The GaveKal Velocity Indicator 

We started doing a lot of work on the velocity of money in the spring of 2001. As we saw it, the world's central banks had been busy adding money in the system (following the popping of the equity bubble), but little of that money was reaching the real economy. The reason: banks were no longer acting as an intermediary.(see The Mark Twain Theory of Commercial Banking -attached).

This odd behavior brought us back to Irving Fisher's equation of MV=PQ (Money Supply * Velocity = Prices * Economic Activity). In the old inflationary days, all one really needed to focus on was M. When M rose, we could be fairly certain that, six-nine months later, P & Q would rise.  Why? Because in an inflationary world, when the central banks printed money, one was forced to use it. Hoarding cash makes no sense. As a result, either prices or activity went up.

But in a deflationary world, this simple strategy no longer worked. As hoarding cash started to make economic sense, the natural floor on the velocity of money disappeared. A central bank could chose to add liquidity into the system, but there was no longer any guarantee that this liquidity would go forth and multiply.

The private sector’s propensity to multiply primary liquidity is what we attempt to measure with our velocity indicator. The reason we do this is that (painful) experience has taught us that changes in the private sector’s propensity to multiply primary liquidity (a fancy way of saying “the willingness to take risk”) has become the main driver of financial markets. But how do we measure it?

We have several components in the indicator:

1.      The first big component of our velocity indicator is the banking multiplier of every major zone (USA, Japan, Euroland & the UK).
2.      Changes in quality spreads (between junk & investment grade, investment grade & governments in the US and Germany etc…).
3.      Changes in government bond yields curves (US, UK, Euroland & Japan),
4.      The performance of bank shares relative to equity and bond markets
5.      Mortgage re-financing in the United States.

By combining official data on what commercial banks are doing, how much debt the consumer is willing to accept, and market data on how much risk the system is willing to take, we believe that we get an accurate measure of the “animal spirit” prevalent in the financial markets.

If you happen to be EcoWin users, I would be happy to email our Velocity indicator so that you can get a closer look. Also, we have written a lot on Velocity in the past and you can browse the "Velocity of Money" on our website, www.gavekal.com, to find more useful information on this topic.

 

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