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.

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