Money velocity (MV) is mostly an academic concern among macroeconomics, and it rarely enters the minds of most financial analysts. However, with the explosive growth of macro-driven funds and investment strategies, MV has become a more popular topic among investment bankers and buy-side analysts, even if established methodologies of incorporating MV into investment strategies remain elusive.
So what is this concept and why does it matter?
As you’d expect, the term refers to how fast money goes from one owner to the next. More transactions will result in more money velocity, because the cash is going from one hand to another faster than an economy with lower transactions. Similarly, economies with many high denomination transactions will have higher MV than economies with many slow denomination transactions.
Why is this important? Consider two economies that both have an equal amount of money. The first has only two market participants: two people who transact with one another every day, making a single purchase each (i.e. Person A buys a basket of food from Person B, who buys some commodities from Person A). This would be a low MV economy—and that lack of MV means that adding more money to the economy will likely cause inflation, because Person A and Person B have relatively less need for the extra currency (note—this view, while accepted in most economic schools of thought, is hotly contested by more heterodox schools).
Now imagine another economy where there are 1,000 people who are all transacting with each other multiple times a day with the same amount of currency. Assuming all else is equal, this economy may suffer instability as a result of a lack of enough currency to match the demand for currency. As a result, this economy could handle having more currency injected without causing inflation—and, in fact, doing so would likely stop it from having a recession.
This is expressed mathematically in the formula: V = PT/M, where v = money velocity, P = price level, T = aggregate real value of transactions, and M = nominal money supply.
As you can tell, money supply and price level are inverted, meaning that you can an increase in money supply needs to be followed with a decrease in prices to have the same velocity, or vice versa. Thus, a country suffering from inflation (rising P) would likely benefit from less money supply (M) and a deflationary country (falling P) would benefit from more money supply (M).
This theory was particularly important in 2008-2009—and may also be why MV became a hot topic for financiers. At the time, controversial and oft incorrect but nonetheless high profile financial guru Peter Schiff warned that hyperinflation was going to come as a result of higher money supply due to the QE programs of the late 2000’s and early 2010’s. He was swiftly proven wrong, and his big bets on gold cost his clients a lot of money as a result.
The reason for Schiff’s error was his imbalanced perspective: by focusing just on money supply and not on money velocity, which incorporates money supply and prices, he came to the erroneous conclusion that more money would cause more inflation.
Since Schiff’s mistake (and, it should be noted, he was far from the only one to make this mistake at the time), many investors and analysts have looked closely at MV to learn from the errors of the past.
One such analyst was a little-known trader at Tudor Investment Corporation, a hedge fund run by billionaire Paul Tudor Jones. One of Jones’s traders spent all of 2013 making one simple trade: buying put options on the Gold ETF (GLD). This trade resulted in a 10x profit by the end of the year, turning $10 million into about $100 million.
While reports of the trader’s bonus were never made public, it can be imagined that this 10x win resulted in a very nice payout for him as well as for Mr. Jones.
How did the trader know to make this trade? If he studied the MV formula and looked closely at money velocity, while also looking at the implied inflation rate priced into gold at the time, it would have made a lot of sense to make this bet and profit from Mr. Schiff’s erroneous countertrade.
Since then, MV has become a more integral component of investment decisions, but there is still much to study. Not all MV is calculated the same, since “money supply” and “price level” are very complex phenomena. Money supply comes in five measurements, from M0 to M4, with M1 referring to currency in circulation ($3.7 trillion in 2018) and M2 referring to M1 as well as short-term deposits in banks and some money market funds. M3 includes all of that and long-term deposits. M4 includes all bank account deposits (M4 is not commonly used in America, but it is used in Europe and parts of Asia).
These complexities imply insights remain hidden from view, allowing a savvy analyst who studies money supply closely an opportunity to recreate the Tudor trade of 2013—while also avoiding the Schiff mistakes of the late 2000’s.