Chapter 2
Where Money Comes From
In This Chapter
Understanding where and how money does its work
Investigating the inner workings of central banks
Understanding money supply from a trading standpoint
Relating to money’s effect on the global financial system and futures markets
Money doesn’t grow on trees. But the truth isn’t far from that. In fact, money is manufactured inside the world’s central banks, especially the United States Federal Reserve System, essentially from thin air.
Okay, so there is some method to the madness. But the global monetary system mostly seems like madness that is far from leading to any certain outcomes, which, of course, is what makes trading a potentially profitable occupation — as long as you know what to look for. The big picture is that central banks are part think tank, part political and public relations offices, and above all, lenders of last resort.
If you know how the system works and how to use it, you can turn it to your advantage. In this chapter, I tell you how the Federal Reserve System in the United States (also referred to as the Fed — the central bank of the United States) and other central banks around the world have branch offices throughout their respective countries, where economists directly monitor economic activity. They do this by going out into the community and talking to businesses, by designing and refining models, and by compiling reports based on all the data collected.
I also let you in on what happens when the Fed and its branch chiefs meet a few times every year to look at all this economic information so they can make informed decisions about how much money to pump into the system and how easy (or hard) they’re going to make it to borrow that money.
You can’t get into the inner workings of the Fed without knowing about the interactions between money supply, interest rates, and inflation, so I also include these topics and tie them together with the Federal Reserve, central banks, and money and the markets in general.
When I talk about the Federal Reserve, unless I say otherwise, I also refer to other central banks, because they all work in similar fashion. When there are important differences in the way they go about their business, I let you know.
Discovering How Money Works: The Fiat System
As a result of globalization, the world’s central banks are finding it difficult to determine their own country’s monetary policy without keeping an eye on what goes on in other countries. They watch how the financial markets respond to the global economy.
The global monetary system is what’s called a fiat system, in which money is a storage medium for purchasing power and a substitute for barter. Each dollar bill, euro, yen, gold ingot, or whatever currency you choose enables you to buy things as the need or want arises, thus making the barter system (trading one service or product for another) mostly obsolete.
Before there was money, if you owned land you produced your own necessities and traded the surplus with other people for whatever else you needed. Money changed that system by its inherent ability to store purchasing power, thus giving people the opportunity to make plans for the future and to specialize. For example, if you’re a good wheat farmer, then you can specialize in wheat, buying equipment, hiring workers, and looking for neighbors’ land to buy to expand your wheat farm.
Markets and central banks value the relative worth of the paper (currency) based on the perception of how a particular country is governing itself, the current state of its economy, and the effects the interplay of those two factors have on interest rates.
Money’s money because we say it’s money
Most of the world’s money is called fiat money, meaning it is accepted as money because a government says that it’s legal tender, and the public has confidence in the money’s ability to serve as a storage medium for purchasing power. A fiat system is based on a government’s mandate that the paper currency it prints is legal tender for making financial transactions. Legal tender means that the money is backed by the full faith and credit of the government that issues it. In other words, the government promises to be good for it. I know how it sounds. But that’s what the world’s financial system is based on.
Fiat money is the opposite of commodity money, which is money that’s based on a valuable commodity, a method of valuation that was used in the past. At times, the commodity itself actually was used as money. For instance, the use of gold, grain, and even furs and other animal products as commodity money preceded the current fiat system.
Where money comes from
Central banks create money either by printing it or by buying bonds in the treasury market. When central banks buy bonds, they usually buy their own country’s treasury bonds, and their purchases are made from banks that own bonds. The money from the central banks goes to the bank vaults, and becomes loan-making capital.
When the Fed wants to increase the money supply in the United States, it buys bonds from banks in the open market. It uses a pretty simple formula to calculate how much money it actually is creating.
Instead of using gold as the basis for the monetary system, as was the custom until 1971, the Fed requires its member banks to keep certain specific amounts of money on reserve as a means of keeping a lid on the uncontrolled expansion of fiat money — in other words, to keep the money supply from exploding. These reserve requirements are the major safeguard of the system.
