What is Liquidity?

Below is an extract from a commentary posted at www.speculative-investor.com on 11th May 2006. 

When we say there's a huge amount of liquidity in the financial system we don't mean that the money supply is growing at a rapid pace. A high rate of money-supply growth will often lead to a period of high liquidity, but it's possible for low/contracting financial market liquidity to coincide with rapid growth in the money supply. For example, the rate of money-supply growth in the US hit a 2-decade high during 2001-2002, but this was a period of low financial market liquidity. On the other hand, the US money supply grew at a relatively slow rate during 2003-2005, but this was a period of high financial market liquidity. Of course, the rampant monetary growth of 2001-2002 helped bring about the highly liquid environment of 2003-2005.

Financial market liquidity is difficult to define and impossible to measure, but the effects of liquidity changes are readily observable. Therefore, although we will never be able to quantify the dollar amount of liquidity there are indicators that tell us whether it is high/expanding or low/contracting. For example, excess liquidity will generally embolden investors and speculators to take-on greater risk to increase their returns, and the increased risk-taking will, in turn, tend to create a more 'liquid' financial environment. That is, a virtuous circle will develop. As a result, high/rising liquidity will invariably be associated with low/falling credit spreads (the gap between the yields on high quality and low quality debt will narrow as investors become less concerned about the risk of default). Furthermore, speculators will usually be eager to 'borrow short' in order to 'lend long' during a period of high liquidity, leading to a contraction in the yield-spread (a rise in short-term interest rates RELATIVE TO long-term interest rates).

In other words, high financial market liquidity tends to be linked to widespread beliefs that a) prices are going to rise enough in the future to more than compensate speculators for the cost of financing, b) the outlook for economic growth is bright, and c) it's reasonable to employ greater-than-usual leverage because the world has become a safer place to invest. Under the right set of circumstances a high rate of money-supply growth can LEAD to these beliefs taking hold and these beliefs can, in turn, lead to an increase in the rate at which new money is borrowed into existence (the virtuous circle mentioned above); but while liquidity is definitely linked to the quantity of money it is, more than anything, a psychological phenomenon. As such, it can disappear very quickly even if the money supply continues to increase. To take an extreme example, financial market liquidity went from high to zero within the space of a few weeks in 1914 as the markets went from being unconcerned about the prospect of war to the realisation that a major war was about to begin. To take a less extreme and more recent example, Asian and Russian debt crises caused financial market liquidity to collapse between July and October of 1998 while the money supply continued to expand at a robust rate.

In addition to narrowing credit and yield spreads, periods of high/rising liquidity tend to go with weakness in gold relative to industrial metals. This link between liquidity and gold's performance relative to industrial metals is illustrated by the following chart comparison of the yield-spread and the gold/silver ratio (silver is primarily an industrial metal). The relationship depicted by the chart was distorted a little by the upward manipulation of the silver price during 1997-1998 on the back of Warren Buffett's buying (well before Buffett's silver accumulation became public knowledge some large traders became aware of what he was doing and acted on the information). This manipulation caused the gold/silver ratio to prematurely bottom during 1998 rather than alongside the H2 2000 peak in liquidity and bottom in the yield-spread, but the long-term positive correlation between gold/silver and the yield-spread is still evident on the chart.

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