The Bernanke Arbitrage

Recently by Michael Pollaro: Monetary Watch December2010: TheMoneySupply, aTripleFromHere?

At THE CONTRARIAN TAKE a lot of time and effort is spent compiling money supply data, analyzing its drivers and charting its course. The reason is quite simple. It is the ebb and flow of the money supply that shapes the ebb and flow of the financial markets and the economies in which they operate. This has been true throughout history, never more though than today, a time dominated by activist central banks the world over, central banks that can and regularly do create money in vast quantities whenever they deem fit. Having said this, all this data crunching would hardly be worth the effort if we were tracking an incorrect measure of the money supply. Luckily for us, we here at THE CONTRARIAN TAKE think we most definitely are not.

So what money supply measure are we tracking? It’s a metric called TMS, for True Money Supply, a formulation based on the monetary insights of the Austrian School of economics. Those mainstream M’s – like M1, M2 and M3 – although widely followed, we submit, are all seriously flawed, for their formulations are founded on a faulty definition of money. Not so TMS. We’re convinced the Austrians have it right.

Now, that doesn’t mean we aren’t all over those mainstream M’s. We are, and for good reason. As Kevin Duffy, co-manager of Bearing Asset Management, said:

Investment management is simply capturing the arbitrage available between perception and reality. It is paramount to know both.

We couldn’t agree more, in this case the reality that is TMS against the perception of reality that are those mainstream M’s. And right now, in the case of the U.S. money supply, the spread between perception and reality is huge. As a consequence, so is the arbitrage opportunity.

Enter the Bernanke Arbitrage

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Bernanke we surmise is not tracking TMS. We doubt he even knows what it is. No, Bernanke we think is tracking those mainstream M’s and in so doing hasn’t got a clue as to the whereabouts of the money supply. Chairman Bernanke, perhaps the world’s most activist central banker, who just so happens to think that economic growth and financial stability can be achieved by printing money, is living in the world of perception. Those mainstreams M’s are telling him the money supply is stagnant. The reality is anything but. The problem, or should I say the arbitrage opportunity is this – Bernanke is acting in accordance with his perception and he is gunning and apt to continue gunning the money supply. The reality is the money supply is anything but stagnant and because of Bernanke’s actions is set to go higher still.

What follows is the what, the why and the how of the Bernanke Arbitrage…

Let’s start by dismissing any doubts you might have that Chairman Bernanke is clueless as to the whereabouts of the money supply. Have a read of this interchange between Bernanke and Congressman Ron Paul at a July 9, 2009 House Financial Services Committee Q&A. First Congressman Paul:

…it seems to me that you are in the midst of massive inflation, but I guess you have a different definition, when you double the money supply that’s not inflation itself. Or are you looking at only prices.

And now Chairman Bernanke’s response:

Inflation is the change in the consumer price level which is very stable right now. And the various measure of money as you know, the broad measure of money… the measure of money in circulation like M1 and M2 are not growing quickly.

Bernanke of course was quite right. At the time of this Q&A, neither M1 nor M2 were growing quickly. After posting sizeable growth for about a year, both had slowed to a crawl. M2, the broadest and most popular of the mainstream money supply measures, was in fact sporting an annualized 3-month rate of change of a negative 1%. TMS was doing nothing of the sort. Echoing Congressman Paul’s concerns, it was growing at a 3-month rate of change of 12% and a year over year rate of change of 14%.

Monetary inflation was alive and well and Bernanke was clueless.

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January 7, 2011