary fallout. Bond yields adjust higher in anticipation of
potentially greater nominal activity and Fed policy is altered appropriately. This rather abrupt change in the
landscape, combined with an already elevated rise in the stock market leading up to the increase in velocity,
forces stock investors to reassess the environment producing a more difficult period for stocks.
A Velocity-Driven 2014?
Since year-end, the S&P 500 Index has risen by almost 25% while velocity is still widely perceived as
declining. However, economic activity is broadening and strengthening in a manner which may suggest
velocity has already begun to improve. In the U.S., the economy seems to be doing much better than
most anticipated since the government shutdown. Indeed, private sector activity is growing above 3%
and with sequester ending, the public sector contraction is fading. Globally, the recovery has broadened
with real growth positive and accelerating simultaneously in the U.S. , Europe, Japan and among
emerging world economies.
An improving global economic recovery has probably been the primary force driving stock markets
higher. However, if velocity is indeed beginning to rise, this positive force may eventually turn negative
for the financial markets similar to past velocity recovery cycles. That is, could 2014 rhyme a bit
with 1966, 1987, and 2004? If velocity rises, will overheating fears surface, will the Fed focus shift
exclusively toward its exit strategy, will the 10-year bond yield surge higher toward 4% and will the
stock market after perhaps rising even higher in the first half of the year (to around 2000ish) eventually
struggle and maybe suffer a correction before the year is over (ending at about where it started the year
at about 1800ish)?
In our view, although corrections will occur along the way, provided inflation stays under control, the
stock market is probably in the middle of a “buy and hold” cycle with several good years left. While we
do not expect inflation to become a serious problem next year, should velocity rise, “fears of inflation”
may become elevated. Consequently, investors may want to prepare for another tough year in the bond
market and perhaps a volatile but flattish 2014 for stocks.
|7|
Economic & Market Perspective Update
Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions.
The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as
investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be
guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital
Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000.
WELLS CAPITAL MANAGEMENT® is a registered service mark of Wells Capital Management, Inc.
Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | ©2013 Wells Capital Management