Deteriorating Global Liquidity
By Niels C. Jensen, Partner
Absolute Return Partners LLP
Below we will take a closer look at one of our favourite leading indicators, namely the global liquidity indicator. Global liquidity may be defined in numerous ways. We tend to like the way Merrill Lynch defines it, mostly because it has proven an excellent predictive measure over the years. According to Merrill Lynch, global USD liquidity equals the sum of the U.S. monetary base plus reserves held in custody by the Federal Reserve for foreigners - mostly Asian central banks.
If the U.S. current account deficit grows, as has been the case in recent years, global liquidity would be expected to improve, because the countries having a current account surplus with the United States would be expected to buy U.S government bonds for at least some of the surplus dollars.
This way, the U.S. current account deficit has played an important role in terms of providing stimulus to the global economy in recent years, a fact often ignored by those being so critical of the large deficit.
Chart 1: Global USD Liquidity
Source: Merrill Lynch
So let's take a closer look at the global liquidity indicator. As you can see from chart 1, the growth in liquidity has actually decelerated quite sharply in the last 6 months, reflecting several factors.
For a start, the U.S. monetary base itself is experiencing slower growth, which is not at all surprising given the rise in the U.S. Fed Funds rate. At the moment it grows by approximately 3% per annum, substantially less than the nominal growth of the U.S. economy.
Secondly, and perhaps more surprisingly, foreign reserves deposited with the Fed are not growing as fast as the current account situation might otherwise suggest. After all, with the U.S. current account deficit being higher than ever, you would expect foreign reserves to continue to grow rapidly. Why is that not happening? There are several reasons for this, but let's focus on two important ones.
A substantial part of foreign reserves held by the Fed belong to Asian central banks. Virtually all Asian countries are importers of oil. The sharp rise in the price of oil has created a new situation, where the growing U.S. current account deficit is not matched by a corresponding growth in the Asian surplus, simply because they are spending more dollars on their oil purchases, just like we are.
In addition to this, because of the sharp rise in the Fed Funds rate (the cost of money in the U.S.), speculators are borrowing considerably less in U.S. dollars than they used to. This, we believe, is a major contributor to the deceleration of global USD liquidity.
However, since there is little evidence of any meaningful de-leveraging going on in financial markets around the world, it is probably safe to assume that much of the speculative borrowing has simply moved from U.S. dollars to other low cost currencies such as euros and Swiss francs. This may also explain why Euroland is one of few areas in the world where the monetary base continues to grow at a healthy rate -- 10%+ per annum at the latest count.
But back to our main story. We assign much significance to the liquidity indicator, because global USD liquidity has proven so valuable in predicting the trend in financial markets. We can best illustrate this by borrowing a few more charts from Merrill Lynch.
Chart 2a: Global Liquidity v. Commodity Prices
Chart 2b: Global Liquidity v. Asian Stock Prices
Chart 2c: Global Liquidity v. Credit Spreads
Chart 2d: Global Liquidity v. Volatility
Source: Merrill Lynch
As you can clearly see from charts 2a through 2d, global USD liquidity is strongly correlated with commodity prices and Asian stock prices and strongly negatively correlated with credit spreads and stock market volatility.