Thursday, March 29, 2007

. Donald L. Kohn. "Asset-Pricing Puzzles, Credit Risk, and Credit Derivatives", Conference on Credit Risk and Credit Derivatives, Washington, D.C. March 22, 2007.

Just over a decade ago, former Fed officials Manuel "Manley" Johnson and Robert Keleher published a book that added enormously to the global liquidity debate: Monetary Policy. A Market Price Approach (Westport, Connecticut: Quorum Books, 1996). According to the authors, globalization makes it almost irrelevant for the Fed to rely on quantity indicators such as GDP, employment, industrial production and monetary aggregates. Market prices such as the foreign exchange value of the dollar, the shape of the yield curve and commodity prices provide more timely and useful information.

For obvious reasons, the book has aged. The fast pace of financial innovation during the past decade means that more and/or different market prices require attention. But Johnson & Keleher's key insight appears to be more useful than ever — here's Fed vice-chairman Donald Kohn speaking at a conference on Credit Risk and Credit Derivatives:

... the staff at the Federal Reserve puts considerable effort into research on asset prices and into reporting the results of that research to policymakers. One reason we do so is to try to understand the expectations that households, businesses, and market participants have about the future. Expectations are critical to understanding the economy and developments in the financial system. Of course, we look at a great deal of data from the nonfinancial side of the economy, such as gross domestic product (GDP) growth, the unemployment rate, and changes in the prices of goods and services.

It's almost as if —within the Fed's hierarchy— GDP and other quantity indicators have been relegated to a distant second place behind ... asset prices. This challenges us "liquidity watchers" to pay more attention to credit derivatives. No problema. Meanwhile, here's some more liquidity talk from the Federal Reserve:

- Fed Governor Randall Kroszner on "Recent Innovations in Credit Markets". CDSs and CDOs have enhanced the transparency and liquidity of the credit markets. This is an important piece of the global liquidity puzzle: thanks to lower transaction costs and better risk diversification, the supply of loanable resources registers a permanent increase, thereby leading to lower long-term interest rates.

- The structured credit market & the supply of loanable resources. Adam Ashcraft and Joao Santos (Federal Reserve Bank of San Francisco) discuss the impact of structured credit markets on the overall credit market. They find evidence that "CDS trading helps borrowers issue syndicated loans more frequently and take on more leverage relative to a matched sample of untraded firms, consistent with an increase in credit supply".

- Timothy Geithner on "Credit Markets Innovations and Their Implications". Not to be undone, New York Fed president and CEO Tim Geithner discusses "the latest wave of credit market innovations". What is the main factor behind the so-called Great Moderation of the business cycle? Digital networks? Low inflation expectations? Nope, says Geithner. It's all down to financial innovation.

- Charles Plosser on the shape of the yield curve. Philadelphia Fed president Charles I. Plosser debates the shape of the yield curve. Here are the two key points: "On average, I expect the yield curve to be flatter than at comparable points in previous business cycles. While this flattening of the yield curve puts pressure on banks’ interest income, given the amount of financial innovation in the industry, banks will be able to adjust".
. Charles Duhigg. "Cheap debt takes the fear out of making a deal", International Herald Tribune.

I watched yesterday's Squawk Box Europe Ken Fisher interview with interest. According to Fisher, the private equity boom will continue as long as the large spread between the cost of debt financing and the return on equity persists. Late last year, Fisher was quoted by the International Herald Tribune:

"Right now, debt is so cheap that you can borrow and buy another company for less than it would cost to build something yourself," Fisher said. "And that's not going to change until the stock market goes up significantly, or bond rates increase. Banks and insurance companies are eager to lend at today's going rates. As long as bond buyers think the future is rosier than stock buyers, there's going to be lots of deals."

From my perspective, the really interesting part was Fisher's comment about the unusually long period of abnormal discrepancies between the cost of debt financing and the return on equity capital: 54 months. Fisher was prompt to add that this had never happened before. Amazingly enough, we are about the enter the 54th month in a row in which our own Global Liquidity Index grows at a 10% (or more) annual rate. This too has never happened before.

Tuesday, March 27, 2007

. "Q&A with the CEO of Lego", Monocle

The key "mystery" of the current global economic expansion is, without a doubt, the low level of long-term interest rates. A year ago, the governor of the Bank of England, Mervyn King, addressed the issue in a speech at a dinner for Kent Business Contacts. Among the causes of low interest rates, King singled out the tepid pace of credit demand: "... business investment in the developed economies has been weak in recent years for reasons we do not fully understand".

For reasons we do not fully understand? How interesting! A couple of years ago, an article by economist-investor Thomas Nugent caught my attention, because it provided a clue to this phenomenon. 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).

