Liquidity Check

The Fed reversed the big infusion of two weeks ago, so the
growth of monetary liquidity remains modest. The temporary
liquidity injection may have added modestly to the basic
money supply, which needed a transfusion.

The broader, credit driven liquidity measure I utilize did
accelerate markedly in April as banks returned to the
real estate market and C&I loans moved up. Yr/yr, my M-3 proxy
is now up 10.2%, high, but in line with the growth of short term
credit demand. Seasonally, we are moving in to a stronger period
for home sales, but I was still a little surprised by the
size of the move up in the real estate book.

The financial system is generating more liquidity than is required
for current dollar economic output, leaving excess liquidity in the
system to fuel financial and commodities markets in favor. since
the volume and diversity of derivatives also continues to grow there
is rich leverage behind the markets. On top of this, the US trade
deficit widened in March, sending more $ abroad. To this hefty brew
we can add the new rule change in China which allows its commercial
banks to diversify IM accounts away from Chinese securities (It will
be interesting to see whether the "big" money in China starts to
exit Shanghai and Shenzen to leave the smaller retail accounts holding
the bag.)

There is a small but growing chorus of markets observers who are
starting to warn of the risks of markets inflated by credit driven
liquidity. I have mentioned a number of times that markets powered
by credit driven liquidity are riskier than when markets are supported
by monetary liquidity growth. In the latter case, you have central
banks on your side.

One economic possibility that all need to watch concerns the US. If the
domestic economy re-accelerates and there is a little bounce in inflation
pressure as well, the excess liquidity will fizzle quickly, gobbled up
by the real economy. I have been cautious on stocks this year because I
am interested in seeing how well the balance of economic supply and
demand may shape up once the economy shakes off its torpor. So far, that
concern has proven premature given a sluggish environment. Perhaps worse
for me, I may well wait until autumn to see whether the cautious approach
pans out or not.