My Favorite Way Of Measuring Market Liquidity And Why It's So Important

|
Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Adem Tumerkan
Summary

For macroeconomics and markets, "monetary conditions" (liquidity) is key.

Thus, being able to track the direction of liquidity (more or less) in the system helps position traders to be bullish or bearish.

Yet regardless of the Fed's tightening over the last three years, monetary conditions have stayed very loose. This is quite paradoxical.

But early signs indicate this trend could be changing.

If there are two things I've learned from Macro trading, it's the importance of market liquidity (the flow of money), and understanding short- and long-term debt cycles.

Both of these things work together hand-in-hand. But I believe liquidity conditions set the stage for the debt cycle.

For instance, if there's ample liquidity, then debtors can continually borrow more and at lower rates (expansionary). But if there's less liquidity, debtors must borrow less and pay higher rates (tightening).

Even infamous traders like Stanley Druckenmiller and George Soros have preached many times before how important liquidity is for moving markets - both up and down.

Like the brilliant traders at Macro-Ops wrote:

"… With the rise of 'blind investing' in the form of passively buying and holding ETFs, the majority of investors don't care about valuation or merit. They just auto-shuttle their excess funds to the nearest robo-advisor without a second thought.

This amount of 'excess funds' is largely dependent on liquidity conditions.

When liquidity is loose, it's cheap to get levered. People have extra cash and plow it into risk assets. Prices rise.

When liquidity is tight, people have less cash to spend. They may even sell stuff to service their existing debt. Prices fall…"

Now, it's easy for someone to find and measure debt loads - but measuring liquidity is much harder...

That's why one of my favorite ways to measure liquidity is to look at the National Financial Conditions Index (NFCI).

Let me give you some context.

The NFCI is measured and posted by the Chicago Federal Reserve. And it's made up of over 105 different indicators that track financial activity like what's going on in money, debt, equity markets, and even the "shadow banking" system.

Combine all this together, and you get a nice, easy-to-read way of measuring market liquidity.

Keep in mind that the NFCI reads inversely - meaning any reading above zero signals tightening monetary conditions (drying liquidity). And anything below zero signals easing monetary conditions (flush with liquidity).

To give you some perspective, when the index spiked above zero (tighter conditions) in 1973, 1980s, 1991, 2000, and 2007, harsh bear markets and economic recessions occurred.

So where things are today?

According to the NFCI and ANFCI (the Adjusted National Financial Conditions Index), despite the Fed's rate hikes and Quantitative Tightening (aggressive tightening), monetary conditions are still "loose".

What gives?

It could be that corporations are now flush with cash - thanks to the Trump Tax Cuts - and that banks still have trillions worth of reserves from the Fed's Quantitative Easing (QE) years.

Not to mention the slowing growth and calamity abroad in the Euro zone, emerging markets, and Asian economies have pushed investors to park their cash in the U.S., giving banks even more excess money.

All this liquidity works to counterbalance the Fed's own tightening.

So, with this all loose monetary conditions, we should be bullish, right?

Well, not exactly.

You see the NFCI is made up of three important sub-indexes:

  • First - The "Risk Sub-index" which looks at volatility and funding risk within the financial sector.
  • Second - The "Credit Sub-index" which looks at measures of credit conditions.
  • And Third - The "Leverage Sub-index" which studies debt and equity measures.

All three are important to watch - but the Leverage Sub-index is what I believe is the most critical to study.

For starters, it's a leading-indicator (any economic factor that changes before the rest of the economy begins to go in a particular direction).

And secondly, since we live in a credit-based world (just like Ludwig Von Mises, Hyman Minsky, and Knut Wicksell all wrote), leverage is what drives the boom and bust cycle.

For example, when leverage is cheap (low rates), people borrow more than they should and bid up riskier assets, pushing prices higher (the boom phase). But when leverage is expensive (higher rates), people borrow less, and even liquidate riskier assets to pay back debts, pushing prices lower (the bust phase).

So where's the Leverage Sub-index today?

It's much tighter than it was 12 months ago.

For context, this time last year, it was at negative -0.61. But now it's only negative -0.26 (remember, the closer to zero and above, the tighter conditions are).

And since it's the leading indicator of the three sub-indexes, I expect them to rise along with it (tighten).

This indicates that the cost of leverage is becoming much more expensive. And according to Minsky and Von Mises could signal the end of the debt-cycle as this trend continues.

For instance, U.S. non-financial corporate debt as a share of GDP is now at an all-time high.

Clearly these firms took advantage of the ample liquidity and low rates to binge on debt.

And making matters further dire, there's a wall of corporate bonds (both high-yield and investment-grade) set to mature over the next four years - with $3.5 trillion coming due in the next three years alone.

At this rate, these firms may end up forced to roll over their debts (refinance) when the cost to borrow is much higher, or worse, the economy is in a recession.

This puts the markets in a fragile position if liquidity dries up (monetary conditions tighten) during a time when entities need trillions in new financing.

So, for now, the NFCI/ANFCI indicates loose monetary conditions (ample liquidity).

But the Leverage Sub-index trend indicates sharp tightening (especially over the last year). This makes sense especially as short-term borrowing costs have risen alongside the Fed's rate hikes (which has inverted the yield curve as investors fear an approaching recession).

This could spell trouble later, especially with so much dollar-denominated debt coming due (domestically and abroad).

So, in conclusion, by using the NFCI/ANFCI, we can track monetary conditions.

For now, things don't look like they'll collapse overnight as long as liquidity remains loose. But this is something that can change very quickly.

So stay on guard.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The piece is from my original write-up at SpeculatorsAnonmyous.com. All ideas expressed and charts are my own.