Bonds & Money Supply

Over the past week I have noticed several voices from respectable investors or investment managers that the expected returns on bonds are finally attractive. See the thoughts of Jeffrey Gundlach’s and Ben Carlson’s.

The biggest risk to (nominal) bonds is, obviously, inflation. The latest figure for the US is for the month of August and is as high as 8.3%. It has come down from the four decade high of 9.1% in June. That’s quite a bit higher than recent yields for Treasury bonds, which are generally in the 3.70%-4.20% range for maturities between 1 year and 30 years. Quite simply, the inflation is generally expected to come down substantially, towards the 2% mark, as the FED is very serious about fighting the dragon.

Not everyone agrees. Larry Summers, who was the Secretary of Treasury under Clinton and President of Harvard afterwards warned recently: “If we’re going to bring down inflation, you likely need a policy more restrictive than the policy that’s contemplated by the markets or the Fed. The Fed continues to be excessively optimistic.” There you have it. FED is tightening at a fastest pace in several decades, some think it has gone too far, others think it will not be enough. The thing is, Larry Summers was generally right being concerned about too much money being created/given away, so one should definitely listen to him as a valid side in this discussion.

I had a look at the data for the money supply (M2), Real GDP growth (RGDP) and inflation (CPI) in order to look for some hints concerning the future trajectory of inflation. I took long time series of data (since 1960) and have analysed the growth of these aggregates over 10 years. I was mildly surprised to notice that the average 10y growth rate of M2 was 6.9%, RGDP averaged 2.9%, while CPI averaged 4.0% over this period. In a sense, this should be expected: the M2 should increase with the growth of the economy, and the “excessive” M2 growth should be reflected in the average price growth – the CPI index’s. But my surprise was that this relationship was so close: 6.9% = 2.9% + 4.0%. This is likely a coincidence, as the compounded average growth rates over the past 62 years (as opposed to average 10 years growth rates) are slightly off: 7.1% for the M2, 3.0% for the RGDP and 3.8% for the CPI. In any case, the relationship seems to hold. This is how the growth rates look over the past 5+ decades:

What one can notice is that there are two distinct periods. The first one is of monetary tightness (1978-2004), when the 10y growth of the monetary supply was below the combined growth rates of RGDP and CPI. In the second period (2004-present) the opposite is true: the M2 growth rates were in excess of the growth of GDP and price index. Note that these are 10y growth rates, the dates mentioned are the end-dates of a 10y period. What we can notice is that ever since 2004, and more so from 2008, the growth in the monetary aggregate was stronger than the growth of RGDP and CPI. While GDP and prices grew at about 2% pace, M2 grew at 6% or slightly higher for ~15 years. The pandemic exacerbated the disconnect – over the past 2 years the difference between the money supply growth and the GDP+price growth increased to more than 4pp. I have quantified the cumulative monetary ‘overhang’ of the past 14-18 years (since 2004-08) and it amounts to 60-65%. This is the red area between the blue and orange lines. What might it all mean?

It might mean that there has been a lot of money printed over the past decade+ which is more than enough to ‘service’ future GDP and price growth. If the whole overhang is to be ‘used’ over the next decade, we’d get about 5% annual RGDP+CPI growth. With a GDP growth of 2% we’d get a 3% CPI growth, which is not bad. But that assumes no increase in money supply for a decade! Which has never happened and is unlikely to happen. If the money supply expanded at a slow pace of 4% p.a. and the whole overhang were to be reflected in prices, we’d get a 7% inflation for a decade. Not a good environment for bonds – especially nominal bonds.

However, the uncertainty concerning future inflation does not concern the TIPS – inflation protected Treasury bonds. They have offered 2.2% real return at the end of September ’22 (for short term TIPS of 1-5 years – STIP ETF) or 1.86% for the TIP ETF, which holds all of the TIPS bonds (with average maturity of 7.3 years). The STIP ETF had a volatility of 2.6% over the past 3 years, while the TIP ETF – 5.7%. This seems like a safer bet to me given all the uncertainty surrounding future inflation rates.

Caveats:
– the model might be wrong, inaccurate or too simplified. Even though the relationship between M2, RGDP and CPI held closely over the past 5+decades, doesn’t mean it will hold in the future.
– the starting point for the period of excessive money printing (2004-08) might be too early and one should only look at the past several years. If one took the monetary overhang only since the start of the pandemic, it is just ~17% and the potential for future inflation is much smaller.

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