Holocene's Financial Conditions Indicators
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"Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets."
Stanley Druckenmiller
The blog post will describe three macroeconomic financial conditions indicators formulated by H-o-l-o-c-e-n-e.com. These indicators exclude the impact of exogenous shocks such as a pandemic or terrorist attacks.
The philosophy of these indicators is derived from the classic principle of reflexivity by George Soros.
"The truth is, successful investing is a kind of alchemy."
George Soros
1. Policy-driven Indicators
Historically, the policy on interest rates was used to dictate financial conditions in the market, but due to ultra-low interest rates, other factors such as money supply and budgetary fiscal expansion, have become influential in driving the liquidity in the market.
The indicator has three elements -
Interest Rates
Money Supply to GDP
Fiscal Budget Deficit to GDP
The weights assigned to them are dynamic where interest rates weighed heavily before 2009, while the fiscal budget deficit weighs heavily since April 2020 for calculating a weighted average indicator.
The following graphs are an example of an indicator of different countries.
a. United States
Source: Holocene and OECD Statistics b. Europe
Source: Holocene and OECD Statistics c. Japan
Source: Holocene and OECD Statistics d. China
Source: Holocene and OECD Statistics 2. Financial Tightening Based on USD Devaluation Index
The indicator is derived from investing in gold using the currency USD (90%) and GBP (10%) and shorting the gold using the following basket of currencies ["CNH", "SEK", "EUR", "CHF", "KRW", "JPY", "TWD", "NOK"]. The financial tightening condition (tightening) indicator is derived by plotting the drawdown of the long-short constructed portfolio.
If the indicator goes down, it means that financial conditions is tightening in the market.
Source: Holocene and Yahoo Finance The significance of this indicator could be checked by comparing this indicator (specifically the tightening episodes) with the carry trade unwinding.
Source: Holocene and Yahoo Finance3. Liquidity Based on Asset Rollover - (Bullishness/Bearishness Sentiment)
It is a type of liquidity that is ephemeral and could quickly unwind based on sentiment change. But it could be a source of excess liquidity in the market. Investors create a positive environment for themselves, proclaimed famously by George Soros - "Investing is a kind of alchemy".
Source: National Association of Active Investment Managers
Source: Jan Brueghel the Younger, Satire on Tulip Mania, c. 1640