This is much more realistic than it sounds. In fact, it may be the only way to explain the simultaneous drop in credit demand and in credit spreads that took place between 2002 and 2006. The issue came back to my mind as I listened to a Q&A session by journalist Tyler Brûlé with Jørgen Vig Knudstorp, CEO of Danish firm Lego. (Brûlé's new journalistic venture is called Monocle). Knudstorp, describing the amazing turn-around in the fortunes of the company, says:

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.

In other words: by "open-sourcing" the company, Lego needs to invest considerably less. This is innovation at its best, and it goes a long way in explaining the weakness in business-loan demand. Wikinomics, anyone?

Monday, March 26, 2007

. Federal Reserve

Bloggers, Fed officials, economists, journalists, investors: everybody is talking about global liquidity! And not only in the US: the French central bank and a Dutch business magazine are joining in. Here are some of the more relevant pieces — I will be discussing some of them in detail during the week:

- The Cleveland Fed & liquidity. "Liquidity ... Lately, I’ve been hearing people say that the world is awash in liquidity", writes Mark Sniderman in comments published in the Cleveland Fed's Economic Trends newsletter. Sniderman is the third Fed official to discuss the L-Word in March (see Kroszner and Warsh on global liquidity).

- Liberté, égalité, liquidité. The French central bank (not the ECB) is worried about the impact of excessive liquidité on asset prices. There is no mention either of the so-called Asian savings glut, nor of "petro-dollars": Banque de France sees the problem only from the perspective of central bank liquidity.

- An entrepreneur-blogger on global liquidity. Blogger/entrepreneur Fabrice Grinda discusses global liquidity, the yield curve, and the prospects for a US recession. Petro-dollars, according to Grinda, have become the key source of global liquidity (for a similar perspective, see this PIMCO study).

- Global liquidity: a myth? Economist John Hussman debunks the "global liquidity myth". Hussman makes an important point: foreign central banks' purchases of US bonds represent "money that has already been spent – goods and services that have already been deployed". Thus, they do not represent "money in the sidelines". Excellent! (However, IMHO, they do have an impact on US interest rates — more on that during the week).

- Standard Life on global liquidity. The UK insurance company derives its investment outlook from "global liquidity" indicators provided by an "independent research consultancy". Interesting! At present, monetary conditions are "their tightest since 2002, but not yet unduly tight". Good point: in late 2004, a number of central banks decided to let their currencies appreciate in order to fight domestic inflationary pressures, thus accumulating less US bonds.

- A Dutch business magazine discusses global liquidity. Citing the above-mentioned piece by the French central bank, Peter Hendriks wonders whether "excessive liquidity in the market" means that "too much money is a dangerous thing" ("Veel goedkoop geld gevaarlijk", FEM Business).

Friday, March 23, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", March 21

- Fed's Treasuries holdings: $773.4bn (-$2.9bn)
- Other central banks' Treasuries holdings: $1,217.4bn (+$3.7bn) (*)
- Other central banks' agency securities: $658.4bn (+$12.4bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2,649.2bn (+$13.2bn)

(*) Off-balance-sheet items.

The global liquidity boom, as defined by an annual increase of 10% or more in our Global Dollar Liquidity Index, is about to enter its 54th month. This is unprecedented. Already in 2007, foreign central banks have added almost $100bn in Treasury and agency securities. Remarkably, the global liquidity boom takes place in the midst of a rather sharp contraction of domestic liquidity — no doubt courtesy of the inverted yield curve. The stock of Treasuries held by the Federal Reserve, a proxy for the monetary base, is growing at a 2.2% annual rate, the weakest since January 2001.

Bank reserves held by the Fed appear to be trending down, a reflection of both sophisticated reserve management tools and lower levels of credit demand. The dollar, meanwhile, fails to rally despite its growing "domestic" scarcity. One can only wonder what will happen to the greenback as the yield curve normalizes and domestic liquidity is replentished.

Thursday, March 22, 2007

. Kudlow's Money Politics

On the Larry Kudlow show yesterday, short-seller Doug Kass warned market bull Jason Trennert: "Liquidity is a double-edged sword". Kass' warning is an important one. But how do we know when too much liquidity is being created? Take central bank liquidity. In G7 countries, with well-developped financial markets, markets themselves provide the answer. A look at the shape of the yield curve, the exchange rate, commodity prices and bond spreads provides more than enough information.

But what about non-OECD suppliers of global liquidity such as BRICs, Mexico, Turkey, Argentina? The lack of local currency bond markets means that there is no yield curve to speak of. My favorite indicator here is the Fed's stock of custody holdings, a key component of our own Global Dollar Liquidity Index. This figure, published every Thursday as an off-balance item to the Fed's weekly balance sheet, has an excellent track-record as a warning sign of excess central bank liquidity in emerging markets. Here, increasing "dollarized" liquidity means increasing confidence, as investors dump dollars held as a store of value and conduct business in their own currencies.

