"FED Net Liquidity", an indicator introduced by Max Anderson, serves as a valuable tool for forecasting market trends and identifying short-selling opportunities. This indicator is computed by Federal Balance Sheet - Treasury General Account - Reverse Repo, offering insights into the actual funds available for circulation within the economy.
Before 2020, the FED Balance Sheet played a dominant role in shaping market liquidity, with the other two components being relatively insignificant in comparison. Consequently, the total asset value closely approximated the liquidity available in the market.
However, in the midst of 2020, the Federal Reserve executed a massive injection of over $3 trillion into the economy through a program known as "quantitative easing" to support the economy during the pandemic. Simultaneously, the Federal Reserve's total liabilities ballooned in response to the pandemic's challenges. This injection of liquidity led to a notable surge in the cost of living for Americans, with prices rising by over 30% in less than two years.
To combat inflation and mitigate the effects of its intervention, the U.S. Treasury reduced the issuance of short-dated T-bills, while the Federal Reserve increased rates on Reverse Repo (RRP). Consequently, more than $2 trillion of liquidity flowed into Reverse Repo. Since then, the proportions of Treasury General Asset (TGA) and Reverse Repo (RRP) have emerged as the primary drivers of market liquidity. This shift in the liquidity landscape inspired Max Anderson to introduce the concept of "Net Liquidity."
Upon its initial introduction, Net Liquidity exhibited a striking correlation of 0.95 with the S&P 500. Anderson stated, "When there is a change in liquidity, it takes approximately two weeks to permeate the economy and influence asset prices. This change in liquidity reliably predicts alterations in asset prices over the subsequent two weeks with an impressive 95% correlation."
Even after a year since its introduction, Net Liquidity continues to maintain a robust correlation of nearly 0.85 with the S&P 500. This enduring correlation underscores the effectiveness of Net Liquidity as an essential tool for monitoring market trends and identifying entry and exit signals for both long and short trades involving SPY (SPDR S&P 500 ETF Trust).