Liquidity Cycle

Previously, we briefly learned about the concept of liquidity in an economy. In this section, let us understand the 'Liquidity cycle' and its parameters. 

What is the Liquidity Cycle and how does it work?

Liquidity cycle plays a very important role in identifying sectors to invest in. Remember, It’s the money flow which makes a particular sector move. Given the economic cycle and the participants in the economic cycle, how does the liquidity cycle work amongst the various economic groups? There are few parameters by which we can understand the liquidity cycle:

1.Money Supply:

The Reserve Bank of India has the sole & exclusive right to print currency notes in the country. Money Supply is one of the major tools any central bank uses to control inflation. If the inflation is negative, RBI increases the money supply and vice-versa. The money supply and the amount of money the central bank prints depends on if the inflation is Demand-pull Inflation or a Cost-Push Inflation. 

2.Businesses & Households:

The increased money supply finds its way into the economy as banks loan out the same to businesses & individuals. It is assumed that this money is either invested into productive resources or used for consumption purposes. Businesses also pay salary to their employees- a part of which is saved.

3.Consumption:

The increased money flow is also used for consumption purposes 

4.Investment:

The savings can either be kept in the form of cash or invested in various asset classes such as Equity, Gold, Real Estate, Fixed Deposits, etc. 

Investment bubbles take place when a certain story or belief is sold to a common investor. There is an increased demand in a particular asset class like a rat race.  Bubbles lead to huge disruption in an economy such as unemployment, recession, etc.

5.Interest Rates:

A key factor that drives liquidity is interest rates as money can only be availed at a cost. Low interest rates drive up the demand for money & vice-versa.

If we look at the table above, it shows the GDP, interest rate and inflation rates of various countries in April 2020. The Euro zone had zero interest rates and Japan had negative interest rates. 

If we look over the data of the past two to three decades, every time a bubble is created, the interest rates go down to mute the impact of that bubble.

The story of India too is quite similar in this regard and the same can be judged from the graph below. Markets crash, interest rates go down and once again equity markets perform phenomenally.

The above image shows us the relationship between interest rates and the stock markets of India. If we look around the year 2008, the stock market crashed heavily due to the Subprime Mortgage Crisis in the US. Gradually the interest rates started dipping from 7% to 4% and the mainline indices regained strength. 

Similarly, the entire sequence of events was repeated in 2020, albeit the pace of the market cycle was much faster this time. Hence, it becomes amply clear that interest rates are the primary driver behind market momentum.