In order to assert that an excess of dollarized central bank liquidity is upon us, one should see and abrupt fall in the value of the dollar (against foreign currencies and gold), a normalization of the yield curve and a falling stock of custody holdings. Right now, the picture is mixed, but tilted in favor of ... stock market bulls.

Wednesday, March 21, 2007

. Chicago Mercantile Exchange

The Milken Institute's 2006 Capital Access Index is out. It measures the degree of "democratization of capital", i.e. the ease with which entrepreneurs get access to financing. Looking at the top and bottom positions, one obvious conclusion comes to mind: entrepreneurs get better access to finance in countries where property rights are stable and the rule of law prevails. Countries with high savings rates but weak property rights, like China, are an important piece of the global liquidity puzzle. As these countries take steps to solidify property rights, we are likely to see more moderate inflows into our own markets.

This is one of the reasons why we are witnessing, right now, an impressive move ―led by the Chicago futures exchanges― to "democratize" access to capital ... within the United States. Coming right after the Housing Futures and Options, the Chicago Mercantile Exchange plans to launch Credit Index Event contracts in the second quarter of 2007. Meanwhile, encouraged by the success of the VIX, the Chicago Board of Options Exchange has just announced a new benchmark index for selling volatility.

More endogenous liquidity is coming our way.

Tuesday, March 20, 2007

. Stephen Jen. "Currencies: March Madness", Morgan Stanley

"Global liquidity is likely to remain abundant", writes Morgan Stanley's FX economist Stephen Jen. Reserve growth is the key source of global liquidity:

Global official reserves are massive, and still growing. The world’s official reserves have just breached the US$5 trillion mark (US$5,130 billion, to be exact, for gross reserves and US$5,078 billion for the currency component). The world’s official reserves are growing at roughly US$75-80 billion a month, with China accounting for about 30% of these increases. While oil exporters and the Asian countries have roughly the same absolute size aggregate C/A surpluses (around US$400 billion a year), so far the Asian countries have accumulated these balance of payments (BoP) surpluses in the form of official reserves, while the oil exporters tend to channel their export proceeds into SWFs. In any case, compared to the total official reserves that prevailed at end-2005 of US$4,175 billion, the world’s official reserves have risen by close to US$1 trillion in a little more than a year: this is a major increase.

On the other hand, Jen seems to agree with Mohamed El-Erian's views on endogenous liquidity:

The 'real' sources (i.e., the world’s savings-investment surplus) of global liquidity remain robust: the Asian countries and the oil exporters continue to generate some US$800 billion worth of combined current accout surplus. Global long-term interest rates, as a result, have remained near a generational low. Unless 'endogenous money' collapses due to risk retrenchment, which I don’t believe will happen, global liquidity conditions could quickly rebound to support new risk-taking.

[HT: Brad Setser].

Monday, March 19, 2007


Jim Rogers & the end of the "liquidity party".
. "Top investor sees U.S. property crash", Reuters

From a Reuters interview with star investor Jim Rogers: "This is the end of the liquidity party ... Some emerging markets will go down 80 percent, some will go down 50 percent. Some will most probably collapse. When you have a financial crisis, it reverberates in other financial markets, especially in those with speculative excess," he said.

Rogers adds: "You can't believe how bad it's going to get before it gets any better," the prominent U.S. fund manager told Reuters by telephone from New York. "It's going to be a disaster for many people who don't have a clue about what happens when a real estate bubble pops. Right now, there is huge speculative excess in emerging markets around the world. There will be a lot of money coming out of emerging markets".

Pretty straightforward stuff. (HT: Big Picture).

"The lion is tame": Myron Scholes on Risk & Liquidity
. Holman W. Jenkins, Jr. "Risk Manager A Nobel laureate says learning can be costly", The Wall Street Journal.

Risk is "a lion", says Myron Scholes in this Wall Street Journal interview. "Right now we're quiet because the lion is tame, and maybe it's the central bankers of the world who are keeping it tame." But this very quietness creates a dangerous state of affairs ― it attracts even more risk-takers: "My belief is that because the system is now more stable, we'll make it less stable through more leverage, more risk taking." Thus Scholes on macro-economic liquidity. But what about micro-economic liquidity?

In chaotic times, speculators (who are business people, in Mr. Scholes's view, providing liquidity services to the market) doubt their models. They want to reassess. In today's ever more globalized and complex economy, "the information set is huge, it's gigantic." As a result, "decision time becomes elongated" and speculators hold back their capital just when their services are most in demand. The lack of liquidity itself then becomes a factor in asset pricing, leading to swift, sharp drops in values.

