Monthly Commentary Howard Wang of Convoy Investments

Tightening money supply

This year has been a process of normalization in financial conditions. Below I show the estimated money supply in the US, which rose fairly steadily before we saw a spike in 2008. That spike lasted until the end of 2014, after which the Fed began to withdraw money from the system. US money supply shrank for the first time in almost a century.

This chart has been the fundamental driver of asset prices over the last decade and will likely continue to drive the markets until the Fed normalizes their monetary policy. On average, more money chasing the same assets means higher prices while less money means lower prices. Below I show the relationship of growth in the US money supply to the long-term return of assets.

The falling money supply since 2014 is driven by a combination of rising rates and direct unwinding of quantitative easing. Below I show the duration adjusted Fed balance sheet. I believe the trend of shrinking money supply in the system will continue for some time to come. This adjustment is a painful but necessary process for healthier markets and economies.

Below I provide an update on a commentary I wrote on the subject of money supply and credit from a few years ago.

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The price of anything is measured in the form of dollars per unit whether it is $/share, $/bond, $/house, $/barrel, etc
(or whatever your base currency is). The price of everything comes down to those two things, supply of assets and
the quantity of money chasing those assets. More money chasing fewer assets means higher prices, and vice versa.

Asset price = quantity of money/supply of assets

While there are some exceptions such as a disruption in oil production, the growth in supply of assets tends to be relatively stable in the short run. So it is changes in the quantity of money that drives short term asset swings. There are two main ways in which the quantity of money chasing an asset can change. To illustrate, I show below a simplified system with $100 in money and 2 assets, a bond and a stock. To start with, let’s say the money is evenly divided between stocks and bonds and the price of each is $50.

First, money can flow from one asset to another because investor preferences change. For example, if growth numbers are bad, investors tend to incrementally move money out of stocks into safety assets like bonds. As money  flows out of an asset, there are fewer dollars chasing the same supply of assets and prices fall. In contrast, as money flows into an asset, more dollars chase the same set of assets and prices rise. This effect is fairly intuitive and is what most people...