Liquidity, as commonly defined by wall street analysts, describes the nature of the assets but not the total amount of it. Consensus definition of the FED liquidity = FED Balance Sheet - TGA - RRP ; this is a measure of "cash-like" assets but not of total assets. For the past 3 years everyone has been looking at this proxy liquidity because of the strong correlation it has with the US stock market total cap. But by just looking at the chart I can see that (1) liquidity doesn't lead the market cap, correlation is not causation; and (2) the correlation has broken several times in the past and is breaking right now.
Let's reverse the reasoning: What is driving market prices? It's the nominal growth (NGDP). The market is actually pricing two thing: NGDP now and its growth over time. Depending on investor sentiment, the expected growth will be revised up or down through market multiples (like forward P/E). The "intrinsic value" of the market is a function of all the total assets (not total cash-like assets) available right now that are contributing to the NGDP.
The FED cannot print real assets, only the US Treasury can by issuing Bills and Bonds, and ultimately by stimulating the real economy. Any FED operation is just a cash asset swap on either the US Treasury or the Banks balance sheet. The ultimate driver of NDGP is the fiscal policy. The FED can only print cash-like assets (reserves) and then COULD BE swapped with real asset like bonds, therefore any liquidity proxy is only coincidental of risk asset price.
Finally I will add a big nuance here, so far I have been talking about the return of risk assets in medium to long term. However in the short term, the FED and the "perceived" liquidity can drive the risk assets during a market crash or down-turn through a repricing of the multiples (P/E etc). Confidence is the name of the game, and when investors are looking down the barrel, only a FED bazooka can restore confidence. Liquidity injection thrives in the tail of the distribution. The monetary bazooka can take any form but eventually it will dampen the volatility. At the end of the day, each situation is unique and require a deep analysis, the regional bank crisis from march 2023 was a good exemple of the central bank creativity: we will restore confidence with the BTFP program which will value your UST at par. Was it debt monetization? The fed's action was simply an asset-swap operation, but by introducing a repricing of the UST at par, it ended up adding real asset value out of thin air. Brilliant!
why you don’t believe Liquidity is the leading indicator of risk assets and you think it’s only coincidental?
Liquidity, as commonly defined by wall street analysts, describes the nature of the assets but not the total amount of it. Consensus definition of the FED liquidity = FED Balance Sheet - TGA - RRP ; this is a measure of "cash-like" assets but not of total assets. For the past 3 years everyone has been looking at this proxy liquidity because of the strong correlation it has with the US stock market total cap. But by just looking at the chart I can see that (1) liquidity doesn't lead the market cap, correlation is not causation; and (2) the correlation has broken several times in the past and is breaking right now.
Let's reverse the reasoning: What is driving market prices? It's the nominal growth (NGDP). The market is actually pricing two thing: NGDP now and its growth over time. Depending on investor sentiment, the expected growth will be revised up or down through market multiples (like forward P/E). The "intrinsic value" of the market is a function of all the total assets (not total cash-like assets) available right now that are contributing to the NGDP.
The FED cannot print real assets, only the US Treasury can by issuing Bills and Bonds, and ultimately by stimulating the real economy. Any FED operation is just a cash asset swap on either the US Treasury or the Banks balance sheet. The ultimate driver of NDGP is the fiscal policy. The FED can only print cash-like assets (reserves) and then COULD BE swapped with real asset like bonds, therefore any liquidity proxy is only coincidental of risk asset price.
Finally I will add a big nuance here, so far I have been talking about the return of risk assets in medium to long term. However in the short term, the FED and the "perceived" liquidity can drive the risk assets during a market crash or down-turn through a repricing of the multiples (P/E etc). Confidence is the name of the game, and when investors are looking down the barrel, only a FED bazooka can restore confidence. Liquidity injection thrives in the tail of the distribution. The monetary bazooka can take any form but eventually it will dampen the volatility. At the end of the day, each situation is unique and require a deep analysis, the regional bank crisis from march 2023 was a good exemple of the central bank creativity: we will restore confidence with the BTFP program which will value your UST at par. Was it debt monetization? The fed's action was simply an asset-swap operation, but by introducing a repricing of the UST at par, it ended up adding real asset value out of thin air. Brilliant!