Friday, March 16, 2007

. Financial Times. Mohamed El-Erian interview

The endless talk about "brimming reservoirs of liquitidy", "liquidity boom", "big and small liquidity" is getting a bit out of hand, I am afraid. The Economist was on to something when it wondered "whether the term [liquidity] has any real meaning". And now comes Mohamed El-Erian, the head of Harvard Management Company, who oversees more than $30 bn in assets. El-Erian coins yet a new term ― "Endogenous liquidity":

I think that if this were normal conditions, the Fed would be looking to cut rates. The economy is slowing. The housing market is under pressure. The corporate sector is not spending. However I think that policy makers are increasingly aware of the source of endogenous liquidity, the liquidity that the market itself creates. Private equity is a perfect example, where a dollar that comes out of the public market, becomes $4 or $5 when it goes back in, through the private equity mechanism. So, I think that policy makers will wait for unambiguous evidence that the economy is slowing, before they move, lest they contribute to excess liquidity.

Like it or not, this "liquidity madness" is here to stay. People are desperately looking for new paradigms in a world of globalized capital markets, where the only sure bet seems to be that measures of domestic liquidity are fast becoming irrelevant.
. Federal Reserve: "Factors Affecting Reserve Balances", March 15

- Fed's Treasuries holdings: $776.3bn (+$0.7bn)
- Other central banks' Treasuries holdings: $1,213.7bn (+$3.9bn) (*)
- Other central banks' agency securities: $646.0bn (+$7.5bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2,636.1bn (+$12.1bn)

(*) Off-balance-sheet items.

It's business as usual on the global liquidity front. While "domestic" liquidity barely moves (courtesy of the inverted yield curve), foreign central banks continue to accumulate Treasuries and agency securities. Our own Global Dollar Liquidity Index is growing at a 11.9% annual rate ― sharply down from the September 2004 "insane" +22.8% peak, but still above +10% for the 53th month in a row.

Thursday, March 15, 2007


Squawk Box just aired an interview with Jack Ablin, chief investment officer at Harris Private Bank. Ablin mentioned two kinds of liquidity: "big liquidity" and "small liquidity". The former refers to investment flows from the global economy, driven by external deficits and by demographics. The latter refers to more microeconomic issues, specific to individual markets. According to Ablin, "big liquidity" trumps "small liquidity" ― risky assets will continue to benefit from huge waves of investment flows.

To my mind, the real issue is: what determines the shape of the yield curve? If "big liquidity" is the key element, then the credit markets are simply responding to an increase in the supply of loanable resources ― a healthy development. On the other hand, if long-term rates reflect a sharp fall in demand for credit, then a 5.25% bank rate will cause a lot of pain. Watch credit spreads and ... the monetary base.
. Andrew Balls. "What Has Changed, What Has Not Changed, and What We are Doing", PIMCO.

As Fed governor Randall S. Kroszner recently wrote, "the use of the term liquidity spans a wide variety of meanings". You only need to check out PIMCO's (magnificent) web site to understand this. Andrew Balls, for one, presents a couple of "money-based measures of global liquidity" (based on M2 and M3, that is). These measures can hardly be called "global" indicators. Remember 1998: domestic liquidity was increasing in the US, but only as a result of an explosive demand for money market funds (flight-to-quality buying).

Global dollarized liquidity, meanwhile, was on the verge of collapse ― as the Asian currency crisis forced other central banks to sell Treasuries. Eventually, the Fed eased. Had the FOMC based its forecast on M2 and M3 (as some monetarist members of the committee argued at that time), a full blown domestic banking crisis would have erupted. Memo to Mr. Balls: forget about M2 and M3 as meaningful global liquidity indicators.

Wednesday, March 14, 2007

. Mark Kiesel. "U.S. Credit Perspectives: A New Era", PIMCO Bonds

In a recent note on the so-called "new sources of liquidity", PIMCO's Mark Kiesel highlights the role of financial innovation in what he calls the "global liquidity boom". Remarkably, Kiesel tells investors to focus on Goldman Sachs' share price [NYSE: GS] as a key liquidity "tell":

New pools of capital are also seeking out alternative investments. This trend has fueled significant growth in the financial advisory services industry for mergers and acquisitions, as well as investment management. Not surprisingly, Goldman Sachs has benefited tremendously from these secular changes in the financial markets. Goldman Sachs is not only one of the largest global advisory firms in the world, but it is also the largest manager of hedge fund assets. It is a primary beneficiary of the growth in collateralized debt obligations (CDOs) and credit derivatives, which have acted to expand liquidity in the credit markets through disintermediation and innovation. Goldman Sachs has aggressively moved into private equity capital fund raising, and reportedly just raised $19 billion through a new fund. The firm's stock is a reflection of today's global liquidity boom.

