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Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!

Thursday, April 28, 2011

Liquidity, Profits and Inflation Cycles

I have not done a major liquidity cycle piece since 2008, when I wrote to mark the bottom of
the last liquidity cycle. This is a general, context setting piece and I plan to do more focused ones
going forward. But first, let's establish the general themes of the expanding part of a liquidity
cycle:

Liquidity
The prior liquidity cycle bottomed over 04/2007 - 06/08 period as the Federal Reserve completed
the process of draining reserves from the financial system as a deep credit crunch took hold. The
new liquidity cycle began over Half 2 '08. The current up-wave in the cycle is the strongest since
the wake of the Great Depression, and, like then, has been highly dependent on quantitative easing
to furnish the liquidity to turn the economy around. Although cycles of growth of monetary liquidity
can stay positive for long periods of time, momentum tends to peak in the early part of a cycle. (The
most recent lengthy liquidity cycle took place over 1982-89 in the wake of a global economic bust.)

The Fed has moved from slashing short term rates to an extended ZIRP which could last for a nearly
four year period if the recovery is shallow. The Fed has also reserved the option of additional
QE if it deems a tepid, unsteady economic recovery warrants it.

Markets players have greatly overdramatized the financial consequences of QE in this cycle. When
one looks at the broader measures of money and credit funding, one sees that the $2 tril. of QE has
not fully offset the liquidation of funding from other major sources such as no reserve jumbo
bank deposits and commercial paper to name just two.

Short Term Business Credit Demand
This factor has its own cycle and plays into the broader liquidity cycle. Rising loan demand is
a key element in Fed policy to raise rates, and the prospect of falling loan demand is central to
development of an accomodative monetary policy. From its peak in late 2008, business short
term credit demand was liquidated by an astounding 26%, and has only recently began to turn
higher. Credit demand vs the supply of loanable funds will not even move up to equilibrium
levels for another few months, at which time the Fed should think more carefully about Its ZIRP.

Corporate Profits
A postive turn in the liquidity cycle leads a rebound in corporate profits by roughly six months.
The profit cycle turned up in early 2009 from extremely depressed levels and the jump in profits
has been the strongest since the early post WW2 recovery. At this point, the strength of the
present liquidity cycle indicates profits could continue expanding well into 2014. On this
analysis, the Fed would need to dramatically reduce Reserve Bank Credit before alarm bells
would go off in the years straight ahead. (Just remember there are other important determinants of
profits as well.)

Special Note: There is prima facie evidence in this cycle that even freezing Reserve Bank Credit
without a more robust round of private sector credit demand in place could damage business
confidence and possibly the economy. When the Fed winds up QE 2 on 6/30, it will be very
important to see how confidence and the economy is affected. I'll be less concerned if we see
private sector credit demand picking up the slack. Keep that May - Aug. 2010 slowdown interval 
in mind.

Inflation
Cyclical acceleration periods of inflation follow upturns in the liquidity cycle. The lag time here
can be a year or longer. A powerful liquidity cycle such as the US is now experiencing does not
assure a strong cyclical acceleration of inflation to follow. There are simply too many other key
variables to consider. But it is safe to say that a strong liquidity cycle does raise a red flag about
inflation and should force analysts to look long and hard at all of the determinants of inflation
including global  economic supply/ demand and operating rates, the trend of commodities prices,
credit and wage rates to name the majority of factors. In this regard, it is important to note that the
US is coming off the most depressed operating base since the Great Depression, has a continuing
weak labor market and is less susceptible to the inflationary potential of rising commodities
prices than are many other economies.

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