TRAVELLING SOUTH ... BE BACK ON FRIDAY ... THE STORY REMAINS THE SAME: VALUATION GENERALLY OK, BUT CREDIT SPREADS WILL CHECK RALLIES

LIQUIDITY NEWS. RATE REDUCTIONS EVERYWHERE!
[Latest Endogenous Liquidity Index: -64.9%; latest Global Dollar Liquidity measure: +40.3%]

As expected, central banks deliver on the interest rate front. But will it work? Not if demand for bank reserves continues to weaken. When demand for bank reserve collapses, central banks may indeed destroy liquidity, even as they lower their target for the short rate. This happened in Japan in the early 1990s. It's called the liquidity trap. Look at the comments on inflation: are we in the midst of a global liquidity trap?

. The RBNZ sets the tone. The Reserve Bank of New Zealand reduces the Official Cash Rate (OCR) from 6.5 percent to 5.0 percent. Note the comment: "Inflation is abating here and overseas". [RBNZ]

. The Riksbank: a leading indicator. The Swedish CB slashes rate in a dramatic move. The Riksbank often leads other CBs in terms of monetary policy. "The Executive Board of the Riksbank has decided to cut the repo rate by 1.75 percentage points to 2 per cent". Again: "A lower interest rate path ..." [Riksbank]

. The Old Lady moves again! The Bank of England reduces the Bank rate by a full 100 bps to 2.00%! According to the Committee: "... measures of inflation expectations fell back sharply". [BoE]

. The laggard. The ECB takes the main refinancing operations of the Eurosystem to 2.50%, own from 3.25% [ECB]

DAILY TWITTER-LIKE POSTS ON GLOBAL LIQUIDITY ...
[Latest Endogenous Liquidity Index: -65.6%; latest Global Dollar Liquidity measure: +40.3%]

. A resilient market as credit spreads widen. The market is showing some resilience here in the face of surging credit spreads. At 612 bps, the Moody's Baa spread trades at record highs — a sure sign that corporate earnings are collapsing as we speak. [Selected Interest Rates]

. Hugh Hendry: bullish on government bonds. Eclectica Asset Management's Hugh Hendry is always a highly entertaining guest over at CNBC Europe. Mr. Hendry looks at inverted yield curves a sure sign of danger in terms of riksy assets. He now thinks that US equities "could remain in the doldrums" for another 15 ... years! [Steve Johnson: "Bold hedge fund star says stellar performance no longer enough", Financial Times]

. The UK & the euro. Denmark's prime minister and central bank chief both recently stated that the key lesson from the financial crisis was that the country had to join the euro. The ECB, after all, represents a very large source of liquidity. Is the United Kingdom now thinking in similar terms? [BBC News: "No 10 denies shift in euro policy"]

SOME TWITTER-LIKE POSTS ON GLOBAL LIQUIDITY ...
[Latest Endogenous Liquidity Index: -66.3%; latest Global Dollar Liquidity measure: +40.3%]

. Credit spreads I. The Moody's Baa spread trades at 601 bps. Difficult to feel too bullish about risky assets with such level of credit spreads. [Selected Interest Rates]

. Credit spreads II. Blackrock's Owen Murfin warns: the information-value of credit spreads is distorded (and undermined) by liquidity considerations, i.e. people being forced to sell corporates. I know that already: market-based indicators are not perfect. But they are doing a heck of a job all the same. [Sophia Grene: "Bond spread not as scary as it first seems", Financial Times]

. Liquidity & checks and balances. Countries with political checks and balances have the best credit systems. The same principle operates at a micro-economic level. Citigroup had no independent risk analysis system in place. What a mess! [Eric Dash & Julie Creswell: "Citigroup Saw No Red Flags Even as It Made Bolder Bets", The New York Times]

. Ben Bernanke on private credit markets. "The Federal Reserve's liquidity programs ... have not yet returned private credit markets to normal functioning". Now that's an understatement! (The Endogenous Liquidity Index is now 66.3% below last year's level). [Ben Bernanke: "Federal Reserve Policies in the Financial Crisis"]

. RBA cuts rates. The Reserve Bank of Australia cuts its target for the cash rate by 100 bps, down to 4.25%. Good news! [RBA]

LIQUIDITY NEWS. THE LEGS OF THE RALLY
[Latest Endogenous Liquidity Index: -60.6%; Latest Global Dollar Liquidity measure: +39.6%]

Does the rally have legs? That's the key question, my friends. More than anything else, the rally that started on Friday is about valuation. Forget all the brouhaha about Mr. Obama's appointees. On that score, stocks still look cheap. Having said that, the real legs of the rally are represented by ... credit spreads. Here, things look rather hellish, I must say. The legs of the rally are very weak. At 586 bps, Moody's Baa ten-year spreads trade at all-time highs — again. If, by early next week, spreads have not declined by at least 40bps, I'll be donning my bear costume. [Federal Reserve: Selected Interest Rates]
_______

LIQUIDITY NEWS. GLOBALIZING THE HKMA SOLUTION
[Latest Endogenous Liquidity Index: -63.9%; Latest Global Dollar Liquidity measure: +40.1%]

Interesting piece by John Muellbauer in today's Financial Times (*). Mr. Muellbauer's idea is to globalize the 1997-1998 unorthodox HKMA solution to the financial crisis. Back then, the Hong Kong Monetary Authority successfully intervened in asset markets, buying stocks from short-sellers in what turned out to be a very profitable trade. Now, says the author, the HKMA solution has to be global in scope: "Since no country is exempt, international co-ordination is needed and made easier because of the obvious common interest". Mr. Muellbauer is adamant about the nature of his plan: it is "reversible, self-financing and immediately applicable", as was the case in Hong Kong ten years back.

International co-ordination will avoid the policy being seen as a sign of weakness or panic at the individual country level, with costs to currencies and government bond markets. The incentive structure for central banks to join such concerted action is less likely to create free rider problems than is the case for fiscal policy. Any central bank considering such action has an incentive not to delay since the potential profitability is likely to be lower for late participants, given that asset prices will generally be bid up in the process.

(*) John Muellbauer: "The world’s central banks must buy assets", Financial Times.

LIQUIDITY NEWS. ON RATES & BUBBLES: LOTS OF MATERIAL!
[Latest Endogenous Liquidity Index: -65.9%; Latest Global Dollar Liquidity measure: +40.1%]

I'm a big fan of the Market Price Approach to monetary policy, as outlined in 1996 by Manuel Johnson and Robert Keleher (*). Largely relying on the work of Swedish economist Knut Wicksell, their recipe is deceptively simple: watch a trifecta of market-based indicators — the shape of yield curve, commodity prices and exchange rates. If the yield curve gets steeper and steeper, and commodity prices increase sharply, and the currency falls apart, then a central bank has an obvious inflation problem on its hands. [By the way, I'm collecting data to build a Market-Price-Approach Liquidity Index!]

Right now, we're in a crisis — and the blame game is in full swing. Some people seem to think that the 1% fed funds rate of 2003 was the key culprit (in terms of the housing boom and the subsequent collapse). Although I tend to symphatize with that view, I've been around long enough to know that bubbles are incredibly complex phenomena. Along with monetary policy considerations, many additional factors intervene: innovation waves, structural economic shifts, and plain old human nature with its inseparable greed and fear elements. Enough said — here's some intellectual ammo on the subject of rates and bubbles:

[1] Fed vice-chairman Donald Kohn. To his credit, Mr. Kohn does not dodge the bullet. "How might these monetary policy actions have fueled speculation?", he asks, rhetorically. His answer: maybe; but then again, it's more complex than that. "In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the Great Moderation back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions". [Donald L. Kohn: "Monetary Policy and Asset Prices Revisited", Federal Reserve Board]

[2] Jim Grant. The Financial Times'' John Authers reviews Mr. Market Miscalculates by James Grant: "As early as 2004, he wrote about how the 1 per cent Fed Funds rate, with which the Greenspan Fed battled the perceived threat of deflation, had “transformed the borrowing patterns of the clientele of the northeast region of Washington Mutual”. WaMu has now passed into history as the biggest US bank failure on record". With such juicy passages in mind, Mr. Authers concludes that Grant's volume "may well be the most perceptive book on the current financial crisis yet published". [John Authers: "Profit from prophesies of doom", Financial Times] [Grant's Interest Rate Observer]

[3] Gerald P. O'Driscoll Jr. This is by far the most Wicksellian piece of all: "With a commodity standard in place, the government would also have price signals that would alert it to the formation of a bubble. Why? Because the price of the commodity would be continuously traded in spot and futures markets. Excessive easing by the Fed would be signaled by rising prices for the commodity. In recent years, Fed officials have claimed that they cannot know when an asset bubble is developing. With a commodity standard in place, it would be clear to anyone watching spot markets whether a bubble is forming. What's more, if Fed officials ignored price signals, outflows of commodity reserves would force them to act against the bubble". Very interesting, although I doubt that such a mechanism would completely "avoid bubbles". [Gerald P. O'Driscoll Jr.: "To Prevent Bubbles, Restrain the Fed", The Wall Street Journal]

[4] Richard Duncan. The author of The Dollar Crisis: Causes, Consequences, Cures is at it again: "Between unnaturally depressed interest rates and the buying spree by Fannie and Freddie, US property prices surged. The US housing bubble followed the ill-fated Nasdaq bubble. However, the inflation of the US housing market was one bubble too far. When it imploded, the global financial system was hurled into crisis, leaving the 21st century version of Anglo-American financial capitalism discredited". [Richard Duncan: "Bring back link between gold and dollar", Financial Times]

(*) Manuel Johnson & Robert Keleher. Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

LIQUIDITY WATCH. A WELCOME RETURN TO NORMALCY
. Federal Reserve: "Factors Affecting Reserve Balances", November 19

- Fed's Treasuries holdings + loans: $1,473.4bn (-$11.5bn)
- Other central banks' Treasuries holdings: $1,609.9bn (+$1.9bn) (*)
- Other central banks' agency securities: $891.2 (-$8.7bn) (*)
- Global Dollar Liquidity Measure: $3,974.4bn (-$18.3bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

After five hectic weeks, a sense of normalcy is a welcome sign. The weekly Fed balance sheet has seen historic changes over the last couple of months. It has been amazing. Really. That's why I welcome the last installment, with its more normal variations. The Global Dollar Liquidity measure declines by $18.3bn, as the transitory character of some Fed operations kicks in, and as foreign CBs sell (quite understandably, one would imagine) some of their Fannie and Freddie positions. Having said that, the phenomenal year-on-year growth rates illustrate the sheer magnitude of central banks' commitment to ease policy at all costs. Thus, the Global Dollar Liquidity measure posts a +40.1% rate of increase, while my proxy for the monetary base increases by a mind-boggling ... 83.3%!

On the monetary policy front, note the aggressive stance adopted by the Swiss National Bank, shaving a full 100 bps off its target for the libor rate, now at 0.5%-1.5%. The resulting weakness of the Swiss franc is another symptom (IMHO) of a coming rally in risky assets.

LIQUIDITY NEWS. A RALLY IS IN SIGHT!
[Latest Endogenous Liquidity Index: -65.8%; Latest Global Dollar Liquidity measure: +39.6%]

A rally is in sight. When valued against the Goldilocks/Stagflation index, the S&P500 trades now at the cheapest level ... ever! This is due to the collapse of ten-year inflation breakevens, courtesy of the phenomenal rally in Treasuries. The last time something like this happened, we duly got a 15% rally on the S&P500. Blood on Wall Street: a rally in sight.

LIQUIDITY NEWS. NICOLE ELLIOTT ON CNBC ... VERY BEARISH!
[Latest Endogenous Liquidity Index: -64.2%; Latest Global Dollar Liquidity measure: +39.6%]

Although I understand what a double bottom is, I am not a big fan of technical analysis. Having said that, there are some technicians I listen to. One is Nicole Elliott, of Mizuho Corporate Bank in London. Really impressive! Nicole is very bearish on risky assets right now. She's been consistently right on euro/yen and on the S&P500, and she sees yet more downside in the coming months. Today on CNBC Europe (I can' t find the video link), she said something that any endogenous liquidity watcher would immediately understand: "There's no money out there; people are desperate to sell all peripheral assets". [Mizuho Technical Analysis]

LIQUIDITY NEWS. ENDOGENOUS LIQUIDITY AT A NEW ALL-TIME LOW
[Latest Endogenous Liquidity Index: -64.6%; Latest Global Dollar Liquidity measure: +39.6%]

- A new all-time low. My Endogenous Liquidity Index, which comprises CDS spreads, cash bond spreads, volatility indicators and others closed on Friday at a new all-time low. The index is now 64.6% below its November 2007 levels. This situation is remarkable, especially when you realize that macroeconomic liquidity —as measured by the size of the Fed's balance sheet— has never been more abundant. The private sector's furious deleveraging process goes hand in hand with an equally furious re-leveraging effort by central banks.
___________

- Misleading readings on inflation expectations? Liquidity @ Financial Times. Mike Pond, an inflation-linked bond strategist at Barclays Capital, says: "A lot of people call the move in nominal Treasuries [without the inflation indexing] a flight to quality. But it is really a flight to liquidity. Tips have the same credit as nominals, but the nominals are indeed much more liquid". Very interesting! In other words: take the message from inflation breakevens with a grain of salt. Liquidity considerations, short squeezes, supply disruptions and even hurricanes can affect the information value of any market-based indicator. You just have to know it. [John Dizard: "Weirdly, Tips yields point to deflation", Financial Times]
___________

LIQUIDITY WATCH. AN IMPROVING SITUATION -- BUT STILL NO LONG-TERM BULLISH SIGNAL
. Federal Reserve: "Factors Affecting Reserve Balances", November 12

- Fed's Treasuries holdings + loans: $1,484.9bn (+$97.0bn)
- Other central banks' Treasuries holdings: $1,608.0bn (+$20.3bn) (*)
- Other central banks' agency securities: $899.9 (-$6.6bn) (*)
- Global Dollar Liquidity Measure: $3,992.9bn (+$110.6bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

My rather crude, but trusted and battle-tested long term buy/sell indicator for risky assets simply adds two rates of growth: that of the Global Dollar Liquidity measure, and that of the inverse of the Moody's Baa spread. It has been in bearish territory since August 2007. Given the phenomenal increase in the size of the Fed's balance sheet, it's time to take a fresh look at the numbers. After all, the Global Dollar Liquidity measure is growing at an astonishing 39.6% annual rate. Things seem to be improving at the margin: the indicator is now at its less bearish point since November 2007. Still, we need as much as 124 bps of improvement in the Moody's Baa spread to get a new bullish signal.

MONTEARY POLICY. PRUDENCE, CANADIAN STYLE
[Latest Endogenous Liquidity Index: -62.1%; Latest Global Dollar Liquidity measure: +37.7%]

Today's Financial Times features an article by James Flaherty, Canada's finance minister, about the beauty of being ... boring. "Canadians by nature are prudent", says Mr. Flaherty. And he adds: "Our financial system has been characterized as unexciting. Canada's regulatory regime ensures that stability and efficiency are balanced". Very interesting indeed! I decided to put Canada's famed prudence to the test. More to the point, I checked the data from Bank of Canada to get a sense of the shape of the yield curve, the ultimate wicksellian criterium of a prudent monetary policy. All in all, Mr. Flaherty's views seem to be backed by the evidence. The yield on the 10-year benchmark bond now trades at a prudent 1.65 times the target for the overnight rate (vs. a record and far-from-prudent 3.66 times in the U.S.)

LIQUIDITY NEWS. KEVIN WARSH: PRIVATE & PUBLIC LIQUIDITY
[Latest Endogenous Liquidity Index: -60.1%; Latest Global Dollar Liquidity measure: +37.7%]

"Public liquidity is an imperfect substitute for private liquidity", says Fed Governor Kevin Warsh. (When it comes to liquidity issues, Mr. Warsh is one of the Fed's most eloquent speakers -- see his well-crafted March 2007 speech on "Martket Liquidity: Definitions and Implications"). But what does he really mean? If I understand him correctly, Mr. Warsh points to excessive central bank liquidity (in the past) as the key culprit of the current mess:

More consequentially, we should recognize that Fed-supplied liquidity is a poor substitute for private-sector-supplied liquidity. When liquidity flows among private-sector participants, the players can more judiciously assess risk and reward, more adroitly learn from the recent turmoil to strengthen the resiliency of credit intermediation, and more ably allocate capital to its most productive uses in the real economy. Moreover, Fed-provided liquidity should not be mistaken for capital.

I take Mr. Warsh's words as an endorsement of the usefulness of my very own ... Endogenous Liquidity Index!

LIQUIDITY NEWS. A 15% GDP CONTRACTION?
[Latest Endogenous Liquidity Index: -60.7%; Latest Global Dollar Liquidity measure: +37.7%]

- A 15% GDP contraction? Liquidity @ Financial Times. As a big fan of credit spreads (the best forward-looking indicator in terms of corporate earnings), I try to pay attention to what people write on the subject. It turns out that, according to Barclay's "model of implied economic forecasts from credit spreads", the market is discounting "as much as a 15 per cent decline in real gross domestic product for the US next year". Now, that's what you'd call a recession! Barclay's strategists are convinced that credit markets are wrong, and that equities at current prices might present "the buying opportunity of a generation". Perhaps. But watch the Moody's Baa ten-year spread (my own key benchmark): at 550 bps, it simply refuses to yield (pun intended). Not a good sign. [John Authers: "Time to buy?", Financial Times]
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- Hong-Kong, Argentina & the dollar peg. Hong-Kong celebrates 25 years of US dollar peg. Meanwhile, Argentina broke away from its own peg in late 2001. Pegging your currency to the dollar is no panacea: you can't avoid episodes of both deflation (1999-2001) and inflation (2005-2007). Hong-Kong is willing to pay the price: "Where else should we go?", asks Donald Tsang, HK's chief executive. In 2008, Argentina faces the specter of stagflation. Its GDP is one of the most volatile in the world; there are no monetary policy rules, no checks and balances, no nothing — the perfect recipe for an ultra-high cost of capital. And while Argentina scrambles to protect is pseudo-currency, the HKMA lowers its target for the base rate to 1.5%. [Tom Mitchell: "Hong Kong celebrates 25 years of US dollar peg", Financial Times]
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LIQUIDITY NEWS. THE TED SPREAD AT ONE-AND-A-HALF MONTH LOWS
[Latest Endogenous Liquidity Index: -60.9%; Latest Global Dollar Liquidity measure: +37.7%]

The spot TED spread, as measured with data from the Fed's daily "Selected Interest Rates", trades at 268 bps (a level not seen since September 16, when Lehman Brothers failed). Now, if only the good money market news would translate into equally good credit markets news. This, alas, is still not the case: the Moody's Baa spread trades at 550 bps, close to its recent highs.

LIQUIDITY WATCH. THE MADNESS CONTINUES
. Federal Reserve: "Factors Affecting Reserve Balances", November 5

- Fed's Treasuries holdings + loans: $1,388.0bn (+$154.1bn)
- Other central banks' Treasuries holdings: $1,587.8bn (+$16.6bn) (*)
- Other central banks' agency securities: $906.5 (-$8.5bn) (*)
- Global Dollar Liquidity Measure: $3,882.3bn (+$162.2bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

When a key central bank states on its website that "the global banking system has experienced its most serious disruption for almost a century", you know that things look pretty scary. Presumably, in that context, you would do well to look at central banks' balance sheets with a grain of salt. You would assume, in other words, that some of the things they are doing are temporary in nature. Look at those incredible numbers from the last Fed weekly balance sheet. My proxy for the monetary base is increasing at a 75% annual rate in November. Let me say this again: SEVENTY-FIVE PERCENT! The Global Dollar Liquidity measure is growing at almost 38% (November 2008 vs. November 2007). Guys, it'd better be temporary. Trust me on this one.

LIQUIDITY NEWS. A TALE OF TWO CENTRAL BANKS
[Latest Endogenous Liquidity Index: -60.8%; Latest Global Dollar Liquidity measure: +29.6%]

Liquidity-wise, the news today is dominated by the policy moves from both the Bank of England and the European Central Bank. The Old Lady moved first, and she decided to surprise financial markets with a 150 bp cut. The Bank rate stands now at 3.00% [communiqué]:

Since mid-September, the global banking system has experienced its most serious disruption for almost a century. While the measures taken on bank capital, funding and liquidity in several countries, including our own, have begun to ease the situation, the availability of credit to households and businesses is likely to remain restricted for some time. As a consequence, money and credit conditions have tightened sharply.

The most serious disruption for almost a century! Now, that's seems to justify the audacity of the move! Now consider the ECB. Shortly after the BoE decision, many market participants thought that the Trichet Boys would go for a 75 bp, or even a 100 bp, cut. To no avail. The ECB opted for a tepid 50 bp move, taking the marginal lending facility to 3.75% [communiqué]. And here comes the interesting part. Guess what's happening to the euro/sterling cross? Actually, the pound is rallying. When FX markets react like that, it means that (nervous) investors are paying attention to asset markets in general, and not only to yields on short-term debt instruments.

[PS. The Swiss National Bank also announces a "relaxation of monetary policy", lowering the three-month Libor target range by 50 basis points to 1.5%–2.5%].

LIQUIDITY NEWS ...
[Latest Endogenous Liquidity Index: -58.5%; Latest Global Dollar Liquidity measure: +29.6%]

- Endogenous Liquidity Watch. The Endogenous Liquidity Index improves once again, courtesy of both the falling VIX and collapsing CDS spreads. As expected, ten-year inflation breakevens have deteriorated somewhat following the recovery in commodity prices. As a result, the Goldilocks/Stagflation Index retreats a bit, which makes equities less attractive at current levels. There are some encouraging signs in terms of junk bond spreads: the "New Junk" spread trades at 877 bps, down from the high of 1013 bps reached on September 21. Still, I am a bit skeptical about further S&P500 rallies if Moody's Baa spreads fail to collaborate. [KDP High Yield Daily Index]
__________

- Denmark & the euro [Liquidity @ Financial Times]. Can Scandinavian countries afford to go it alone? The banking crisis highlights the pitfalls of monetary sovereignty in the age of ... connectivity. The Danish central bank has been forced to sell FX reserves and to raise interest rates twice to shore up the krone: "The spread between Danish interest rates and the ECB's was just 25 basis points in May; it is now at an all-time high of 175 basis points. This could widen further if the ECB cuts rates as expected by half a per cent on Thursday and the Danish central bank does not follow. The interest rate rises threaten to push housing prices down further, hurt consumer spending and depress an already stagnating economy". [Robert Anderson: "Danish PM seeks backing for euro referendum", Financial Times]
__________

LIQUIDITY WATCH. THE MOST SUCCESSFUL FED MOVE SO FAR?
[Latest Endogenous Liquidity Index: -61.4%; Latest Global Dollar Liquidity measure: +29.6%]

- A very successful move by the Fed. I am more convinced than ever that the recent swap agreement between the Fed and the central banks of Brazil, Korea, Mexico and Singapore was nothing short of a brilliant stroke. Why do I say that? Because the Emerging Markets CDS has collapsed from 1056 bps on October 23 to 658 bps yesterday. I am reminded of an episode I read about a while back in Ron Chernow's The Warburgs: The Twentieth-Century Odyssey of a Remarkable Jewish Family (New York: Random House, 1993). In the Vienna of the late 1850s, a devastating panic in the banking sector is brought to an end by news that a train loaded with silver ingots (arranged by the Warburg family) is on its way from Germany. In the event, not an ounce of the silver was sold. The mere announcement of the incoming train was enough to calm the markets down. This is happening right now in some of the most important emerging markets. The swap lines have remained untouched, but the panic has receded. As a result, the Endogenous Liquidity Index continues to improve. Bravo!
_________

- Liquidity @ Financial Times. Today's FT editorial comment stresses the need for fiscal stimulus as a crucial element of any strategy designed to get the world economy out of the "liquidity trap". There is something to be said in favor of this position. If a broad and prolonged recession puts permanent downward pressure on the demand for bank reserves, then CBs may find themseleves forced to destroy liquidity just to prevent their target rates from collapsing. This is what happened in Japan in the 1990s.
_________

- Another stunning move Down Under. The Reserve Bank of Australia delivers another bold rate cut: -75 bps to a 5.25% target rate. From the communiqué: "International economic data have continued to point to significant weakness in the major industrial economies, and there have been further signs that China and other parts of the developing world are slowing as well. These conditions have contributed to further falls in world commodity prices".

LIQUIDITY ANALYSIS. WHEN IT COMES TO LIQUIDITY, SIZE MATTERS
[Latest Endogenous Liquidity Index: -65.3%; Latest Global Dollar Liquidity measure: +29.6%]

As the Belgian bank giant Fortis collapses, citizens of that country appreciate the bonheur of belonging to the eurozone. Had it not been for the euro, Belgium would have devalued and sharply increased interest rates — just as Iceland was forced to do. The banking and financial crisis is quickly changing perceptions. Across Europe, there is a bit of a scramble to join the euro. Politicians from Scandinavia to Eastern Europe, fearful of the abyss, are re-evaluating the wisdom of going it alone (Denmark, Sweden, Norway) or postponing structural reform (Hungary, Poland). Brazil and Mexico have secured a swap line from the Federal Reserve Bank. When it comes to liquidity conditions, size seems to matter after all (*).

(*) See the very good piece by Wolgang Münchau: "Now they see the benefits of the eurozone", Financial Times.

