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April 24, 2006

Where's The Liquidity?
by David Yu

Many of us assumed that the Federal Reserve ceased reporting M3 aggregate money supply so that it may conceal its attempt to flood the system with even more liquidity. While we may still be correct in our assessment, there's no sign of liquidity "flooding" so far.

Even without the latest M3 data, it's not all that difficult to keep track of the general money supply. We can still keep track of M2, which is the largest of the three money supply components. Excluding M2, the rest of the M3 is only about half of M2. And, there's an almost perfect (0.99) correlation coefficient between the increases of M2 and M3. Chart 1 displays this positive correlation (or covariation) from May 2004 to March 6, 2006, the final release date of M3 data. When two things co-vary as closely, it means that the change of one thing is concomitant with the change in another. And the change of M2 has shown no signs of flooding effect thus far.

Chart 1

Chart 2 shows that since the beginning of March, the discontinuance of M3 data, M2 has been moving closer and closer to its 10-week moving average line (red line). This indicates a slowdown in M2 money supply. This slowdown in money supply can also be seen on M2's 26-week ROC (Rate of Change) chart.

Chart 2

Chart 3 shows the 26-week (half a year) M2 rate of change declined from the January high of 3.55% to 2.47%. For the week ended April 10, M2 actually declined by approx. $24 billion from the previous week. And, the almost prefect correlation coefficient between M2 and M3 indicates that this slowdown in M2 is concomitant with the slowdown in m3 money supply.

Chart 3

In addition, the Fed's REPO activities have also shown signs of slowing down lately. The weekly total of $39.25 billion, for the week ended April 21, is below the 12-month average (red horizontal line) of $42 billion and is almost the same as the same period a year ago. Blue arrow also shows that weekly repo has been forming lower highs since the final weeks of December.

Chart 4

Thus, while it's evident that the overall money supply has been slowing down lately, billions of cash continue to flow into the equity market. Chart 5 shows that since the beginning of the year there's more net cash inflow into the equity funds than ever (higher curve in blue circle). Equity fund inflows totaled approximately $44 billion year to date.

Chart 5

If the Fed had little to do with this, then whoda?

The foreigners. Other things being equal, the foreigners, particularly the foreign private investment, may have contributed to the recent rise of liquidity in the equity market. Over the last 6 months, the Total Net Foreign Purchases of U.S. Stocks increased by $83.13 billion, according to the Department of Treasury. This is $63.24 billion more than the prior 6-month period. 98% of the net purchases were by foreign private investors. For the last 12 months, the foreigners net purchases of U.S. stocks totaled $103 billion, which is 255% higher than the 12-month period prior to that.

Total Net Foreign Purchases of U.S. Equities is the difference between the Gross purchases by foreigners of U.S. equities from U.S. residents and the Gross sales by foreigners of U.S. equities to U.S. residents. Chart 6 below shows that since the final months of 2004 (red arrow), foreigners have purchased more U.S. equities from U.S. residents than U.S. residents have bought these U.S. equities back from the foreign investors. This net foreign purchase (inflow) since the final months of 2004 amounts to approx. $140 billion. The Fed is by all means fully aware of this. And, that may explain why there's no need for the Fed to increase money supply as of yet.

The question then is what dives these foreign private investors to the U.S. equity market?

Chart 6

Most prominently, the greenback. Chart 7 shows that towards the end of 2004, the USD hit the bottom and began to bounce back. The dollar index then went on to close at 92.39 in November of 2005 - a gain of almost 15% in about 11 months. This is why these foreign private investors, who, as I've referenced in my Competitive Tightening thesis, "control increasingly large amounts of assets that they can move around globally in search of high profits," flocked to the U.S. equity market. However, they can leave (i.e. Iceland stock market) just as quickly as they came.

Chart 7

The USD has experienced further deterioration since I used this chart (Chart 7) in my 3/26/2006 article; it has depreciated another 2.25% in less than a month, and the Slope indicator in the lower pane has made another lower high before it dropped below zero once again. Fortunately, few have abandoned the ship yet. The anticipation of further rate hike by the Fed has kept most foreign investors at bay, which has in turn kept the U.S. equity market afloat.

But, as I've mentioned before, the Fed is no longer the only central bank of the world that's competing for the global capital flows. In this cycle of global competitive tightening, it'd take more than just a steady increase of interest rates to stabilize ones currency. The dollar's reserve currency status has given it unparalleled advantages. But the recent change in the Chinese currency regime "may be the beginning of the unraveling of the so-called Bretton Woods 2 regime, a regime that has allowed until now the cheap financing of the U.S. twin deficits," said Nouriel Roubini, Professor of Economics and International Business Stern School of Business, New York University. For more details, please refer to Part III of my Competitive Tightening article. At any rate, it'd be a disaster if higher U.S. interest rates, which have already started hurting the demand side of the economy, aren't even enough to attract foreign private investors.

One thing, at least for stock investors and traders alike, to keep an eye on is the red dot on Chart 6 above. That's where the recent high of foreign net purchase took place. In September 2005, total net foreign purchase of U.S. stocks reached $23.02 billion. Whether or not, foreign investors have started to leave depends on whether this high can be surpassed in the future.

David Yu,
Davids Stock Market Chartmentary
email: david_3011 @ yahoo.com
Space before and after @ was left intentionally to avoid spamming. Please remove this space when sending your emails.

Copyright © 2005-2008 David Yu

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