In this topic, we will share our concept of liquidity and help you understand the context in which we operate.
First and foremost, let's define what liquidity is and why it is essential. In our understanding, liquidity is the flow of cash and cash-like assets that stimulate spending in both the financial and real economies.
As macro-investors, we are interested in whether market participants will be buying or selling assets. Ideally, we could anticipate these movements and profit from them. Take, for example, purchasing an asset before its bid...
For an asset to increase in price, there must be buyers. These buyers must have the financial means to purchase the asset. To obtain these funds, a buyer can turn to one of three sources: savings (income exceeding expenses), borrowing, or selling some assets.
These sources are the means of generating demand for a particular asset. It is crucial to understand that savings and obligations are spent just like cash, i.e., $100 of income exceeding consumption is spent like $100. The same applies to obligations; a $100 bank loan costs $100.
Selling assets, on the other hand, is not the same as savings and liabilities due to the risk of asset losses. If you want to sell your house to buy stocks, there is a risk that you may not get the nominal value of your house, i.e., there is a risk. Furthermore, you...
...cannot instantly sell your house; it is not liquid. However, a savings deposit can be easily used to buy stocks. Thus, the more assets we can instantly sell close to their nominal value, the more "liquid" the active part of the balance sheet is.
It is essential to note that changes in the active part of the balance sheet must be equal to changes in the passive part of the balance sheet. We will illustrate this in the figure below:
Here, it is crucial to understand that the riskier the asset side, the more likely the sum of liabilities may sharply decrease. Thus, liquidity is a measure of the quality of the sources and use of funds. This can be done from both the asset and liability sides...
So, each asset exists somewhere on the liquidity spectrum. This hierarchy is determined by the issuer of the asset. The state has the most liquid assets since it controls the currency, followed by financial institutions licensed to create money, such as...
...assets, and so on. Thus, each asset has a certain degree of liquidity, but some are much more liquid than others. Calculating the level of liquidity in the system is complex but is a crucial addition to growth and inflation indicators. While growth and inflation determine the relative...
...distribution of asset income, liquidity stimulates the size of movements. In practice, there are two main types of liquidity: political and private. Political liquidity is created by the joint actions of the Federal Reserve and the Treasury. This happens through...
...adjusting the volume of circulating government assets by changing the distribution of these assets by maturity and changing the interest rate on these assets. Increasing the volume of obligations, increasing the volume of assets with short maturities, and lowering interest rates reduce risk and increase liquidity, and vice versa.
The role of state liquidity has shifted from completely negative to somewhat mixed. Rates have risen, state obligations have increased after a sharp drop last year, and issuance has become more short-term. As a result, the function has shifted...
from unequivocally negative to somewhat fixed. This allowed the private sector to dominate again in nominal activity. We see this in the markets for commercial papers, bank loans, money market funds, and repo operations...
The combination of these factors creates a favorable liquidity background, especially against the backdrop of last year's liquidity drain. It is essential to keep in mind that in the current liquidity situation, there is an extremely high procyclical risk.
...rallies in stocks. This creates a significant reflexive downside potential for stocks if and when nominal activity contracts. This will largely depend on the results in profit and labor markets...
Finally, a simple equation for the Federal Reserve's balance sheet will not be able to reflect this situation. The reason you will not see liquidity assessment calculations is one of two: some people genuinely work to gain an advantage and will guard it, while others just use it as a universal tool.
We hope this brings some clarity to the conceptual issue and helps understand the current liquidity situation.