The growth rate in liquidity flows is slowing. Investors should take notice because the slower growth in the all-important liquidity flows index is occurring when the growth rate of nominal GDP is rebounding, absorbing a bigger piece of the pie. The lead-time before changes in liquidity flows show up in the economy is about 6 months and half as fast in finance.
Liquidity Flows Index
The statistical branch of the Bureau of Economic Analysis (BEA) created the liquidity flows index* decades ago. The initial index had three components: the level of real broad money, the change in business and consumer credit, and the change in liquid assets. The liquidity index had a nearly flawless record foreshadowing change in the economy and finance. It should because it captured all the way transactions can be financed, cash, credit, and savings.
Budget cutbacks forced BEA long ago to stop publishing this and other series. BEA provided me with the methodology to maintain the series. I made one change in the initial design, adding the new flows into stock and bond funds in the liquid asset component.
The original liquid asset series excluded bond and stock mutual funds because they did not meet the Federal Reserve definition that a liquid financial asset had to have a maturity of less than 12 months. But fundamental changes and technological advances in finance have made bond and equity mutual funds highly liquid assets. In other words, funds could be transferred, quickly and cheaply, to bank accounts and available to spend the next business day.
The statistical branch at BEA reviewed the re-designed series. Based on a broad set of criteria the revised index scored very high, even slightly above the original series. It has been a trusted indicator foreshadowing changes in the economy and finance long before it shows up in the hard data.
To be fair, the slowdown in the liquidity flows index has only started to emerge in the past two months. For example, the monthly growth rate in broad money (M2) in July was a mere 0.9% versus an average gain of 4.2% over the prior four months. Adjusted for inflation, real money growth barely rose in July. Also, the growth rate for business and consumer credit growth turned negative in June and again in July, following a long string of monthly gains.
The liquid asset component consists of the old M3 plus saving bonds, commercial paper, short-term Treasury securities, and new flows into bond and equity funds, are reported quarterly. Based on available data the growth rate in liquid assets remains positive.
However, the three components have equal weights. So the weak trends in broad money and credit do point to a significant slowdown in growth rate in the overall liquidity flows compared to what took place when the Federal Reserve launched its cannons of liquidity back in March.
The current slowdown in liquidity flows is unusual. That’s because the growth rate of liquidity flows slows when there is a sustained rise in interest rates, driven by a mark-up of official rates. But this time market and official rates have not changed. Perhaps the drop in the growth rate of liquidity flows will prove to be only temporary, as money and credit conditions level off from the huge Fed-induced gains in the spring.
Liquidity flows are the "lifeblood" of economic and financial cycles. I recall the sharp break in liquidity flows in early 2000 proved to be the tipping point for the crack in the tech-driven equity market. With price/earnings ratios equal to or even above the levels of 2000 equity markets are most vulnerable to a sustained slowdown in liquidity flows. The speed of the sell-off could prove to be lightning-fast since markets are driven nowadays by computers and algorithms. Stay tuned.
*The liquidity index was originally called "Money and Financial Flows Index".