During yesterday's session, not long after midday, trader Todd Harrison actually acted on this insight:

I have, so you know, nibbled a bit on some puts with a stop level through GS $210. Either GS is gonna pull the tape higher or the weight of the world will pull it lower. Not advice, natch, just sharing my process with hopes that it helps yours.

He had been quoted by the Wall Street Journal on this very issue:

One might think that I'm smarting after being quoted in the WSJ saying "what happens in Goldman's shares on any given day is a good indicator of what's happening in the market," just in time for this chasm (GS up, tape down). But au contraire, Mon Frere, I think that is that very reason the market is still afloat. No other stock in the universe would have this much "pull" and it's a testament to the mojo therein.
. Ramin Toloui. "Petrodollars, Asset Prices, and the Global Financial", PIMCO Bonds

PIMCO's Ramin Toloui dissects the dynamics of petro-dollar flows and their impact on global financial markets. Since 2001, oil exporters have poured about $1 trillion into world financial markets. Accordingly, a clear understanding of how these flows operate has become a key element in the outlook for global liquidity, financial markets, and the so-called New Bretton Woods arrangement. Here's a brief overview of Tolouis's main points:

- Governments of oil-producing countries have become the largest source of global savings, having surpassed Asia in 2005. They added $500bn to global financial markets in 2006 alone;

- While their combined current account surplus amounted to only 1/5th of the US current account deficit in 2001, it now represents as much as 2/3ds of the world's largest economy's external deficit;

- Savings from oil producing countries are highly concentrated; only three countries make up the lion's share of petro-dollar flows: Russia, Saudi Arabia and Norway;

- The bulk of petro-dollar savings takes the form of central bank reserves: nearly 80% of the their cumulative surpluses from 2002-2005 were used to build up central bank reserves. The "explosion" is such that even with oil prices at $50/barrel, these countries would channel as much as $300bn into global markets annualy;

- There is evidence to support the view that central bank reserves are being diversified away from the US Treasury market, into bank deposits and / or into other currencies, notably the euro. For example, Russia's reserves are growing, but its holdings of Treasuries remain flat.

- Middle East accounts tend to diversify much more aggressively than their Asian counterparts. This may lead to sustained levels of M&A activity, ongoing downward pressure on credit spreads, and less investment flows into the US Treasury market. This last point, in turn, raises doubts over the sustainability of the New Bretton Woods system.

Tuesday, March 13, 2007

. Alan Greenspan. "Technological innovation and the economy", remarks before the White House Conference on the New Economy, Washington, D.C. April 5, 2000

While foreign central banks continue to act as the key providers of global dollar liquidity, the "domestic" scene is dominated by the restrictive stance of the Federal Reserve. The stock of Treasury securities held by the Fed ―the main counterpart to the monetary base on the asset side― is growing at 2.25%, the lowest rate since ... January 2001. The shape of the yield curve is the key "tell" here ― as the Maestro himself told us in an April 2000 speech. There is no way to avoid a lenghty quote:

As our experience over the past century and more attests, such surges in prospective investment profitability carry with them consequences for interest rates, which ultimately are part of the process that balances saving and investment in a noninflationary economy. In these circumstances, rising credit demand is almost always reflected in an increase in corporate borrowing costs and that has, indeed, been our recent experience, especially in longer-dated debt issues. Real interest rates on corporate bonds have risen more than a percentage point in the past couple of years. Home mortgage rates have risen comparably. The Federal Reserve has responded in a similar manner, by gradually raising the federal funds rate over the past year. Certainly, to have done otherwise--to have held the federal funds rate at last year's level even as credit demands and market interest rates rose--would have required an inappropriately inflationary expansion of liquidity. It is difficult to imagine product price levels remaining tame over the longer haul had there been such an expansion of liquidity. In the event, of course, inflation has remained largely contained.

Back then, Greenspan was referring to a normal yield curve, with long-term yields solidly above the Fed funds target. But the same reasoning applies to today's situation ― with the opposite conclusions. To the extent that it reflects a decreasing demand for bank reserves, an inverted yield curve must lead to one of the following scenarios: (a) the Fed validates the new equilibrium (and lower) target; (b) the Fed destroys bank reserves (by selling bonds in the open market) to keep its current target intact. In that case, the mechanics of an inverted yield lead to an automatic contraction of (domestic) liquidity.
. Randall S. Kroszner: remarks on "Liquidity and Monetary Policy" to the U.S. Monetary Policy Forum, Washington, D.C.March 9, 2007

On March 5 Fed board governor Kevin Warsh gave a presentation on "Market Liquidity: Definitions and Implications". (See our review here). Now Randall S. Kroszner, another board member, discusses "Liquidity and Monetary Policy". This appears to be the critical issue at the moment. As Kroszner says: "A quick search of LexisNexis turned up 2,795 separate articles in the past six months alone that mentioned the word 'liquidity' in the context of its abundance in financial markets. The use of the term liquidity in these articles spans a wide variety of meanings--perhaps 2,795 of them! "