LIQUIDITY WATCH. WHAT A MESS!
. Federal Reserve: "Factors Affecting Reserve Balances", October 30

- Fed's Treasuries holdings + loans: $1,233.9bn (+$50.5bn)
- Other central banks' Treasuries holdings: $1,571.2bn (+$15.9bn) (*)
- Other central banks' agency securities: $915.0 (-$8.4bn) (*)
- Global Dollar Liquidity Measure: $3,290.4bn (+$58.0bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

The weekly Fed balance sheet is a complete mess. (Other words that come to my mind: chaos, confusion, anarchy). New items are being added every week. And we're talking hundreds of billions of dollars. Literally. My new Global Dollar Liquidity measure, which (hopefully) reflects the impact of all recent liquidity programs, now reaches almost $3.3 trillion. The numbers are trully mind-boggling. Monthly average figures (not displayed here) show a 46.5% increase in my proxy for the monetary base. Think about it: prior to the Lehman Brothers collapse, we were dealing with a 2.6% contraction. This is by far the greatest balance sheet expansion in the history of the Federal Reserve Bank. The Global Dollar Liquidity is growing at the phenomenal rate of 29.6% per annum. Totally unheard of!

Ladies and gentlemen, it's not that complicated after all: the massive delevarging efforts by the private sector are being matched by an equally massive releveraging process from G7 central banks. Keynesian economics, anyone?

LIQUIDITY ANALYSIS. A TRULY HISTORIC AGREEMENT; THE TROUBLE WITH "HELICOPTER BEN"
[Latest Endogenous Liquidity Index: -65.5%; Latest Global Dollar Liquidity measure: +28.7%]

- A truly historic agreement! Yesterday's swap lines agreement between the Fed, Banco Central do Brasil, Banco de México, Bank of Korea and Singapore's Monetary Authority is a historic event. As any reader of Thomas Barnett's books on globalization would instantly recognize, these facilities confirm the inescapable reality of today's economic and financial connectivity. The message for commodity-exporting countries is clear: you can benefit from global trade flows, provided that you recognize the risks and that you play by the rules. Look at the list of CBs included in the "swap club": the Reserve Bank of Australia, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank, and the Swiss National Bank. These are all independent central banks, which makes the inclusion of Banco de Mexico and Banco Central do Brasil all the more impressive. Henrique Meirelles, the Banco Central do Brasil chairman, waisted no time in putting forward the importance of the agreement: "O acordo é importante pela inclusão formal do Brasil com outras economias relevantes do globo". [Banco do Brasil: "Nota à imprensa"; Federal Reserve: "Press Release"]
__________

- The trouble with "Helicopter Ben". Remember Ben Bernanke's recent remarks at the Economic Club of New York? The thing that caught my attention was his response to a question on ... financial bubbles. In essence, Mr. Bernanke seemed to suggest that bubbles pop up whenever bank regulation fails. In other words: they have little to do with monetary policy itself. This was a clever answer, since we all know that it was the then Fed vice-chairman who in 2003 argued forcefully for a 1% fed funds rate. Now "Helicopter Ben" is at it again. I know, I know: in times of crisis, you just throw prudence to the wind. My point is, if you want to avoid a permanent spike in long-term rates, you need a monetary policy rule-set. And what is the FOMC's rule-set? I dunno. [Ben Bernanke: "Stabilizing the Financial Markets and the Economy", Federal Reserve]
_________

- Endogenous Liquidity daily watch. The Endogenous Liquidity Index improves modestly (+0.65%) on the heels of falling CDS spreads — especially Emerging Market spreads, as commodities rally and the dollar falls. Inflation breakevens are rebounding somewhat, and I suspect that they will move further up in coming days (they are still close to all-time lows, though). On a spot basis, the recent slight improvement in the 3-month TED spread is now history: we're back at 373 bps. The real worry, in my opinion, is the credit spreads situation. The 10-year Moody's Baa spread refuses to back down. That, my friends, is a sure sign of trouble in terms of corporate earnings. [Selected Interest Rates]
_________

LIQUIDITY NEWS ...
[Latest Endogenous Liquidity Index: -65.8%; Latest Global Dollar Liquidity measure: +28.7%]

- The Fed cuts rates. The FOMC lowers the fed funds target to 1.00% from 1.50%; in a related action, the Board of Governors unanimously approves a 50-basis-point decrease in the discount rate to 1.25%. [Communiqué]

- Two new swap lines. The Fed announces the establishment of temporary reciprocal currency arrangements (a.k.a swap lines) with the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore. (A similar announcement was made yesterday with respect to the Reserve Bank of New Zealand.)

- Norway's central bank lowers key rate from 5.25% to 4.75%. From the communiqué: "There is now unusually high uncertainty surrounding economic developments ahead. An overall assessment of the outlook and the balance of risks suggests that it is now appropriate to reduce the key policy rate by 0.50 percentage point. Weight is given to moving forward the reduction in the key policy rate so that lending rates for households and businesses can gradually be reduced".

- The People's Bank of China cuts one-year lending rate from 6.93% to 6.66%. From Bloomberg: "This cut was driven by the slowdown in the third quarter and the likelihood that the U.S. and other central banks will cut rates,'' said Xing Ziqiang, an economist at China International Capital Corp. in Beijing". Coordinated rate cuts, anyone?

LIQUIDITY ANALYSIS. A NEW HIGH FOR THE GOLDILOCKS/STAGFLATION INDEX (IF YOU CAN BELIEVE IT)
[Latest Endogenous Liquidity Index: -65.8%; Latest Global Dollar Liquidity measure: +28.7%]

- The TED spread & credit spreads. Pointing to the slightly lower TED spread, CNBC's Steve Liesman keeps talking about "improving credit markets" conditions. Wrong, in my opinion. Money markets are not credit markets. Take a look at the 10-year Moody's Baa spread: at 560 bps, it trades at an all-time high. This is hardly what you would expect in the context of "improving credit markets". [Selected Interest Rates]
________

- Don't cry for me, Argentina (again). Argentine policymakers just don't get it. If you destroy property rights, credit markets will respond in kind. The supply of loanable resources is all but collapsing; interest rates are skyrocketting in Buenos Aires and beyond. Ladies and gentlemen: checks and balances do matter. The arbitrary exercise of government power generally results in very high long-term (real) interest rates. The great Montesquieu said as much in The Spirit of the Laws. Now just ask Vladimir Putin and Nestor Kirchner. [Financial Times: "Argentine own goal"]
__________

- The Goldilocks/Stagflation Index at a new high (if you can believe it). Inflation expectations are collapsing at a much faster rate than economic growth: that's the message behind the new high in my Goldilocks/Stagflation Index. With the denominator (ten year-inflation breakevens) at such an impressive all-time low (77 bps), even the lackluster performance of the numerator (the platinum-gold ratio) cannot impede the index to reach new highs. Does that really matter? When valued against the Goldilocks/Stagflation Index, the S&P500 trades at a new all-time low. If credit spreads would collaborate (not a sure bet, by any means), the ensuing rally would be —as a well-known CNBC commentator recently put it— "jaw-dropping".
________

LIBERTÉ, EGALITÉ, LIQUIDITÉ!

Just when the most impressive liquidity crisis in recent memory makes headlines everywhere, the editor of the Global Liquidity Blog finds himself incredibly busy with a number of different projects. Plus, I'll be in Paris for the Easter week-end. In other words, no blog until next Tuesday. Liberté, egalité, liquidité!

Cheers,

Agustin.

LIQUIDITY NEWS. WILD RUMORS, WEAK DOLLAR
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -50.6%]

There are all sorts of rumors out there about hedge funds, and even about some big financial institution going under. The liquidity crisis, apparently, is fast becoming a ... solvency crisis! Here's my two cents on the rumors: I don't believe them. I trully think that the new market-based, securitization-driven financial market has succeeded in diversifying credit risk. Of course, we are only now becoming aware of the phenomenal downside: a spectacular information crunch, whereby nodody really knows the extent of the damage sustained by one's credit counterparties.

Overall, the Fed's liquidity operations are well designed. But perhaps Mr. Bernanke should be more explicit about his goal: to solve the liquidity puzzle while not giving the impression that he stamps his signature on mere American ... pesos.

LIQUIDITY NEWS. THE "TAF" INCREASE IS A SMART MOVE
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -50.6%]

[1] The TAF increase: a smart move! On Friday, the Federal Reserve announced that the amounts outstanding in the Term Auction Facility (TAF) would be increased to $100 billion. In a separate move, the Fed will initiate "a series of term repurchase transactions that are expected to cumulate to $100 billion". These are smart moves, reminiscent of the European Central Bank's recent liquidity policies. The aim is to provide liquidity without altering the target rate of the fed funds. For most of 2007, Fed policy has been rather restrictive: fed funds traded above Treasury market rates, and monetary base growth was very weak. Now, the triple combination of a steeper yield curve, rising commodity prices and a faltering dollar is signalling that the fed funds rate is fast approaching an appropiatley accomodative level. The Fed needs to be more creative. The TAF increase is a smart move. [Press release]

[2] Panic in credit-land! The Moody's Baa spread has reached 335bp, a level not seen since January 2003. And the Credit Default Swap market is in turmoil. On Friday, the iTraxx Japan 80 index traded at 155bp, a 30bp increase in just one session! According to the Financial Times, "Institutions that lapped up credit risk products in recent years – many financing their purchases through borrowing – are scrambling to reduce their exposure following heavy losses ... The spread widening is so severe, you’re seeing a rise in borrowing rates across the board for everybody except top-quality governments. It’s affecting both the price and availability of credit". We'll be closely watching the U.S. investment grade CDS market, now trading at 178bp over Libor. A move above 200bp, according to Bank of America, "could trigger a jump towards 220bp". Meanwhile, Cumberland Advisors's David Kotok sees the current panic as an opportunity: "My negative and disagreeable email is approaching the peak levels I last saw in 2000. Then we were buying 6% tax-free bonds while investors were selling them to buy Cisco and Microsoft at 100 times earnings". [Robert Cookson: "Credit derivatives turmoil strikes", Financial Times] [David Kotok: "J'ai Peur", Cumberland Advisors]

LIQUIDITY WATCH. WHO CARES ABOUT 'MACRO' LIQUIDITY WHEN MARKET LIQUIDITY IS EVAPORATING?
. Federal Reserve: "Factors Affecting Reserve Balances", March 5

- Fed's Treasuries holdings: $789.6bn (+$12.9bn)
- Other central banks' Treasuries holdings: $1,280.6bn (+$10.3bn) (*)
- Other central banks' agency securities: $869.4 (-$1.8bn) (*)
- Global Dollar Liquidity Measure: $2,939.6bn (+$21.5bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

Who cares about funding (or macroeconomic) liquidity when market liquidity is all but collapsing? The answer: FX and commodity markets traders. They like what they see: foreign central banks desperately trying to avoid the unavoidable — namely, sharp interest rate increases in places like China, Russia and Argentina, to name but a few. We may be witnessing the last phase of extravagant moves in some of these markets. Meanwhile, our Endogenous Liquidity Index saw one of its worst days ever, as all components —including all CDS indices— fell sharply (a very rare occurrence).The ELI is now down more than 50% from a year ago! The hedge fund community, in particular, is feeling the heat. Peloton Partners, trying to pick the bottom in credit markets, is now out of the game. Carlyle Capital, which had geared up 32 times to buy a $22bn book a triple-A mortgages, is making headlines (for the wrong reasons, presumably).

To put it in perspective, here are a few quotes from analysts interviewed by the Financial Times: "The repricing of liquidity and credit lines to hedge funds will squeeze more credit funds out of business" (Huw van Steenis, Morgan Stanley); "... The most chaotic times in the credit markets since the Great Depression" (William O'Donnell, UBS); "There is an extreme lack of liquidity and markets are being moved by liquidation fears and margin calls" (Tom Di Galoma, Jefferies). There you have it. [Michael Mackenzie: "Hedge funds spark fixed income stress", Financial Times] [James Mackintosh: "Gloom set to worsen as threat of spiral grows", Financial Times].

LIQUIDITY NEWS. FREDERIC MISHKIN & DAVID RICARDO
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -47.3%]

In his discussion of the dynamics of inflation expectations, Federal Reserve Governor Frederic Mishkin discounts the current uptick in the spread between "nominal Treasuries" and TIPS as a reflection (in part) of "changes in ... the relative liquidity of TIPS and similar maturity nominal Treasuries". Hmmm ... Now let's not forget that Mr. Mishkin is referring to a market-based indicator here. He should, perhaps, show more respect for other market-based indicators. Long ago, Manuel Johnson and Robert Keleher taught us the following golden rule, partly based on the teachings of British economist David Ricardo (1772-1823): whenever a currency falls in terms of other currencies, AND in terms of gold, AND its yield curve gets steeper, AND commodity prices soar, there's no way to hide the ugly truth — there is indeed an inflation problem.

LIQUIDITY NEWS. CREDIT SPREADS TAKE CENTER STAGE
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -48.6%]

As I wrote yesterday, credit spreads are surging on a global basis. The Moody's Baa spread trades at a new five-year high of 322 basis points. Federal Reserve Governor Frederic Mishkin mentioned credit spreads on at least three occasions in his latest speech. First, he notes that corporate bond spreads are rising because investors are becoming "less willing to bear risk, more concerned about the valuations of a wide range of complex financial instruments, and more concerned about counterparty credit risk". He then notes that rising credit spreads point to a deterioration in "business sentiment" (translation: corporate profits will fall).

Finally, Mr. Mishkin notes, in the context of the housing market, that "a decline in house prices can increase the wedge between the default-free interest rate and the effective interest rate facing the homeowner. That is, in the eyes of the lenders, declining house prices diminish the quality of the borrowers' collateral, which effectively reduces the availability of credit to households that can be used to finance consumer purchases". Credit spreads, my friends, are taking center stage. Not a minute too soon! In today's Financial Times "Markets & Investing column", PIMCO's Bill Gross makes an important point about rising credit spreads:

Despite the rapid decline in Treasury yields, mortgage and corporate credit markets are not co-operating, producing aggregate price declines in total. Historically high levels of consumption as a percentage of gross domestic product are not being supported any more by leverageable assets that appreciate perpetually in price ... The American economy, so dependent on asset inflation of one sort or another, is now experiencing price deflation in all three major categories – real estate, stocks, and yes, bonds.

Even with the recent bout of price inflation in the Treasury market, rising credit spreads mean that the bond market as a whole is "deflating". While one could argue with the remark that the U.S. economy is "so dependent on asset inflation" —Bill Gross has a perma-bear-like tendency to sistematically discount the positive impact of business innovation on the economy— the point about price deflation in all three major categories is an important one.

[1] Frederic S. Mishkin: "Outlook and Risks for the U.S. Economy", Federal Reserve Board

[2] Bill Gross: "Urgent action needed to stave off rise of Bushville", Financial Times

LIQUIDITY NEWS. CDS SPREADS EXPLOSE GLOBALLY
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -48.5%]

[1] Credit spreads are surging globally. Most of the international CDS indices that I track are posting new highs in terms of spreads. Emerging markets appear to fare a touch better as of this writing. But take a look at Markit's iTraxx series. All of them, without exception, are trading at new highs in terms of spreads: Europe, Europe Crossover, Japan, Asia ex-Japan, Australia, and Japan 80. There is a whiff of panic in the air, as some spreads have surged more than 30% in just one session. Ladies and gentlemen: the credit spread explosion has gone global, no doubt about it.

[2] A Petrodollar tsunami? (Liquidity @ Financial Times). Morgan Stanley's Stephen Jen warns about the upcoming "petrodollar tsunami" that is likely to occur as oil trades at $100/barrel. Here's the key excerpt: "At $100 a barrel, the total proven reserves of the oil exporting countries is about $104,000bn – equivalent to the combined total value of publicly-traded equities and bonds in the world". Jen thinks that the tsunami has two broad implications in terms of financial markets: (a) equities will outperform bonds; (2) emerging market currencies are likely to gain both in terms of the dollar and the euro [Stephen Jen: "Petrodollar tsunami to hit euro and dollar", Financial Times]

LIQUIDITY NEWS. A NEW LOW FOR THE ENDOGENOUS LIQUIDITY INDEX
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -48.1%]

[1] Endogenous liquidity: a new low! Surging credit spreads on both CDS and cash bonds, the higher VIX, and plunging stock prices of financial innovators: all these factors are conspiring to send our Endogenous Liquidity Index to yet a new low (-48.1% year-on-year). The most worrying factor, in my mind, continues to be the path of the Moody's Baa spread. At 317 bps, it trades at highs not seen since February 2003. This provides a clear forecast in terms of corporate earnings: down!

[2] Bank Credit Analyst's own ... Goldilocks-Stagflation indicator! Since Friday, the Goldilocks-Stagflation indicator has competition: Bank Credit Analyst, the top-notch Canadian consultants, have launched their own indicator. Unlike our measure, which is market-based, BCA's is a quantity indicator: it results from computing stories that mention "goldilocks", "rising inflation" and "recession". See for yourself.

LIQUIDITY WATCH. BUSINESS AS USUAL: STRONG FUNDING LIQUIDITY, WEAK MARKET LIQUIDITY
. Federal Reserve: "Factors Affecting Reserve Balances", February 27

- Fed's Treasuries holdings: $776.7bn (-$2.2bn)
- Other central banks' Treasuries holdings: $1,270.3bn (+$6.2bn) (*)
- Other central banks' agency securities: $871.2 (+$5.1bn) (*)
- Global Dollar Liquidity Measure: $2,918.1bn (+$9.0bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

Market liquidity remains under stress, with both CDS spreads and cash bond spreads toying with recent highs. Global "funding" or "macroeconomic" liquidity, on the other hand, is still healthy, thanks to the ongoing recycling of emerging economies' surplus dollars into US treasury and agency securities. Believe or not, February 2008 marks the 63th month in a row with the Global Dollar Liquidity growing at an annual rate of 10% or more. This is, of course, unprecedented. Note, too, that the sharp fall in the stock of Treasury securities held by the Fed has been arrested by the much steeper yield curve resulting from the FOMC's strong medicine. Good news for euro-based investors!

LIQUIDITY NEWS. THE LARGEST EVER PEACETIME LIQUIDITY CRISIS?
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -43.7%]

Rachel Lomax, Deputy Governor for Monetary Policy at the Bank of England, was certain to make headlines with her speech at the Institute of Economic Affairs (*). According to Lomax, "this must surely be the largest ever peacetime liquidity crisis". Now, that's a statement! And she added, for good measure: "There may be more shocks to come". Aside from the journalistic excitement created by these lines, and bearing in mind that Ms. Lomax does not deal with the still booming macroeconomic global liquidity, the really important part of the speech deals with the outlook for inflation expectations and their impact on monetary policy:

If people put their trust in the regime, or a ‘credible central bank’, they are unlikely to revise their expectations about future inflation much, especially if the nature of the current situation is well and honestly explained, including how long it will take inflation to return to target. But if they forecast future inflation using simple rules of thumb based on past actual inflation rates, anything that dislodges inflation from target will affect what people use as their best forecast for future inflation ... In the context of the current outlook, the real risk facing the Committee is that a further period of above target inflation, prompted by a cost shock over which it has no immediate control, will lead people to revise their expectations about future inflation, and to act accordingly. This will make it more costly to bring inflation back to target.

Interesting stuff indeed. I guess well' have to closely watch ... inflation breakevens.

(*) Speech (pdf); Bank of England asbstract; Angela Monaghan: "BoE fears largest ever peacetime liquidity crisis", The Telegraph

LIQUIDITY ANALYSIS. GOVERNOR MISHKIN ON THE TERM AUCTION FACILITY
. Frederic S. Mishkin: "The Federal Reserve's Tools for Responding to Financial Disruptions", February 15

Federal Reserve Board governor Frederic Mishkin does a useful job here. The main point is the detailed discussion of the Term Auction Facility, announced on December 12. This new instrument, described as one of the "tools for supporting market liquidity", is aimed at providing credit to eligible borrowers for a term "substantially longer than overnight":

Despite the Federal Reserve's provision of liquidity through open market operations and the discount window, strains in term funding markets persisted and became particularly elevated in early December in response to year-end pressures. The magnitude of these strains can be gauged using the spread between Libor--that is, the London interbank offered rate--and the overnight indexed swap (OIS) rate at the same maturity, because the OIS rate reflects the average overnight interbank rate expected over that maturity but is not subject to pressures associated with credit and liquidity risks to the same degree as Libor.

As shown in chart 2, the one-month and three-month Libor-OIS spreads were at low levels through the month of July but increased markedly in August and early September at the onset of the financial market turmoil.6 The one-month spread declined during the fall but rose sharply again toward the end of the year. In association with these wider spreads, liquidity in term bank funding markets deteriorated substantially.

To address these pressures, the Federal Reserve introduced a new policy tool called the Term Auction Facility (TAF).7 With this tool, the Federal Reserve auctions a pre-announced quantity of credit to eligible borrowers for a term substantially longer than overnight; thus far, each auction has involved a term of one month. As with primary credit, a depository institution is eligible to participate in a TAF auction if the bank is judged to be in generally sound financial condition, and a wide variety of collateral can be used to secure the loan. The minimum bid rate for each auction is established at the OIS rate corresponding to the maturity of the credit being auctioned.

The introduction of the TAF was announced on December 12 in conjunction with related announcements by the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank (Board of Governors, 2007c).8 The first two auctions were held on December 17 and 20, for amounts of $20 billion each, and were very well subscribed: A large number of banks participated in each auction, and the total value of bids was about three times as large as the amount of credit auctioned. The resulting interest rate in both cases was about 50 basis points above the minimum bid rate but well below the one-month Libor rate prevailing in financial markets at that time. In recent weeks, the Federal Reserve has conducted three more auctions (most recently, last Monday) for amounts of $30 billion each. The spread over the minimum bid rate was about 7 basis points for the January 14 auction, 2 basis points for the January 28 auction, and 15 basis points for the February 11 auction; these spreads were much lower than in December, apparently reflecting some subsequent easing in the pressures on banks' access to term funding.

The TAF appears to have been quite successful in overcoming the two problems with conventional discount window lending. Thus far, the TAF appears to have been largely free of the stigma associated with borrowing at the discount window, as indicated by the large number of bidders and the total value of bids submitted.9 Furthermore, because the Federal Reserve was able to predetermine the amounts to be auctioned, the open market desk has faced minimal uncertainty about the effects of the operation on bank reserves; hence, the TAF has not hampered the Federal Reserve's ability to keep the effective federal funds rate close to its target.

Isolating the impact of the TAF on financial markets is not easy, particularly given other recent market developments and the evolution of expectations regarding the federal funds rate. Nonetheless, the interest rates in term markets provide some evidence that the TAF may have had significant beneficial effects on financial markets. As can be seen in chart 2, term funding rates have dropped substantially relative to OIS rates: The one-month spread exceeded 100 basis points in early December but has dropped below 30 basis points in recent weeks--though still above the low level that prevailed before the onset of the financial disruption last August.

ESSAY REVIEW. A NEW DEFINITION OF LIQUIDITY: THE GROWTH RATE OF REPOS
. Tobias Adrian & Hyun Song Shin. "Liquidity, Monetary Policy and Financial Cycles", New York Fed Current Trends in Economics and Finance, Vol. 14, No.1, January-February 2008

Henry B. kindly directs my attention to this very interesting piece by Tobias Adrian and Hyun Song Shin. The authors propose of a new definition of financial market liquidity, one that seeks to adequately reflect the nature of the new market-based financial system. The need to come up with a revised definition of liquidity responds to what the authors call "the rapid move toward a market-based financial system in recent years [that has] accelerated the trend toward greater reliance on nontraditional, non-deposit-based funding and toward greater use of the interbank market, the market for commercial paper, and asset-backed securities".

Adrian and Song Shin define liquidity as "The growth rate of financial intermediaries' balance sheets", that is to say "the growth rate of the stock of collateralized lending", or —even more precisely— "the growth rate of outstanding repurchase agreements". They detect a pattern whereby financial intermediaries "increase their leverage during booms and reduce it during downturns". Financial institution leverage is thus pro-cyclical. Unsurprisingly, they find a direct link between the growth of repos and the easing/tightening of monetary policy. While I tend to agree with their analysis, the fact remains that the indicator suggested by Adrian and Song Shin remains a quantity —not a market-based!— indicator. This is the great paradox of this otherwise very enticing piece (*).

(*) Interestingly enough, the VIX index —a truly market-based indicator— is singled out by the authors as the key indicator of "shifts in risk appetite". For a magnificent discussion of the relative merits of market-based indicators relative to quantity indicators, see the already aged, but still immensely valuable book by Manuel Johnson & Robert Keleher. Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

LIQUIDITY WATCH. WHAT A DIFFERENCE A WEEK MAKES!
. Federal Reserve: "Factors Affecting Reserve Balances", February 20

- Fed's Treasuries holdings: $778.9bn (+$23.6bn)
- Other central banks' Treasuries holdings: $1,264.1bn (-$2.6bn) (*)
- Other central banks' agency securities: $866.2 (+$19.9bn) (*)
- Global Dollar Liquidity Measure: $2,909.1bn (+$40.9bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

What a difference a week makes! After last week's across-the-board declines, the latest Fed balance sheet manages to produce very robust gains. First, let me discount the increase in the Fed's own stock of Treasury holdings: ever since the central bank started its special liquidity program, the accounts have become more difficult to interpret. Thus, "Federal Reserve Credit" registers a normal increase, while the (rather misterious) "Other Federal Reserve Assets" plunge by more than $15bn.

