Understanding Liquidity

The purpose of this piece is to explain how we define liquidity and why we define it in this way. At Variant Perception, we above all look for relationships that lead, and result in actionable ideas; this is what underpins our framework.

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> Real narrow money growth leads changes in economic activity.

The main measure for liquidity we use is M1 minus inflation, which we often call narrow money. Restrictive monetary policies are generally bad for growth, while looser monetary policies generally are supportive of economic growth.

> Excess liquidity leads ups and downs in equities and commodities.

There is a very good relationship between excess liquidity and the subsequent performance of risk assets.

> Foreign exchange reserves are often invoked as a measure of liquidity, but they do not lead business cycles or the credit cycle.

FX reserves are of limited use when it comes to trying to get a lead on what assets will do.

> Lending is often confused with liquidity.

But the volume of credit lags the business cycle, while the pricing of credit leads the business cycle.

Overview

Economists and traders speak of liquidity loosely, and they often mean very different things. Ludwig Wittgenstein once said, “The limits of my language are the limits of my world.” This report will explain key concepts involving liquidity and show the difference between narrow money and broader measures of credit.

To begin with, we need to be clear by what we mean by liquidity. Each person’s idea of what liquidity is comes with loaded ideas of how it can be used in an investment framework. Our aim in this piece is to clearly define what we mean by liquidity, and why this definition is of most use to investors.

Looking for practical solutions for investors forms the bedrock of Variant Perception. This is why, above all, we are data driven. We base our opinions on a dispassionate evaluation of the data – we have no axe to grind. We look for relationships where the data give us a lead on where we are in the business cycle. We also look for relationships that give us some idea of how risk assets will perform in the future. For these, we use liquidity-based leading indicators.