Liquidity Cycle

The liquidity cycle is moving into its latter stage when funding for the economy and the capital
markets is more strongly dependent on private sector credit. The Fed's balance sheet and the
monetary base have been flat for the past 15 months. The growth of the basic money supply has
been decelerating from very high levels since late 2011, and is now around 5% yr/yr. Thus, M-1,
though shrinking, remains a source of support the economy. Total private sector funding growth
remains around 5% yr/yr. It exceeds the demands of the real economy which, in sum, has been
growing at about 3%. So, excess liquidity is being generated, which with negligible short term
interest rates and inflation, continues as a source of support for both equities and bonds so long
as investor confidence is not seriously shaken.

It appears that when the Fed raised short rates late in 2015, it triggered a very temporary liquidity
squeeze as fixed income managers of varied stripes went to vault cash to avoid losses on cash
equivalent securities. The monetary base wound up shrinking by about $350 billion in Jan. of the
current year. The funds have subsequently been re-placed. Only God knows who may have made
money on these stunts, and sadly enough, it may have made the sell-off in equities in Jan. worse
than it need have been. It will be interesting and important to see whether folks 'bury' funds again
the next time the Fed pushes up rates. Bonus compensation programs can add excitement to the
game. No?

It is important to note that when the Fed freezes its balance sheet and the monetary base, both
economic and stock market risk rise. The collapse of the oil price notwithstanding, the stock market
and the economy have struggled since late 2014, when the huge QE 3 program ended. The
transition away from monetary-driven liquidity to credit-driven has been difficult. Hopefully,
the recent rise in the short term leading economic indicators signals a brighter time ahead.