When the economy slows down, the Fed attempts to jump-start it by lowering interest rates. The Fed lowers interest rates by injecting money into the system through the purchase of government bonds from the banking system. This is the nuts and bolts of what happens when they lower the Fed Funds rate. The monetary injection is sort of like a flu shot for an ailing economy. But instead of a vaccine, the Fed injects money into the system by buying bonds from the banks.
To keep the system from becoming inflationary, the Fed keeps a lid on how much banks can actually lend by using a bank reserve management system. The reserve management system, to be sure, is not an exact science, but over the long haul, it tends to work as long as the public buys the validity of the system, which, in the United States, it does.
Here’s how the reserve requirements work:
If the current formula calls for a 10 percent reserve ratio, it means that for every dollar that a bank keeps in reserve, it can lend ten dollars to its clients.
At the same time, if the Fed buys $500 million in bonds in the open market, it creates $5 billion in new money that makes its way to the public via bank loans.
The reverse, or opposite, is true when the Fed wants to tighten credit and slow down the economy. It sells bonds to banks, thus draining money from the system, again based on the reserve formula.
The public’s acceptance of the legal-tender mandate. See the earlier section, “Money’s money because we say it’s money.”
The market’s expectations that a government’s promise to make its currency legal tender, by law, will hold.
Introducing Central Banks (Including the Federal Reserve)
Central banks are designed to make sure that their respective domestic economies run as smoothly as possible. In most countries, central banks are expected at the very least to combat inflationary pressures.
The overarching goal of the central banks is to repeal (or keep in check) the boom-and-bust cycles in the global economy. So far this goal is only an intention, because boom and bust cycles remain in place and are now referred to as the business cycle.
One good impact has come from the actions of the Fed and other central banks. They’ve been able to lengthen the amount of time between boom and bust cycles to the extent that they’ve smoothed out volatile trends and created an environment in which the futures markets offer a perfect vehicle for hedging and speculation.
Prior to the advent of central banks, booms and busts in the global economy came about as often as every harvest season. Because money was hard to come by prior to the centralization of the global economies, a bad harvest, a spell of bad weather, or just a bad set of investment decisions by a local bank in a farming community could devastate the economy in an area or even a country.
The central bank of the United States (and the world): The Federal Reserve
The Federal Reserve, otherwise known as the Fed, is the prototype central bank because of its relative success, not because it was the first central bank. Created in 1913 to stabilize the activities of the money and credit markets, it administers the Federal Reserve Act, which mandated the creation of an agency intent on “improving the supervision” of banking and “creating an elastic currency.”
The current objectives of the Fed are to fight inflation and maintain full employment to keep the consumption-based U.S. and global economies moving.
Under Chairman Alan Greenspan (whose appointment as a member of the Fed Board of Governors expired on January 31, 2006), the Federal Reserve became the most important financial institution in the world. In reality, the Fed is the central bank to the world, especially having grown in prestige and deeds during Greenspan’s more than 18 years as chairman.
Greenspan’s successor, Ben Bernanke, was tested in his abilities to guide the U.S. economy during the summer of 2007, as the subprime mortgage crisis unfolded. Despite having a different management style than Greenspan, Bernanke had no choice but to lower interest rates, which he did in August and September of 2007 with moderate success, at least as of late September 2007.
The Fed had a tough act to follow in Greenspan. His 18-year tenure gave the markets a time-tested pattern of action from a central bank that, prior to his stewardship, had been less than stellar during several crucial periods.
Inside the central banks’ boom and bust cycle
Just because the world’s central banks have somewhat smoothed out the boom and bust cycle, the system is still nowhere near risk free. And that means opportunity for you and me as futures traders.
Sure, innovation is a good thing, as is tweaking an old practice in order to make it available to more people for less money. But, history shows that every so-called “new” financial practice eventually leads to excess, and outright cheating. The cheating eventually leads to the collapse of the trend, and a liquidity crisis. When the eventual liquidity crisis comes along, the world’s central banks are essentially forced to act in order to keep the global economy from collapsing.
