Well, are they or aren't they?

Yesterday, when all my troubles seemed so far away, I troubled myself to put up a post drawing from one (supposed) expert saying the world' central bankers were creating "excessive liquidity". Now, today, I finally got around to reading John Mauldin's weekly newsletter from March 31st. I've mentioned his newsletter before and recommended you subscribe for a free weekly read of his thoughts from the frontline. In this newsletter, he passes on research from other experts who claim global liquidity is being drained out of the system by CenBanks. I have no way of judging the source or extent of the apparent discrepancy, so present you the story, and you can decide if you have any interest.

Velocity Versus Money Supply

Central banks around the world are draining liquidity from the system as fast as they can. Those very smart people from GaveKal track global liquidity. As you can see from the chart below, it is falling and has been for what looks like 18 months.


Note that extended periods of contracting liquidity have often resulted in a slowing economy. But banks, consumers, businesses and hedge funds are not cooperating. They are busy adding to liquidity as fast as they can leverage up. This can be seen through the velocity of money; i.e., how fast money is going through the system. Velocity is the number of times a dollar is spent, or turns over, in a specific period of time. Velocity affects the amount of economic activity generated by a given money supply.

Below is a graph of the velocity of money from the St. Louis Fed: http://research.stlouisfed.org/publications/mt/page12.pdf. Velocity has gone down throughout the '90s and on into the late recession. But since that time, it has started to rise. As an aside, this is one of the reasons Greenspan could really grow the money supply without seeing a return of inflation. We simply were not using the dollars as "rapidly" as in the past. But now, that trend has changed.


Which brings us back to another graph from GaveKal. This one tells an even more interesting tale. They chart the difference between liquidity and velocity. Quoting from a recent paper to their clients [my comments in brackets]: "...the central banks pile on the brakes [taking away liquidity] while the private sector is happy piling on the leverage [borrowing for business investment and consumption and the carry trade, which is borrowing in a currency with cheap interest rates to invest in places with higher returns]. But can such a situation last for long? To be honest, we started getting very worried about the divergence between our M [global liquidity above] and our V [velocity] indicators at the end of the summer. But since then the divergence has continued to grow."


This divergence is at its most extreme for the last 13 years. Further, increased velocity is often associated with an increase in "inflation pressures." That cannot escape the notice of a central banker.

Why the increase in leverage? Because of the great irony that people - business, investors, and consumers - see less risk in today's world. They are more comfortable, therefore, in taking on even more risk. And in an era of perceived lower risk we have seen returns in almost all asset classes fall. But periods of lower risk premiums do not usually end up neatly.

As Bill Gross noted this week: "When one can buy a U.S. agency guaranteed FNMA mortgage at a higher yield than almost all emerging market debt, then there exists an irrational pricing of credit. In general, almost all risk and associated "premia" are now trading at illogically low levels and as Alan Greenspan warned just months ago, history has not dealt kindly with the aftermath of protracted periods of low risk premiums. 'Periods of relative stability' in fact, 'often engender unrealistic expectations of permanence and at times lead to financial excess and economic stress,' he said."

Thus, we are getting toward the end of a cycle which has been played out numerous times, as GaveKal and others (including your humble analyst) have noted. First, there is a downward shift in the risk return curve. Thus, as investors are getting lower returns they also get less volatility. So, in an effort to increase yield they move up the volatility curve. They can do this two ways; either move into more risky investments (i.e., emerging market bonds, stocks, commodities, etc.) or employ increased leverage. When rates are low enough and there is lower volatility, then why not do both? It seems so easy.

Thus, as leverage increases, central banks get nervous and put on the brakes. They begin to raise rates. And let me note, this is a battle that central bankers will win. They can slow down the train if they decide to.

With Higher Leverage, Cost of Capital Rises Above Returns

"As the desire to leverage increases, the demand for capital accelerates. With the higher demand for capital, its price usually goes up. At the same time, central banks start to lean against the increase in leverage, hereby further increasing the cost of capital. At some point, the rising cost of capital meets up with the falling returns on invested capital.

And that precipitates a financial panic. The momentum and carry trade investors get "taken out" and the "return to the mean" investors thrive. At this stage, one wants to own nothing but cash, and government bonds." (GaveKal)

I suggest you read the whole newsletter, even if you have to give your email address as the "price" of the othewise free admission (you can always unsubscribe if it starts to annoy rather than provoke). It has some very interesting insights provided by, as well as about, Art Cashin, the guy who looks like a waitress with the order pad, always making notes, on CNBC most afternoons. Also, you can judge his take on whether, as he believes, the Fed will continue to "entertain" raising rates beyond 5%.