In this post, we’ll unpack all you need to know about global liquidity, defining exactly what it is, what drives it, why it matters, how it influences assets and more.
What Is Global Liquidity?
Global Liquidity is a wholesale measure of balance sheet capacity that captures flows of savings and credit through the entire World financial system.
In other words, GL refers to how much capital is free to be used in the economy for asset purchases in the financial economy and investment, trade and consumption in the industrial economy.
T-bill issuance and bank balance sheets are the new drivers of asset prices.
Global Liquidity As Collateral
Collateral is crucial to maintaining the supply of liquidity. Capitalism needs growth. Growth requires credit. Credit requires collateral.
Debt needs liquidity for refinancing. Liquidity needs good quality debt for collateral.
Liquidity = Balance Sheet Capacity
What Drives Global Liquidity
There are 3 key drivers of global liquidity:
- The size of central bank balance sheets — specifically the Federal Reserve and the People’s Bank of China (PBoC).
- The size of commercial bank balance sheets.
- The size of collateral held by banks that can be easily converted into cash through the repo market.
Other influencing factors include bond volatility, term premium and yields. As treasury prices decrease due to higher yields, the ability to turn collateral into cash decreases, reducing liquidity in the system.
All the money that is anywhere must be deployed somewhere.
How To Measure Liquidity
Liquidity is a measure of how easily an individual or company can meet its short-term financial needs.
Therefore, as a formula, liquidity can be expressed as follows:
Liquidity = (Assets Owned – Debt Owed) / Duration
For example, $50,000 – $20,000 / 6 months = $5,000 Per Month. If an individual or company needs less than $5,000, they will survive.
Why It Matters
GL directly influences market movements and therefore, by extension, asset prices.
For example, global liquidity has a 97% correlation with the NASDAQ…
…and an 85% correlation with Bitcoin.
So essentially, GL is a leading indicator. In fact, it’s the leading indicator.
Specifically, it leads asset prices by roughly 3-9 months, as illustrated in the chart below that shows the correlation between GL and Bitcoin with a 13-week lag.
The Global Liquidity Cycle
Just like everything else, global liquidity moves in cycles which tend to span 4-6 years, as illustrated in this chart by Cross Boarder Capital.
The Global Liquidity cycle is a debt re-fi cycle.
The GL cycle works through alternating phases of liquidity expansion which is when liquidity increases and liquidity contraction which is when liquidity decreases.
When liquidity increases, there is more capital available for investment which drives asset prices up.
When liquidity decreases, there is less capital available for investment which drives asset prices down.
Global Liquidity & Interest Rates
Interest rates should be understood as the premiums paid to access future liquidity at different times and with varying certainty and not the price of money, which is always the exchange rate.
Interest rates are a weak indicator of financial conditions and capital flows. Global liquidity is a strong indicator of financial conditions and capital flows.
While interest rates do influence liquidity to some degree, the overall trend of GL — whether it’s increasing or decreasing — has a greater impact on asset prices.
This is because, for example, rate cuts, which are typically associated with increased stimulus, can decrease liquidity because cheaper borrowing encourages more debt and refinancing, which ties up cash.
Global Liquidity Sensitivity
Different assets possess different degrees of sensitivity to changes in GL.
Historically, for every 10% move either up or down in GL, commodities tend to move by ~11%, the S&P 500 tends to move by ~13%, gold tends to move by ~15%, and Bitcoin tends to move by ~50%.
Global Liquidity & Financial Stability
Financial stability requires a near-constant ratio between the total stock of debt and the total pool of liquidity of ~2.5:1. In other words, for every $100 of global debt requires roughly $40 of liquidity to refinance it.
Rising debt requires more liquidity for refinancing. Rising liquidity demands more debt for collateral.
Too much debt relative to liquidity leads to financial crises because debts mature and cannot be rolled-over.
Too much liquidity relative to liquidity leads to financial bubbles because of monetary inflation.
In other words, there’s a goldilocks zone. If debt and liquidity are in balance, the economy can grow sustainably without financial crises or bubbles, as illustrated in the chart below.
Financial booms climb a wall of worry. Financial crises strike a wall of debt.
Why Liquidity Must Increase When Governments Refinance Debt
- Governments accumulate large amounts of debt that eventually mature.
- To repay the maturing debt, governments must issue new debt (rollover).
- For this new debt to be absorbed by markets, buyers must have enough cash and credit (liquidity).
- Central banks inject liquidity into the financial system (via asset purchases and looser monetary policy).
- Increased liquidity boosts demand for government bonds because investors have more cash to deploy and are incentivised to seek yield in safe assets.
- Increases demand for government bonds keeps borrowing costs low and enables smooth debt rollover because it pushes bond prices up and yields down, reducing the interest burden on new debt issuance.
Summary (TL;DR)
Global liquidity refers to the availability of cash and credit in financial markets.
The main drivers of GL are the size of central bank balance sheets, the size of commercial bank balance sheets and the size of collateral held by banks.
GL operates in alternating cycles of liquidity expansion and liquidity contraction which tend to span 4-6 years. When liquidity increases, there is more capital available for investment which drives asset prices up. When liquidity decreases, there is less capital available for investment which drives asset prices down.
GL is important to understand because it directly influences asset prices.