The difference between what has happened in modern times and what happened in past cycles is that the actions of the Federal Reserve, despite significant criticism, have at least kept the U.S. economy from reaching a recession so deep that it could be called a Depression. In the 20-year period from 1987 to 2007, the Federal Reserve has, depending on your point of view, “corrected” or “bailed out” Wall Street and the U.S. economy, in one way or another, at least seven times by lowering interest rates and providing loans as the lender of last resort. Here’s a list of those occasions:
1987 — Junk bonds and the savings and loan crisis led to the stock market crash of 1987.
1991 — The U.S. economy was in a recession that worsened due to worries about the first Gulf War.
1994 — The United States was in a run-of-the-mill economic recession.
1997 to 1998 — The Asian currency crisis, a phenomenon that started in Thailand, spread throughout Asia and eventually led to the Russian debt default and the bail-out of the Long Term Capital Management hedge fund in a deal brokered by then Fed Chairman Alan Greenspan.
2000 — The dot.com boom imploded, an event that led to the start of a bear market in the U.S. Stock market, which lasted well into 2003.
2001 — The 9/11 attacks on the World Trade Center accelerated an economic contraction in the United States that was already in progress due to the dot.com implosion. When the Twin Towers fell, money started to move to foreign shores, a fact that was accelerated by the aggressive lowering of interest rates by the Federal Reserve.
2007 — The subprime mortgage crisis is the latest example of the boom-bust cycle that has not been eradicated, as central banks would have you believe. In fact, this example of the phenomenon followed the script fairly well. Too many people made bets that were too far beyond their ability to pay off. And the result was the same as always, the financial ruin of many at all levels of the food chain.
How central banks function
The Fed has two official mandates: keeping inflation under control and maintaining full employment. However, it has some leeway and in many ways has outgrown its mandates, becoming lender of last resort and source- of money in times of crises. In many speeches, especially after September 11, 2001, Greenspan and other Fed governors made it clear that their perception of the Fed’s duties included maintaining the stability of the financial system and containing systemic risk.
Some central banks, such as the European Central Bank (ECB), use inflationary targets to gauge their successes. Unlike the Fed (which didn’t set such targets under Chairman Alan Greenspan, but may do so in the future), the ECB must keep raising interest rates until the target is achieved, even if unemployment is high in Europe, as long as inflation is above the central bank’s target.
The positive side of inflation targeting is that it gives the market a sense of direction with regard to what the central bank’s actions may be toward interest rates. The negative side, as is evident in Europe, is that the use of inflation targets often prevents the ECB from moving on interest rates. As a result, the European economy has lagged in its ability to grow. In other words, the dogma of adhering to the target set by the central bank has hurt the European economy. In contrast, despite frequent criticism, the U.S. economy, albeit in fits and starts, has continued to be the leading economy in the world. Much of that is because of the relatively good management of interest rates by the Fed.
The ECB’s mandate opens up opportunities for trading currency, interest rates, and commodity futures, because after a central bank starts down a certain policy route, it usually stays with it for months, creating an intermediate-term trend on which to base the direction of trading.
For example, after September 11, 2001, the Fed lowered interest rates six times, — starting on September 17, 2001 — and left them at 1 percent until the summer of 2004, when it began to raise them until the summer of 2006. The Fed had already lowered interest rates six times prior to the post 9/11 reductions. In September 2007, the Federal Reserve lowered the Discount rate and the Fed Funds rate, in response to the subprime mortgage crisis.
Understanding Money Supply
Money supply is how much money is available in the economy to buy goods, services, and securities. The Federal Reserve stopped emphasizing the role of money supply on the economy in the year 2000, and stopped publishing the M3 money supply figure in March 2006, because “M3 did not appear to convey any additional information about economic activity that was not already embodied in M2. Consequently, the Board judged that the costs of collecting the data and publishing M3 outweigh the benefits,” according to a summary of money supply on the New York Fed’s Web site. That leaves three figures to get to know:
MO: The total of all physical currency plus the currency in accounts held at the Federal Reserve that can be exchanged for physical currency.
