If there’s two things I’ve learned from Macro trading – it’s the importance of market liquidity (the flow of money). And understanding short-and-long term debt cycles.

Both of these things work together hand-in-hand. But I believe liquidity conditions set the stage for the debt cycle.

For instance – if there’s ample liquidity – then debtors can continually borrow more and at lower rates (expansionary). But if there’s less liquidity – debtors must borrow less and pay higher rates (tightening).

Even infamous traders like Stanely Druckenmiller and George Soros have preached many times before how important liquidity is for moving markets – both up and down.

Like the brilliant traders at Macro-Ops wrote:

“… With the rise of “blind investing” in the form of passively buying and holding ETFs, the majority of investors don’t care about valuation or merit. They just auto-shuttle their excess funds to the nearest robo-advisor without a second thought.

This amount of “excess funds” is largely dependent on liquidity conditions.

When liquidity is loose, it’s cheap to get levered. People have extra cash and plow it into risk assets. Prices rise.

When liquidity is tight, people have less cash to spend. They may even sell stuff to service their existing debt. Prices fall…”

Now – it’s easy for someone to find and measure debt loads – but measuring liquidity is much harder. . .

That’s why one of my favorite ways to measure liquidity is to look at the National Financial Conditions Index (NFCI).

Let me give you some context. . .

The NFCI is measured and posted by the Chicago Federal Reserve. And it’s made up of over 105 different indicators that track financial activity – like what’s going on in money, debt, equity markets – and even the “shadow banking” system.

Combine all this together – and you get a nice, easy-to-read way of measuring market liquidity. . .

Keep in mind that the NFCI reads inversely – meaning any reading above zero signals tightening monetary conditions (drying liquidity). And anything below zero signals easing monetary conditions (flush with liquidity).

To give you some perspective – when the index spiked above zero (tighter conditions) in 1973, 1980’s, 1991, 2000, and 2007 – harsh bear markets and economic recessions occurred.

So – where things are today?

According to the NFCI and ANFCI (the Adjusted National Financial Conditions Index) – despite the Fed’s rate hikes and Quantitative Tightening (aggressive tightening) – monetary conditions are still ‘loose’.

What gives?

It could be that corporations are now flush with cash – thanks to the Trump Tax Cuts – and that banks still have trillions worth of reserves from the Fed’s Quantitative Easing (QE) years.

Not to mention – the slowing growth and calamity abroad in the Euro zone, Emerging Markets, and Asian economies have pushed investors to park their cash in the U.S. – giving banks even more excess money.

All this liquidity works to counter-balance the Fed’s own tightening.

So – with this all loose monetary conditions – we should be bullish, right?

Well, not exactly.

You see – the NFCI is made up of three important sub-indexes:

First – the ‘Risk Sub-index’ – which looks at volatility and funding risk within the financial sector. . .

Second – the ‘Credit Sub-index’ – which looks at measures of credit conditions. . .

And Third – the ‘Leverage Sub-index’ – which studies debt and equity measures. . .

All three are important to watch – but the Leverage Sub-index is what I believe is the most critical to study.

For starters – it’s a ‘leading-indicator’ (any economic factor that changes before the rest of the economy begins to go in a particular direction).

And secondly – since we live in a credit-based world (just like Ludwig Von Mises, Hyman Minsky, and Knut Wicksell all wrote) – leverage is what drives the boom and bust cycle.

For instance; when leverage is cheap (low rates), people borrow more than they should and bid up riskier assets – pushing prices higher (the boom phase). But when leverage is expensive (higher rates), people borrow less – and even liquidate riskier assets to pay back debts – pushing prices lower (the bust phase).

So – what can we learn from this key Sub-index today?

That leverage has tightened significantly over the last 12 months. . .

To give you some context – this time last year, it was at negative -0.61. But now it’s only negative -0.26 (remember, the closer to zero and above – the tighter conditions are).

This indicates that the cost of leverage is becoming much more expensive. And according to Minsky and Von Mises – could signal the end of the debt-cycle as this this trend continues.

For instance – U.S. non-financial corporate debt as a share of GDP is now at an all-time high.

Clearly these firms took advantage of the ample liquidity and low rates to binge on debt. . .

And making matters further dire – there’s a wall of corporate bonds (both high-yield and investment grade) set to mature over the next four years – with $3.5 trillion coming due in the next three years alone.

At this rate – these firms may end up forced to roll over their debts (refinance) when the cost to borrow is much higher – or worse – the economy’s in a recession.

This puts the markets in a fragile position if liquidity dries up (monetary conditions tighten) during a time when entities need trillions in new financing. . .

So – for now – the NFCI/ANFCI indicates loose monetary conditions (ample liquidity).

But the Leverage Sub-index trend indicates sharp tightening (especially over the last year). This makes sense especially as short-term borrowing costs have risen alongside the Fed’s rate hikes (which has inverted the yield-curve as investors fear an approaching recession).

This could spell trouble later – especially with so much dollar-denominated debt coming due (domestically and abroad) . .

So in conclusion – by using the NFCI/ANFCI – we can track monetary conditions.

For now – things don’t look like they’ll collapse overnight as long as liquidity remains loose. But this is something that can change very quickly.

So stay on guard.

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