Having said that, the data are unambiguously positive. Foreign central banks' holdings of agency securities have reached a new all-time high ($866bn), reflecting the still very positive mood of investors in the emerging world. Because they desire to invest more in their own countries, they sell dollars to their (commercial) banks, which forces the local central bank to increase the amount of securities held under custody at the Federal Reserve Bank in New York. As Fed Governor Kevin Warsh says, "liquidity is confidence".

LIQUIDITY NEWS
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -45.4%]

[1] Notes yielding less than Bunds. When it comes to the dollar, I fully understand the bearish case and the very negative sentiment that surrounds the greenback. But why are ten-year notes yielding less than Bunds? Speaking on CNBC, an economist at an investment bank sees this as yet another bearish sign for the dollar (yields are lower in the U.S. because growth is weaker, etc). I beg to disagree. The higher Bund yield may be a sign of decreasing relative confidence in ... the euro.

[2] Checks and balances ... again. Readers of this blog are familiar with one of my key convictions: the cost of capital is lower in countries with political checks and balances. There is a micro side to this largely macro story: as I pointed out in December, the success of Goldman Sachs is largely due to its "culture of partnership which entails a high degree of mutual surveillance in the common interest", as John Plender puts it. I'm glad to know that Paul Strebel, Professor at IMD, makes a similar point:

In an industry that can bring down the whole economy and one with technically complex products, the board should include leadership checks and balances, plus a critical mass of industry experts, as at Goldman Sachs and Credit Suisse, who are independent enough to shape management's risk appetite and if necessary tame it by raising the red flag.

Is Prof. Strebel reading the blog?

[3] More stagflation talk. Every now and then, journalists are kind enough to direct our attention to the "growing risk of stagflation" (*). Now, I take this issue rather seriously — that's why I follow the market-based "Goldilocks-Stagflation" indicator. While the indicator took a beating yesterday on the back of higher inflation breakevens and some profit taking in the platinum market, it still confidently points to strong global economic growth with subdued inflation expectations. What a crazy world.

(*) Krishna Guha, Daniel Pimlott & Michael Mackenzie: "New Jump in prices raises worry of US stagflation", Financial Times

LIQUIDITY NEWS. MARTIN WOLF & THE BEARISH CASE
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -46.5%]

Today's Financial Times carries a rather gloomy piece by Martin Wolf. Mr. Wolf summarizes the ultra-bearish case as presented by economist Nouriel Roubini of RGE Monitor (*). Now, is there a bearish case to be made from the global liquidity perspective? You bet there is. Let me show you the results of backtesting a very simple model that combines elements of both macroeconomic and market liquidity. Whenever the sum of the rate of change of the Global Dollar Liquidity measure and the rate of change of the inverse of Moody's Baa spread is positive (negative), the "model" says be bullish (bearish).

- June 1997: Bullish. S&P500 at 885.14
- January 1998: Bearish. S&P500 at 980.28
- September 1999: Bullish. S&P500 at 1282.71
- October 2000: Bearish. S&P500 at 1429.71
- October 2001: Bullish. S&P500 at 1139.45
- January 2002: Bearish. S&P500 at 1130.20
- February 2002: Bullish. S&P500 at 1106.73
- May 2002: Bearish. S&P500 at 1067.14
- September 2002: Bullish. S&P500 at 815.28
- October 2002. Bearish. S&P500 at 885.77
- Januayr 2003. Bullish. S&P500 at 855.70
- August 2007. Bearish. S&P500 at 1473.99

(*) An earlier version of this post contained a harsh, and poorly documented, comment on Mr. Roubini as a forecaster. I am now withdrawing that comment: I want to focus on liquidity conditions — ad hominem remarks have no place in this blog. My apologies [Agustin].

LIQUIDITY WATCH. ACROSS-THE-BOARD DECLINES!
. Federal Reserve: "Factors Affecting Reserve Balances", February 13

- Fed's Treasuries holdings: $75530bn (-$2.2bn)
- Other central banks' Treasuries holdings: $1,266.7bn (-$0.5bn) (*)
- Other central banks' agency securities: $846.2 (-$4.2bn) (*)
- Global Dollar Liquidity Measure: $2,822.0bn (-$6.9bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

The weekly Fed balance sheet shows modest, but across-the-board declines. All components of the Global Dollar Liquidity measure are down: the Fed's own stock of Treasury securities, foreign central banks holdings of Treasuries, and foreign central banks holdings of agency securities. This is a very rare occurrence indeed! Most striking of all, the "domestic" (*) component is now down for two months in a row. The last time we had back-to-back contractions in this proxy of the monetary base was in ... December 2000/January 2001!

(*) Strictly speaking, the adjective "domestic" is a bit of a misnomer here. The Fed destroys liquidity whenever it defends a target for the fed funds rate that is too high relative to the demand for bank reserves. The weakness in the demand for bank reserves, in turn, may reflect both domestic and international factors.

LIQUIDITY NEWS
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -46.2%

[1] Hail to the VIX! I am a big fan of market-based volatility indicators: the VIX, the VXN, the RVX, the V-DAX and others. (For all things VIX, see Bill Luby's blog — he's now analyzing the VXV, the new kid in town). The VIX is the key market proxy of the "Great Moderation" of the business cycle hypothesis, a key element in terms of endogenous liquidity. Here, the message is pretty clear: the Great Moderation is alive and well. The global economy is incredibly diverse; its multiple sources of demand and liquidity all but negate the possibility of a worldwide economic depression à la 1930s [VIX and more]

[2] Main Street v. Wall Street — again (Liquidity @ Financial Times). Don't miss this piece by Francesco Guerrera et al., which highlights the divergent views of (bearish) economists and (bullish) business people. One sentence summarises it well: "... economists are from Mars and businesspeople are from Venus". This is precisely what we are seeing at the Global Liquidity Blog: while credit markets are weak, world economic growth is strong. [Francesco Guerrera, James Politi & Aline van Duyn: "Full steam ahead?", Financial Times]

[3] The FT & "Liquidity reform" (Liquidity @ Financial Times). The L-word is mentioned no less than 15 times in this somewhat confusing FT editorial comment. The key part: "Most regulatory regimes today are far too simplistic: they must evolve to become complex simulations that test which events, from closure of the asset-backed bond market to a currency crisis, would put liquidity stress on a bank, and whether they are properly insured against it. Regulators also need to co-operate: a bank may seem illiquid in one country, but have mountains of cash waiting in another". [Financial Times: "Liquidity reform"]

LIQUIDITY ANALYSIS. THE LIQUIDITY CONUNDRUM INTENSIFIES
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -46.0%]

First, the good news. Surging platinum prices and well-behaved ten-year inflation breakevens have taken the market-based "Goldilocks-Stagflation" indicator to an all-time high of 0.93 (*). In addition, the latest Fed balance sheet reveals a $6.5bn increase in the Global Dollar Liquidity measure, driven by foreign central bank purchases of Treasury securities. The global economy is growing strongly!

At the same time, however, credit spreads continue to surge, which tends to portend bad news in terms of corporate earnings. Higher CDS- and cash spreads have pushed the Endogenous Liquidity Index to a new ... all-time low! I will fully admit it: (a) I find these market/economy conditions somewhat perplexing; (b) I have some catching up to do in terms of reading. I hope to come up with something interesting soon! Meanwhile, the extended trading range scenario is likely to prevail.

(*) Platinum-Gold = 1943/1906 = 2.14. Ten-year inflation breakevens = note yield - TIIPS yield = 230 bps. Goldilocks-Stagflation = 2.14/2.30 = 0.93.

LIQUIDITY ANALYSIS. THE MOODY'S BAA SPREAD HITS 300 BPS
[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -45.4%]

Not seen since March 2003: the Moody's Baa spread relative to 10-year Treasuries trades at just over 300 bps. Watch out for a massive blow to corporate earnings.

LIQUIDITY ANALYSIS. THE INCREDIBLE SHRINKING MONETARY BASE
[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -44.6%]

Surely the most intriguing element of the Fed's balance sheet is the sharp contraction in the stock of Treasury securities held by the central bank. This reliable proxy of the monetary base is down 1.7% from January 2007 — the first monthly contraction since ... January 2001! The only way to make sense of the incredible shrinking monetary base, in my view, is to consider the odd shape of the yield curve (ten-year note yield vs. fed funds rate target). A year and a half of inversion has taken its toll on high-powered money. When demand for credit weakens and demand for bank reserves follows suit, there are only two equilibrium points: (a) the Fed announces a new, lower target for the fed funds rate; (b) the Fed contracts the supply of bank reserves by selling bonds.

Clearly, alternative (b) was the path chosen by Bernanke and Co. until very recently. Believe it or not, there is an ongoing dollar ... scarcity! With the latest FOMC move, which took the fed funds rate all the way down to 3%, the yield curve has recovered its normal shape. One last issue remains to be mentioned: do trends in the monetary base matter at all? From the persective of the Global Liquidity Blog, the answer is clearly: yes — and a lot. Shrinking base money completely justifies the aggressive easing of monetary policy. And don't rule out additional steps!

LIQUIDITY ANALYSIS. A SHORT HISTORY OF THE "GLOBAL LIQUIDITY MEASURE" (PART I)
[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -42.0%]

Henry, a.k.a. the Picky Investor, asked yesterday for background information on ... methodology. His question led me to think about penning a short history of the Global Dollar Liquidity measure. Also, I realized that it was a good time to launch an older project of mine, namely to "open-source" my liquidity indicators. By sharing the information, and by discussing the (numerous) shortcomings of all these measures, I hope to benefit from the interaction with readers. So let's begin with a short history of the GDL measure ...

I. - From Jacques Rueff to John Mueller
As a young international economist working at a boutique investment bank in the 1990s, I was puzzled (together with my boss, who happened to be the chairman of the bank) by the effects of the "Tequila" contagion in early 1995. After reading a Barron's piece by John Mueller, chief economist of Washington, D.C.-based consultants Lehrman, Bell, Mueller & Cannon, we decided to hire them for a couple of months. Mueller's (and Lehman's) insights were based on the writings of French economist Jacques Rueff (1898-1982). In the 1930s, Rueff had given birth to the notion of an international reserve currency. Later, as an advisor to French president Charles de Gaulle, he fought vehemently for the demise of the Bretton Woods System. In order to check the growing power of America, de Gaulle and Rueff urged Western Europe to dump the dollar as the key reserve asset. France was doing just that, with Banque de France buying huge amounts of physical gold against its massive greenback holdings [1].

Rueff's key insight was as simple as it was powerful: when countries invest the proceeds of their trade surplus into the credit markets of the deficit countries, they create a "double pyramid of credit". Interest rates are kept at artificially low levels, the (reserve) currency suffers from chronic overvalution, and dangerous financial bubbles arise. The "neo-Rueffians" at LBMC had created a proprietary measure of these flows, dubbed the World Dollar Base. Clients did not have access to LBMC's methodology. As soon as our contract expired, I decided to take matters into my own hands. Having lived in France as a child, I could read in French (I still can!) After digesting the first pages of Jacques Rueff's Le peché monétaire de l'Occident (Paris: Plon, 1971), I decided to set up my own "Rueffian" liquidity indicators ...

[To be continued]

[1] See Francis J. Gavin. Gold, Dollars, & Power. The Politics of International Monetary Relations 1958-1971 (Chapell Hill: The University of North Carolina Press, 2004).

LIQUIDITY ANALYSIS. I'M BAAACK!
[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -40.4%]

Hello everybody, I'm baaack! After a long summer break (I was in South America), I'm back in the saddle, trying to make sense of financial markets and liquidity indicators. Plugging in the numbers, here's what I see: business as usual. In other words: while funding liquidity is still relatively strong, market liquidity looks awful. Most of the damage is caused by surging credit spreads; volatility indicators, however, appear to behave in a way that is consistent with the "Great Moderation" of the business cycle thesis. Finally, and quite surprising, I note that my market-based "Goldilocks-Stagflation" indicator is trading at a ... 3-month high! In a nutshell: earnings will take a hit -- but the global economy still looks good. A recipe for an extended trading range?

[1] Funding liquidity is still strong. The Global Dollar Liquidity measure shows a 11.4% increase with respect to January 2007. That fits my definition of a "liquidity boom": a 10%-plus rate of growth. Moreover, January marks the 62th month in a row of this funding liquidity boom. There are no precedents for such an extended period of strong growth in central banks' dollar reserves.

[2] Market liquidity looks awful. At -40.4%, our Endogenous Liquidity Index is plumbing new lows. Within the index, however, we note two diverging trends. Volatility and financial innovation indicators (chiefly, the VIX index and the GS share price) are relatively well behaved. But credit spreads are hurting a lot. The Moody's Baa spread is approaching 300 bps, a five-year high. Not good in terms of corportate earnings!

[3] Surprising Goldilocks. At 1.94, the platinum-gold ratio (a market-based proxy for the world economy) trades at a six-month high. At 234 bps, ten-year inflation breakevens look reasonable, given the FOMC's aggressiveness. Thus the "Goldilocks-Stagflation" measure, which plots one indicator against the other, trades at a 3-month high. Against this background, stocks do not look particularly expensive, even after the recent rally.

[4] Long-term picture still bearish. On August 31, 2007, my trusted long-term model for risky assets went bearish. It combines the rate of growth of both the Global Dollar Liquidity measure and the inverse of the Moody's Baa spread. Because it does no take account of volatility indicators, the model may be unduly skewed to the bearish side. All in all, a very sharp fall in credit spreads (more than 100 bps) is required for the model to flash out a bullish signal.

TAKING A BREAK HERE ... POSTING WILL BE LIGHT ...

LIQUIDITY WATCH. GOOD TIMES, BAD TIMES
. Federal Reserve: "Factors Affecting Reserve Balances", December 26

- Fed's Treasuries holdings: $775.0bn (-$13.4bn)
- Other central banks' Treasuries holdings: $1,226.2bn (+$1.6bn) (*)
- Other central banks' agency securities: $830.2 (+$7.0bn) (*)
- Global Dollar Liquidity Measure: $2,831.4bn (-$4.5bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

As the year draws to an end, one question remains unanswered: will the dichotomy between strong funding liquidity and weak market liquidity persist? Let me put it this way: what could cause my trusted long-term model for risky assets to flash a "buy" signal? (The model combines the rate of change of the inverse of the Moody's Baa spread and the rate of change of the Global Dollar Liquidity measure; it finds itself in mildly bearish territory since August). The math shows that spreads would need to fall about 70 bps; alternatively, funding liquidity would need to explode (+37%). None of this portrays a likely scenario, even with central banks easing aggressively. My own guess is that my model has become skewed to the bearish side, because it does not adequately reflect (among other components of market liquidity) the growing impact of the "Great Moderation" of the business cycle. Here, the VIX and other volatility indicators have a key role to play — and their recent performance is indeed encouraging. Bottom line, my friends: while I'm busy re-calibrating my models, I just don't see how risky asset markets could break out of their 2007 trading range any time soon.

CHECKS & BALANCES AND CREDIT CREATION: THE BEST OF 2007
[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -28.5%]

Years spent at emerging markets trading desks have taught me a lesson that I am not about to forget: the availability of credit depends crucially on the stability of property rights — which in turn depends on the existence of political ... checks and balances. In Iceland, the credit market is three times the size of the GDP; in Argentina, it barely reaches 12% of GDP. Iceland regularly features among the top-ten countries in terms of judicial independence, freedom of the press, connectivity and central bank autonomy (see data). Meanwhile, the quality of Argentina's governance ranks below that of stalwarts Pakistan, Nigeria and Madagascar. In order for credit to flourish, power needs to be fragmented. In that spirit, I have selected the 2007 events/firms/products that have made a positive contribution in terms of credit creation and checks & balances.

[1] Goldman Sachs. Financial Times reporters writing on the saga of Goldman Sachs have uncovered one of the key secrets of the firm: its governance structure, especially in terms of risk management. "The culture of partnership", writes John Plender, "which entails a high degree of mutual surveillance in the common interest, still survives in spite of Goldman's status as a listed company". The key phrase here is: mutual surveillance. That's the very definition of ... checks and balances! In another FT piece on Goldman, we learn that the back-office is considered a prestigious place to work. Insiders call it the Federation — yet another allusion to the notion of checks and balances. And if this wasn't enough, consider the recent Michael Skapinker piece on Chuck Prince and Stan O'Neal. These guys behaved in almost authoritarian ways, something that (presumably) will not happen at Goldman Sachs. [John Plender: "Market insight: Goldman offers example of governance", Financial Times] [Ben White: "Man in the News: David Viniar", Financial Times] [Michael Skapinker: "Silencing the dissenters can end your career", Financial Times]

[2] The euro. In a remarkable speech at the 2004 Bundesbank Lecture, former Fed chairman Alan Greenspan said: "... if other currencies, such as the euro, emerge to share the dollar's role as a global reserve currency, that process, too, is likely to be benign". The Maestro was alluding to the diffusion of "current imbalances", a.k.a the U.S. current account deficit. In other words: the euro acts as a check on the propensity of the United States to over-use the dollar as the key international reserve asset. Far from being a bearish factor in terms of global credit creation, the surging euro is a ... balancing factor! [Alan Greenspan: "Globalization", Bundesbank Lecture, 2004]

[3] Sovereign Wealth Funds. SWFs are increasingly acting as a key element in terms of the global credit markets. Let me quote, on this subject, Richard Gnodde, co-CEO of Goldman Sachs International: "We have one global economy, but it is increasingly powered by multiple engines, with multiple sources of demand and liquidity ... This emergence of new flows and new actors from new models of capitalism reflects a natural diversity of social and economic practices that is in no way incompatible with the process of globalisation". More diversity, less risk. [Richard Gnodde: "A role for new actors in the global economy", Financial Times]

[4] Islamic finance. "Islamic finance takes off", writes Thomas Barnett, in my view the top globalization expert. He adds: "An estimated 300 Islamic banks hold half a trillion in assets. About 7-8 years ago, when Malaysia started pushing this crazy notion, there was no Islamic finance to speak of. Now it grows at more than 10% a year, and you’ve got Citigroup, HBC, Deutsche Bank and Asian giants all chasing this pie". Again: more diversity, less risk. [Thomas P.M. Barnett: " Islamic finance takes off"]

LIQUIDITY WATCH. FINALLY, SOME DECENT NUMBERS!
. Federal Reserve: "Factors Affecting Reserve Balances", December 19

- Fed's Treasuries holdings: $788.4bn (+$6.0bn)
- Other central banks' Treasuries holdings: $1,224.6bn (-$4.0bn) (*)
- Other central banks' agency securities: $823.3 (+$11.6bn) (*)
- Global Dollar Liquidity Measure: $2,836.3bn (+$13.6bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

[1] Decent numbers! After several weeks in the doldrums, the weekly Fed balance sheet finally manages to produce a set of decent numbers. The Global Dollar Liquidity measure surges on the back of renewed central bank activity — both domestically and internationally. Note also the pick up in lending through the discount window, now at levels not seen since the September 2001 terrorist attacks. The annual rate of growth of the Global Dollar Liquidity measure recovers somewhat, to 12.7% from 12.4%. But look at the growth rate of securirties held by the Federal Reserve itself: only 1.5%. Dare I say it? Dollars are ... scarce! There you have it.

[2] The VIX & the mini-rally. Is the current mini-rally in stocks sustainable? Remember the last attempt to get past 1525 on the S&P500. The VIX did not collaborate: its refusal to trade through 20 sounded the death knell of the rally. Given the dreadful signals sent by credit spreads (Moody's Baa spreads are still toying with four-year highs), the VIX offers the only glimmer of hope in terms of "endogenous liquidity". Watch it carefully!

LIQUIDITY TALK. A CONFUSING PIECE ON "NEW MONETARISM"
[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -32.3%]

Über-bear David Roche has just coined the term "New Monetarism". His aim is to "properly define" the notion of liquidity in order to highlight "the potentially disastrous outlook for the global economy and financial markets". "What is liquidity?", he asks rhetorically. Sadly, his answer does nothing to alleviate the confusion: "To redefine liquidity under what I call New Monetarism, one must add, to the traditional definition of broad money, all the credit being created and moved off banks' balance sheets and onto the balance sheets of nonbank financial intermediaries. This new form of liquidity changed the very nature of the credit beast". As the Lex Column would say, Mr. Roche's views provide yet another example of a "catch-all phrase to denote, variously, loose central bank policy rates, broad money supply growth, aggressive lending to private equity, yen borrowing and even the growth of debt derivative products". In Mr. Roche' usage, "liquidity is too, well, wishy-washy, to be useful". [David Roche: "The Global Money Machine", Yale Global Online]

LIQUIDITY TALK. WELCOME TO THE NEW YORK FED - PRINCETON "LIQUIDITY CONFERENCE"!
[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -33.1%]

The New York Fed-Princeton Liquidity Conference; M2 & liquidity conditions; William Dudley on the TIPS market; record platinum prices.

[1] Liquidity, an increasingly popular topic! Liquidity issues are making headlines. Today's FT carrries a front-page headline about the ECB's liquidity injections. Last week, the Federal Reserve Bank of New York organized a "Liquidity Conference" together with Princeton University. At the Global Liquidity Blog we welcome this sudden popularity! In his introductory remarks, New York Fed president and CEO Timothy Geithner uttered the L-Word no less than ... 19 times! Describing the current situation in money markets, Mr. Geithner points to factors that tend both to reduce the supply and to increase the demand for funds: "Financial institutions faced a sharp drop in demand for a range of assets, impairing the securitization market as a source of funding. And a substantial amount of these illiquid assets were held in vehicles with implicit or explicit liquidity guarantees provided by banks. This produced a large unexpected increase in demand for funding from banks at the same time banks confronted a reduced capacity to raise financing. As market participants have adjusted to what has been a very acute change in expectations about economic and credit risk, they have become more cautious in how they use their liquidity and capital". [Timothy Geithner: "Restoring Market Liquidity in a Financial Crisis", New York Fed] [The Second New York Fed — Princeton Liquidity Conference]

[2] James Picerno: M2 & liquidity. James Picerno, the editor of the Capital Spectator blog, is at it again. Analyzing trends in M2, he warns readers about the risks of "excess liquidity" created by the Fed. As I have written many times here, M2 is not a liquidity measure. The Fed has little control over M2. Moreover, in times of financial stress, strong M2 growth is a sure sign that liquidity is actually ... decreasing! Flight-to-quality buying of money market funds may artificially inflate M2, just as the monetary base —a true liquidity indicator— may show signs of faltering. This is what happened in 1998. The turmoil led to a memorable debate within the FOMC. While monetarist members led by Jerry Jordan and William Poole argued for increases in the Fed funds rate, "internationalists" such as chairman Alan Greenspan made the case for a rate cut. In the event, Greenspan prevailed and the central bank lowered the Fed funds target — a move that was instrumental in avoiding a major banking crisis. The "monetary multiplier" is a notion that needs to be applied with a considerable degree of caution, especially if the currency in question is also an international reserve asset. Indeed, to the extent that a lower Fed funds rate eases the flight-to-quality stress (and the consequent rush to buy money-market funds), it may well lead to ... less M2 growth! [James Picerno: "Stable prices won't come cheap", Capital Spectator]

[3] William Dudley on the TIPS market. William Dudley, the former Goldman Sachs economist now at the New York Fed, analyzes the Treasury Inflation-Protected Securities market. Key point: "... the 5-year, 5-year forward breakeven inflation measure is a very important part of the monetary policymaking process. Without a TIPS market, this tool would be unavailable and I think it would be safe to say that monetary policy would suffer as a consequence. How much is this tool worth? Of course, it is very difficult to say. Perhaps, we would flatter ourselves and think that we could do just as well without such a market-based, real-time measure of inflation expectations. But I doubt it. After all, inflation expectations, when untethered, are very difficult to re-anchor. TIPS help make it easier to keep inflation expectations firmly in check". [William Dudley: "Reflections on the Treasury Inflation-Protected Securities Market", New York Fed]

[4] Platinum prices at a record high. Platinum hit a record $1,519/oz yesterday. As readers of this blog know, we closely follow the platinum-gold ratio as a key indicator of global economic growth. [Chris Flood: "Platinum jumps to record of $1,519", Financial Times]

LIQUIDITY TALK. NOT ALL MARKET CORRECTIONS ARE CREATED EQUAL (AND THAT'S GOOD NEWS!)
[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -33.3%]

Stocks not expensive; liquidity @ Financial Times

[1] On market corrections. Not all market corrections are created equal: this truism has been particularly useful in 2007. As one would expect in a trading range environment, rallies in risky assets prices have been followed by sharp corrections. The key question to ask, in my mind, is the following: what happens both in terms of economic growth and inflation expectations as the market corrects? When the S&P500 sold-off in the second week of November, our market-based "Stagflation-Goldilocks" indicator duly followed suit. There was little value in stocks even as they fell in price. By this same measure, the current correction is an altogether different animal. Ten-year inflation breakevens are relatively well behaved, and the platinum-gold ratio has just reached a two-month high, signalling strong global growth. The S&P500 doesn't look particularly expensive here.