M1: The M1 money supply is M0 minus those portions of MO held as reserves or cash held in vaults plus the amounts in checking or current accounts.
M2: The M2 money supply is M1 plus money housed in other types of savings accounts, such as money market funds and certificates of deposit (CDs) of less than $100,000.
Equating money supply and inflation
It would be easy to get into the esoteric aspects of money supply, but it wouldn’t do a whole lot of good. So, the key is to understand the following concept: At some point in the future, it may come to pass that global central banks will have put so much money into circulation that money supply may become as important an indicator as it was in decades past. If and when that time comes, the inflation-sensitive markets, such as gold, energy, and grains, are likely to become very active. When that happens, you need to be able to trade them effectively. See the remember icon, directly ahead, for a more specific summary.
Velocity × Money Supply = Gross Domestic Product (GDP) × GDP Deflator
Velocity is a measure of how fast money is changing hands, because it records how many times per year the money actually is exchanged. GDP is the sum of all the goods and services produced by the economy. The GDP deflator is a measure of inflation, or a sustained rise in prices. Inflation is usually defined as a monetary phenomenon in which prices rise because too much money is in circulation, and that money’s chasing too few goods.
Money supply is related to inflation because of the number of times it actually changes hands (see the definition of velocity in thepreceding paragraph).
More money in the system — chasing goods and services at a faster rate — is inflationary.
A rising money supply tends to spur the economy and eventually fuels demand for commodities.
A rising money supply usually is spawned by lower interest rates.
Whenever the money supply rises to a key level, which differs in every cycle, eventually inflationary pressures begin to appear, and the Fed starts reducing the money supply.
Deflation is when money supply shrinks because nobody wants to buy anything. Deflation usually results from oversupply, or a glut of goods in the marketplace. The key psychology of deflation is that in contrast to inflation, consumers put off buying things, hoping that prices will fall farther — as opposed to times of inflation when consumers are willing to pay high prices in fear that they will rise farther.
Reflation is when central banks start pumping money into the economic system, hoping that lower borrowing costs will spur demand for goods and services, create jobs, and create a stronger economy.
The more money that’s available, the more likely it is that some of it will make its way into the futures markets.
Metals, agricultural products, oil, and livestock contracts generally tend to rise along with money supply. This tendency is not a daily occurrence but rather one that you can see over an extended period of time if you compare graphs and charts of economic indicators with futures prices. The overall trend is toward higher consumer prices, which have resulted from higher commodity prices.
Bonds and other interest-rate products do the opposite. Generally, bond prices fall, and interest rates or bond yields rise in response to inflation (see Chapter 10).
Stock index futures are more variable in their relationship with the money supply, but eventually, they tend to rise when interest rates — either from the Fed or market rates in the bond and money markets — are falling, and they tend to fall when interest rates reach a high enough level. In other words, the relationship of money supply to the stock market and stock index futures is indirect and has more to do with how effectively the Fed and the bond market are bringing about the desired effect on the economy, whether slowing it down or speeding it up. However, during some periods, such as 1994 and most of 2005 when the Fed raised interest rates, stocks and stock index futures stayed in a trading range.
Currencies tend to fall in value during times of inflation.
In a global economy, many of these dynamics occur simultaneously or in close proximity to each other, which is why an understanding of the global economy is more important when trading futures than when trading individual stocks.
Seeing how something from something is something more
The wildest thing about money is how one dollar counts as two dollars whenever it goes around the loop enough times in an interesting little concept known as the multiplier effect. For example, say the Fed buys $1 worth of bonds from Bank X, and Bank X lends it to Person 1. Person 1 then buys something from Person 2, who then deposits the dollar in Bank 2. Bank 2 then lends the money to Person 3, who then deposits it in Bank 1, where the $1, in terms of money supply, is now $2, because it has been counted twice.