Unlike Warsh's piece, Kroszner's is a rather disappointing lecture on the role played by inflation expectations in the credit markets. Yes, lower inflation expectations lead to an increase in the supply of loanable funds and thus to lower long-term interest rates. We all know that. Mr. Kroszner then adds: "Explanations of these phenomena should have an international component". Fine: but where's the international component in his analysis? What is the role played by the dollar as the key international reserve currency? Why do foreign governments invest in such a massive scale in the US bond market? Is it all down to inflation expectations?
. Buttonwood. "We all fall down", The Economist

Buttonwood reflects on the recent market turmoil and notes: "There is a healthy debate about how to measure this liquidity, or indeed whether the term has any real meaning" (*). It then cites JPMorgan estimates:

... most people agree that the savings surpluses in Asia and the oil exporters have played an important part in fuelling financial markets. JPMorgan estimates that global liquidity increased by $3.9 trillion between 2002 and 2006, of which around 50% came from Asia and 40% from the oil producers. The bulk of this money went at first into risk-free assets such as Treasury bills and bonds. That drove down the yield on such assets. So other investors were then naturally tempted to look elsewhere for higher returns.

Our own Dollar Liquidity Index yields a much lower figure: about $1.3 trillion between 2002 and 2006. JPMorgan must be considering US bond purchases not only by central banks, but by other official sources and by private investors as well.

(*) See also, by The Economist, "Liquidity, liquidity everywhere".

Monday, March 12, 2007

. Financial Times

- Goldman Sachs & the "inevitable liquidity drought". David Wighton, writing for the Financial Times' Corporate Finance supplement, reveals that Goldman Sachs has been quietly "taking advantage of cheap long-term funding to extend the maturities of its debt with unusually relaxed covenants". Wighton also quotes a Citigroup banker: "Now is the time to prepare for less certain capital availability".

- Central banks & hedge funds. In a letter to the Financial Times, former IMF-economist Vito Tanzi warns about the dangers of central banks investing in hedge funds, as some did (with disastrous consequences) before and during the Asian currency/LTCM crisis. This is likely to happen, according to Tanzi, if "the US keeps injecting more liquidity in the international financial system". OK, except that the Federal Reserve is not running a lax monetary policy.

- The BIS on global liquidity (*). Malcom D. Knight, General Manager of the Bank for International Settlements, assesses "the evolving nature of financial risk" and warns against the danger of complacency. He admits, however, that we may be witnessing long-term, structural shifts involving the very notion of "liquidity":

We may be witnessing a progressive change in the characteristics of business fluctuations, in a new environment defined by liberalised financial markets, globalisation and central bank anti-inflation credentials. Indeed, market participants often refer quite aptly to the loose notion of "ample liquidity", in the sense of low financing costs and easy access to credit or funding liquidity.

(*) Malcom D. Knight. "Now you see it, now you don't: risk in the small and in the large", Keynote address at the Eighth Annual Risk Management Convention of the Global Association of Risk Professionals, 27-28 February 2007.

Sunday, March 11, 2007

. Chrystia Freeland & James Politi. "George Soros interview", Financial Times

The Financial Times interviews George Soros, and the legendary investor talks ... liquidity! Soros adds little to the current debate, but the very simplicity of his views makes them worth pondering. On the yen carry trade, Soros says:

... the fact that the yen is basically interest free and a lot of money is coming from borrowing and a lot of Japanese money going abroad. And the yen was weakening so a lot of people got into that trade and there’s a little bit of a shake-up going on ... I mean the appreciation of the yen shows that there is a shake-out.

On global liquidity, Soros takes the view of classical economists ― the US current account deficit is the key driver of liquidity growth:

... you have got the slowdown in the US economy, the housing situation where you haven’t yet seen the total effect of the slowdown. It’s still halfway through. So will that actually result in a significant slowdown in consumer spending? That is yet to be seen because you have had mortgage equity withdrawals of nearly $900bn a year. Now it has fallen to $300bn and it basically will disappear. And that will affect consumer spending. Now, as the US slows down, the emerging markets are still going very strong, China and India, so you will actually go back to a more balanced economy with more growth abroad and correcting the deficit.

But that will see less liquidity in the market because it’s really the trading balance creating the same trillion dollars of Chinese reserves and similar amounts in other countries. That has actually fed this global liquidity splurge ... It will have an effect on the [Chinese stock] market and I don’t think that we are in any way nearer a crash. But it’s a warning crack ... But, on the other hand, they don’t want it to fall out of bed either so I think that you’ve had that sort of initial impulse and I think the Chinese market will be kept on an even keel, certainly until after the Olympics.

