Tracking global liquidity is essential because it influences all assets, which has significant implications for portfolio construction. However, analysing global liquidity is complex: while measuring the initial supply is relatively straightforward, understanding how it spreads and multiplies is challenging.
Executive summary
- Tracking global liquidity is essential because it influences all assets. Liquidity flows from central banks, governments, and regulations through the economy down to markets, shaped by risk-perception, spending, asset purchases, and levered by credit.
- Because liquidity is driven by multiple evolving factors, modelling it helps reduce subjective bias. Besides, upstream liquidity doesn’t spread evenly downstream, leading to an uneven concentration of risks.
- Liquidity also transmits with varying delays, offering both forward-looking signals and backward-looking explanations. Given the role of investor psychology, behavioural understanding is necessary.
- Tracking liquidity is a continuous process that must adapt to the increasing complexity of the financial system and the changing nature of shocks.
- Importantly, assets behave asymmetrically across liquidity regimes. Liquidity risk is also convex - meaning there is a ‘cliff effect’ when liquidity dries up – and assets themselves have nonlinear sensitivity to liquidity. Understanding these convexities is critical.
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