By multiplying this little exercise by billions of transactions, you can arrive at the massive money supply numbers in the United States, where, as of late 2004, the M0 alone was $688 billion. As of March 7, 2008, M1 was $1.38 trillion, unchanged from March 2005 and M2 was $7.63 trillion, compared to $6.41 trillion in March 2005. The growth in M2 was one of the reasons that gold prices were rising during this period as inflation was heating up.
Getting a handle on money supply from a trader’s point of view
Although you and I can use money supply data in many ways from an academic point of view, believe me, it won’t make you the life of the dinner party. The key to making money by using money supply information is to have a good grip on whether the Fed actually is putting money into the system or taking it out. What’s even more important is how fast the Fed is doing whatever it’s doing at the time. In the old days, I used to keep strict money supply data and plug it into a formula that I invented. It used to work fairly well. But like other indicators that used to work, it became fairly irrelevant, and I stopped using it.
Instead, I pay more attention to what the Fed says and does, and how the market anticipates events and responds to the words and actions of the central bank(s). In other words, the market, by its actions, factors in what it thinks the money supply is doing, and what effects it will have on the economy and the way the world works. All you and I, as traders, have to do is to pay attention and follow the overall trend of the market.
For example, if the Federal Reserve starts to lower interest rates, and the market responds by rallying gold prices, lowering the dollar, and raising long-term bond yields, the market is betting on inflation becoming a factor at some point in the future.
I can follow those trends and trade those markets. That, in my view, is better than using a formula that stopped working a few years ago.
Recognize when the Fed is being cautious in its conduction of monetary policy, say, by using ambiguous statements after its Federal Open Market Committee meetings or in its members’ speeches to the public. You need to be cautious in how you trade, but you also need to be monitoring the markets for their response. You don’t want to let a good set of opportunities pass you by.
A perfect example is what happened in September 2007 and into 2008. The Federal Reserve, and other global central banks, lowered interest rates and offered discount rate loans to banks and financial institutions in response to a liquidity crunch in the global credit markets, which had resulted from the subprime mortgage crisis. The response of the markets to the Fed’s actions was to deliver not only a rally in stocks, at least initially, but also a rally in gold, along with a significant breakdown in the U.S. dollar and significant volatility in the U.S. Treasury bond market. That combination of events suggested that the market was concerned about inflation at some point in the future.
Putting Fiat to Work for You
The average person may find the fiat concept difficult to grasp. But as a futures trader, it is the center of your universe. If you can figure out which way interest rates are headed and where money is flowing, most of what happens in the markets in general will fall into place, and you can make better decisions about which way to trade. Keep these relationships in mind:
Futures markets often move based on the relationship between the bond market and the Fed, which means that when either the Fed or the bond market moves interest rates in one direction, the other eventually will follow. See Chapters 6 and 10.
Higher interest rates tend to eventually slow economic growth, while lower interest rates tend to spur economies.
Another excellent example of how the system works occurred after the events of September 11, 2001. In response to the catastrophe, the Fed lowered key official interest rates, such as the Fed funds and discount rates, but it also bought massive amounts of government treasuries, thus making much more money available to the banking system.
Currency traders, who are not well known for their patriotism, sold dollars and bought euros, yen, and other currencies, and effectively moved money out of the United States.
Much of the money that the Fed injected into the system made its way to China and ended up fueling the major economic boom in that country that marked the post September 11, 2001, economic recovery. China used the infusion of foreign money to finance a building boom that, in turn, led to increased demand for oil and raw materials, such as copper, steel, and lumber. This major change in the flow of money spread to all the major futures markets and led to a bull market in commodities because China bought increasing amounts of steel, copper, and the fuel needed to power the boom — oil.
When the Fed began to raise interest rates, it did so partially with the intention of cooling off the growth in China and diverting the flow of dollars away from Beijing and back to the U.S.
Normally, you begin to see these markets come to life at some point before or after the Fed makes a move. For example, if you see the copper market starting to move, you want to check on what the bond and stock markets are doing, because smart money starts pricing in expectations of a change in trend by the Fed.
