There is not enough time in today’s essay to cover all the reasons why money demand growth is falling or why money velocity is falling rapidly. What is important to understand here is that without an increasing money supply or increased velocity of money, the wherewithal to keep the markets and economy levitated becomes limited. The rapid rise in the stock market this year corresponds directly with an increase in the supply of money. Now that the supply of money is contracting, there is less money to keep the economy and the markets expanding. This will become critical in the months ahead because this is a liquidity driven market. The stock market is liquidity-driven. As the supply of money and credit contracts, so will the markets.
We have now arrived at a point in time where the monetary environment has become highly unstable, possessing the potential for both major deflation and inflation. In its attempts to prevent the occurrence of deflation, the Fed increases the danger of creating inflation. The Fed believes that it can reverse course immediately if the inflation dragon rears its ugly head. However with an economy this heavily leveraged, it won’t be so easy this time around. Just imagine what happens to the mortgage and housing markets if rates suddenly turn upward? Higher interest rates would shut down the mortgage refi markets and without that additional credit, consumer spending would come to a screeching halt.
On the corporate side of credit, what will happen to corporate debt ratios if stock prices suddenly turn down in the face of higher interest rates? Many of today’s debt-laden companies could soon find themselves in the position of a credit squeeze unable to get credit or renew their loans. Declining stock prices and debt laden balance sheets will focus investors' attention on default risks once again as they were back during the bursting of the market bubble. As mentioned earlier, corporate credit quality is improving. The main reason is rising stock prices and not falling debt. In summary, debt remains one of biggest impediments to a sustained economic recovery and continuation of this bear market rally. It is one reason why we still remain bearish. All of the malinvestments of the previous boom have yet to be liquidated. The Fed has merely postponed the day of reckoning not eliminated it.
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