Net Liquidity

The financial system is addicted to liquidity, but few understand the full picture. Let's dive in.

The Taper has begun, but markets seem to be holding up. Liquidity, traditionally thought of as just central bank reserves- is far more complex than most would believe.

Let’s start with the traditional definition. Liquidity generally refers to the “ease and speed with which an asset or security can be bought or sold in the market without significantly impacting its price”. It’s essentially the degree to which an asset can be converted into cash quickly without causing a substantial change in its value. Highly liquid assets, like major currencies or stocks with high trading volumes, can be easily bought or sold at stable prices. 

However, for our purposes, liquidity is essentially a measure of the available cash sitting ready to buy and trade financial assets. In a recent Blockworks interview on November 15th, Michael Howell of CrossBorder Capital laid out his definition and framework on how to view this concept, and it’s useful to understand this as we lay out our calculation of Net Liquidity:

“What we mean here by global liquidity is the flow of money through financial markets. This is a concept which is not  M1 or M2 the traditional monetary Aggregates - those are already measuring money in the real economy and that basically by definition flows through banks. What this is looking at is flows generally through financial markets. Global liquidity is a much much bigger concept than money supply, the amount we are talking about here is $170T. 

It’s something like 50-60% bigger than even worldwide broad money supply measures.

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Now why is it so important in the world? It's very important really from two dimensions - one is by definition-it provides funding for transactions generally in financial markets. It’s particularly important when it comes to rolling over debt, and funding debt. If you look at where financial markets are today, they are no longer purely vehicles to raise new capital for a plant or equipment- they are basically refinancing mechanisms for debt. And if you are refinancing debt, it’s the capacity of the financial system that’s important, not the interest rate that you are using to roll the debt over. That clearly is a factor, but it’s not a crucial one. 

Think of it like a home mortgage; if you need to roll your mortgage, say it comes up after a 20 year period. Don’t worry about what the interest rate is, you just desperately need to roll, otherwise you’re homeless.

Same with debt. Debt has a life- the average duration of credit in the world economy is about 5 years. With something like $350 Trillion of debt around, you’re talking about refinancing $70T of debt each year. You need balance sheet capacity to do that, and balance sheet capacity is one of the ways we define global liquidity. So that’s what we're really talking about here, it’s not the conventional money supply measure, it’s the flow of funds through financial markets.”

For the normal economy, M2 is a decent (although flawed) measure of money supply, such that increases in M2 liquidity means a general increase in prices. This was touched on in depth in our recent piece “The Singularity”, where we showed the direct correlation between M2 and inflation, as well as the hidden link that converts bank reserves into deposits. When the Fed runs QE and this secret valve is activated, base money supply increases, and with more dollars chasing the same amount of goods, prices go up. 

The same is true for the financial system. As liquidity is added, more dollars chase the same amount of equities, bonds, ETFs, derivatives, and crypto, driving up prices of these instruments. Massive stimulus programs have provided markets with a huge push upwards, especially since 2008, making markets extremely dependent on QE. Thus, the correlation coefficient between the Fed’s balance sheet and SPY for example, has trended around 0.9 for most of the past decade.

This is vitally important, given that this strong of positive correlation is rarely seen elsewhere in financial markets.

Here’s the equation for Net Liquidity;