[2] Liquidity @ Financial Times: ECB emergency measures. According to the FT, the ECB announced last night that it would offer "unlimited funds at below market interest rates in a special operation to head off a year-end liquidity crisis" (I can't find the link to the ECB website). Appartently, funds injected today will be "mopped up" later on by the central bank. [Ralph Atkins & al: "ECB steps up fight to safeguard liquidity", Financial Times]

[3] Liquidity @ Financial Times: credit creation & vehicular finance. Amid the sometimes sensless gyrations in financial markets, it pays to read articles that put it all in context. As a fan of Joseph Schumpeter (who thought that innovation went hand in hand with 'credit creation'), I was struck by this timely piece on vehicular finance: "... in the past decade, this financial model has changed radically. On the one hand, banks have increasingly started to sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans into bonds; at the same time, regulatory reforms have permitted the banks to reduce the amount of capital that they need to hold against the danger that borrowers default. The net consequence is that the western financial system embraced what Paul Tucker (BoE), has described as the age of 'vehicular finance'. This system has given banks huge incentives to pass on their loans to new vehicles, either by creating these themselves or by sponsoring outside fund managers to run them. The role of such entities in creating credit has increased vastly in the past three years. For example, the asset-backed commercial paper market, which supplies the lion’s share of funding to SIVs and conduits in the form of cheap, short-term cash, saw a step-change in growth at the end of 2004. The volumes of such paper in issue had fluctuated between $600bn and $700bn for at least four years; at the market’s peak this summer they stood at almost $1,200bn". [Gillian Tett & Paul J. Davies: "Out of the shadows. How banking's hidden system broke down", Financial Times]

LIQUIDITY TALK. A 'CONSENTING ADULTS' VIEW ON THE US CURRENT ACCOUT DEFICIT
[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -31.9%]

Kudos to Brad Setser! Economist Richard Iley, who holds sharply different views on the US current account, is 'guest-blogging' at RGE Monitor (*). I have always felt that large current account deficits could be treated with benign neglect provided that: (a) property rights remain stable; (b) productivity gains persist. In the event, this is largely the case in the U.S. According to Mr. Iley: "The obsession with ‘official’ inflows into the US seemingly arises from two controversial conclusions. First, that central bank purchases are somehow special, if not outright ‘abnormal’".

"Flowing on this is the usually tacit but sometimes explicit assumption that central bank purchases may prove more ephemeral or footloose than more inherently normal private capital flows. Both assumptions are highly dubious ... The lesson of recent years has been that foreign demand for US assets – both private and ‘official’ – appears more structural and hence more sustainable than anyone thought ... the marginal productivity of holding dollars appears to be higher than most economists believed".

Read the whole thing!

(*) Richard A. Iley & Mervyn K. Lewis. Untangling the US Deficit. Evaluating Causes, Cures and Global Imbalances. (Cheltenham: Edward Elgar, 2007).

LIQUIDITY WATCH. THE DISCOUNT WINDOW RE-OPENS. TOO LITTLE, TOO LATE?
. Federal Reserve: "Factors Affecting Reserve Balances", December 12

- Fed's Treasuries holdings: $782.4bn (-$8.1bn)
- Other central banks' Treasuries holdings: $1,228.6bn (+$2.9bn) (*)
- Other central banks' agency securities: $811.7 (+$0.7bn) (*)
- Global Dollar Liquidity Measure: $2,822.7bn (-$4.6bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

For the first time since mid-September, banks are borrowing at the discount window. The weekly Fed balance sheet registers a $2.7bn increase in "primary credit", a sure sign that the discount window has indeed re-opened. But is it not a case of "too little, too late?" Overall, the stock of Treasury holdings at the central bank shows a sharp $8.1bn decline, a reflection (IMHO) of the bizarre shape of the yield curve, with the Fed funds rate target still above the ten-year note yield. The annual rate of growth of the Global Dollar Liquidity measure takes another hit: at 12.4%, the situation still qualifies as a "funding liquidity boom". But if current trends persist, it will not be long before we see sub-10% growth rates. This may be the message sent by a slightly stronger dollar, although some commodities markets —especially in the grains complex— are still "dancin' in liquidity".

LIQUIDITY TALK. WILLEM BUITER & "SCHMORAL HAZARD"
[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -31.9%]

Bank Credit Analyst & the yield curve; liquidity @ Financial Times

[1] It's the yield curve, stupid! Bank Credit Analyst, the top-notch Canadian consultant, makes a good point about Fed policy: what matters is the yield curve. BCA's starting point is the swap curve, as defined by "the spread between the 5-year swap rate (a proxy for the rate that banks lend at) and the 6-month libor rate (a proxy for bank funding costs)", which "is at its most inverted level in the history of the series". They conclude: "The Fed likely needs to dramatically steepen the swap curve as occurred in the early 1990s and early 2000s, in order to facilitate a healing process". The spread between the ten-year note and the Fed funds (the measure I follow) is inverted since ... june 2006! Clearly, more work needs to be done. [Bank Credit Analyst:"What Can The Fed Do?"]

[2] Liquidity @ Financial Times: good coverage! The FT provides good coverage of the coordinated central bank action to ease the liquidity situation. Prof. Willem Buiter (whose lectures I attended a long time ago) is quoted about moral hazard: "Prof. Buiter said the concern about moral hazard was overplayed: Moral hazard, schmoral hazard". [Chris Giles: "Co-ordinated action attracts praise", Financial Times]

LIQUIDITY TALK ...
[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -32.8%]

- The globalization of liquidity provision. The Federal Reserve, together with the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank is announcing measures "designed to address elevated pressures in short-term funding markets". Welcome to the globalization of liquidity provision! From the press release: "By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress". Well done! [Federal Reserve Board press release][ECB press release]

- Liquidity @ Financial Times: Martin Wolf. The FT's international economist makes some good points about the credibility of what he dubbs the Anglo-Saxon model of transactions-orientated financial capitalism: "Not for a long time will people listen to US officials lecture on the virtues of free financial markets with a straight face". This is what he has to say on liquidity: "What, more precisely, should a central bank do when liquidity dries up in important markets? Equally, the crisis suggests that liquidity has been significantly underpriced". These are all interesting points. Not so long ago, however, Mr. Wolf used to refer to the global economic landscape as a "new Golden Era". Perhaps we should discount both his earlier bullishness and his current bearishness. The credit squeez is not a "turning point for the world". [Martin Wolf: "Why the credit squeeze is a turning point for the world", Financial Times]

- The trading range asserts its rights. The S&P500 almost made it to 1525! In retrospect, I should have noted the VIX's refusal to trade below 20 as a warning sign (memo to self: keep better track of such divergences — they can be very useful!). Anyway, it was a wild ride: a gain of almost 8% in little more than two weeks. Bravo! The FOMC communiqué turned out to be the perfect excuse to take profits, especially when you realize that the Moody's Baa spread continues to forge ahead. At 259 bps, it now trades at levels not seen since March 2003 — and that does not bode well in terms of corporate profits. The trading range scenario is asserting its rights again. Having said that, what strikes me is the fact that the S&P500 —when valued against the "Goldilocks-Stagflation" index— does not look particularly expensive. We continue to see relatively strong global economic growth, and well-behaved inflation breakevens.

LIQUIDITY TALK!
[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -28.7%]

- Liquidity @ Financial Times: liquidity & transparency. Larry Tabb makes a good point about the lack of transparency in the OTC debt market: "So what would happen if by fiat – or, more likely, by some government act – the asset-backed (or other OTC) market were to become listed overnight? Liquidity would dry up and pricing would be more volatile. The reason OTC markets tend to be OTC is that there is not enough liquidity provided by 'the general market' to enable buyers and sellers to execute without the aid of large-broker capital". [Larry Tabb: "Market insight: Transparency would muddy OTC waters", Financial Times]

- Endogenous Liquidity watch. Our Endogenous Liquidity Index is up 12.9% since its November 26 low. This stellar performance was led by the falling VIX; I view it as a sign that the "Great Moderation" of the business cycle is alive and well. Spreads on Credit Default Swaps and on high yield bonds are also sharply lower. But note the discrepancy with Moody's Aaa and Baa spreads, which continue to surge. What is going on? Long-time spreads watcher Ken Fisher is not worried: according to Forbes' Rich Karlgaard, Mr. Fisher emphasized the (bullish) fact that "Triple-A-rated companies can borrow at lower rates than they could six months ago". (This is true). Note, also, the very bullish fall in 10-year inflation breakevens (225 bps), which are fast approaching late August lows. Here, the FOMC will likely have an impact. [Rich Karlgaard: "Three Bulls Walk Into A Forbes Cruise", Forbes Digital Rules]

- Liquidity @ Financial Times: Bullish Pictet Asset Management. John-Paul Smith, chief strategist at Pictet Asset Management, describes himself as a value-based investor with a strong contrarian streak. I like that — and I like his views on the dollar and on commodities. Mr. Smith thinks the dollar will recover "once investors realise that the long-term prognosis for the US economy is actually very good, as evidenced by its high productivity and positive demographic trends". On the subject of commodities, he thinks that the "intellectual foundations of the commodity boom are pretty shaky", and that "there is a tendency over the very long-term of real commodity prices to decline". Given the not-so-hot rate of growth of the Global Dollar Liquidity measure, and the related collapse in US monetary base growth, I tend to agree with Mr. Smith. [John-Paul Smith: "Investors should shut their ears to the bears", Financial Times]

LIQUIDITY TALK. BRAD SETSER & THE GLOBAL RESERVES GAME
[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -30.0%]

Brad Setser on global reserves; Cumberland Advisors on the FOMC meeting.

[1] Brad Setser on global reserves (i): no free lunch! Don't miss this post by Brad Setser, who discusses discusses JP Morgan's Bernhard Eschweiler's views on central bank diversification (he wrote in the FT: ): "The idea that central banks are undermining the dollar makes neither sense nor is there evidence in the data. The principle mistake that many commentators make is the assumption that central banks can separate the currency allocation of reserves from their exchange rate objectives. In practice, this is often not the case, especially for the large surplus economies in Asia as well as the oil-exporting countries. These countries all follow some sort of dollar standard, whether it is an outright peg or a dirty float. So, when they intervene to prevent their currencies from appreciating against the dollar, they get mostly – or even exclusively – dollars (also because most of their trade and capital flows are dollar denominated). However, it is difficult to sell those dollars back to the market without causing renewed dollar weakness and, thus, trigger new interventions. Some small central banks may get away with it, but not the group of large reserve holders. There is no free lunch: if you shadow the dollar you also have to hold it". [Brad Setser: "Are central banks diversifying away from the dollar?", RGE Monitor]

[2] Brad Setser on global reserves (ii): diversification vs. sales. In the more informal comments section, Mr. Setser outlines his own views: "I define diversification as reducing the $ share of your reserves (Russia, early 2006 = clear example). Market folks tend to define it as sale of dollars, whether to meet an existing portfolio benchmark or to meet a new (higher) portfolio benchmark for euros/ pounds. And this year -- given the increased scale of reserve growth -- there clearly has been more $ sales even if there hasn't been much diversification. Russia is an interesting example: by virtue of having diversified in 2006 (in the sense of reducing the $ share of their reserve portfolio), they were in a position where they had to sell a lot of $ to buy euros and pounds to meet their benchmarks when capital inflows into russia picked up and russian reserve growth accelerated. no further diversification, but a lot larger $ sales". Excellent! In other words: central banks can act as large dollar sellers, even without diversifiying in terms of their portfolio benchmarks.

[3] Brad Setser on global reserves (iii): the hidden data. If central banks continue to accumulate dollar reserces, as Brad suggests, why has this failed to show up in US data? "Mr. Eschweiler argues that China hasn't been able to reduce the dollar share of its reserves, and may even be increasing the dollar share. The US data, of course, doesn't show such an increase, but as Eschweiler notes, the US data doesn't capture Chinese purchases from banks in Europe and Asia". Color me a skeptic on that one. The New York Fed custody data has seen aenemic growth over the last couple of months. Meanwhile, market liquidity is faltering. Maybe —just maybe— less bullish investors in emerging markets are slowly increasing their own holdings of dollars as a precautionary move. Keep an eye on the dollar exchange rate vis-à-vis the emerging market currencies. This could become a key tell here.

[4] Cumberland Advisors on the FOMC meeting. David Kotoc expects a 25 basis points cut, but thinks 50 would be more appropiate: "The place to look for significant policy changes is in the Discount Window rules and rate decision on December 11. We think the Fed will lower the Discount Window Rate by 25 basis points more than the Federal Funds Rate. The rules for using the “window” may be liberalized again as has been repeatedly done during this turmoil period. In addition the Fed will approve lengthening the term of repurchase agreements. That is another form of easing ... Why do we believe the Fed should drop the Fed Funds rate by 50 and the Discount rate by more than 50? Simply put: that is what it will take to get the London Inter-bank interest rate (LIBOR) to clear transactions between banks at an interest rate which reflects some return to normal credit spreads. Current US dollar LIBOR rates are higher than the Discount Window rate. They have induced some banks to obtain funds from the Discount Window as we saw in last Thursday’s reserve report. The Fed saw it, too. They published it. They know that LIBOR is not clearing well. They also know that half of the total world’s finance is tied to LIBOR ($150 trillion including derivatives according to Jim Bianco’s estimate). The Fed knows it must change this and the risk of recession and contagion grow every single day that they fail to do so". [David Kotoc: "The Fed & December 11th Meeting Outcome", Cumberland Advisors]

LIQUIDITY WATCH. DANCIN' IN LIQUIDITY? DON'T COUNT ON ME
. Federal Reserve: "Factors Affecting Reserve Balances", December 5

- Fed's Treasuries holdings: $790.5bn (-$3.3bn)
- Other central banks' Treasuries holdings: $1,225.7bn (+$0.4bn) (*)
- Other central banks' agency securities: $811.0 (+$4.8bn) (*)
- Global Dollar Liquidity Measure: $2,827.3bn (+$2.0bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

[1] Weekly Fed balance sheet watch: an early December surprise. I haven't missed a single weekly Fed balance sheet for the last ... eleven years! In other words: I only need a brief glance at the numbers to get a sense of what's coming. Then, I duly put the data into an Excel sheet for an extensive massage session. As soon I saw the latest numbers, I knew that the annual rate of change of the Global Dollar Liquidity measure would take a hit — a big one. At 12.7%, it is the lowest since March. Moreover, the stock of Treasury securities held by the Federal Reserve —a proxy for the monetary base— has all but collapsed. Its annual rate of growth (+1.9%) is the lowest since ... January 2001! The good news is that another rate cut is now firmly in the cards. And there may be some trades here: long dollar against the majors, and short commodities ...

[2] Credit Default Swaps & liquidity conditions [Liquidity @ Financial Times]. The collapse in market liquidity has taken its toll on Credit Default Swaps, widely seen as "one of the most liquid corners of the derivatives markets". While the market for single-name CDS is "almost totally illiquid in Europe", even benchmark CDS indices are seeing lower volumes. As I read this FT piece, I note that, over the last two sessions, CDS spreads have narrowed considerably more than spreads on cash bonds. Along with the anemic VIX, this has helped the Endogenous Liquidity Index, which is now down "only" 29.7%. [Sarah O'Connor: "Credit default swaps in treacherous waters", Financial Times]

LIQUIDITY TALK. THE YEAR OF THE TRADING RANGE
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -31.6%]

The trading range scenario; Bill Gross on quality spreads; liquidity @ Financial Times; the Bank of England eases!

[1] No way out of the trading range. Almost everywhere, central banks are adding liquidity — and not only for lame year-end reasons. Slowly but surely, inflation expectations are receding: the dollar is a tad stronger; oil and gold prices have eased somewhat; ten-year inflation breakevens are back at the very reasonable level of 230 bps. The VIX is running out of gas. According to Jim Cramer, the price discovery mechanism is working again inside the financial world. That's the good news. Now for the bad news — rising quality spreads. At 254 bps, the Moody's Baa spread trades at four-year highs: this is a warning sign in terms of the outlook for corporate earnings. I still think that, on valuation grounds, a 1525 target is on the cards for the S&P500. But if spreads do not improve, look for the trading range scenario to assert its rights again.

[2] Bill Gross on spreads & the Fed. It took longer than usual, but Bill Gross' December investment outlook is out. Mr. Gross dwells on the overlooked situation in terms of quality spreads: "Fed ease has lowered Treasury yields, but for the rest of the market—the segment that influences the bottom line of U.S. corporations, homeowners, and consumers—not much has changed. Those that claim that the current cycle of Fed ease will inevitably—and shortly—lead to vigorous economic growth do not really have their ears to the ground or their eyes on their Bloomberg screens. The Fed needs to bring Fed Funds levels down steadily and significantly more in order to counteract the contraction of the shadow banking system which has imposed, and will continue to require, higher risk premiums for non-Treasury securities in an increasingly risky financial environment". The PIMCO manager is looking for a 3.00%/3.50% target for the Fed funds rate. [Bill Gross: "The Shadow Knows", PIMCO Investment Outlook]

[3] More stagflation talk [Liquidity @ Financial Times]. This time from Barclays Capital's Tim Bond: "The outlook for financial markets in 2008 is not encouraging ... The US economy is heading the way, having already entered a stagflationary phase". Really? Our own market-based "Goldilocks-Stagflation" indicator is trading at levels not seen since October. While the platinum-gold ratio continues to recover, ten-year inflation breakevens have not been this low in a month-and-a-half. The stagflation hypothesis merits serious consideration: that's the reason why I follow a such an array of exotic indicators. But its proponents need to do a better job at explaining why long-term Treasury paper yields less than 4%, even as inflation is (supposedly) about to take off. [Tim Bond: "Financial assets owners need to get their heads out of the sand", Financial Times]

[4] The Bank of England eases! From the communiqué: "The Bank of England’s Monetary Policy Committee today voted to reduce the official Bank Rate paid on commercial bank reserves by 0.25 percentage points to 5.5% ... conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead". [Bank of England: "Bank of England Reduces Bank Rate by 0.25 Percentage Points to 5.5%"]

LIQUIDITY ANALYSIS. MEMO TO CENTRAL BANKS: JUST DO IT!
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -33.0%]

Just do it!; Sotheby's as a liquidity tell; the complete index of Checks & Balances.

[1] Central banks to the rescue. Can they afford it? Yes — that was the clear message sent yesterday by Bank of Canada: "Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further". Note that US problems are mentioned! The financial system is truly a global marketplace, and the BoC has the courage to acknowledge it. Can the BoE and the ECB take a similar step? Their inverting yield curves (ten-year sovereigns relative to central bank policy rates) and the strength of their currencies (especially the euro) are the key "tells" here. And the message is pretty clear: Just do it! [Bank of Canada: "Bank of Canada lowers overnight rate target by 1/4 percentage point to 4 1/4 per cent"]

[2] Sotheby's stock price as a liquidity indicator. At the Global Liquidity Blog we view the Goldman Sachs stock price as a proxy for financial innovation. Thomas Tan thinks that BID can be seen as an indicator of global liquidity: "It could be used as a gauge to measure hot money and liquidity flowing around the world. The argument: when super rich people have too much money to burn, they will bid up the prices of expensive art sales by setting one record after another". [Thomas Tan: "Sotheby's (Falling) Stock as a Market Indicator", Seeking Alpha]

[3] The complete Index of Checks & Balances. The are four results for each country: Fraser Institute's grades on judicial independence, Freedon House's grades on freedom of the press, the WEF's grades on network readiness, and the Index of Checks & Balances. The US continues to lose ground in terms of judicial independence (courtesy of the "War on Terror"); all of the Nordic countries make it to the top-ten; China's poor results sharply improve when Hong Kong is included:

- New Zealand [8.9, 8.7, 6.9, 8.5]; Netherlands [9.0, 8.9, 6.3, 8.4]; Norway [8.9, 9.0, 6.4, 8.4]; Denmark [8.8, 9.0, 6.6, 8.4]; Germany [9.2, 8.4, 5.6, 8.3]; Iceland [8.4, 91, 7.0, 8.3]; Australia [8.8, 8.1, 6.7, 8.2]; Finland [8.6, 9.1, 6.1, 8.2]; Switzerland [8.6, 8.9, 6.2, 8.2]; Sweden [8.1, 9.0, 7.0, 8.1].

- United Kingdom [8.7, 8.1, 6.1, 8.1]; Ireland [8.6, 8.5, 5.1, 7.9]; Israel [8.9, 7.2, 4.8, 7.7]; Hong Kong [8.2, 7.1, 6.6, 7.7]; Canada [7.9, 8.2, 6.4, 7.7]; Austria [8.1, 7.9, 5.5, 7.5]; Portugal [7.8, 8.6, 5.4, 7.5]; Luxemburg [7.4, 8.9, 5.6, 7.3]; Japan [7.6, 8.0, 5.8, 7.3]; Malta [7.2, 8.2, 6.8, 7.3].

- Belgium [7.0, 8.9, 4.9, 7.0]; Estonia [7.1, 8.4, 5.0, 6.9]; United States [6.6, 8.4, 6.5, 6.9]; France [6.8, 7.9, 4.3, 6.5]; Cyprus [7.0, 7.8, 3.8, 6.5]; India [8.2, 6.3, 1.5, 6.5]; South Africa [7.6, 7.3, 1.9, 6.4]; Costa Rica [6.9, 8.2, 3.0, 6.4]; Singapore [7.0, 3.4, 6.5, 6.2]; Slovenia [5.9, 8.0, 4.7, 6.1].

- Uruguay [6.6, 7.2, 2.6, 5.9]; Namibia [7.1, 7.0, 1.2, 5.9]; Botswana [7.2, 6.5, 1.3, 5.9]; Malaysia [7.2, 3.5, 4.1, 5.8]; Taiwan [5.1, 8.0, 5.8, 5.8]; South Korea [5.2, 7.0, 6.1, 5.7]; Jamaica [5.4, 8.3, 4.0, 5.7]; Maurice [6.1, 7.4, 2.8, 5.7]; Ghana [6.7, 7.2, 1.0, 5.7]; Kuwait [7.0, 4.4, 2.8, 5.6].

- Greece [5.6, 7.2, 3.6, 5.5]; Hungary [5.4, 7.9, 3.4, 5.5]; Czech Republic [4.7, 8.0, 4.8, 5.4]; UAE [6.3, 3.5, 3.9, 5.3]; Chile [4.8, 7.4, 4.3, 5.2]; Latvia [4.6, 8.1, 3.7, 5.1]; Spain [4.5, 7.9, 3.9, 5.1]; Jordan [6.5, 3.9, 1.9, 5.1]; Trinidad & Tobago [5.3, 7.4, 1.9, 5.0]; Slovakia [4.3, 8.0, 4.2, 5.0].

- Egypt [6.4, 3.9, 1.5, 4.9]; Thailand [5.7, 5.0, 2.2, 4.9]; Italy [4.3, 6.5, 4.7, 4.8]; Tunisia [6.8, 1.7, 1.9, 4.8]; Poloand [4.2, 7.9, 3.1, 4.7]; Lithuania [4.0, 8.2, 3.2, 4.7]; Turkey [5.3, 5.2, 2.1, 4.6]; Malawi [5.9, 4.5, 0.9, 4.6]; Mali [4.4; 7.6; 0.9; 4.3]; Mexico [4.4, 5.2, 2.5, 4.2].

- Tanzania [4.9, 5.0, 1.0, 4.1]; Dominican Republic [4.2, 6.3, 1.7, 4.1]; Croatia [3.7, 6.1, 3.2, 4.1]; Uganda [4.6, 4.8, 1.0, 3.9]; Philippines [3.9, 6.0, 1.7, 3.9]; Colombia [4.4, 3.9, 2.2, 3.9]; Algeria [4.6, 3.9, 1.5, 3.8]; Morroco [4.1, 3.9, 2.1, 3.7]; Sri Lanka [4.2, 4.2, 1.1, 3.6]; Bahrain [4.1, 2.8, 2.7, 3.6].

- Brazil [3.0, 6.1, 2.6, 3.5]; Romania [3.1, 5.6, 2.7, 3.5]; Senegal [3.5, 5.6, 1.2, 3.5]; Bulgaria [2.5, 6.7, 3.1, 3.5]; Guatemala [3.8, 4.2, 1.5, 3.4]; El Salvador [3.1, 5.7, 1.7, 3.3]; Pakistan [3.8, 3.9, 1.3, 3.3]; Nigeria [3.6, 4.6, 1.2, 3.3]; Madagascar [3.3, 5.1, 0.9, 3.2]; Vietnam [4.1, 2.1, 1.5, 3.2].

- Bolivia [2.5, 6.7, 1.2, 3.1]; China [3.9, 1.7, 2.0, 3.1]; Kenya [3.3, 4.2, 1.2, 3.0]; Argentina [2.0, 5.5, 3.5, 3.0]; Indonesia [3.0, 4.2, 1.6, 3.0]; Macedonia [2.4, 5.1, 2.4, 2.9]; Panama [2.4, 5.7, 1.8, 2.9]; Ukraine [2.6, 4.7, 1.8, 2.9]; Albania [2.4, 5.0, 1.9, 2.8]; Mozambique [2.5, 5.7, 0.8, 2.8].

- Angola [3.1, 3.5, 0.8, 2.7]; Azerbaijan [3.0, 2.7, 1.8, 2.7]; Zambia [2.9, 3.6, 1.0, 2.7]; Honduras [2.4, 4.8, 1.2, 2.6]; Ecuador [1.9, 5.9, 1.5, 2.6]; Peru [1.6, 6.1, 2.2, 2.6]; Kahzakstan [2.9, 2.5, 1.3, 2.5]; Bangladesh [2.5, 3.2, 0.8, 2.3]; Russia [2.1, 2.8, 2.2, 2.2]; Armenia [2.1, 3.6, 1.2, 2.2].

