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Liquidity is one the most important yet misunderstood macro variables.
This thread will help you understand how it works.
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This thread will help you understand how it works.
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This is one of the most popular and yet misleading charts in macro.
People like simple narratives: the Fed is ''pumping money'' into the ''system'' and that's why equity markets go up.
That’s just NOT how it works - let’s explain why.
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People like simple narratives: the Fed is ''pumping money'' into the ''system'' and that's why equity markets go up.
That’s just NOT how it works - let’s explain why.
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A good starting point is asking ourselves what’s ‘‘money’’ and what’s the ‘‘system’’.
Let’s start from money.
Central Banks' balance sheets expand mostly through monetary operations: the most known is QE, but there are also other tools like the recently created Fed's BTFP.
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Let’s start from money.
Central Banks' balance sheets expand mostly through monetary operations: the most known is QE, but there are also other tools like the recently created Fed's BTFP.
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In any case, when the CB expands its balance sheet by acquiring assets (QE) or providing financing in exchange of collateral (e.g. BTFP, TLTRO) it also expands the liability side - it prints ''money'', but to be more precise it prints bank reserves.
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Bank reserves are bank-money, not real-economy money: only banks can transact in bank reserves with each others, and these reserves can never (I repeat, never) reach the private sector.
Banks DO NOT buy stocks with bank reserves!
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Banks DO NOT buy stocks with bank reserves!
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The idea behind the ''famous'' chart is just wrong: as the Fed creates new bank reserves (''liquidity'') there would be a mechanism for which banks deploy these reserves in financial assets hence pushing equity markets up.
But banks don't do that.
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But banks don't do that.
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What are reserves (''liquidity'') used for?
Mostly to settle transactions against other banks.
They also account as a High Quality Liquid Asset (HQLA) together with government bonds and certain corporate and mortgage-backed securities.
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Mostly to settle transactions against other banks.
They also account as a High Quality Liquid Asset (HQLA) together with government bonds and certain corporate and mortgage-backed securities.
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I know what you are thinking now: the portfolio rebalancing effect.
If banks are bidding corporate bonds away from each other's HQLA buffers, spreads will tighten and this should invite a more aggressive stance from equity investors too.
That's partially true...
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If banks are bidding corporate bonds away from each other's HQLA buffers, spreads will tighten and this should invite a more aggressive stance from equity investors too.
That's partially true...
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...but it's a potential second-order effect which also requires fundamentals (!) to back the thesis: banks aren't gonna blindly over-allocate to corporate bonds because they have more reserves if they smell the risk of rising defaults.
2008 is a good example.
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2008 is a good example.
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These two series trended up over the last 15 years for different reasons:
- Central Banks kept accommodating through QE (''they added liquidity'')
- The Nasdaq went up because tech stocks delivered excellent earnings, had strong balance sheets, and low rates helped
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- Central Banks kept accommodating through QE (''they added liquidity'')
- The Nasdaq went up because tech stocks delivered excellent earnings, had strong balance sheets, and low rates helped
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Don’t believe me yet?
Let’s do some basic math.
If it's really true that ''liquidity'' drives stock market returns, regressing one against another should show liquidity has excellent explanatory power.
It doesn't: only 3% (!) of SPX returns can be explain by liquidity
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Let’s do some basic math.
If it's really true that ''liquidity'' drives stock market returns, regressing one against another should show liquidity has excellent explanatory power.
It doesn't: only 3% (!) of SPX returns can be explain by liquidity
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Central Banks pumping ''money'' into the ''system'' and driving stock higher is an easy narrative to follow
But it's plain wrong: bank reserves are not used to buy stocks, and simple math shows ''liquidity'' doesn't have explanatory power on future stock returns
Finally...
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But it's plain wrong: bank reserves are not used to buy stocks, and simple math shows ''liquidity'' doesn't have explanatory power on future stock returns
Finally...
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