Today's article is by Richard Duncan and Gordon Long. Central bank forward guidance and communication are all fine and good, but it is liquidity that moves the markets. When liquidity is plentiful asset prices tend to rise and when it is scarce asset prices tend to fall. What investors require, therefore, is a simple way to measure and forecast liquidity, a liquidity gauge.

A liquidity gauge for the United States is relatively easy to construct. When the government borrows dollars to fund its budget deficit, it absorbs liquidity. When the Fed creates dollars through Quantitative Easing, it injects liquidity into the financial markets. During 2013, the government absorbed $680 billion to fund its budget deficit, while the Fed injected just over $1 trillion through QE. The difference between what the government absorbed and what the Fed injected was $320 billion of excess liquidity.

That is not the full story, however. The Fed was not the only central bank creating fiat money and buying dollar assets last year. In order to prevent their currencies from appreciating, many central banks around the world created their own money and used it to buy the dollars entering their economies as a result of their trade surpluses with the United States. Once they had acquired the dollars, they invested them in US dollar assets to earn a return. This, then, was a second source of liquidity. It can be measured by the increase in foreign exchange reserves. In 2013, foreign exchange reserves increased by approximately $700 billion. Roughly 70% of those reserves were US dollars. This second source of liquidity thus added another $500 billion or so to US liquidity, bringing total liquidity to $1.5 trillion and excess liquidity to $820 billion.

When total liquidity (i.e. Quantitative Easing combined with the amount of dollars accumulated as foreign exchange reserves) is larger than the budget deficit, there is excess liquidity and asset prices tend to rise. But when total liquidity is less than the budget deficit, there is a liquidity drain and asset prices tend to fall. The $820 billion of excess liquidity in 2013 was the most ever recorded. That explains why the stock market rose nearly 30% and why home prices rebound by 13%.

This liquidity gauge also explains past booms in asset prices. Although QE only began in late 2008, central banks outside the US have been accumulating large amounts of dollars as foreign exchange reserves since the 1980s. The previous two peaks in excess liquidity occurred in 2000 at the time of the NASDAQ bubble and in 2006 at the time of the property bubble. The excess liquidity caused those bubbles.

The liquidity gauge becomes a useful tool for investors when it is used to forecast future levels of liquidity. That is also relatively easy to do. The Congressional Budget Office publishes it projections for the budget deficit and the Fed has provided a tentative taper schedule that provides estimates of how much fiat money it will create each month during 2014. All that is missing is the amount of dollars that will be accumulated as foreign exchange reserves. Here, estimates of the US current account deficit can serves as a proxy. Since 1970, the amount of dollars accumulated as foreign exchange reserves has been similar to the size of the US current account deficit during most years.

Plugging in estimates for the budget deficit, the Fed's taper schedule and estimates for the current account deficit on a quarter by quarter basis for 2014 suggests that liquidity will remain excessive during the first half of the year, but that a liquidity drain will begin in the third quarter and become significantly worse in the fourth quarter. If this analysis is correct, asset prices are likely to fall during the second half - unless the Fed provides more Quantitative Easing than it is currently signaling.

Given that the Fed has been driving the economic recovery by inflating the price of stocks and property, it is unlikely to allow falling asset prices to drag the economy back down any time soon. To prevent that from happening, it looks as though the Fed will have to extend QE into 2015 and perhaps significantly beyond.

Video: Richard Duncan Explains the "Liquidity Guage"

About Richard Duncan

Richard Duncan is the publisher of Macro Watch, a video-newsletter that analyzes trends in credit growth, liquidity and government policy in order to anticipate their impact on asset prices and economic growth.

He is also the author of three books on the global economic crisis. The Dollar Crisis: Causes, Consequences, Cures (2003); The Corruption of Capitalism (2009); and, The New Depression: The Breakdown Of The Paper Money Economy (2012).

Since beginning his career as an equities analyst in Hong Kong in 1986, Richard has served as global head of investment strategy at ABN AMRO Asset Management in London, worked as a financial sector specialist for the World Bank in Washington D.C., and headed equity research departments for James Capel Securities and Salomon Brothers in Bangkok. He also worked as a consultant for the IMF in Thailand during the Asia Crisis.

Richard has appeared frequently on CNBC, CNN, BBC and Bloomberg Television, as well as on BBC World Service Radio.