- Georgia [1.9, 4.3, 1.2, 2.2]; Cameroon [2.1, 3.5, 0.9, 2.1]; Nicaragua [0.8, 5.6, 1.0, 1.8]; Paraguay [1.1, 4.3, 1.0, 1.7]; Tchad [1.3, 2.7, 0.7, 1.5]; Zimbabwe [1.1, 1.0, 1.3, 1.1]; Venezuela [0.3, 2.8, 1.9, 1.1]; Haiti [0.2, 3.2, 1.2, 1.0].

LIQUIDITY ANALYSIS. ANOTHER EXOTIC TAKE ON ENDOGENOUS LIQUIDITY
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -31.2%]

In April 2001, in the midst of the worst deflation episode in half-a-century, Argentina granted "special powers" to economic czar Domingo Cavallo. Mr. Cavallo promptly issued a decree to put an end to the dollar-based currency board, widely seen as an aggravating factor in terms of deflation. Many in Argentina were encouraged by the move: people thought that the euro would continue to fall, and that Mr. Cavallo's new scheme —a currency basket with both the dollar and the euro— would offer some relief to battered Argentine exporters. In early May, a local pension fund kindly requested my opinion on the matter. My answer was straightforward: "I can't predict what will happen to the euro, but I can predict one thing — Mr. Cavallo's scheme will collapse".

My Argentinean forecast turned out to be one my few 2001 winners. The way I saw it, the matter clearly transcended the economics of exchange-rate determination. Mr. Cavallo's so-called "super-powers" were at the root of the problem. If one individual has the power to arbitrarily modify the currency, then property rights are ... gone. Interest rates have to go up, because the supply of loanable resources in the credit market will shrink fast — very fast. Sadly, this is what happened in Argentina in 2001. I bring up this issue because I have just found an academic paper in which the authors contend that high inventory-to-sales ratios may be caused by ... weak judiciaries! [1]. Now, inventory-to-sales ratios provide one of the best ways to analyze the volatility of the business cycle, a key component of ... endogenous liquidity.

Thus, the general principle can be stated like this: the lack of political checks and balances leads to weak property rights, to smaller credit markets, and to a higher cost of capital. As the great James Madison said: "Where an excess of power prevails, property of no sort is duly respected. No man is safe in his opinions, his person, his faculties, or his possessions" [2]. I recently took the trouble to put together an "Index of Checks & Balances", made up by Fraser Institute's grades on judicial independence, Freedon House's grades on freedom of the press and the WEF's grades on network readiness. The ten top-countries are to ones in which one would expect to find the lowest cost of capital: New Zealand, The Netherlands, Norway, Denmark, Germany, Iceland, Australia, Finland, Switzerland and Sweden. Now get ready for the ten bottom countries: Russia, Armenia, Georgia, Cameroon, Nicaragua, Paraguay, Tchad, Zimbabwe, Venezuela and Haiti.

[1] Angara V. Raja, Hans-Bernd Schaefer: "Are Inventories a Buffer Against Weak Legal Systems?", Kyklos, Vol. 60, No. 3, 2007, 415-441.

[2] James Madison: "Property", 29 Mar. 1792, Papers 14: 266--68.

LIQUIDITY WATCH. MOODY'S BAA SPREADS AT 4 YEAR-HIGHS
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -30.6%]

Spreads are hurting; Malpass on liquidity conditions; liquidity @ Financial Times.

[1] Spreads are hurting. At 246 bps, the Moody's Baa spread relative to Treasuries trades at levels not seen since September 2003. At 135 bps (a 3 year-high), its Aaa cousing is faring a little better. Bear Stearns economist David Malpass discounts the negative implications of rising spreads: "Despite wider credit spreads relative to Treasuries, we note the relatively low interest rates in most credit markets". Does the evidence support that view? Not really — unless you factor in a slightly higher inflation rate. The fact is, quality spreads are rising across the board. Despite its horrendous track-record in terms of short-term market moves, my trusted long-term "Combo Model" for risky assets —which adds the rate of growth of the Global Dollar Liquidity measure to the inverse of the Moody's Baa spread— has entered its fourth consecutive month in bearish territory. The August and September signals were so weak that I suggested a trading-range scenario rather than an outright bear market (which turned out to be OK big picture-wise, especially in euro or gold terms). Now, spreads have become more stubborn; they refuse to back down; signals are becoming louder. Stay tuned.

[2] David Malpass on liquidity. Rich Karlgaard quotes Bear Stearns economist David Malpass on liquidity conditions: "Extra cash in the global financial system remains massive. The feeling of a credit crunch is coming more from the slowdown in velocity or turnover of money than from a scarcity of liquidity". In other words, Mr. Malpass is describing the five-month old dichotomy between strong funding liquidtity and weak market liquidity. [Rich Karlgaard: "Malpass: Slowdown, not Recession", Forbes Digital Rules]

[3] Brad Setser on China & the yen. Brad Setser on China's latest rumoured FX moves: "Put the latest from Stratfor and Yves Smith (Naked Capitalism) together, and it seems like China may be scaling back on its holdings of US treasuries in order to buy yen. Stratfor hints that China may have a policy of reducing its holdings of Treasuries; Smith argues that China is buying yen: My Asia sources tell me that China is willing to let the yuan appreciate only if the yen rises first, and they are actively buying yen to make sure that comes to pass". Interesting stuff. [Brad Setser: "China: selling Treasuries and buying yen?"]

[4] Liquidity @ Financial Times: the Stagflation debate. The stagflation debate has been going on for a while now. If I remember correctly, PIMCO's Paul McCulley embraced that scary notion back in 2005 (he has now moved to the deflation camp). In this solid FT piece, Krishna Guha reviews the main issues involved. The key question, well emphasized by Guha, is this: if inflation risks are are so high, why are long-term nonimal interest rates so low? To track 'stagflation', we have devised a market-based indicator: the "Goldilocks-Stagflation" indicator. The numerator is the platinum-gold spread (a gauge of goblal economic growth), and the denominator is the ten-year inflation breakeven (a proxy for inflation expectations). At 0.79, the "Goldilocks-Stagflation" indicator looks neither too hot nor too cold. [Krishna Guha: "Cooler yet the pressure rises", Financial Times]

LIQUIDITY WATCH. HALF EMPTY OR HALF FULL?
. Federal Reserve: "Factors Affecting Reserve Balances", November 28

- Fed's Treasuries holdings: $793.8bn (+$0.9bn)
- Other central banks' Treasuries holdings: $1,225.3bn (+$2.0bn) (*)
- Other central banks' agency securities: $806.2 (+$3.7bn) (*)
- Global Dollar Liquidity Measure: $2,825.3bn (+$6.6bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

[1] Weekly Fed balance sheet watch: half empty or half full? In terms of the Global Dollar Liquidity measure, the month of November is now officially the second weakest of the year. As Peter Garnham puts it in today's FT, "the monthly increase [in Chineses foreign exchange reserves] represented the smallest rise since September 2006". Is the glass half empty, as I suggested last week? Or is it half full, as the Citigroup-ADIA and Fortis-Ping An deals indicate? In other words, is the slowing pace of foreign CBs reserve accumulation indicating growing interest in stocks and acquisitions? Or is it —rather onimously— a sign of flight-to-quality dollar-buying within emerging economies? To look for clues, quantity indicators (such as monetary aggregates) will be pretty useless here. Market-based indicators should provide the answers. See below...

[2] Market-based indicators: encouraging news — but still in a range. Our Endogenous Liquidity Index surged 8.5% over the last three trading sessions, spurred mostly by the shyness of the VIX and by improving junk bond spreads. Even more encouraging, ten year-inflation breakevens have once again fallen sharply (232 bps), suggesting the likelihood of further rate cuts from the Fed. Meanwhile, the platinum-gold ratio is holding well in the midst of the precious metals sell-off. When valued against this market-based "Goldilocks-Stagflation" indicator, a 1525 target for the S&P500 looks possible. Beyond that, caution should prevail: surging Moody's Baa spreads are telling us in no uncertain terms that corporate earnings are increasingly at risk.

LIQUIDITY WATCH. THE EURO, CHECKS & BALANCES, AND ... THE VIX
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -31.3%]

The euro, checks & balances, and the VIX; nimble; Fortis-China deal.

[1] The euro, checks & balances and ... the VIX. Über-bears and 'stagflationists' are on record with their bleak 1970s-2000s comparisons. Having written my MA thesis on the subject of Bretton Woods, what strikes me is this key difference: the euro. In a remarkable speech on 'Globalization', Alan Greenspan said: "Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption. And if other currencies, such as the euro, emerge to share the dollar's role as a global reserve currency, that process, too, is likely to be benign". In today's Financial Times, Richard Laming makes a similar point: "... the reality is that no currency and no national economy are strong enough to play that role any more. Welcome to the multi-polar world". Bingo! Checks and balances, ladies and gentlemen, are always to be welcomed. That may indeed be the message of the not-so-hot VIX. [Alan Greenspan: "Globalization", Bundesbank Lecture, 2004] [Richard Laming: "Europe has already learnt the lesson of a multi-polar world", Financial Times]

[2] Nimble. In his speech at the Council on Foreign Relations, Fed governor Donald Kohn uttered the L-word eleven times. (The all-time record-holder is his colleague Frederic Mishkin, who mentioned 'liquidity' no less than thirty times in an October 2007 speech). To be honest, I feel underwhelmed. Mr. Kohn lacks the technical brilliance of Randy Kroszner, or the rhetorical skills of Kevin Warsh. People were mesmerized by one sentence at the end of the speech: "... these uncertainties require flexible and pragmatic policymaking--nimble is the adjective I used a few weeks ago". [Donald L. Kohn: "Financial Markets and Central Banking", Federal Reserve Board]

[3] Another day, another deal. It looks like Gillian Tett, the Financial Times editor, was on to something when she wrote that "Gulf investors (could) be about to ride to the rescue of the US credit markets". Exhibit A: the Citigroup-ADIA deal, with terms that "are eerly similar to those Prince Alaweed bin Talal secured when he helped Citi out in 1991" (Lex Column). Ms. Tett should have been even more inclusive. The trend also involves Chinese investors and European banks: "Shares of Ping An Insurance (Group) Co (2318.HK: Quote, Profile, Research) jumped 5.13 percent after China's No.2 life insurer said it had paid 1.81 billion euros ($2.7 billion) for a stake in Europe's Fortis (FOR.AS: Quote, Profile, Research) (FOR.BR: Quote, Profile, Research)". [Reuters: "China's Ping An Insurance jumps amid Fortis deal"]

LIQUIDITY WATCH. "PRICE DISCOVERY", THE NEW BUZZWORD
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -34.8%]

"Price Discovery", the new buzzword; the wisdom of Charles Plosser; Liquidity @ Financial Times.

[1] The new buzzword. "Price discovery" is the new buzzword at the Federal Reserve. This Hayekian notion is being relentlessly put forward —among others— by governor Randall Kroszner, who recently devoted an entire speech to this "process by which buyers and sellers' preferences, as well as any other available market information, results in the 'discovery' of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources". The lack of price discovery is the price participants are paying for the new, securitization-driven financial system with highly dispersed credit risk. [Randall Kroszner: "Risk Management and the Economic Outlook"; "Recent Events in Financial Markets", Federal Reserve Board]

[2] The wisdom of Charles Plosser (I). Unsurprisingly, the Philly Fed president and CEO takes up the issue of ... price discovery. Plosser is even more explicit: "This price discovery process is still underway, and it is likely to be some time before it is completely sorted out. It is important to recognize that the Federal Reserve cannot resolve this price discovery problem. The markets will have to figure this out. Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks. Indeed, in some circumstances, lowering interest rates may prolong the painful process of price discovery" (italics mine). There you have it. Markets will have to figure it out!

[3] The wisdom of Charles Plosser (II). Mr. Plosser's speech has been characterized as highly "hawkish". I beg to disagree. While he repeatedly stated that the Fed "must resist the temptation to respond to short-term, transitory disturbances" by "arbitrarily lowering interest rates" (on inflation expectations/moral hazard grounds), he also outlined his criteria for setting the Fed funds target. An exceedingly high target would result in the creation of "too little liquidity, leading to ... too little inflation or perhaps even deflation". Further, Mr. Plosser states that "is important to appreciate the fact that slow-growing economies exhibit real, or inflation-adjusted, interest rates that are somewhat lower than those of fast-growing economies". In other words, he appears to have the yield curve in mind. With the ten-year note yield 50 bps below the Fed funds rate target, there is clearly a case for more rate cuts from the central bank. [Charles I. Plosser: "Economic Outlook and Central Bank Policy", Federal Reserve Bank of Philadelphia]

[4] Liquidity @ Financial Times: Martin Wolf, monday morning quarterback? Martin Wolf describes modern banking as "an accident waiting to happen". The banking system, in his view, is dangeroulsy subsidized, prone to excessive risk-taking, etc. Bad, very bad! A strong whiff of monday-morning-quarterbacking lingers over this piece. If I remember correctly, Mr. Wolf used to describe the recent period of world economic growth as a "New Golden Age". Time to recall Schumpeter's words: "Stabilized capitalism is a contradiction in terms ... The history of capitalism is studded with violent bursts and catastrophes. It is no gentle process of adjustment but something more like a series of explosions". [Martin Wolf: "Why banking remains an accident waiting to happen", Financial Times] [Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007; web page; prologue; interview; podcast]

[5] Liquidity @ Financial Times: Illiquidity or insolvency? Max Keiser, founder of Karma Banque, says that banks engaged in a "global Ponzi scheme backed by what we now know to be largely counterfeit mortgage paper". He concludes: "Therefore it is insolvency along with its corollaries – opacity, misleading statements, dishonesty and larceny – that constitute the problem and illiquidity that is its symptom". [Max Keiser: "Problem with banks was insolvency", Financial Times]

LIQUIDITY WATCH. IT'S AUGUST DÉJÀ VU!
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -36.5%]

It's August déjà vu; New York Fed statement; Liquidity @ Financial Times; Smart money & the VIX.

[1] It's August déjà vu. So says Morgan Stanley's Richard Berner in an insightful piece: "Fed officials again confront deteriorating credit markets, dwindling money-market liquidity and consequent downside risks to US economic growth, possibly requiring them to ease by more than the 25 bp we currently expect. The pressures are also evident in offshore markets, and represent a challenge for other central banks". From the perspective of our Endogenous Liquidity Index, I coudn't agree more: it has now reached a new low, just below that of August 16. While CDS spreads and cash bond spreads best reflect the panic, the VIX appears to have woken from its slumber. As Mr. Berner puts it: "Unlike the past, when financial markets could cushion the banks or vice-versa, this time they are deleveraging and shrinking together, representing a constraint on the supply of credit". Now, keep in mind that the August sell-off led to a spectacular recovery. Will the news of the Citigroup-Abu Dhabi link-up be the catalyst for the rebound? That's certainly the bet in the futures markets this morning. [Richard Berner: "Testing Time for the Fed", Morgan Stanley GEF] [Dan Wilchins: "Citi to sell $7.5 bln stake to Abu Dhabi group", Reuters]

[2] New York Fed statement on pressures in money markets. The New York Fed issued a statement regarding the turmoil in the money markets, where rates trade slightly above the Fed funds target: "In response to heightened pressures in money markets for funding through the year-end, the Federal Reserve Bank of New York’s Open Market Trading Desk plans to conduct a series of term repurchase agreements that will extend into the new year. The first such operation will be arranged and settle on Wednesday, November 28, and mature on January 10, 2008, for an amount of about $8 billion ... In addition, the Desk plans to provide sufficient reserves to resist upward pressures on the federal funds rate above the FOMC’s target rate around year-end". [Michael Mackenzie & Saskia Scholtes: "Banks quiver as Fed shoots wide of target", Financial Times]

[3] Liquidity @ Financial Times: the euro as an international reserve currency? Simon Tilford, chief economist at the Center for European Reform, disects the pros and cons of the euro as an international reserve currency. The chief benefit, undoubtedly, comes from the opportunities afforded by seigniorage: "As is the case at present in the US, the eurozone would benefit from what are in effect very low interest loans in the form of large central bank holdings of euros. Also, the growth of international trade would boost demand for euros, with the result that the eurozone could cheaply finance an external deficit, much as the US has been doing for decades". But the downsides, writes Mr. Tilford, are even greater. Read the whole thing. (By the way, this precisely what I told students at the University of Leiden, when I helped Prof. Hosli teach a course on European Monetary Union). [Simon Tilford: "Could the euro rule supreme? It’s not worth it", Financial Times]

[4] Smart Money & the VIX. Bill Luby writes an interesting post on the topic of "smart money and the VIX". Quoting Bernie Schaeffer's “Monday Morning Outlook”, which he describes as "generally an excellent perspective for any trader to contemplate going into the trading week", Bill concludes that "the VIX is the footprints of the smart money". Hey, that's precisely why it features so prominently in our Endogenous Liquidity Index! [Bill Luby: "Smart Money and the VIX", VIX and More]

LIQUIDITY WATCH. LATE FOR THE RENDEZ-VOUS?
. Federal Reserve: "Factors Affecting Reserve Balances", November 21

- Fed's Treasuries holdings: $792.6bn (+$5.2bn)
- Other central banks' Treasuries holdings: $1,223.3bn (-$11.2bn) (*)
- Other central banks' agency securities: $802.5 (+$8.2bn) (*)
- Global Dollar Liquidity Measure: $2,818.6bn (+$2.2bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

Will funding liquidity come to the rescue of market liquidity? Our Endogenous Liquidity Index managed to post a solid 2.4% gain on Friday thanks to both falling CDS spreads and to the rather lame VIX. Yet, the index is still perilously close to its August 16 low. Bulls hope that funding or macroeconomic liquidity will come to its rescue. But November has failed to deliver on that front. The weekly Fed balance sheet shows a meagre $2.2bn gain in our Global Dollar Liquidity measure, as Treasuries sales by foreign CBs are partly compensated by agency securities purchases. All in all, the increase leaves much to be desired, because the volume of repos continues to surge — which only serves to highlight the sense of fragility in money markets. The bottom line is: funding liquidity is failing to rescue its wounded cousin, a.k.a. market liquidity.

LIQUIDITY WATCH. THE DOLLAR GRABS THE HEADLINES
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -35.2%]

Liquidity @ Financial Times; good point by Brad Setser.

[1] Liquidity @ Financial Times. (a) The US dollar, according to economist David Hale, has both a flow and a stock problem: the US would like to keep its reserve currency status intact, yet it calls for a "significant revaluation of the Chinese currency in spite of its role in funding the US budget deficit"; (b) Ralph Atkins quotes former German finance minister Hans Eichel: "The euro could become a reserve currency with equal status to the dollar". But the now the chickens have come home to roost, and many in Europe appear to entertain second thoughts about their ambitions for the euro. This is certainly not the case of former Bundesbank economist Ottmar Issing: "As a central bank, the currency is your baby. And if it is so widely appreciated, it is an expression of credibility and trust in the future stability of the currency". Between early 2002 and the second quarter of 2007, the euro's share of foreign exchange reserves rose from 19.7% to 25.6%, according to IMF data. [David Hale: "Where the dollar’s decline is taking the world", Financial Times][Ralph Atkins: "Dollar safe from challenge of the euro", Financial Times]

[2] Liquidity @ Financial Times. (c) The dollar is killing us! The FT's leading headline, another dollar-related story, features this comment by Tom Enders, CEO of Airbus: "The dollar has passed the pain barrier. This is life-threatening. We need to question our business model. This is no longer sustainable"; (d) Gillian Tett revisits a well-known dichotomy: while liquidity is booming in parts of the world (read: petrodollars), it is all but collapsing in Western financial markets. (Funding v. market liquidity, anyone?). Her conclusion: "... it is one thing to expect Gulf investors to grab the odd chunk of a bank; it is quite another to hope they will bail out, say, the corporate leveraged market or subprime world. And that second scenario, I suspect, is still a dream too far. So, for the moment, we are doomed to remain in a schizophrenic financial world - where cash gluts co-exist with liquidity droughts".
[Peggy Hollinger: "Low dollar ‘threatens the life’ of Airbus", Financial Times] [Gillian Tett: "Gulf liquidity offers glimmer of hope", Financial Times]

[3] Brad Setser: Good point! Brad Setser analyzes the rencent statement on the dollar by Chinese premier Wen Jiabao: "I have a feeling that the current (unrealized) mark-to-market losses on China's investment in Blackstone drew attention to the broader financial risks that China is taking by holding so many foreign assets". Excellent point! [Brad Setser: "A little too late", RGE]

LIQUIDITY WATCH. Mr. HOENIG & THE CHALLENGE OF LIQUIDITY
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -32.7%]

Mr. Hoenig & the challenge of liquidity; the People's Bank of China & the ECB; booming Islamic finance.

[1] Mr. Hoenig & liquidity. Thomas M. Hoenig, the President and CEO of the Federal Reserve of Bank of Kansas City, was the lone dissenter at the October 30-31 meeting, when the FOMC voted to lower the target for the Fed funds rate by 25 bps to 4.5%. Yet, an interesting and overlooked piece of information emerges from the minutes: "He also recognized that liquidity remains a near-term challenge and that the Federal Reserve would be prepared to act if needed". This is where things get interesting. In a recent speech delivered in Sydney, Mr. Hoenig reveals himselft as a keen watcher of liquidity trends. To understand what is going on, he suggests, one needs to think within the framework of the (relatively) new "market-centered" financial system. In this context, it is not clear that the mere provision of liquidity to banks will solve all the problems, as was the case in the older "bank-centered" financial system.

"As a case in point", he adds, "the Federal Reserve's Discount window facility was not used as much as we might have liked in the recent crisis". In other words: policy-makers lack the appropiate knowledge about liquidity crisis in the new financial system — they will need to "focus more attention on research into the microstructure of financial markets to understand why liquidity crisis develop and why markets seize up in times of crisis". Very interesting, but where does that leave us in terms of Mr. Hoenig's vote at the next FOMC meeting? The following sentence says it all: "Until we have this understanding, we will be forced to deal with these pressures indirectly via the banking system" (italics mine). In other words: as market liquidity deteriorates even further, look for an unanimous vote at the next formal or informal FOMC meeting. [FOMC Minutes] [Thomas M. Hoenig: "Maintaining Stability in a Challenging Financial System: Some Lessons Relearned Again?", Kansas City Fed]

[2] The People's Bank of China & the ECB: diverging paths? According to Bank Credit Analyst, Chinese authorities will soon focus on the need to raise short term interest rates, rather than tightening reserve requirements: "Bank lending does not appear to be excessive and the root cause of China’s liquidity overflow is the massive accumulation of foreign reserves. In fact, the country’s low interest rates and ultra-weak currency are serious economic distortions. The risk of economic overheating will continue to build if China’s hyper-stimulative monetary environment is not reversed in a more timely manner". In a separate note, the Canadian consultants warn about excessively tight financial conditions in the eurozone: "the ECB might formally cut rates". [BCA Research: "China: More Tightening Needed"] [BCA Research: "The ECB Can’t Get Any Tighter"]

[3] Booming Islamic liquidity [Liquidity @ Financial Times]. Another day, another sukuk issuance. See the advertisement on page 17 of yesterday's Financial Times. JP Morgan is the sole bookrunner of a Sukuk structure with a forward setting exchange price. The amount: $1bn. The issuer: Dana Gas. The meaning: more diversity into the financial world — a bullish sign.

LIQUIDITY WATCH. THE DOLLAR & ... THE VIX
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -32.2%]

The dollar and ... the VIX; more stagflation talk.

[1] The dollar & the VIX. The euro is, in all likelihood, headed towards its $1.50/1.52 target. Talk shows and newspapers are full of stories about an impending US recession, a global financial crash, a major financial institution going under, and so on. Yet the VIX, which only managed to register a 2% gain, will likely come under pressure today. Am I missing something here? Ladies & gentlemen: I am now officially embracing the Benign Global Adjustment Theory (BGAT). This is how Morgan Stanley's Stephen Jen puts it: "What is happening to the global economy is quite healthy. The US household savings rate is likely to recover sharply over the near year, as housing wealth is eroded. We are witnessing the necessary and sufficient ingredients for global rebalancing, which should not elicit confusion or fear".

Earlier this month, in a Financial Times piece on the "silver lining in America's subprime cloud", George Schultz and John Taylor summarized the "three-pronged" strategy underlying the adjustment process: "reducing the US budget deficit to decrease government dissaving, raising economic growth abroad relative to the US in order to stimulate US exports and increasing the flexibility of exchange rates, especially in China, to facilitate the adjustment". An earlier version of the benign adjustment theory had been expressed by Alan Greenspan: "Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption. And if other currencies, such as the euro, emerge to share the dollar's role as a global reserve currency, that process, too, is likely to be benign".