Friday, March 9, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", March 8

- Fed's Treasuries holdings: $775.5bn (-$1.5bn)
- Other central banks' Treasuries holdings: $1209.9bn (+$9.4bn) (*)
- Other central banks' other securities: $638.5bn (+$7.9bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2623.9bn (+$13.6bn)

(*) Off-balance-sheet items.

The first weekly Fed balance sheet for the month of March reveals a $13.6bn increase in our Global Dollar Liquidity Index. Liquidity bulls are firmly in control. The data support the view that the shape of the yield curve is losing relevance as a liquidity "tell" in a globalized world. Yes, the stock of Treasury securities held by the Fed is growing rather slowly (+2.25%, the weakest rate since January 2001).

But compare this to the explosive rate of growth of non-Treasury securities held by foreign central banks. According to my estimates, they went from roughly $104bn in early 2001 to almost $639bn now. In that same period, Treasuries held by the Fed grew "only" by 43%. In other words: when it comes to global liquidity, Asia is the place that matters.
. Jean-Claude Trichet, President of the ECB, Frankfurt am Main, 8 March 2007

The European Central Bank raised its target for the key short-term rate from 3.50% to 3.75%, "in view of the upside risks to price stability over the medium term that we have identified through both our economic and monetary analyses". Mr. Trichet mentioned the L-word at least three times in his statement: "... money and credit growth [remain] vigorous, and liquidity in the euro area ample by all plausible measures ... Following several years of robust monetary growth, the liquidity situation in the euro area is ample by all plausible measures ... In an environment of ample liquidity..."

Remarkably, the decision was criticized by Banque de France. The French central bank published a report that raises "serious questions about the reliability of M3 growth as a pillar of the ECB's monetary policy strategy". (Mr Trichet said the ECB acted in part to curb the 9.8% rise in the M3 money supply, the highest since the creation of the euro.) The Daily Telegraph has more:

"The existence of a strong, stable, and predictable relation between money and prices in the euro area cannot be taken for granted," it said. The implication is that M3 data is causing the ECB to over-tighten.The policy revolt comes after repeated attacks on the ECB by French political leaders, who argue that rising rates are pushing up the euro, with dire effects for Airbus and France's car industry.

Aside from the obvious politics at play (general elections coming up in May), I think Banque de France does have a point. The more your currency becomes an international reserve asset, the less relevant the purely domestic monetary indicators. Remember 1998 in the US?

Thursday, March 8, 2007

. Prepared Remarks by Treasury Secretary Henry M. Paulson, Jr. on the Growth and Future of China's Financial Markets

Message from Treasury Secretary Hank Paulsen to the Chinese: you can become a part of the dynamic center of the world economy, instead of acting like a mere exporting periphery. To succeed, however, you need to modernize the financial system ― and strenghten property rights:

The global economy, which over the last several years has been as strong as any I have seen during my business lifetime – has been characterized by strong growth, low inflation, and high levels of liquidity... Deep, liquid, and efficient capital markets pave the way for prosperity, opportunity, and economic dynamism, while minimizing and diversifying risks ... Open, competitive, world-class financial markets are the backbone of stable and balanced growth. Markets connect money with ideas and ambition – which are the lifeblood of innovation and dynamism. They offer a diverse array of financing channels, providing for more innovation and a lower cost of finance.

Strong capital markets require strong property rights; a robust supervisory regime with clear, transparent rules which strike the appropriate balance to ensure market integrity while promoting the entrepreneurial spirit and innovation; sound accounting standards; strong corporate governance; strong financial institutions; objective, independent financial information, analysis, and research; a meaningful disclosure regime; and independent credit rating agencies ... One lesson I have learned over the years is that although perhaps not as easy politically, it is better to implement reforms during periods of economic strength.
. Jim Griffin. "Bank of Japan Stings Like A Butterfly", ING Investment Weekly

ING's Jim Griffin waxes lyrical over the irrelevance of the US credit market yield curve, and tells investors to focus on Japan instead:

So we follow the Fed obsessively, even though it has a recent record of not being able to move markets, while we blow off BoJ, which is where the operationally relevant global yield curve is anchored.

On Wall Street, it would seem, strategists are increasingly taking positions with regard to the liquidity controversy. Yesterday on CNBC, Joe Battipaglia, strategist at Ryan Beck & Co., cast himself as a liquidity bear. The Federal Reserve, says Big Joe, is on the verge of creating a credit crunch. Liquidity bears take their clues from Fed policy ― especially from the shape of the yield curve.

The other side was taken by Vince Farrell, market strategist at Scotsman Capital Management. Farrell argued that liquidity is still ample, given the impact of financial innovation, petro-dollars, and foreign central banks. (That said, he added, a "test of the recent lows" was in order). Liquidity bulls vs. liquidity bears: the new debate on Wall Street.

