The Liquidity Gauge
Posted March 21, 2014
Central bank forward guidance and communication are all fine and good, but it is liquidity that moves the markets. When liquidity is plentiful asset prices tend to rise and when it is scarce asset prices tend to fall. What investors require, therefore, is a simple way to measure and forecast liquidity, a liquidity gauge.
A liquidity gauge for the United States is relatively easy to construct. When the government borrows dollars to fund its budget deficit, it absorbs liquidity. When the Fed creates dollars through Quantitative Easing, it injects liquidity into the financial markets. During 2013, the government absorbed $680 billion to fund its budget deficit, while the Fed injected just over $1 trillion through QE. The difference between what the government absorbed and what the Fed injected was $320 billion of excess liquidity.
That is not the full story, however. The Fed was not the only central bank creating fiat money and buying dollar assets last year. In order to prevent their currencies from appreciating, many central banks around the world created their own money and used it to buy the dollars entering their economies as a result of their trade surpluses with the United States. Once they had acquired the dollars, they invested them in US dollar assets to earn a return. This, then, was a second source of liquidity. It can be measured by the increase in foreign exchange reserves. In 2013, foreign exchange reserves increased by approximately $700 billion. Roughly 60% of those reserves were US dollars. This second source of liquidity thus added another $420 billion or so to US liquidity, bringing total liquidity to $1.42 trillion and excess liquidity to $740 billion.
When total liquidity (i.e. Quantitative Easing combined with the amount of dollars accumulated as foreign exchange reserves) is larger than the budget deficit, there is excess liquidity and asset prices tend to rise. But when total liquidity is less than the budget deficit, there is a liquidity drain and asset prices tend to fall. The $740 billion of excess liquidity in 2013 was the most ever recorded. That explains why the stock market rose nearly 30% and why home prices rebound by 13%.
This liquidity gauge also explains past booms in asset prices. Although QE only began in late 2008, central banks outside the US have been accumulating large amounts of dollars as foreign exchange reserves since the 1980s. The previous two peaks in excess liquidity occurred in 2000 at the time of the NASDAQ bubble and in 2006 at the time of the property bubble. The excess liquidity caused those bubbles.
The liquidity gauge becomes a useful tool for investors when it is used to forecast future levels of liquidity. That is also relatively easy to do. The Congressional Budget Office publishes its projections for the budget deficit and the Fed has provided a tentative taper schedule that provides estimates of how much fiat money it will create each month during 2014. All that is missing is the amount of dollars that will be accumulated as foreign exchange reserves. Here, estimates of the US current account deficit can serves as a proxy. Since 1970, the amount of dollars accumulated as foreign exchange reserves has been similar to the size of the US current account deficit during most years.
Plugging in estimates for the budget deficit, the Fed’s taper schedule and estimates for the current account deficit on a quarter by quarter basis for 2014 suggests that liquidity will remain excessive during the first half of the year, but that a liquidity drain will begin in the third quarter and become significantly worse in the fourth quarter. If this analysis is correct, asset prices are likely to fall during the second half – unless the Fed provides more Quantitative Easing than it is currently signaling.
Given that the Fed has been driving the economic recovery by inflating the price of stocks and property, it is unlikely to allow falling asset prices to drag the economy back down any time soon. To prevent that from happening, it looks as though the Fed will have to extend QE into 2015 and perhaps significantly beyond.
For a detailed explanation of how I calculate the Liquidity Gauge, please subscribe to Macro Watch:
Provides a excellent analysis of what is taking place.The fact that governments have these tools at their disposal ,doesn’t mean they will not manipulate to their own short term advantage.The Window of Opportunity to avoid the next bust is going to be missed or even ignored.
If liquidity is removed on a net basis as you explain, what happens to 10-year US Treasury yield and the price of gold and silver?
If the Fed really does end QE, government bond yields are likely to go up and gold and silver are likely to go down. And, stock prices and property prices are likely to fall; and the US is likely to go back into recession.
Every time the Fed has tapered–yields have gone down not up. It is possible because of QE–the private credit market is fearful of inflation therefore avoiding long term treasury bonds? Once the fed tapers and we go into recession wont yields go back down? Maybe even sub 1 percent as private money comes back in to treasuries. In Japan the 10 yr treasury is under one percent. No one is expecting that. I see wall street is creating and marketing lots of ” interest rate are going to rise products” A good contrarian indicator.
Assuming constant foreign exchange reserves, how would liquidity be affected if bank lending increases substantially in the U.S. to the point where combined credit growth (Fed + banking system) remains the same overall without QE?
Any thoughts on turning this new bubble into inflation? You could use the minimum wage law to push wage inflation.
How does your H1-H2 thinking change, if at all, when the major averages begin to struggle, even with system liquidity in H1 still ample?
I just uploaded the new issue of Macro Watch (Q2 2014). Please look for a detailed answer to this question there. The short answer is that I still think asset prices could boom in Q2 and then have a very hard time during the second half as Liquidity dries up.
Very interesting analysis is it really that straight forward though? Arguably the most solid modern economic theory suggests the money supply is endogenous rather than exogenous. In other words the majority of the money in the economy is derived not from government injection of currency into the system but rather through private borrowing. This is arguably the reason QE is relatively ineffective. Yes, it’s arguably been a driving factor in inflating the stock market by leaving more reserves on bank balance sheets to invest but it hasn’t stimulated lending since bank lending isn’t reserves constrained.
It’s definitely indisputable that QE relative to government borrowing as you’re mentioning has impacted the level of bank reserves but since the majority of money is derived from private bank loans how significant is this impact?