Liquidity In Pictures

I saw an interesting chart this weekend and I wanted to review it. It was described as “The Liquidity Ratio”.

The chart compares the 30-Year US Treasury with the 3-Month US Treasury. When the number is high, it means that the Fed has driven short term interest rates low in an effort to flood the system with cheap Capital and increase economic activity.

It also means that long-term interest rates are high relative to short-term rates. This is how banks make money – they borrow short-term money via CDs and Money Market Funds and make long-term loans like 30-year mortgages and 5-year Auto Loans. So when the number is high, banks are borrowing from you at near zero % and making loans at several percentage point higher rates.

Even better for the banks, when they are leveraged up 30 to 1, they can borrow $1 million at 0.25% and then loan out $30 million at say 5%. The complaint about the Federal Reserve has always been that it and the banks it blesses have an effective monopoly for creating money and charging for it. How do you not make money in that business? Oh, that’s right, you get too highly leveraged in junk and run out of capital when the losses hit your Balance Sheet.

Here is the chart -

$TYX is the 30-Year Treasury Yield
$IRX is the 3-Month Treasury Yield
$TYX:$IRX is the differential between the two

When the number is rising, $IRX is falling away from $TYX. For the majority of the last 50-years (if not more, that is where my data stops) this ratio has been between 0.5 and 1.5. It spiked to 2.5 in 1992 when Clinton came into office and needed to finance his tax increases, thus leading to Greenspan’s “Irrational Exuberance” speech later in the decade. Maybe a little more action (raising rates?) and little less talk would have been a better idea, eh Al…

After 9/11, the Fed hit the panic button and the ratio went to almost 6! Super-cheap money led to a bubble in Real Estate and a reflation of the Stock Market.

This time around, the Fed panicked in August 2008, driving short term rates to near zero.

In December 2008, the ratio actually got to over 500! The number going parabolic is the definition of massive liquidity being pumped into the system. I had to break the charts up into segments, because 500 is so high, that is skews the other data points.

Here is the chart of the Liquidity ratio with the S&P 500. Do you see how the ratio was ramped up to 6 when the markets crashed in 2002?

How scared do you think the Fed was when they ramped the ratio to over 500 in late 2008? Holy Cow!

What scares me most is that the Fed has done nothing to decrease the issue that caused the 2008 Panic – Massive Leverage in worthless securities. We enter this new potential recovery with several Trillion Dollars more Debt than we had when we entered the crisis. The new bubble is US Treasuries. We are toast…