How to measure liquidity

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Regular liquidity update

Unhedged looks at liquidity conditions every two months because we believe – at least in the abstract – in what we can loosely call the theory of market liquidity: that when there’s an increasing amount of cash around, investors try to escape of things, an attempt that pushes asset prices higher. Similarly, when the cash tide rolls in, asset prices will tend to fall. This is in contrast to fundamental market theory, where asset prices fluctuate around a stable mean set by the present value of their future cash flows.

The problem is that liquidity is not at all easy to track. The amount of cash in the system is hard to quantify, and showing how and when it affects prices is difficult.

With that somewhat unpleasant introduction, let’s take a look at the current conditions. In June, we looked at the popular federal liquidity proxy, which consists of:

• The Fed’s balance sheet or Treasuries and agency securities it bought in the market, replacing them with cash

• Plus the bank term financing program, a Fed cash facility for banks

• Minus the Fed’s reverse repo balances, which the Fed uses to control its policy rate by pulling cash out of the system overnight

• Minus the Treasury’s general account, which represents taxes collected but not yet distributed – that is, cash taken out of the system

Charting the proxy alongside the S&P 500 was very popular in 2021 and 2022 when the two moved together. But they stopped doing so, and the divergence has only grown since I wrote in June. Fed liquidity drops for good and the market continues to rise:

The pure theory of federal liquidity, aka “printer go Brr” (or is it “Brrr”? We need a style decision on this) looks worse all the time.

Several readers argued that the liquidity proxy should include something else: treasury and agency securities held on banks’ balance sheets. The idea is that although issuing government bonds has no net effect on liquidity (the government has more cash, the private sector has less), when the bond is held by a bank, it is equated to a deposit on the liability side of the balance sheet the bank. — and the amount of money in the financial system is increased. For example: The government writes me a $1,000 stimulus check. I deposit the money in a bank and the bank uses the deposit to buy a Treasury. Now there are more deposits (money) in the system. If I had just received the check and bought the Treasuries directly, there would have been no impact on liquidity.

The level of government bonds on bank balance sheets increased this year, from about $4 billion to about $4.4 billion. But adding this to the federal liquidity proxy isn’t enough to correlate — even broadly — with the stock market’s surge over the past year:

Perhaps we need a different, and preferably broader, measure of liquidity. Readers urged me to simply look at US bank reserves held at the Fed as a measure of additional liquidation in the system. But they also fell this year, in the opposite direction of the market:

So let’s go even simpler and just look at the money supply. Here is the M2:

At least M2 is growing. But only very gently. Can that really explain the strength of this rally?

Given the refusal of the US large-cap stock index – the world’s largest and deepest reservoir of risk assets – to line up perfectly with all these measures of liquidity, can the liquidity theory of asset prices be saved? Here are some options:

1. We could argue that liquidity operates on assets with (to use a clear phrase I just proposed) long and variable lags. What matters, in other words, is the huge increase in total level of liquidity from 2020 to 2022 (and even in the years following the Great Financial Crisis), rather than change in liquidity for shorter periods. This massive level continues to respond to markets in an uneven manner. I find this idea quite appealing, although it does have a downside. Look at liquidity theory for its predictive power. It says “there has been a huge burst of money, and that will keep asset prices high for an unknown amount of time.” Probably true, not very useful.

2. We could argue that prices are anticipating an increase in liquidity, which will be driven by Fed rate cuts. As rates fall, everything else should increase credit creation (indeed, total bank credit has increased slightly since the start of this year). And credit creation is money creation. We will have to see if this comes to fruition; if there is a recession, it won’t be.

3. I would argue that the most important form of liquidity creation is government deficit spending, which is and has been very large and overwhelms any other measure. I also find this point of view attractive, but if it is correct, why not drop all talk of liquidity and say, contentedly, “as long as deficits remain high, corporate profits will remain high and the market will rise”?

4. An even more comprehensive, global account of liquidity can be built. This is what, for example, Michael Howell of CrossBorder Capital does. He believes that while central banks are withdrawing liquidity (not only in the US, but also in Japan, Europe and the UK; China is the exception), there are several compensating factors. For example: As rates fall, the value of sovereign bonds rises, meaning financial market players can borrow more against them, adding liquidity. Reinforcing this effect is the fact that bond volatility has fallen (somewhat unevenly) since early August. When bond volatility is low, borrowers need fewer bonds as collateral for loans.

5. We could argue that the liquidity effect is mitigated right now because there is a low velocity of money in the financial system. I mean, there’s a lot of cash around, but it’s just sitting there in money market funds earning a decent return instead of chasing risk assets. This theory would assume that as cash rates and yields fall, the liquidity effect on asset prices will reassert itself. But if you don’t have a good measure of the velocity of money within the financial system specifically (as opposed to the velocity of money in the economy as a whole, for which there are standard measures), then this is just a hand gesture at something that sounds like “animal “. spirits’ or ‘gluttony’. And if feeling is the deciding factor, we should only talk about feeling.

Which of these approaches do readers prefer? Are there others? Or should we abandon the theory of liquidity altogether?

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