Bonding with the Fed: The Nuts and Bolts of Interest Rates
If you want to make money in futures, you need to become intimately familiar with what the Fed does and how it goes about it. Credit makes the world go around. Credit enables everyone to have the things they want now and to pay for them later. How much stuff you can buy depends on how easy the Fed makes it for you to borrow the money. The Fed wants to create an environment that prompts consumers to buy as much stuff as they want without letting them create inflation.
One way the Fed raises and lowers interest rates is by buying or selling U.S. Treasury bonds in the open market. In past decades, the market had to guess what the Fed was trying to do with interest rates where the bond market was concerned. In the latter years of Alan Greenspan’s terms as Fed chairman, the central bank became more open in its communications with the markets, but a fair amount of Fedspeak, the often-difficult-to-decipher language from the central bank, still was in use. In some cases, it was even conjecture.
Greenspan’s successor, Chairman Ben Bernanke, used a different formula in 2007, at least initially, in order to calm the credit markets during the subprime mortgage crisis. Instead of initially lowering the Fed Funds rate, Greenspan’s favorite weapon, Bernanke lowered the Discount Rate, the rate of last resort used by banks that can’t get credit anywhere else and have to borrow from the Fed. Because he didn’t want to flood the whole economy with easy money, Bernanke targeted those financial institutions that were in trouble and “destigmatized” the Discount window by making it known that the Fed would not be penalizing those banks that used the credit facility. This bought Bernanke some time, which he used to gather more data, before finally lowering the Fed Funds rate a couple of weeks after lowering the Discount rate.
No matter what you think of the Fed and central banks in general, they’re a fact of life, and the better you can understand them and decipher some of the things they say and do, the better you can trade and make other decisions about your money. Finding out how central banks work is easier than trying to decipher what they say and do. They buy and sell bonds and inject or extract money from the banking system they control. When the Fed buys bonds, it gives the markets and the economy money. When the Fed sells bonds, it takes money out of the markets and the economy. Pretty simple, right?
The amount of money that the Fed uses to buy bonds can signal which way the Fed’s Board of Governors wants interest rates to go. This relationship is pretty simple any more, because the Fed rarely goes into the bond market — other than for routine maintenance of the money supply — without making a statement. The New York Fed conducts routine maintenance. An example is when the Fed adds more reserves than usual during holiday periods, such as Christmas, to make sure banks have enough money on hand to handle the shopping season. In the new year, the Fed drains the extra reserves from the system. The Fed usually doesn’t mean this maneuver as a major economic action.
The Bernanke Fed, following the tradition started by the Greenspan Fed, will usually announce its “target rate” for the Fed Funds rate. This is the rate that banks charge each other for overnight loans, and is the primary interest rate that the Federal Reserve manipulates to set the overall trend for all other rates. When the Fed makes significant changes in monetary policy, the central bank clearly announces it has made a move, and why it has made it.
Central Banks
Central banks have convinced the world’s corporations and population that money and its wonderful extension, credit, are the centerpieces of the world’s economic system. And the easier it is to borrow money, the more things get done and the bigger things get built.
When central banks buy bonds from banks and dealers, they’re putting money into circulation, making it easy for people and businesses to borrow. At the juncture where money becomes easier to borrow, the potential for commodity markets to become explosive reaches its zenith.
Commodity markets thrive on money, and their actions are directly related to
Interest rates
Underlying supply
The perceptions and actions of the public, governments, and traders, as they react to
• Supply: How much is available and how fast it’s going to be used up
• Demand: How long this period of rising demand is likely to last
If you keep good tabs on the rate of growth of the money supply, you’ll probably be ahead of the curve on what future trends in the markets are going to be.
These moves can come before or after any changes in money supply or adjustments to borrowing power appear. However, when a market trends in one direction (up or down) for a considerable amount of time and suddenly changes direction after you notice a blip in the money supply data, you know that something important is happening, and you need to pay close attention to it.