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How Liquidity Gauges the Confidence of Crowds

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Markets and social mood are closely connected. And liquidity and credit are the best barometers for understanding both of them.

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As Todd Harrison says, "where you stand is a function of where you sit." And where you sit is largely dependent on what you did to get in that chair. So goes the process of price discovery. Although we're barely six weeks into the year, we've seen a few themes start to emerge largely as a function of where we ended 2011.

The first is Europe, which shouldn't surprise any of us. This isn't just a Greek tragedy, it's a Greek tragedy while watching paint dry. The endless barrage of budget cuts, finance minister meetings, and false hopes is taking a toll on everyone, and the stakes for Greece are the biggest of all.

The other theme that keeps coming up is liquidity. While the indices are all up on the year, the lack of volume powering this move is mentioned in the very next breath. Why is that important? Because volume is a key metric in understanding market health.

Volume is also an important indicator of market liquidity, which has been on a lot of people's minds for a long time. The problem is, liquidity is used so often and in so many different ways that nobody really understands it anymore. It's like the old Supreme Court ruling on pornography played in the key of market indicators: I may not know what it is, but I know it when I see it.

Recently the Bank for International Settlements and European Central Bank held a workshop devoted to trying to understand liquidity. In a speech by ECB Board Member Benoit Coeure, liquidity was broken into two components: official and private. In Coeure's speech, official liquidity is "the funding that is unconditionally available to settle claims through monetary authorities":

Official liquidity can be generated through various instruments. Central banks can create it in their domestic currency through regular monetary operations or through emergency liquidity assistance. In addition, authorities can provide official liquidity in foreign currency by selling foreign exchange reserves and through swap lines between central banks.
Private liquidity comes from "cross-border operations of banks and other financial institutions, and increasingly within the shadow banking system." If you read those definitions carefully, the difference between the two should be clear.

Official liquidity mostly deals with an economy's money supply. The Federal Reserve's quantitative easing programs have been an attempt to increase money supply by buying Treasuries and mortgage-backed securities. The purchases were in turn supposed to lead to an increase in lending by banks to consumers and businesses. The linchpin to the strategy was boosting the "liquidness" of Treasuries and MBS by purchasing them from banks and giving the banks cash in return. Why? Because you can lend cash a lot easier than you can securities.

Private liquidity, on the other hand, has nothing to do with an economy's money supply and everything to do with confidence. How? The Fed's activities have been focused on cross-border lending and the shadow banking system. A recent report by Fitch showed that as of the end of last year, money market funds have cut their eurozone asset allocation by roughly two-thirds since their peak in 2009.

Another asset class that used to be included here was commercial paper, and asset-backed commercial paper (or ABCP) in particular. ABCP was a key funding instrument for shadow bank entities and a favorite investment vehicle for money market funds. That market has been napalmed.



The question is why? How did this all go wrong? Dirk Bezemer puts it thusly (hat-tip Credit Plumber):

This is indeed a credit crisis, in two senses. First, its most urgent symptom is banks' inability to continue their social function of providing credit to society: there is a liquidity crisis. But underlying this symptom, there also is a credit cause for the crisis. This is the neglect of the basic accounting fact that every credit is accompanied by a debt. In that sense, the credit crisis really is a debt crisis. Society has neglected to ensure that credit would be directed towards self-amortizing investment, with real returns that would allow the paying off of debts. Instead, credit flows have led to the accumulation of debt, balanced for a time by rising asset values. Their plunge left the banking sector with a large net debt, ruined balance sheets and incapacitated to serve the economy well.

So what we've suffered from has been a problem of extremes in confidence. As Peter Atwater suggested (See Europe: Truly Prepared for a Greek Default or Merely Overconfident?):

Based on the work that I have done, it is evident to me that changes in our level of confidence change what we believe and the decisions we make, both individually and as groups. One of the negatives of rising confidence, however, is that it makes us feel more certain about the future. The result is that we often believe that we are more prepared than we really are. (And in extremes of overconfidence, we view preparedness largely as unnecessary.)

In the early to mid aughties, banks and society at large didn't see the need to prepare for declining asset values. Social mood was positive and horizon preferences were long range and expansive. "Things will stay like this forever and it will be the same everywhere" could've been a mantra for that era.

But then, that confidence got shaken to its core. This chart on total bank credit shows our confidence is still in need of repair. Because credit is the ultimate expression of social mood: lending money today on the promise you will get your money back some time later.



Europe poses a big test of the nascent confidence we're starting to see, and our recovery in general. If Clint Eastwood is right, the second half is coming, and we'll bring our A-game. If he's wrong, we may spend the second half watching the clock, hoping and praying for the game to end.

Twitter: @japhychron
No positions in stocks mentioned.
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