This is not the 1970s redux. There's Chindia. There are alternatives to the dollar. And the world is embracing capitalism: Africa is rapidly becoming the new frontier — and even North Korea is developping a "fledging merchant class". [Stephen Jen: "The Undervalued Dollar To Keep Weakening", GEM] George Shultz & John Taylor: "The silver lining in America’s subprime cloud", Financial Times] [Alan Greenspan: "Bundesbank Lecture 2004"]

[2] More stagflation talk [Liquidity @ Financial Times]. More ruminations on the stagflation scenario. Here's Paul Ashworth of Capital Economics: "... the price of petrol at the pumps has already risen past $3 a gallon; if crude prices remain near $100 a barrel, it could reach $3.60 before too long ... The resulting squeeze on real incomes couldn't have come at a worse time, with the credit crunch, the downturn in housing and a softening labour market all pointing to slowing consumption growth". This is something we monitor on a daily basis at the Global Liquidity Blog. Our market-based "Goldilocks-Stagflation" indicator improved further yesterday, led by a higher platinum-gold ratio. ["View of the Day - Paul Ashworth, Capital Economics", Financial Times]

LIQUIDITY WATCH. LOOKING BETTER
. Federal Reserve: "Factors Affecting Reserve Balances", November 14

- Fed's Treasuries holdings: $787.7bn (+$2.6bn)
- Other central banks' Treasuries holdings: $1,234.5bn (-$2.7bn) (*)
- Other central banks' agency securities: $794.3 (-$1.1bn) (*)
- Global Dollar Liquidity Measure: $2,8164n (-$1.3bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

[1] Looking better. Is Goldilocks fighting back? That's certainly the message from our market-based Goldilocks-Stagflation indicator (which seems to yield interesting signals in times of financial stress). The recent sell-off in the gold and oil markets has created a better tone for risky assets. The platinum-gold ratio is back at 1.85, a two-week high, and ten-year inflation breakevens also trade at around two-week lows (236 bps). All in all, and provided that the dollar keeps its composure, a 1525 print for the S&P500 now looks like a distinct possibility.

[2] Weekly Fed balance sheet watch. The second weekly Fed balance sheet for the month of November is out — with very little in the way of news. Our Global Dollar Liquidity measure sheds $1.3bn as foreign CBs sales narrowly outweight the Fed's own repo operations. The annual rate of growth stands unchanged at 14.1%, thus portraying a solid, if not booming, state of affairs in the global economy.

[3] Liquidity puts? Peter Cohan defines liquidity puts as "the right of Collateralized Debt Obligation (CDO) holders to sell back the CDO to its issuer at the original price". And he adds: "The liquidity put is responsible for the $25 billion worth of CDOs on Citi's balance sheet" [HT: Portfolio.com].

[4] Liquidity & Business turnrounds [Liquidity @ Financial Times]. Fascinating article on the interplay between global liquidity conditions and the market for corporate restructuring. On the one hand, easy access to liquidity and innovative debt instruments have encouraged greater flexibility in restructuring. On the other hand, balance sheets have become much more complicated. Credit Default Swaps holders have introduced a set of new players to the game. Overall, restructuring experts are cautiously optimistic here: the lack of "big international failures" appears to support the view that credit risk is indeed widely dispersed. [John Willman: "Challenges ahead as funding dries up", Financial Times]

[5] U.S. Deflation ahead? Don't rule out the possibility, says Canadian consultants Bank Credit Analyst. Not surprisingly, they expect more rate cuts from the Federal Reserve. [BCA Research: "U.S. Inflation …. Or Deflation?"]

[6] Synthetic CDO market alive & well. Newspapers are awash with news on the liquidity crisis and the credit crunch. Now take a look at this: "ING Investment Management is marketing a synthetic collateralized debt obligation with UBS. ING will manage the USD1.3 billion dollar corporate-backed CDO, which is a big step up from the manager’s previous synthetic offerings issued this year that were USD140 million and USD280 million respectively ... The latest deal, called ING Managed Synthetic 2007-3, is a plan vanilla structure, according to an investor who has seen the deal. The investor added that the structured credit group at UBS has made strides in the past year in winning mandates from strong managers making early forays into synthetic". [Daily Institutional Investor: "ING Markets Big Managed Synthetic"]

GLOBAL LIQUIDITY WATCH
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -30.6%]

- Endogenous Liquidity Watch. Another punishing session yesterday, as volatility measures, bond spreads and CDS spreads again closed sharply up. The Moody's Baa spread, in particular, trades at a new record for the year (218 bps). In all likelyhood, my trusted long-term model for risky assets will flash a sell signal for the fourth month in a row. On a slightly more encouraging note, the platinum-gold ratio is again trading above 1.80, while 10-year inflation breakevens are stabilizing around 240 bps. On the basis of that "Goldilocks-Stagflation" indicator, the S&P500 appears to be fairly valued at 1450.

- Liquidity @ Financial Times. [1] Renewed stress on interbank lending: Two-month sterling at a two-month high; overnight dollar libor up; Barclays unveils a £1.3bn writedown (Dave Shellock: "Mixed data and tight liquidity"). [2] Mark-to-market & subprime losses: the current crisis compared with other episodes (Gillian Tett: "Fog and fear obscure the reality behind subprime losses"). [3] The United Arab Emirates & the dollar peg: increased speculation that the UAE favor a move to drop the dollar peg and track a basket of currencies instead. Bring it on! (Peter Garnham: "Gulf states’ dollar peg comes under threat"). [4] Citigroups' funding woes: "In a further sign of falling confidence in the bank, it now costs more to insure its bonds against default in credit derivatives than it does for emerging market countries such as Mexico and Malaysia" (David Oakley: "Citigroup’s lending charges shoot up"). [5] China & US: China warns exporters could be 'devastated' by US slowdown. "China's central bank estimates that every 1 per cent drop in US economic growth translates into a 6 per cent fall in Chinese exports" (Jamil Anderlini: "China warns exporters 'could be devastated' by US slowdown").

- ECB Monthly Bulletin: not a pretty picture. [1] Growth v. inflation dynamics: "On balance, risks to the outlook for growth are judged to lie on the downside ... Risks to the medium-term outlook for price developments are fully confirmed to lie on the upside". Not good! [2] Financial volatility: "... in view of the potential impact of prolonged financial market volatility and the re-pricing of risk on the real economy, the level of uncertainty remains high"; [3] Monetary growth: influenced by "temporary or special factors" (read: flight-to-quality buying of euro-denominated money market funds, mostly from the eurozone's periphery), but still too strong for comfort. [Editorial] [full text pdf] [Ralph Atkins: "Rapid food price rises fuel inflation fears, ECB warns", Financial Times].

LIQUIDITY WATCH. TWO CRISIS, ONE KEY DIFFERENCE
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -28.4%]

Two crisis, one sharp difference; Bank Credit Analyst & the Fed; Advance, overshoot and correct; strong economic growth in the Netherlands.

[1] Two crisis, one key difference. There is a crucial difference between the current turmoil in credit markets and the late-summer crisis: inflation breakevens. Back then, inflation expectations had all but collapsed on the back of rising credit spreads. Ten-year inflation breakevens reached a high of 246 bps on June 14, only to fall back sharply to 219 bps in eary September. [While on vacation, I wrote a quick post on August 8: MOST IMPORTANT PIECE OF NEWS: THE COLLAPSE IN INFLATION EXPECTATIONS, COURTESY OF THE INVERTED YIELD CURVE]. That's what the Fed had been expecting — and it duly acted on September 18. By the time "Helicotper Ben" eased again on October 31, inflation breakevens were back at 234 bps. Right now, rising inflation breakevens (at 240 bps), coupled with a much steeper yield curve, seem to preclude any further aggressive move by the central bank.

[2] Bank Credit Analyst & the Fed. The highly rated (and rightly so) Canadian consultants see things from a very different perspective indeed. They argue that the Fed may have fallen behind the curve in terms of policy easing: "The shift to a neutral bias by the FOMC was misplaced given the renewed rioting in the financial markets ... Rather than panic and bet on Armageddon, investors should stay focused on the rapidly rising odds of a major reflationary program, i.e. much lower rates and yields than most have envisioned. The Fed may already be easing by stealth". [Bank Credit Analyst: "Has the Fed Fallen Behind the Curve?"].

[3] Governor Warsh: "Advance, overshoot, and correct". I've always liked Governor Warsh's "watchful optimism". Credit markets may be in turmoil, but that is, perhaps, the price to pay for the ... "democratization of credit and growing access to capital"! In very Schumpeterian terms, he draws this poignant conclusion: "As in the political realm, the path to the end of history may well prove to be prone to advance, overshoot, and correct". [Kevin Warsh: "The End of History?", Federal Reserve Board].

[4] Great Moderation Watch: Dutch economic growth. Things look pretty good from Amsterdam. Yesterday, the leading local business newspaper carried a headline about the robust growth of the Dutch economy (+4.1% in Q3). Even as the euro gets stronger and the credit market turmoil deepens, exports grew at the astonishing rate of 7.5%. [Het Financieele Dagblad: "Export voert Nederlandse groei naar record hoogte"].

LIQUIDITY ANALYSIS. LIBERTÉ, ÉGALITÉ, LIQUIDITÉ
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -32.4%]

Banque de France, the French central bank, has just published a Focus paper on "Ten key words to make sense of the crisis". First on the list: the L-Word — liquidité. The paper notes the paradox of "co-habitation": abundant macroeconomic liquidity coupled with a liquidity squeeze in certain segments of the global capital markets. The key thing to keep in mind is that "various types of liquidity exist":

Macroeconomic liquidity differs from market liquidity: the former is defined as the quantity of monetary assets available in the economy, while the latter constitutes the market's ability to absorb the sale of assets rapidly without a significant fall in prices. While the former is permanent and results from medium-term economic developments, the latter is more fragile; its existence is contingent on the confidence on the quality of the assets traded or in that of the counterparties involved and may, without this confidence, dry up suddenly.

Market liquidity, however, appears to be an increasingly important determinant of bank liquidity, i.e the ability of banks to meet their liabilities or unwind or settle their positions. Banks' growing use of market financing and the size of their off-balance sheet exposures have indeed increased the volatility of bank liquidity, making banks more reliant on the provision of liquidity by the central bank during periods of market stress.

The recent turmoil has showed that a system based on market financing is more vulnerable to a sudden drying up of liquidity than a system of bank intermediation is to traditional bank runs, even though the latter may still occur in the absence of ayhsyan adequate system of guarantees.

LIQUIDITY WATCH. LIQUIDITY, VOLATILITY, BILL LUBY!
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -31.8%]

Bill Luby's on fire (again); a look at endogenous liquidity; over-hyped geo-political risk?

[1] Liquidity, volatility, Bill Luby! "Liquidity is the inverse of volatility", says Minyanville's Todd Harrison. And that's, IMHO, largely true. That's why I have incorporated the inverse of the VIX (and other financial volatility measures) into the Endogenous Liquidity Index. And that's also, by the way, a view held at the Bank of Canada. Now, Bill Luby follows trends in financial volatility very, very closely indeed. Lately, he has been bearish on the S&P500 and bullish on the VIX. Well done! Bill told me yesterday on his blog: "I'm still bearish and will be looking closely to see if the bulls are able to make any headway in the coming week".

[2] Toying with all-time lows: a look at the Endogenous Liquidity Index. The carnage continues, as volatility creeps up and credit spreads widen even more. The Endogenous Liquidity Index is now down 32%. From the perspective of our market-based "Goldilocks-Stagflation" indicator, things still look pretty bad. Platinum prices fell sharply on Friday, sending the platinum-gold ratio down to 1.73, a three-year low. While inflation breakevens appear to have stabilized somewhat, the S&P500 continues to look rather expensive. In order for the 1450 support to hold, bulls desperately need to see a sharp fall both in the euro and in gold prices.

[3] Over-hyped geo-political risk? Looking for a silver lining somewhere, the overall geo-political picture is showing signs of improvement — which bodes ill for both oil and gold prices in the short to medium term. While I don't claim any particular expertise in that field, I am an avid reader of Thomas Barnett's blog. Dr. Barnett's key insight: connectivity is reshaping the world faster than you think. Gee, he's even calling for a Sino-American strategic alliance! This would be the key to connect the "Gap": Africa, parts the Caribbean, most of the Middle East, North Korea, etc. While that may sound like pipe dreams, consider the following news: (a) The US military is diffusing Washington rhetoric on Iran; (b) Trade and investment flows between Turkey and Iraqi Kurdistan are sharply up; (c) Former Sunni insurgents are collaborating with the U.S. like never before; (d) Iraqi citizens are guiding U.S. troops to arms caches like never before (again); (e) "Talk to Iran", says the former head of the Israeli intelligence agency Mossad. Etc, etc.

LIQUIDITY WATCH. MIXED NEWS AT BEST
. Federal Reserve: "Factors Affecting Reserve Balances", November 7

- Fed's Treasuries holdings: $785.1bn (+$2.5bn)
- Other central banks' Treasuries holdings: $1,237.2bn (+$5.7bn) (*)
- Other central banks' agency securities: $795.4 (-$5.4bn) (*)
- Global Dollar Liquidity Measure: $2,817.7bn (+$2.8bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

[1] Weekly Fed Balance sheet review: mixed news at best. The first weekly Fed balance sheet for the month of November yields a small gain (+$2.8bn) in terms of the Global Dollar Liquidity measure. A number of foreign central banks may have swapped agency securities for Treasuries, perhaps as part of a flight-to-quality move within their overall custody holdings. The annual rate of growth of the Global Dollar Liquidity measure has fallen sharply to 14.11%. Because tough comparisons lie ahead, central banks must step up to the plate in order for our global liquidity measure to post meaningful gains.

[2] Endogenous Liquidity Watch: a horror movie ... again! So much for the credit wildfire hypothesis. Our Endogenous Liquidity Index (-29.9%) is perilously close to its August 16 all-time low. All components show weakness: CDS and corporate bond spreads, (the inverse of) volatility measures, indicators of financial innovation, etc. Most disquieting of all, the Moody's Baa spread has once again shot up to 210 bps, threatening to match is recent September 12 high of 213 bps. Meanwhile, our market-based "Goldilocks-Stagflation" indicator refuses to improve, as the platinum-gold ratio reaches new lows. (Mercifully, inflation breakeavens appear to be cooling a bit). In other words: even at 1475, the S&P500 does not look particularly cheap.

[3] Commodity prices: a looming correction? Can commodity prices rally in the face of declining measures of funding and market liquidity? While reflecting on the $100-per-barrel-oil-price-hype, I stumbled upon this intriguing post. Steve de Angelis, who travels regularly to Kurdistan, argues that booming trade and investment flows between Turkey and Iraqi Kurdistan have created a dynamic and complex situation. The Turkish government cannot just invade and destroy this economic connectivity: it would be too costly. Say that current oil prices carry a $20 "geo-political" premium. Stories like this, coupled with the overall liquidity situation, make me wonder: Is it time to short the damned thing? [Steve de Angelis: "Kurdistan's Economic Boom and Relations with Turkey", Enterprise Resilience Management Blog; Richard A. Oppel: "Turkish-Bred Prosperity Makes War Less Likely in Iraqi Kurdistan", The New York Times].

LIQUIDITY ANALYSIS. I LIKE BUBBLES!
[Latest Global Dollar Liquidity measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -28.5%]

"Bubbles are good. I've made a lot of money on bubbles". Tom Perkins

There is a fascinating debate going on among readers of the Financial Times on the tricky subject of ... financial bubbles [1]. Are they a good or a bad thing? Do central banks have to prick them? Here's my two cents on the controversy: I like bubbles! Here's why. To begin with, there are no financial bubbles in North Korea, Cuba, or the Congo; there were no bubbles in the former Soviet Union either. To the best of my knowledge, nobody has ever heard about a financial bubble in Maoist China. See the point? As the great Canadian economist Reuven Brenner once said (in the midst of the dot.com bubble), a bubble gives young entrepreneurs a unique opportunity to experiment with cheap capital. In his recent book Pop! Why Bubbles Are Great For The Economy (New York: HarperCollins, 2007) [webpage] [review], Newsweek blogger Daniel Gross makes an interesting point.

During the mid-XIXth century telegraph mania, says Gross, "Investors lost gobs of money, but the United States soon had the world’s most extensive telegraph system: more than 23,000 miles by 1852, with an additional 10,000 under construction, compared with just 750 miles in France". But the greatest bubble fan of all was none other than Austrian economist Joseph A. Schumpeter. Quoting the great Harvard professor, biographer Thomas McCraw writes: "Financial speculation, though it gets a very bad press, is an important part of this process [of creative destruction]. Speculators often turn out to be investment bankers funding the entrepreneurs who in turn push innovations through the economy" [2]. Ladies and gentlemen: this is precisely what we are witnessing right now.

The trick, of course, is to be long risky assets when "creation" prevails, and short (or long risk-free assets) whenever "destruction" rules. Right now, "destruction" appears to be having a field day: witness the massive writeoffs, to the tune of $60 billion, and the collapse in our Endogenous Liquidity Index. But its reign will be short-lived. Innovation is rampant, and markets will find a way to finance it.

[1] See the relevant "litterature" as published by the Financial Times. Michael Savage: "Medicine may be worse than the asset bubble disease"; George Cooper: "We may have witnessed an old-fashioned monetisation"; Paul DeGraauwe: "Central banks should prick asset bubbles".

[2] Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007, p. 178. [web page] [prologue] [interview] [podcast]

LIQUIDITY WATCH. THE DOLLAR & THE "GOLDILOCKS-STAGFLATION" INDICATOR
[Latest Global Dollar Liquidity measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -23.7%]

The Goldilocks-Stagflation indicator; buying 10-Year Note Puts; credit recession?

[1] The Dollar & the "Goldilocks-Stagflation" Indicator. The sharp fall in the dollar is taking its toll on our market-based "Goldilocks-Stagflation" indicator. The numerator is the platinum-gold ratio, an indicator of global economic growth. Although platinum prices trade at- or near record highs, gold has climbed even faster. The ratio, which closed at 2.01 in mid-May, trades now at 1.79. On the other hand, the denominator (ten year inflation-breakevens) is back at 241 bps, a level not seen since early July. Again, the weak dollar is the main culprit. Valued against the "Goldilocks-Stagflation" indicator, the S&P500 now looks rather expensive. A sharp correction, both in the euro and the S&P500, would be a ... wonderful thing.

[2] Buying 10-Year Note Puts. Steen Jakobsen, the Saxo Bank fund manager, tells readers of his blog that he is buying 109-50 and 110-50 December puts on the 10-year note futures. In his view, the rapidly falling dollar threatens the inflation outlook: "The 1st reaction before final collapse of the US dollar must be the market taking the long-end of the US higher, based on inflation and weak US dollar. Hence my surprisingly negative view on 10y notes (prices)...."

[3] A confusing piece on a confusing situation. Morgan Stanley economists Richard Berner and David Greenlaw write a confusing piece on a ... very confusing situation! They worry about the global consequences of the credit market turmoil: "... the liquidity squeeze and tighter financial conditions could hobble growth in some key regions abroad, notably in the UK and some liquidity-fueled emerging market economies. ... In fact, the liquidity crunch may claim its next victim in European growth. Our colleague Eric Chaney notes that the US and Europe are both coupled financially by a tightening in lending standards. While the tightening is more severe on this side of the pond, what matters is how European lenders respond and its impact on capital spending" [Richard Berner & David Greenlaw: "The Credit Recession", Morgan Stanley GEF].

BOOK REVIEW. JOSEPH SCHUMPETER & CREDIT CREATION
. Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007 [web page] [prologue] [interview] [podcast]

As Larry Kudlow used to say, Joseph Schumpeter is my favorite dead economist. We all know about the importance of the innovative entrepreneur. And we have all heard about "creative destruction", Schumpeter's "wonderful metaphor" (only second to Adam Smith's "invisible hand"). But somebody needed to put it all in context — a task at which Thomas McCraw excels like no other. Schumpeter led a very agitated life, constantly moving from one place to the other. He finally settled down at Harvard in the early 1930s. In sharp contrast to John Maynard Keynes' quiet life in England, Schumpeter's perpetual travels forced him to take a dynamic view of capitalism. The Keynes-Schumpeter rivalry is one of the most exciting elements of the book. From the perspective of the Global Liquidity Blog, however, I will concentrate on the parts that deal with money and credit.

Innovation & credit creation
Already in his Theory of Economic Development (1911), Schumpeter lays down the assumption that innovation implies the constant creation of ... credit. In a 1917 article, he emphasizes the role of money and credit in economic progress. As McCraw aptly puts it in the prologue:

The core ethos of capitalism looks constantly ahead and relies on credit in launching new ventures. From the Latin root credo —'I believe'— credit represents a wager on a better future. The entrepreneurs and consumers who make these bets often care little about the past and have scant patience with the present. They undertake innovative projects and make expensive purchases (houses, for example) that require far greater resources than those laying at hand. In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations (p. 7).

In a 1928 essay on "The Instability of Capitalism", published in Keynes's Economic Journal, he again focuses on the crucial role of credit. "Innovation", he writes, "being discontinuous and involving considerable change and being typically embodied in new firms, requires large expenditures previous to the emergence of any revenue. 'Credit-creation', therefore, becomes an essential part both of the mechanism of the process and of the theory explaining it". These large bets on the success of a new venture, McCraw adds, "can be lost completely if the venture fails". During the 1930s, Schumpeter struggled with what he called his "money book", a long treatise on money that was never completed. Instead, he opted for a monumental analysis of business cycles. And here's where things get really interesting.

Business Cycles
In his monumental Business Cycles (1939), Schumpeter analyses the dynamics of past industrial revolutions. He emphazises three key institutional innovations crucial to the rise of capitalism: "the factory, the corporation, and the modern financial system" (p. 254). The "railroadization" of the United States, beginning in the 1840s, is characterized by huge amounts of "credit creation":

Huge amounts of money flowed into the United States from Britain and Europe, through the purchase of railroad bonds and the use of overdrafts on banks (lines of credit). Some of these British overdrafts were granted 'with almost unbelievable freedom and carelessness'. In the United States itself, credit creation was often even more reckless — but it was also extremely innovative (p. 263).

The automobile industry was one of Schumpeter's favorite examples of capitalist growth. "In the invention of new financial techniques", writes McCraw, "the automobile industry was 'amost in a class by itself'. General Motor's introduction of installment buying created an immense amount of credit by turning consumers into significant borrowers ... With some many customers borrowing and repaying money to own a car, automotive manufacturers were able to minimize their own debts" (p. 267). There you have it. Right from the horse's mouth. Financial innovation follows business innovation: that's the good part. But euphoria leads to "freedom and carelessness" on the part of investors: that's the bad part. As I reflect on the current credit market mess, I can't help thinking: "We've been through this before. Big deal".

Are there any lessons to be learned from the book? I would point to the following:

[a] The "Great Moderation" thesis. From a Schumpeterian point of view, this notion does not make much sense. In contrast to Keynes' stagnationism, Schumpeter held the view that capitalism was no gentle process of adjustment but something more "like a series of explosions" (p. 255). [b] The US current account and liquidity conditions. Some commentators worry about the impact of an eventually declining U.S. current account deficit on financial innovation and liquidity conditions. Again, what drives financial innovation is ... business innovation. Don't worry about that one. [c] Economic growth and credit demand. Innovation and growth can occur without corporations having to raise large sums of cash. General Motors did it in the 1920s, and Apple is doing it right now. [d] Shorter cycles ahead? The more I read about business innovation, the more I am convinced that the process is alive and kicking: renewable energy, medical techniques, biosynthetics, Interet 2.0, etc. To me, that spells more, and shorter, cycles of euphoria and panic. And, yes, more financial innovation down the road.

. Monetary Policy. A not-so-dovish dove. Frederic Mishkin, one the FOMC doves, sounds considerably less dovish in his speech today at the Risk USA 2007 Conference. Key excerpts: "Because monetary policy makers can never be certain of the amount of policy easing that is needed to forestall the adverse effects of disruptions in financial markets, decisive policy actions may, from time to time, go too far and thus produce unwelcome inflationary pressures ... The combined 75 basis points of policy easing put in place at the past two meetings should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should help promote moderate growth over time".

- Frederic S. Mishkin: "Financial Instability and Monetary Policy", Federal Reserve Board of Governors.

. Liquidity & Markets. Gold prices. Philip Manduca, the sharp Titanium Capital strategist, says it's time to take profits in the gold market. (Though the long term trend is still up, he added this morning on Bloomberg TV). Speaking of gold, Manuel Hinds and Benn Steil warn about the dollar running out of luck: "The dollar sustained its role as the international standard of value because of good fortune on two fronts. First, the Fed under Paul Volcker hammered out inflationary expectations with a painful but necessary period of high interest rates. Second, there was no viable alternative. It may not be so lucky this time. Today, not only does the euro wait in the wings as understudy, but gold banks have risen in tandem with the dollar’s decline and offer the world a viable private alternative that has permanent intrinsic value".

- Manuel Hinds & Benn Steil: "History's warning about the price of money", Council on Foreign Relations.

. Endogenous Liquidity Watch. Tumbling! Needless to say, our Endogenous Liquidity Index tumbled last week (-6.1%). The fall was led by rising financial volatility measures — a clear message to complacent "Global Decoupling" bulls. CDS and junk bond spreads were sharlpy up; our market-based measure of financial innovation suffered less devastating losses. The index now trades at levels not seen since September 17, when markets for risky assets began to recover from the mid-August collapse.