Wednesday, March 7, 2007

. Kevin Warsh. "Market Liquidity: Definitions and Implications", remarks at the Institute of International Bankers Annual Washington Conference, Washington, D.C. March 5, 2007.

"Liquidity is confidence", says Fed Governor Kevin M. Warsh. Now, that's a statement. Warsh's speech is worth reading, because it provides an attempt at defining global liquidity in more than just monetary terms. In fact, Warsh's argument is based on a "loanable funds theory of interest-rate determination" (*). This is much simpler than it sounds: financial innovation, he implies, leads to an increase in the supply of loanable funds ― and thus to a lower cost of capital across the board.

Warsh is thus an unabashed liquidity bull. The conventional definition of liquidity ―in purely monetary terms― no longer holds: "Instead, market observers are more likely to be referring to liquidity in broader terms, incorporating notions of credit availability, fund flows, asset prices, and leverage".

As to the yield curve, its days as a recession predictor are all but over: "Thus, to the extent that low long-term Treasury yields and the negative slope of the yield curve reflects a lower term premium, rather than a lower expected short rate, it is less likely to signal future economic weakness". Interesting ―and important― stuff.

(*) Frank Jones & Benjamin Wolkowitz. "The Determinants of Interest Rates on Fixed-Income Securities", in Frank J. Fabozzi (ed.). The Handbook of Fixed Income Securities (Homewood, Ill., 1991).

Tuesday, March 6, 2007


A look at spreads. No panic
. Federal Reserve. Selected Interest Rates.

Sharp falls in asset prices go hand in hand with higher corporate bond spreads. Looking at Moody's Aaa/Baa, we see a modest flight-to-quality move. Aaa shows a 5 bp decline with respect to December 2006, while Baa shows a 3 bp increase. Nothing dramatic. Junk bonds spreads did move a little bit: Nasdaq-Bloomberg's High Yield measure registers a 15 bp increase, a move confirmed by "New Junk". Once again: nothing to write home about.

The yield curve (10 Year Treasury-Fed funds) inverted to as much as 79 bp on monday, the highest level of inversion in the current cycle. Liquidity bears and bulls argue over how to interpret the shape of the yield curve. Bears see a deflationary credit contraction; bulls point to new sources of liquidity, thus disregarding the shape of the yield curve.

New sources of global liquidity
. Mark Kiesel. "U.S. Credit Perspectives: A New Era", PIMCO Bonds

Good article by Mark Kiesel on the so-called "new sources" of liquidity. While Kiesel warns about the risks of complacency (think about the increasingly restrictive stance of G7 C-Banks), he points to other sources of liquidity. (Kiesel uses the word "liquidity" no less than 15 times!)

These new sources include: (a) companies' cash (over 12% of GDP in the US); (b) BRICs' central banks (they help to keep US interest rates low with their purchases of US bonds); (c) petro-dollars; (d) financial innovation (CDOs and credit derivatives free up resources that swell the supply of loanable resouces in the credit markets).

As a liquidity "tell", Kiesel favours Goldman Sachs's share price [NYSE: GS].

India & the price of onions
. Navdip Dhariwal. "Indians shed tears over onions", BBC.

First it was the price of lettuce in Argentina, then tomatoes in Iran, and finally poultry in Venezuela. Now onion prices are surging in India: a clear sign of stress in the periphery of the "New Bretton Woods".
. Paul McCulley. "Global Central Bank Focus", PIMCO Bonds

Paul McCulley, the PIMCO economist, sees a deflationary credit contraction ahead. If the "ongoing meltdown in the sub-prime mortgage" spreads to other parts of the credit markets, the Federal Reserve's stance is likely to become unambiguously more restrictive. Presumably, this is due to the dynamics of an inverted yield curve: if demand for bank reserves decreases (following a more general slump in credit demand), then the Fed has to destroy bank reserves in order to prevent a downward move in the fed funds rate .

David Malpass: new sources of liquidity
While McCulley may be right, he may be disregarding the impact of other sources of liquidity.The point is made by Bear Stearns economist David Malpass:

We note brimming reservoirs of global liquidity at corporations, foreign central banks, petro-dollars, hedge funds and private equity funds, huge increases in global monetary base ready for money multipliers, $4 trillion in low-yielding Chinese bank deposits, $5 trillion in low-yielding U.S. time deposits, $10 trillion in low-yielding Japanese financial net worth, $27 trillion in medium-yielding U.S. household financial net worth. We disagree with the view that the world is over-leveraged, in that many pools of liquidity aren't leveraged.

The shape of the yield curve seems to confirm McCulley's bearish views. FX and commodity markets participants, on the other hand, look more bullish.