Liquidity Review

For a variety of reasons, central banks having been increasing "money" supply like gangbusters recently, the ultimate future effect being even more increases of the price of the stuff we need for every day survival. In April of 2005, Jim Sinclair (jsmineset.com) wrote a piece on liquidity which is good to review now since this action is going to extremes right now:


"Tonight, let’s talk about liquidity. Liquidity in the traditional sense is a product of Federal Reserve money market activities.

In the case of open market operations, the Fed constantly buys and sells U.S. government securities in financial markets, which in turn influences the level of reserves in the banking system. These decisions also affect the volume and the price of credit (interest rates).

The term "open market" means that the Fed doesn't independently decide which securities dealers it will do business with on a particular day. Rather, the choice emerges from an open market where the primary securities dealers compete. Open market operations are the most frequently employed tool of monetary policy.

In the non-traditional sense, liquidity became not a national equation but an international phenomenon. As the Bernanke Electric Mayhem Money Printing Press began to function, there was no consideration of bank reserves as a major tool of monetary policy nor was the dealership traded with just the Wall Street crowd. Also included were the City in London, the Banhofstrasse and all others willing to offer US Treasuries across all maturities.

The funding for this operation was not an internal exercise of the normal Fed blank check but rather the huge intervention Japan was practicing in order to maintain a non market related dollar/yen level.

Liquidity under the definition of the non-traditional method was international and in a practical sense out of control. That conclusion is best explained by the fact that the US Treasury instruments purchased cannot be sold nor can the liquidity injected into the system be withdrawn.

Liquidity is not the grease of the wheels of business but rather the grease of the wheels of the market that it selects to chase. When a particular market's wheels are greased, it moves faster on the UPSIDE.

In the 1930s when there was a de-linking of currency from gold and international liquidity was increased, a huge rally in the equities market took place. Today, the excess liquidity in the system has selected the equity market to follow.

The thesis pointed out by Chairman Greenspan is that liquidity injections affect the equities market which in turn impacts the thinking and actions of consumers and business executives producing a business activity recovery.

You just experienced that and during the Bernanke experiment, the equities market achieved its high water mark in this counter-trend rally in a long term equities bear market. This is a simple replay of the 1930s with one major difference: Today, the largest amount of liquidity ever injected into the world monetary system in the shortest time in history CANNOT BE WITHDRAWN.

As the equities market was making new highs, the shift began in this liquidity juggernaut from equities into commodities and the CRB was making new highs as equities made new highs. That is an unsustainable phenomenon because of the impact on profits as raw material rise in price. Something had to give.

What may well have given up the ghost is the equity market but the liquidity is STILL OUT THERE now looking for a new home. The difference between the huge equity rally of the 30s and today is the critical component of NO PRACTICAL METHOD OF LIQUIDITY WITHDRAWAL. Indeed, it will also be the MAJOR FACTOR in forming the future.

The inability of the Federal Reserve to drain liquidity negates any possible increase in the cost of money to dampen the impact of a mountain of Bernanke-produced liquidity. While that liquidity was pleasant at first, it will now blast any commodity with positive fundamentals up to heights that cannot be easily explained. Look at crude today as one example.

It is this mountain of liquidity that will pounce on the dollar and ram gold through $480 and to $529 and in time to over $1650. The reason is that there is no tool or policy to drain this international liquidity until it exhausts itself in its own bubble. That bubble will form from this moment forward to blow its top between 2011 and 2013. The game has just begun!

A few salient points:

1. Liquidity is the placement of cash into the hands of financial institutions - not businesses or the common man.
2. Those financial entities will put this new found cash to work in some form or another.
3. It is normal that their first target will always be the equities market.
4. The positive action of the equity markets impacts the decision making powers of the consumer and the companies that provide them with consumer products.
5. The positive decisions of consumers and producers will produce a recovery in economic indices.
6. In time, this liquidity - sensing that the equities market should be distributed and profits taken - will begin to accumulate cash again.
7. As cash is accumulated by the now Fatter Cats, it transitions to the commodities market with positive basic fundamentals.
8. For sometime, both the equity and commodities markets move up in tandem.
9. The cost of basic goods increase and profits are reduced as the cost of goods produced climb.

In normal circumstances, the Fed steps in draining liquidity in the traditional sense thereby increasing the cost of money and killing the entire party.

However, now the international explosion of liquidity cannot in any practical sense be drained, so anything with a clear fundamental case in commodities will be blasted to the moon beyond the capacity and knowledge of talking heads to understand. No one outside of you will understand why this locomotive of inflation, which does not depend on business activity, can be blunted in its power or impact on prices by interest rates.

Now you have to add currencies to the game because this is the largest of all markets into which this liquidity must go. So those currencies with positive fundamentals will go up beyond reason and those with negative fundamentals will go down beyond reason.

This is why I have been saying against all other advisors that the currency market is the most fundamental of all markets. Here the fundamentals will flatten the technicals, bottom callers, the Chairman of the Federal Reserve, soothsayers and anybody else that assumes any short covering rally is meaningful or long term.

Interest rates have NO ability whatsoever to blunt anything except the hope of a reduction in the US Federal Budget Deficit. They only serve as another tax on the consumer and business and thereafter on individual income and corporate profits. Therefore, there is no question in my mind about the US dollar plunging below .8000. That being said, gold is going to $480 and $529 and in time to $1650."