. Financial Innovation. A new revolution coming our way? Writing for the Financial Times's weekly review of the fund management industry, Steve Johnson highlights the coming mass-marketization of the hedge fund industry, chiefly as a consequence of the European Union's Ucits III legislation. Says Guy Monson, chief investment officer at Sarasin Chiswell: "It's a big bang and we have only just scratched the surface of what we are going to see in the next two or three years. It's hard to underestimate what a revolution this is. You ain't seen nothing yet". Read the whole thing.

- Steve Johnson: "Sophistication goes mass market", Financial Times.

LIQUIDITY WATCH. WEEKLY FED BALANCE SHEET, NEW YORK FED & SYSTEMIC RISK
. Federal Reserve: "Factors Affecting Reserve Balances", October 31

- Fed's Treasuries holdings: $782.7bn (+$2.1bn)
- Other central banks' Treasuries holdings: $1,231.5bn (-$2.6bn) (*)
- Other central banks' agency securities: $800.8 (+$4.3bn) (*)
- Global Dollar Liquidity Measure: $2,815.0bn (+$3.8bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
__________________

[1] Not a bad month, liquidity-wise. The last weekly Fed balance sheet for the month of October yields little in the way of surprises. A modest increase in our Global Dollar Liquidity measure is enough to propel the annual rate of growth to 14.7%, a four-month high. Foreign central banks, as usual, are leading the charge: custody holdings are back at +20.1%. This could change, of course, if the effective Fed funds rate were to persistently trade above the new 4.5% target over the next couple of weeks.

[2] New York Fed conference on systemic risk. The Federal Reserve Bank of New York has just published an overview of its recent conference on "New Directions for Understanding Systemic Risk". If I had to summarize the findings in just a couple of words, I'd say two things. First, the new financial system —with "disintermediation" as its core feature— is less prone to systemic risk, as credit risk is spread more widely. Second, as more assets are subject to mark-to-market discipline, liquidity crisis are bound to create ... new sets of risks! ["New Directions for Understanding Systemic Risk", Economic Policy Review, Volume 13, Number 2, November 2007].

[3] "Great Moderation" Watch: liquidity & "global decoupling" [Liquidity @ Financial Times]. Manisha Girotra, chairman of UBS India, dismisses the notion of "global decoupling" as just another case of ... excess liquidity! "With growth in the US slowing down, funds are getting redirected to Asia". In other words, it's all down to ... funding liquidity (which, at least according to the numbers I follow, is still in pretty good shape) [Sundeep Tucker, Joe Leahy and Geoff Dyer: "Defying gravity? Asia’s continued rise spurs ‘decoupling’ debate", Financial Times].

WIKINOMICS & THE CRAZIEST CREDIT MARKET HYPOTHESIS EVER (AGAIN)
[Latest Global Dollar Liquidity measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -16.8%]

Economist Edward Yardeni recently wrote: "The global economy is in the midst of the greatest boom of all times". The IMF's World Economic Outlook estimates global growth at "a solid 4.75%". Commodity prices tend to confirm that bullish view. Yet one fact remains hard to explain: interest rates are generally low, both in real and nominal terms. Whatever happened to credit demand? Why are interest rates so low in the midst of "the greatest boom of all times"? While walking by the Olympic Stadium in the south district of Amsterdam, I had an eureka moment as I saw this IKEA advertisement: "Design your own life". It reminded me of one of the craziest posts I ever wrote for this blog, back in March: Wikinomics & the Credit Demand Conundrum.

The post dealt with an article by economist-investor Thomas Nugent, which provided a clue to the low interest rate environment. This is the key quote:

What is interesting is that, with a booming economy, business-loan demand is falling, not rising. This is not your father’s traditional economic expansion. Productivity is mitigating the need for bank borrowing. To see this, think about the notion of infinite operating leverage whereby business technology is, in effect, “taking over.” Higher sales-GDP from applications can be considered “pure productivity” that doesn’t tax resources or drive up prices.

If Apple Computer sells more songs over the Internet, people are simply downloading more songs at a buck a song. This transaction has neither fixed nor variable expenses and therefore adds to GDP as pure productivity gains. This type of activity increases GDP without price pressure. It’s pure productivity, and it brings into question the entire rationale for expectations that the Fed will be raising interest rates just because GDP is growing (at least until more evidence accumulates of potential labor-market tightness).

Now back to IKEA. The furniture giant is in effect "crowdsourcing" its design process. Scandinavians are, apparently, very good at that. Back in March, I listened a Monocle interview on the amazing turnaround at Danish toy maker Lego. According to CEO Jørgen Vig Knudstorp:

We completely changed the way we run the business. We really involve users to an extreme degree ... They even decide their own products ... We are not involved in the design process ... We have become more virtual ... We have open-sourced the company and it does not take a lot of investment to generate a lot of cash.

Bingo! By "open-sourcing" the company, Lego needs to invest ... less. That is also, apparently, IKEA's bet. Demand for credit slows down, even as the economy continues to march forward. Wikinomics, anyone?

[UPDATE: take a look at the Lego Factory, Lego's crowdsourcing device].

LIQUIDITY WATCH. GOVERNOR MISHKIN & THE L-WORD
[Latest Global Dollar Liquidity measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -20.2%]

Gold as a barometer of liquidity conditions; Governor Mishkin & the L-Word; Some common sense on the "Great Moderation".

[1] Bank Credit Analyst: gold as a barometer of liquidity conditions. "In our opinion, gold is an excellent barometer of liquidity conditions, and the latest move provides confirmation that the market is anticipating further reflation". So says Bank Credit Analyst, the outstanding Canadian consultant. I'm not fully convinced, though. [Bank Credit Analyst: "More Reflation On The Way?"].

[2] Frederic Mishkin & the L-Word. In his recent remarks on the role of the Federal Reserve bank as a liquidity provider, governor Mishkin mentions the L-word no less than ... 30 times! This is, hands down, the new world record. "Moral hazard could also arise when a central bank lends in response to liquidity problems, but I would argue that the risk of that happening might be lower than in the case of lending to troubled institutions. I have in mind situations in which markets become impaired for exogenous reasons. In those circumstances--when financial institutions that are otherwise perfectly solid are at risk of failure because market infrastructures are disrupted or, more generally, when financial instability originates outside the banking sector--an intervention by the Federal Reserve would certainly be beneficial, and the creation of perverse incentives would probably be limited". [Frederic S. Mishkin: "Financial Instability and the Federal Reserve as a Liquidity Provider", Federal Reserve Board].

[3] Great Moderation Watch: finally some common sense [Liquidity @ Financial Times]. William Gamble, president of Emerging Market Strategies, warns about emerging nations' "information deficit". While "excess liquidity" has allowed a "disassociation bewteen perceived and actual risk", the truth is that emerging countries lack "credit reporting, efficient courts, private banks or even free speech, in short accurate and timely information, has so far buried potential issues". Further, "the bankruptcy systems, the plumbing of economics, is either non existent or dysfunctional in all but the most developed economies. If things go south, which in time they always do, putting these economies back together will be a long and difficult process". [William Gamble: "Beware information deficit in emerging nations", Financial Times] [See also Mr. Gamble's blog].

LIQUIDITY WATCH. EVERYBODY IS TALKING ABOUT THE "GREAT MODERATION"!
[Latest Global Dollar Liquidity measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -19.0%]

Great Moderation Watch, again; liquidity @ Financial Times; bearish Bill Gross; Bill Luby and a new era for the VIX; the Financial Ninja & the mysterious spike in the Fed funds rate.

[1] Great Moderation Watch: the IMF. I don't know what to make of this, but the fact is, everybody is talking about the "Great Moderation" of the business cycle and related ideas ("great divergence", "global decoupling", etc). Readers of this blog will recall that, IMHO, the "Great Moderation" is a key component of market liquidity. In chapter 5 of the World Economic Outlook, IMF ecomomists ask themselves: 'What is Driving the Moderation of the Global Business Cycle?' They single out three key variables: (a) Institutional quality; (b) Macroeconomic policies; (c) Financial deepening. (They discard, rather surprisingly, the role played by inventory management techniques). They conclude with guarded optimism: "... the increased stability of economies and the associated increase in the durability of expansions largely reflect sources that are likely to prove persistent ... Overconfidence in the ability of the current policy framework to deliver stability indefinitely would certainly not be warranted. Although the business cycle has changed for the better, policymakers must remember that it has not disappeared". [IMF: "The Changing Dynamics of the Global Business Cycle", World Economic Outlook].

[2] Great Moderation Watch: Liquidity @ Financial Times. The FT's Andrew Wood interviews a number of economists about the "great divergence" and the associated issue of "global decoupling". According to Geoff Lewis at JF Asset Management in Hong Kong, "decoupling is a fact", and it is largely due to the 'domestic nature' of Asian economic growth. Mr. Lewis feels confident enough to shrugg off 'the view that any credit squeeze-induced slowdown in the US would affect Asia'. But decoupling has many doubters, as Andrew Wood points out. He cites Markus Rosgen (Citigroup) and Bryan Olson (Charles Schwab) as chief sceptics. Monetary and exchange rate policies are not decoupled, they argue. My own two cents: in the short term, decoupling is a fact, and it will help the "Great Moderation" cause. But I worry about ... the medium term. [Andrew Wood: "Why the talk about a great divergence could be premature", Financial Times].

[3] Great Moderation Watch: Morgan Stanley. Richard Berner analyzes inventory to sales ratios, both in nominal and real terms, and concludes that 'the downside risks from the inventory accelerator are limited'. Indeed, he adds, 'the offshoring of production has a silver lining: It shifts the inventory cycle to overseas locations and reduces the cyclicality of US output'. [Richard Berner: "Inventories: A Recession Trigger?", Morgan Stanley GEF]. Berner's collegue Stephen Jen reviews the definition of Sovereign Wealth Funds and argues that 'SWFs already played a meaningful role in September, facilitating the recovery in EM equities and equities in general. Having such a different ‘temperament’ from private funds, SWFs should reduce the risk of ‘herd behaviour’ ... Furthermore, market efficiency is a function of market liquidity. To the extent that SWFs improve market liquidity, particularly in a way that is not ‘herdish’ like other types of short-term capital flows, SWFs should be a positive factor for markets in general". In other words, SWFs are seen as a source of stability, and as such they contribute to market liquidity. [Stephen Jen: "The Definition of a Sovereign Wealth Fund", Morgan Stanley GEF].

[4] Bearish Bill Gross. The very bearish PIMCO manager sees more pain ahead — much more: "An increasingly recessionary looking U.S. economy will likely require 1% real short rates and 3½% Fed Funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s or, to be honest, Roosevelt’s depressionary 1930s". [Bill Gross: "Shadow Dancing". PIMCO Bonds].

[5] Bill Luby & the VIX. Because the VIX plays a non-trivial role in my Endogenous Liquidity Index, I always pay attention to what Bill Luby has to say. Well, Bill is a cautious bull — on the VIX, that is (I guess I could call him an "endogenous liquidity bear"). According to Bill, a 15 VIX increasingly looks like a long-term bottom. [Bill Luby: "Volatility in a 130/30 Era", VIX and More].

[6] A mysterious spike in the Fed funds rate? Ben Bittrolff has detected an "ominous spike in the Fed Funds rate on 10/25/07 to 15%. The data is here". Any ideas? ["WTF Happened to the Fed Funds Rate?", The Financial Ninja].

[7] Bearish David Malpass. The Bear Stearns chief international economist, a keen watcher of liquidity trends, sounds very bearish. [HT: Rich Karlgaard & his excellent blog]. "We expect", writes Malpass, "a credit-driven economic slowdown beginning in the fourth quarter due to the August changes in credit markets. We think the U.S. slowdown and global credit market disruptions will pressure earnings, equity prices, commodities and foreign growth more than is reflected in the current consensus ... We expect inflation to be problematic in coming months as prices make up for dollar weakness. We think the Fed underestimates this linkage". [Rich Karlgaard: "Third Quarter Strength, Stagflation Ahead", Digital Rules].

LIQUIDITY WATCH. ON CHIANTI WINE & THE EURO, THE WEEKLY FED BALANCE SHEET, THE GREAT MODERATION, ETC.
. Federal Reserve: "Factors Affecting Reserve Balances", October 24

- Fed's Treasuries holdings: $780.6bn (-$3.1bn)
- Other central banks' Treasuries holdings: $1,234.1bn (+$3.9bn) (*)
- Other central banks' agency securities: $796.5 (+$8.5bn) (*)
- Global Dollar Liquidity Measure: $2,811.2bn (+$9.3bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
__________________

[1] A wedding party in Tuscany: on Chianti wine & the euro. On Wednesday evening Claudia and I finally made it to the Tuscan village of Pietraviva, about 20 miles from Siena. Our friend's wedding party took place on Thursday near the village of Pogi, and by Saturday evening we were back in Amsterdam. Now, Bill Luby is the financial blogosphere's wine specialist. Although I know next to nothing on the subject, I will say this: the Dievole Novecento Riserva Chianti Classico 2001 was ... spectacular. The Dievole company, by the way, is a fine example of Italian entrepreneurs fighting the strong euro with their only remaining weapons: creativity, innovation, risk-taking.

[2] More on Chianti wine & the euro. By turning old and inefficient farms into lavish, lucrative wine-tasting facilities, these entrepreneurs are transforming the Tuscan landscape. Dumping the lira in favour of an international reserve currency was always going to be a risky venture: damaging bouts of exchange rate appreciation —like the one we are witnessing right now across the eurozone— would inevitably occur. The minute you cease to act as an exporting periphery, you have no choice but to turn yourself into a center of growth and innovation. One can only hope that many more Italian entrepreneurs will follow the example of Tuscan wine producers.

[3] Weekly Fed balance sheet watch. Another impressive performance, and a clear sign of resilience in the world economy. Our Global Dollar Liquidity measure registers a $9.3bn increase — taking it to a new all-time high of $2,811bn. This, in turn, translates into a 14.6% annual rate of growth. Note the striking absence of the Federal Reserve as a provider of domestic liquidity, which brings the growth rate of its stock of Treasuries (a proxy of the monetary base) to less than 3%. Will euro bulls take note?

[4] Great Moderation Watch: Jeff Immelt & global liquidity [Liquidity @ Financial Times]. "In the world as a whole", says Jeffrey Immelt, the head of General Electric, "there is still a lot of liquidity". Here, Mr. Immelt refers to global macroeconomic liquidity. But there's more on the subject of market liquidity. First, the GE capo mentions SWFs: "The impact of sovereign wealth funds is considerable". Second, and crucially important in terms of the Great Moderation thesis: "China and India will shield GE from US downturn ... If you consider the problems in the credit markets, they will not have an impact on the vast majority of GE's business. In other words, the overall effect on GE will be limited". Bingo! No wonder Peter Marsh concludes: "[Immelt's] comments will be welcomed by adherents of the theory of 'decoupling' ... in which growth in the world becomes the key component of economic expansion". [Peter Marsh: "China and India will shield GE from US downturn, says Immelt", Financial Times].

OUT TO A WEDDING PARTY IN TUSCANY ... SEE YOU ON MONDAY!

LIQUIDITY WATCH. SAAS, ANYONE? ("GREAT MODERATION" WATCH)
[Latest Global Dollar Liquidity measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: -21.7%]

Great Moderation Watch; LiquidityHub goes live; liquidity @ Financial Times; Bear Stearns & Citic deal.

[1] Great Moderation Watch: Saas, anyone? In his remarkable speech on "Liquidity, liquidity, liquidity", Bank of Canada Deputy Governor David Longworth singled out "better inventory management" as one of the causes of the "Great Moderation" of the business cycle — a crucial component of market liquidity. The way I see it, the key indicator to gauge the impact of inventory management is the inventory-to-sales ratio. Is there room for even more improvement? From what I read, the answer is inequivocally: "Yes". Thanks to Software as a Service, otherwise known as SaaS, small- and medium-sized businesses will soon have the opportunity to manage their inventories with the help of efficiently-priced software. [Phil Wainewright: "Ketera tames the supply chain’s long tail", ZDNet].

[2] Great Moderation Watch: surging Bric IPOs [Liquidity @ Financial Times]. According to an Ernst & Young report on IPOs, "Seven out of the top 10 IPOs in the third quarter were from emerging markets. The Asia-Pacific - led by China and Hong Kong - had the lion's share in terms of both the number of IPOs completed and the total capital raised. The record numbers of IPOs in the emerging markets show that it is these countries that are driving global economic growth". Even Argentina, with its rather hostile financial climate, has managed to produce a $532 m IPO. [Joanna Chung: "Record level of 'Bric' economy IPOs offsets fall", Financial Times]. See also Morgan Stanley's Stephen Jen's comment on the economic impact of Sovereign Wealth Funds: "SWFs help shift the balance of power in favour of the ‘periphery’ and against the ‘core’ economies in the world".

[3] LiquidityHub goes live! (Liquidity @ Financial Times). LiquidityHub, the bank-sponsored trading platform designed to facilitate access to interest rate swaps and US Treasuries went live yesterday with euro interest-rate swaps. "The battle for trading liquidity has seen the formation of numerous dark liquidity pools that allow transactions to take place on private inter-bank or intra-bank platforms, in competition with exchanges and other traditional marketplaces ... LiquidityHub's launch will help to facilitate deeper pools of liquidity in the market while leveraging the latest capabilities in electronic trading of fixed income products". [Paul J. Davies: "LiquidityHub launches swaps product", Financial Times].

[4] Flows & stocks in reserve analysis [Liquidity @ Financial Times]. Win Thin, currency strategist at Brown Brothers Harriman & Co., aruges that China is not dumping US assets: "... diversification does not automatically mean outright dollar sales, which is supported by the ongoing purchases of dollar assets by China. China may be diversifying its new inflows, but it is still a net buyer of dollars and dollar paper. Our understanding is that most reserve managers are diversifying their new flows, not their existing stocks of dollar holdings". Good point. Many analysts tend to confuse flows and stocks: more on that soon. [Win Thin: "Claims that China is dumping US assets are spurious", Financial Times].

[5] The Bear Stearns-Citic deal. "The key thing is keeping the money on the table", says Thomas Barnett, the author of the Pentagon's New Map. War and Peace in the XXI century (Putnam, 2003) (blog). Barnett is, IMHO, the world's top globalization expert. "To keep the money on the table": that's what the Bear Stearns-Citic deal is all about. [Sundeep Tucker: "Bear Stearns unveils Citic deal", Financial Times].

WEEKLY FED BALANCE SHEET REVIEW. RESILIENCE AMID THE GLOOM & DOOM
. Federal Reserve: "Factors Affecting Reserve Balances", October 17

- Fed's Treasuries holdings: $783.7bn (+$0.4bn)
- Other central banks' Treasuries holdings: $1,230.2bn (+$8.4bn) (*)
- Other central banks' agency securities: $788.0 (+$6.0bn) (*)
- Global Dollar Liquidity Measure: $2,801.9bn (+$14.7bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
__________________

Amid all the gloom and doom surrounding the dollar and the earnings outlook in the banking sector, the weekly Fed balance sheet manages to produce an unmistakable sign of resilience. In all likelihood, October will end as the 59th month in a row with our Global Dollar Liquidity measure rising at more than 10% annually. This is, of course, unprecedented — and I take it as a vote of confidence in the strength of the global economy.

Until proven wrong on that score, I will stick to the following key insights when interpreting the data: [1] The custody numbers, while woefully incomplete, are delivered in almost real-time, and are as such much more valuable than their TIC cousins; [2] To the extent that BRICs entrepreneurs are willing to take on more risks in their own currencies, their actions will naturally be reflected in official CB intervention in the U.S. bond market. (In other words, is official intervention such a bad thing?)

BANK OF CANADA: "LIQUIDITY, LIQUIDITY, LIQUIDITY"
. David Longworth: "Liquidity, liquidity, liquidity", Bank of Canada

Memo to liquidity watchers worldwide: do not miss this speech by David Longworth, Deputy Governor of the Bank of Canada. "Liquidity", says Mr. Longworth, "is one of those words that are used to mean slightly different things in different contexts". There are three concepts of liquidity that are relevant to the world of finance: [1] macroeconomic liquidity; [2] market liquidity; [3] balance-sheet liquidity. Macroeconomic liquidity has to do with "overall monetary conditions", including interest rates, credit conditions, and the growth of monetary and credit aggregates.

This concept, in turn, can be seen from a domestic and from a global perspective. From the domestic point of view, Mr. Longworth singles out the monetary base as the key central bank tool to influence short-term interest rates. He says little about global macroeconomic liquidity, although he remarks that "one can aggregate macroeconomic liquidity across countries to obtain average world real interest rates and the average growth of monetary and credit aggregates". From the perspective of the Global Liquidity Blog, the truly interesting part of the speech starts with the definition of market liquidity.

Market liquidity & the "Great Moderation"
"Liquidity", says the Deputy Governor, "is the lifeblood of markets ... [It] is essential to the well-functioning of both the real economy and financial markets". The more liquid the market, the better — with an important caveat: complacent investors may be tempted to take on too much risk. Mr. Longworth then proceeds to define market liquidity:

Market liquidity refers to the extent to which one is able to quickly and easily buy and sell financial assets in the market, without moving the price. Market liquidity captures the aspects of immediacy, breadth, depth, and resiliency in markets. Immediacy refers to the speed with which a trade of a given size and cost can be completed. Breadth, often measured by the bid/ask spread, refers to the costs of providing liquidity. Depth refers to the maximum size of a trade for any given bid/ask spread. Resiliency refers to how quickly prices revert to fundamental values after a large transaction.

Several factors help to explain the tremendous growth in market liquidity over the past 15 years: the appearance of new players such as hedge funds, financial innovation (derivatives, CDOs), the growth of electronic trading, back-office innovations. But here's —at least from my perspective— the key statement of the speech:

... efficiency gains in the financial sector, better inventory management, and better macro policy – including monetary policy – resulted in what has come to be called the "Great Moderation," which was a significant reduction in the variability of output, inflation, and long-term interest rates across most G-7 countries, starting in the mid-1980s. And this moderation has, in turn, contributed to the liquidity of financial markets by reducing some of the fundamental sources of financial volatility and risk.

Bingo! This is the very raison d'être of our own Endogenous Liquidity Index! The rest of the speech is devoted to "recent events around the world". Note the connection between market and macroeconomic liquidity: as credit markets froze in the second week of August, "the rate on overnight collateralized transactions moved above the target overnight rate". This forced the central bank to inject macroeconomic liquidity in order to avoid sharp discrepancies between the target rate and money market rates.

LIQUIDITY ROUNDUP. THE DECONSTRUCTION OF THE "CONUNDRUM"
[Latest Global Dollar Liquidity measure: +14.2% annual growth rate; latest Endogenous Liquidity Index: -15.7%]

The "conundrum" deconstructed; Intel results & endogenous liquidity; central banks & credit creation; liquidity @ Financial Times.

[1] The deconstruction of the conundrum. Morgan Stanley's Joachim Fels and Manoj Pradhan note the renewed steepness of the U.S. Treasury yield curve and proceed to deconstruct Greenspan's conundrum, as defined by the former chairman himself: "I was perturbed because we had increased the federal funds rate, and not only had yields on ten-year treasury notes failed to rise, they'd actually declined. (…) Seeing yields decline at the beginning of a tightening cycle was extremely unusual". (The Age of Turbulence, New York 2007, p.377). The key to the deconstruction is the convergence between an easier Fed monetary policy and a more agressive, risk-oriented investment policy by Sovereign Wealth Funds. [Joachim Fels & Manoj Pradhan: "The Bond Un-Conundrum", Morgan Stanley GEF].

[2] Intel results. Intel shorts get squeezed as the company announces stellar results and raises guidance (release). I was struck by the distribution of "geographical revenue": +52% in Asia Pacific, +20% in the Americas, +18% in Europe. While demand naturally slows in G7 countries, the Asian economic boom is intact. Anecdotical evidence from Infineon and ASML points in the same direction. While Ifineon products are eagerly snapped up by Shanghai's DareGlobal Technologies, ASML boasts about the productivity enhancements achieved by Taiwanese clients. My point, ladies and gentlemen, is simple: the "Great Moderation" of the business cycle is alive and well. G7 weakness, if it does indeed materialize, can be offset —at least in the short term— by BRIC strength. Endogenous liquidity conditions should improve. [See also Dan Harris: "China's Little Dirty Secret", China Law Blog].

[3] Liquidity @ Financial Times: on central banks & credit creation. Claire Jones, editor of Central Bank News, argues that central banks kept interest rates deliberately low "because they wanted to encourage borrowing in order to maintain growth following the bursting of the dotcom bubble. It was the response of the banking industry to this policy, not central bankers being 'still in denial' over the relationship between credit and interest rates, that is ultimately to blame for today's mess". As John Adams would say, "human nature will never change". [Claire Jones: "Don't pillory the central bankers", Financial Times].

[4] Liquidity @ Financial Times: credit markets recovery. Three FT stories seem to point in the same direction: credit markets are recovering. "Banks led by Citigroup yesterday sold $2.2bn in junk bonds to fund KKR's leveraged buy-out of First Data, completed in September, amid resurgent demand for risky, high-yield debt", writes Stacy-Marie Ishmael. David Oakley, in turn, sees signs that the sterling corporate bond market has reopened: "In the first corporate issue since June, Veolia Environnement, the French utility, raised £500m in a highly popular deal". Finally, Paul J. Davies analyzes the short-covering rally in the LevX senior index.

