Monday, September 14, 2009

It is liquidity driving the market

The economist David Rosenberg makes the headline statement in today's missive that "It's not liquidity driving the market".  Rather than guess at his motivations - let's have a look at how liquidity is driving the market.

First up, define liquidity as referring to the relative ease with which an asset can be sold.  Typically, selling an asset for cash is the most expedient way to realise an asset's value.  In a sense, cash is the most liquid of assets (as a store of value its pretty darn good most of the time and everyone is happy to use it as a medium of exchange).  For this reason, cash is at the very heart of the liquidity concept.

When there is an abundance of liquidity for a given asset, selling it can be achieved quickly and with minimum price disturbance to that asset.  When there is an abundance of liquidity in an economy as a whole, there is lots of cash available to buy assets - it is relatively easy to sell assets across the risk spectrum.

From this definition, the impact of liquidity on markets seems straightforward.  To get a sense of how it can be measured, a former roomie of Mr Rosenberg, Stephen Roach, points to a useful indicator:

My favorite gauge of the quantity dimension of liquidity is the so-called “Marshallian K” -- the difference between growth in the money supply and nominal GDP.  In essence, this measures the surplus of money that is not absorbed by the real economy.

When the money supply is growing faster than nominal GDP, then excess liquidity tends to flow to financial assets.  On the flip side, if money supply is growing more slowly than nominal GDP, then the real economy absorbs more available liquidity.

Under this model, asset price inflation will be the result of excess liquidity.  For example have a look at some research from BCA on the correlation of the US$ gold price with the Marshallian K and then as compared to CPI:

Now while David makes the point that the Fed's most recent pumping of the monetary base has had little impact on broader money aggregates (as bank lending continues to contract at record rates), by taking a step back from the four week data we can see that the Fed has provided the system with a mountain of cash (charts from the St Louis Fed):

US Adjusted Monetary base

Conceptually, this view of liquidity helps explain how treasuries can continue to rally in tandem with equities markets and economic indicators pointing to a recovery (latest being the OECD leading indicators - have a look at the charts, there are some scary ones).

The conclusion - it may be an over-simplification to say "liquidity is driving the market", but as a generalisation it has greater merit than suggesting the opposite.

The actions of central banks around the world are predicated on the basis that they are enhancing liquidity.  The objective might be to loosen up the money multiplier/creation process (not that they are necessarily having much luck on this front) but the effect is clearly being felt in asset prices.  Banks may not be lending but they are investing all this cheap money they have been given in carry trades where ever they can find them.

Which leads us back to the question, where is liquidity going? - or rephrased, how long will governments continue with quantitative easing?  The Fed has indicated a strategic withdrawal in October.  Without the methyl, I'm expecting asset prices to correct...