Financial System Liquidity

My broad measure of credit driven liquidity is down 1.5% yr / yr,
and has decreased at a 4.0% annual rate over the past 6 mos. With
deep recession and its immediate aftermath, private sector credit
demand has been declining. The weakness shows not just with
shadow banking, which has collapsed, but with the banking system's
loan book as well. The big roll-off on the banks' book is business or
C&I loans. Readers will recall I have discussed this probability for
months, and also that the C&I loan book could decline significantly
for another year or so. The banks are charging off the loans that
some businesses cannot service, and viable companies are
reducing exposure because with business depressed, working capital
needs have shrunk. Moreover, as the economy recovers, many
companies will generate cash flow well above spending needs, at
least in the early stages.

Monetary liquidity -- the narrow money supply -- is up about 15%
yr / yr, and this has been, as always, the platform to turn the
economy positive. Monetary liquidity represents only 10 -15% of
the broader measures of financial liquidity and cannot sustain an
economic expansion for very long without a positive turn in private
sector borrowing, but it is the kick starter. The Fed, for seasonal
reasons, is presently allowing monetary liquidity growth to
accelerate via its open market activities.

Despite a reduction in the broader credit driven composite, the
velocity of money has declined sharply, as the cyclical economy is
down much more yr / yr. The excess liquidity thus created has
supported the cyclical recovery in stocks, although it should be noted
that velocity has started to recover and that excess liquidity is
easing. A "V" shaped recovery, suggested by the leading indicators,
would likely bring down excess liquidity rather rapidly and give stocks
much less of a tailwind.

The world's major central banks are keeping large currency swap lines
to cushion the decline in global capital flows fostered by the 2007-08
credit crunch and a collapse in global trade. The outflow of US dollars
through the trade window is down 50% over the past 2 years.

Banking system loan loss reserves have increased only modestly in
recent months following a large leap from late 2007. Even so, bank
capital remains flat as cash flow is moderating on a declining loan
book. Thus, as the economy recovers, and with it private sector loan
demand, more than a few banks will need to raise additional primary
equity capital.