LIQUIDITY ROUNDUP. LIQUIDITY IS ... A PUBLIC GOOD!
[Latest Global Dollar Liquidity measure: +14.2% annual growth rate; latest Endogenous Liquidity Index: -14.1%]

Liquidity is a public good; PIMCO strategy; Bank Credit Analyst on the Fed.

[1] Liquidity @ Financial Times: liquidity is a public good. The debate about liquidity risk goes on. Jonathan Ward presents the case against over-regulation: "Liquidity is a public good, which banks are partly responsible for providing. For a bank to insure itself against the very worst liquidity crises on the assumption that there is no central bank would not be rational. Liquidity risk arises from different sources and is managed in different ways. It depends on the unpredictable collective behaviour of counterparties and depositors. It is not easily susceptible to quantification: most of the time liquidity costs are predictable and small; occasionally, liquidity collapses. Rigid 'one size fits all' rules are not appropriate here". [Jonathan Ward: "An international liquidity accord is no solution", Financial Times].

[2] PIMCO's Powers on investment strategy. (a) Liquidity & spreads: "At recent forums, we have noted that credit was trading at abnormally tight spreads because of a global glut of liquidity and bids from structured products for corporate exposure"; (b) Bullish on BRIC currencies: "We favor the Brazilian real, the Mexican peso and the Russian ruble"; (c) Steepening trades: "A review of prior Fed easing cycles shows that a curve steepening of two-year notes versus 10-year notes contributes more powerfully than a bet on rates"; (d) Cautiously bearish on volatility: "Our secular view is that the developing world will continue to grow at 8%-11% despite much slower growth in the developed world in the area of 2%, allowing the global economy to continue growing at 4%-5% ... As volatility has crept back into the market, prospects for volatility sales look more interesting going forward". [PIMCO: "William C. Powers Discusses PIMCO’s Cyclical Outlook and Global Strategy"].

[3] Bank Credit Analyst on the Fed. More easing ahead, but its timing remains elusive, says the Canadian global markets consultant: "The economy is soggy, not collapsing, giving the Fed time to assess how the outlook is shifting. Policy is still too tight relative to underlying economic trends, and we expect more easing in the coming year, taking the funds rate to 4% or below. But the timing will be less predictable than when the Fed was raising rates". [BCA Research: "What Next for Fed Policy?"].

LIQUIDITY ROUNDUP. RISK MANAGEMENT & THE GREAT MODERATION
[Latest Global Dollar Liquidity measure: +14.2% annual growth rate; latest Endogenous Liquidity Index: -11.9%]

Risk management & the Great Moderation; liquidity @ Financial Times; Brad Setser on missing Chinese reserves.

[1] Liquidity @ Financial Times: Risk management & the Great Moderation. In early 2006, the Chicago Mercantile Exchange launched Snowfall Futures and Options contracts. The exchange also offers the Hurricane Event futures and options and its sister contracts: the Hurricane Seasonal futures and options and the Hurricane Seasonal Maximum futures and options [CME]. In early June, just as our Endogenous Liquidity Index was reaching new highs, Goldman Sachs even launched a CDO based on CAT bonds! Today's FT carries a front page-story on freight derivatives, which is on course to become a ... $150bn market! Ladies & gentlemen, my point is that the growing panoply of financial instruments created to price and trade risk is itself a key element of the "Great Moderation" of the business cycle — which bodes well for liquidity conditions. Sell volatility on rallies! [Jennifer Hughes: "Weather derivatives: Bonds help cushion a catastrophe", Financial Times; David Oakley: "China factor helps drive freight derivatives", Financial Times].

[2] Liquidity @ Financial Times: liquidity regulation. Karel Lannoo, CEO of the Centre for European Policy Studies (CEPS), argues against "another EU directive to regulate bank liquidity". According to Mr. Lannoo, "Liquidity is very much a relative concept, which lends itself to standards, not to tight rules. It is a function of the risk profile of a bank, which will be difficult to put down in a directive, unless it becomes an unworkable piece of regulation". [Karel Lannoo: "Tight rules not suited to liquidity", Financial Times].

[3] Liquidity @ Financial Times: a $75bn super-fund? The Master Liquidity Enhancement Conduit (MLEC), announced on Monday by Citigroup, Bank of America and JPMorgan, could be up and running within 3 months. According to FT reporters, "The plan is an attempt to address concerns about SIVs and conduits, vehicles that are often off-balance sheet but closely affiliated to banks. They typically fund themselves in the short-term asset-backed commercial paper market but purchase long-term securities". [Gillian Tett, Krishna Guha & David Wighton: "Banks agree $75bn mortgage debt fund", Financial Times].

[4] Brad Setser on Chinese reserve growth. Brad Setser detects a $45-$50bn shortfall in valuation-adjusted Chinese reserves. His hypothesis: the Chinese are beefing up their Sovereign Wealth Fund: "I would estimate that $50b was shifted to the CIC". Brad's hypothesis raises an important question for liquidity watchers: can we rely solely on quantity indicators? My own answer would be: watch market-based indicators such as credit spreads and volatility readings. Or, in this blog's terminology: pay slightly more attention to "endogenous" liquidity indicators, and slightly less attention to monetary aggregates. [Brad Setser: "Why did China only add $100b to its fx reserves in the third quarter?", RGE Monitor].

WEEKLY FED BALANCE SHEET REVIEW. WATCHING PAINT DRY
. Federal Reserve: "Factors Affecting Reserve Balances", October 10

- Fed's Treasuries holdings: $783.3bn (-$3.0bn)
- Other central banks' Treasuries holdings: $1,221.8bn (+$7.7bn) (*)
- Other central banks' agency securities: $782.0 (-$2.3bn) (*)
- Global Dollar Liquidity Measure: $2,787.2bn (+$2.5bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
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Dull, lacking in liveliness or surprise, uninteresting, colorless and boring: these are the adjectives that best describe the weekly Fed balance sheet. And this has been the norm for months now. There is, I believe, a simple explanation: the real action is taking place ... elsewhere. When you read about liquidity crisis and/or surging current account deficits in the periphery of the eurozone, and when you see the euro trading above $1.42, you know the ECB is getting all the fun (or the stress). It's high time for a Global Euro Liquidity measure! Meanwhile, here's my daily liquidity roundup:

[1] Morgan Stanley: an October pause? "The combination of healing in stressed financial markets and mixed economic news", write Richard Berner and David Greenlaw, "gives the Fed latitude to pause before easing monetary policy again. Since the Fed eased on September 18, the improvement in most markets has been dramatic, although incomplete. As the Fed intended, that improvement has partially offset the financial restraint from the summer liquidity squeeze". [Richard Berner & David Greenlaw: "Fed to Pause in October", Morgan Stanley GEF].

[2] South Africa Reserve Bank raises rates. South African Reserve Bank Governor Tito Mboweni said on Thursday that the bank had decided to raise the repo rate by 50 basis points to 10.5%. The current tightening cycle that began in June last year increases to 350 basis points. Is this the end of the tightening cycle? [Mail & Guardian: "Reserve Bank raises interest rates"].

[3] Liquidity @ Financial Times. Fred Bergsten on Asia & the euro: "... eurozone leaders should be addressing their concerns to Beijing, and to some extent Tokyo and Riyadh, rather than Washington, especially with the US current account deficit now falling and the budget deficit for fiscal 2007 at a mere 1.2 per cent of GDP" ("Europe must look east to deal with the euro"); Gillian Tett on the impact of volatility on VAR models (no link); Stacy-Marie Ishmael on a tentative recovery in the junk-rated bond market ("Appetite for high-yield debt improves"); Michael Mackenzie & Sakia Scholtes on the high levels of 3-month interbank rates (no link).

STEEN JAKOBSEN COMES ALIVE!
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -11.3%]

Steen Jakobsen, the Saxo Bank asset manager, is now posting his positions on his blog. Latest trades:

EURNOK - Long @ 7.6951 (15% of net value of fund); EURSEK - We remain short from 9.2017 & 9.1781 (30%); NOKSEK- short 1.1877 (19%); JPY c USD p, strike 116, Price 41 pips (Net risk 10 bps); Dec Dax- short 8.055,50 (16%); 10y Notes (dec) - Long 108 23.5/32 (37%).

LIQUIDITY ROUNDUP. LIQUIDITY IS A STATE OF MIND!
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -11.3%]

Liquidity as a state of mind; Bank Credit Analyst & Goldilocks; bearish David Malpass; liquidity @ Financial Times; Endogenous Liquidity watch.

[1] Liquidity is a state of mind! PIMCO's Paul McCulley unearths good old Keynes and posts a timely reminder: "Liquidity is not a pool of money, but rather a state of mind ... At the macro (systemic) level, liquidity is not about how many pieces of paper with pictures of dead presidents on them we have in our wallets, but rather about how much utility we derive from having them in our wallets". Bingo! McCulley's point, IMHO, is sometimes neglected by international reserves analysts, who fail to notice that central banks's purchases of U.S. securitires reflect local residents' confidence about taking risks in their own currencies. As governor Warsh says: "Liquidity is confidence". [Paul McCulley: "A Reverse Minsky Journey", PIMCO Bonds].

[2] Bank Credit Analyst: Just enough liquidity. "The global economy is on a Goldilocks path: Just enough liquidity and just enough growth", writes the top-notch Canadian consultant. These guys have an astonishing track record. But what does our own Goldilocks/Stagflation indicator say? The good news is that the numerator is on fire: yesterday, platinum prices surged $30, and the platinum/gold ratio (a market-based indicator of global economic growth) trades at 1.88, a 40-day high. No such luck in terms of the denominator, though: ten-year inflation breakevens are back above 230 basis points. All in all, a rather decent picture. [Bank Credit Analyst: "Commodities: Just Right"]

[3] Bearish Malpass? Bear Stearns chief economist David Malpass is feeling less bullish about the prospects for the global economy and risky assets: "The momentum in many asset classes has been a byproduct of prolonged excess liquidity provided by the Fed. Clear signals of a slowdown in global economic growth are needed to break the momentum". [Doug Kass: "Six Reasons a Noted Economist Is Less Bullish", The Street.com].

[4] Liquidity @ Financial Times: China. The FT special report on China provides tons of information: "In China, the loosening of rules on home purchases kick-started the mortgage process and gave ordinary citizens a hefty chunk of collateral to finance other big-ticket purchases". Right in the money! Secure property rights tend to produce explosive moves in credit markets, as the value of trillions in assets is unlocked. Previously dormant assets become liquid assets, ready to act as collateral in credit markets. See Hernando de Soto: The Mystery of Capital. Why Capitalism Triumphs in the West and Fails Everywhere Else (Basic Books: 2000). [Lionel Barber: "A 21st century narrative with many contradictions", Financial Times].

[5] Liquidity @ Financial Times: the ECB's burden. More on the ECB's burden: financial crisis at the periphery of the system lead to unwanted bouts of currency appreciation (the euro, in this case). "Russia’s central bank is to lower minimum reserve requirements for banks from Thursday as it battles a growing liquidity squeeze in the Russian banking system following the US subprime crisis. The decision comes as part of a number of measures designed to fend off a potential liquidity crisis during the next few months ... There isn’t enough funds available to support normal operations so the banks need to borrow every day via repo operations ... Renaissance Capital calculates $7.15bn in eurobond issues and about Rbs40bn [$1.5bn] in ruble bond issues have been postponed since the crisis hit". Affaire à suivre. [Catherine Belton: "Russia cuts bank reserve requirements", Financial Times].

[6] Endogenous Liquidity watch. Good news on the ELI front. Thanks to the rapidly shrinking Moody's Baa spread (190 bps), my trusted long-term model for risky assets in now back into a bullish mode. Caveats apply: the model is all but useless as a short-term trading tool, and the margin is very, very slight.

LIQUIDITY ROUNDUP. WEAK DOMESTIC LIQUIDITY, BOOMING GLOBAL LIQUIDITY
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -10.7%]

Domestic v. global liquidity; McKinsey & petrodollars; Governor Warsh on liquidity & market-based indicators; amazing Larry Kudlow; a look at the Endogenous Liquidity Index; liquidity @ Financial Times.

[1] Domestic v. global liquidity. John Husman does a good job at debunking one of today's most persistent myths, namely that the Fed is "inundating" markets with liquidity. This is certainly not the case: "... investors are putting so much false hope on the notion that the Fed is 'injecting' all sorts of 'liquidity' into the markets". My own numbers show that the stock of Treasury securities held by the Fed is growing at around ... 3%. Moreover, Husman hits the nail on the head as he mentions foreign holdings of U.S. bonds: "Foreign purchases of U.S. Treasuries outweigh the Fed's actions many, many times over". Yet, one is left with the impression that Dr. Husman pays perhaps too much attention to (anemic) domestic liquidity, and not enough attention to (booming) global dollar liquidity. [John P. Husman: "The Bag Will Not Inflate, And Liquidity Will Not Be Flowing", Husman Funds Weekly Market Comment] [HT: JJ].

[2] McKinsey & petrodollars. Bloomberg's Daniel Kruger cites a McKinsey report on the impact of petrodollars in terms of the U.S. credit markets: "Oil exporters eclipsed Asian nations last year as the biggest source of global capital for the first time since the 1970s, McKinsey found. At $70 a barrel, $628 billion of fresh petrodollars will flood through global financial markets yearly". Here's the really important part: "Yields on 10-year notes are 21 basis points lower because of the additional petrodollar reinvestment". That sounds about right to me. The essence of Bretton Woods-type models is to avoid adjustment through the recycling of savings carried out by surplus countries. [Daniel Kruger: "Treasuries Fueled by Petrodollars From Mideast Funds", Bloomberg].

[3] Governor Warsh & market price indicators. Liquidity analysis isn't always concerned with quantity indicators (monetary aggregates). Market prices provide an alternative route — especially in times of crisis. That is the key lesson from the already aged, but wonderful book by Manuel Johnson & Robert Keleher. Monetary Policy. A Market Price Approach (Westport, Connecticut: Quorum Books, 1996). Fed governor Kevin Warsh appears to agree: "Particularly in times of financial distress, we must draw on a full range of market indicators ... Signs of illiquidity were evident in a number of important markets ... In this respect, market-based indicators are certainly informative". All sorts of spreads are taken into consideration. But note the conspicuous absence of ... FX markets. [Kevin Warsh: "Financial Stability and the Federal Reserve", Federal Reserve Board].

[4] Amazing Larry Kudlow. CNBC's Larry Kudlow and an astonishing piece on Ben Bernanke's "liquidity flip-flop": "On the afternoon of August 7, the Federal Reserve chair was an inflation hawk — according to the unchanged FOMC policy statement — fearful of adding liquidity to the markets. By day’s end on August 9, however, he was leading the liquidity charge, initiating a process that would help unlock the credit seize-up that started in late-July ... And he got the liquidity ball rolling. As we now know, the Fed started pouring liquidity into the system on August 9. Then, on August 17, it slashed its base discount rate for member-bank loans by 50 basis points. Finally, on September 18, it enacted a shock-and-awe liquidity-adding half-point drop in the federal funds rate". [Larry Kudlow: "Anatomy of a Fabulous Fed Flip-Flop", National Review Online].

[5] Endogenous Liquidity watch. Our Endogenous Liquidity Index surged 4.2% yesterday, spurred by the falling VIX, by tightening CDS spreads, and by surging share prices of financial innovators (Goldman Sachs at a new all-time high).

[6] Liquidity @ Financial Times: John Plender. The former FT editor, now chairman of Quintain, argues vehemently in favor of incorporating liquidity risk into the next Basel regulatory round: "Bill Cuthbert of Liquidatum, an advisory and data services firm specialising in liquidity risk, points out that liquidity risk has become the poor cousin of other types of risk. A survey by his firm of the annual reports of 59 of the world's biggest banks shows that liquidity risk is consistently granted much fewer mentions than market risk, credit risk and operational risk". Mr. Plender mentions the L-word no less tan ... eleven times (a new record) [John Plender: "Let's not forget to mention liquidity risk at the Basel round", Financial Times].

[7] Liquidity @ Financial Times: Kazakhstan. Remember the ECB's burden? Now things are taking a spectacular turn. Banking systems at the periphery of the eurozone are getting shaky; local investors rush to protect their property by buying ... euros! The euro appreciates, and politicians in Brussels complain. Dear ECB: welcome to the not-always-pleasant world of the issuers of international reserve currencies! (More on that soon) [Joanna Chung and Stacy-Marie Ishmael: "Kazakhstan hit hard by the shortage of liquidity", Financial Times].

[More updates coming up].

LIQUIDITY ROUNDUP. THE ECB'S BURDEN
[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -14.3%]

The ECB's burden; liquidity & entrepreneurship; liquidity @ Financial Times: Lagarde, Magnus, Lex.

[1] The ECB's burden. The European Central Bank is discovering the pitfalls of managing an international reserve currency. Ten years ago, surging demand for dollars worldwide baffled the Fed and led to a memorable debate within the FOMC. Monetarists, led by Bill Poole and Jerry Jordan, worried about surging M2 and M3 aggregates, and wished to raise rates. "Internationalists" argued that a global flight-to-quality move was artificially swelling money market funds within M2 and M3. They insisted on lowering the Fed funds target to ease the panic. Now, the ECB is grappling with similar issues: "... the August annual growth rate of close to 12% in the monetary aggregate M3 may have been influenced by a number of temporary or special factors, such as the flattening of the yield curve and the recent financial market volatility, and may therefore overstate the underlying rate of money and credit expansion". Fascinating stuff. [Jean Claude Trichet: "Introductory statement", ECB].

[2] Liquidity & entrepreneurship. Hans Hvide, a professor of finance at the University of Aberdeen, proposes a simple model to test an idea that can be traced back to Adam Smith, who in the Wealth of Nations stated that entrepreneurs: "... have all the knowledge, in short, that is necessary for a great merchant, which nothing hinders him from becoming but the want of sufficient capital." Overall, the model tends to support the view that "entrepreneurs may be unable to establish a venture at an efficient scale due to liquidity-constraints arising from capital market imperfections" [Hans Hvide: "Does lack of liquidity impair entrepreneurs?", VOX].

[3] Liquidity @ Financial Times: Christine Lagarde. The French minister of economy and finance —who recently argued in favor of a "semi-incestuous relationship between the exchanges, bankers, insurers, lawyers and accountants"— calls for a better assessment of liquidity risk by rating agencies: " ... the liquidity of secondary markets for such complex securities can disappear very quickly. Both rating agencies and investors should be able to assess this liquidity risk. Rating agencies should enhance their methodology for assessing structured products so as to capture liquidity risks". The L-word is mentioned no less than five times. [Christine Lagarde: "Securitisation must lose the excesses of youth", Financial Times].

[4] Liquidity @ Financial Times: George Magnus. The UBS Investment Bank advisor warns readers that the credit crisis is not over yet: "The scramble for liquidity is still ongoing, as evidenced by euro interbank rates, which are still hitting new highs". Mr. Magnus doesn't buy into the notion that BRICs-led "global decoupling" will be enough to offset the upcoming slowdown in OECD economies. For my part, as I have stated repeatedly, I'll keep an eye on volatility readings to gauge the validity of the decoupling thesis. So far, the verdict is largely a positive one. [George Magnus: "The credit crisis: why it is still too early to relax", Financial Times].

[5] Liquidity @ Financial Times: Lex. There is little need for another rate cut from the Fed, says Lex: "Last time round, the Fed delighted unsure investors with 25 basis points more than expected. This month, it might be time to remind them that while helicopter Ben has shown he will take off in an emergency, he does not simply hover over the markets unleashing cheaper money on demand". [Lex: "The first cut is the deepest", Financial Times]

[6] Liquidity @ Financial Times: Islamic bonds. This is a truly worrying piece of news. Islamic finance, one of the global credit market's bright spots, now looks vulnerable to the West's credit problems: "Dana Gas, a Middle Eastern natural gas producer, was on Monday forced to lower the size of an Islamic bond issue and offer investors bigger premiums as the credit squeeze took its toll on one of the fastest-growing sectors of the market.
The United Arab Emirates company finally raised $875m with a coupon (or profit rate) of 7.5 per cent. However, the company had initially hoped to raise $1bn with a premium of between 6.5 per cent and 7.25 per cent". [David Oakley: "Dana Gas trims Islamic bond issue", Financial Times].

[7] Liquidity @ Financial Times: the dollar & the adjustment burden. Alan Ruskin, chief international strategist at RBS Greenwich Capital, writes that massive FX intervention by emerging market countries "has shifted much of the adjustment burden of the weaker dollar to the more flexible 'major' currencies". This is precisely the 'magic' of a Bretton Woods-style monetary system: the issuer of the reserve currency enjoys the (temporary, and ultimately self-defeating) benefit of deficits without tears, as Jacques Rueff, Charles de Gaulle's economic advisor, used to describe it in the 1960s. [Alan Ruskin: "Beware moral hazard that has encouraged a weak dollar", Financial Times].

WEEKLY FED BALANCE SHEET REVIEW. TRADING RANGE, ANYONE?
. Federal Reserve: "Factors Affecting Reserve Balances", October 3

- Fed's Treasuries holdings: $786.3bn (+$2.7bn)
- Other central banks' Treasuries holdings: $1,214.1bn (-$0.7bn) (*)
- Other central banks' agency securities: $784.3 (+$3.9bn) (*)
- Global Dollar Liquidity Measure: $2,784.7bn (+$5.8bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
__________________

The week ends with a modest (+$5.8bn) increase in our Global Dollar Liquidity measure. The annual rate of growth rose half a percentage point to 14.1%. The message I take away from October's first weekly Fed balance sheet is that the global economy continues to act as an ... oasis of prosperity. Custody holdings are back at +19%, a bullish sign. However, comparisons will only get tougher as 2008 approaches: the same applies to credit spreads and to our models for risky assets (and to corporate profits for that matter). The truth is that, for all the brouhaha surrounding the credit squeeze, the S&P500 is back to its mid-July level. Trading range, anyone?

LIQUIDITY ROUNDUP. LIQUIDITY IS PRICELESS!
[Latest Global Dollar Liquidity Measure: +13.6% annual growth rate; latest Endogenous Liquidity Index: -16.9%]

Liquidity is priceless; Brad Setser on central bank reserves; Vietnam & the dollar; China's economy & the global business cycle; daily Endogenous Liquidity watch.

[1] Liquidity is priceless! The Financial Times's John Gapper draws "Three lessons from the credit squeeze". One such lesson is that "liquidity is priceless". Here's Mr. Gapper: "Until August ... liquidity was free. You could get liquidity at the local drug store ... This, however, was an illusion. Although there was still money around in August and September – deposits were flowing into Treasury bonds and money market funds – the tap turned off in the interbank market. 'Liquidity is a very tricky risk to manage', says James Wiener, a managing director at the financial consultancy, Oliver Wyman. 'Many times, there is either an abundance or a complete lack of it'. In the latter times, financial institutions rediscover that liquidity is priceless, first because they are unable to obtain funding at all and second because everything else follows from it. An illiquid broker or bank is potentially a bankrupt one; no matter how much its assets are worth, or may be worth in the future, it must jettison them at fire-sale prices to stave off collapse".

[2] Brad Setser on central bank reserves. Another long and well thought out piece from Brad Setser, the doyen of central bank reserve analysis. ("Central banks came close to financing the entire US current account deficit"). Brad contends that "all the heavy lifting required to finance the US external deficit is being done by the world's central banks". The relative paucity of private flows worries him. But one could also argue that central banks' actions are merely reflecting investors' willingness to hold yuan, won, roubles, reals, pesos, etc. This all but forces foreign CBs to buy more treasury and agency securities. In other words, it would be like the Asian crisis in reverse: a show of confidence in local currencies.

[3] Vietnam & the dollar. Über-bear Ambrose Evans-Pritchard is at it again ("Dollar's double blow from Vietnam and Qatar", Telegraph). The Vietnamese central bank, apparently, has had it with the New Bretton Woods: "The Saigon Times said this morning that the State Bank of Vietnam was abandoning the attempt to hold down the Vietnamese currency through heavy purchases of dollars. The policy is causing the economy to overheat, driving up inflation to 8.8pc". Fellow bear Hans Redeker is cited: "Vietnam is a relatively small country but it is symptomatic of Asia. The entire region is seeing inflation move up as a result of mercantilist policies of holding down their currencies with 'dirty floats', which are designed to help their export sectors". It will be interesting to see how the Vietnamese manage the transition from an exporting periphery to a centre of growth and innovation.

[4] China's economy & the global business cycle. "The fate of the world economy", says The Economist, "now hinges not just on America, but also on China's economic fitness continuing over at least the next two years" ("How fit is the panda?"). Let me add one thing: the fate of endogenous liquidity is also at stake. A balanced global economic cycle, with strong growth from China somehow compensating for G7 weakness, would reduce financial volatility and hence boost market liquidity. The Economist then quotes Tao Wang, Bank of America's economist in Beijing, who "is optimistic about China's economy in the short term and the long term, but thinks the medium term looks risky". I fully agree with that view.

[5] Endogenous Liquidity Watch. Our Endogenous Liquidity Index eased slightly yesterday (-0.22%). Once again, the impact of mildly higher volatility readings was held in check by falling CDS spreads. Nothing to write home about, really. The index is acting in a less volatile fashion, which may indicate, as a Lehman Brothers analyst puts it, that "The credit machine is slowly restarting".

UPDATE: Bank of England mantains the official bank rate at 5.75% [communiqué]; European Central Bank leaves key rates unchanged (4.00%) [statement].