LIQUIDITY ANALYSIS. THE BANK OF ENGLAND REPORT
. Bank of England. Financial Stability Report, April 2007, issue No. 21

I'll be mostly out today, so no real posting. Liquidity watchers, however, have their hands full with the lavishly illustrated Financial Stability Report published last week by the Bank of England. Funding liquidity, market liquidity, liquidity risk, contingency liquidity, cross-border liquidity, liquidity standards, the carry trade: all these issues are discussed in detail. Enjoy!

WEEKLY FED BALANCE SHEET REVIEW. FIRST CONTRACTION IN SIXTEEN WEEKS (AND A TINY ONE AT THAT)
. Federal Reserve: "Factors Affecting Reserve Balances", April 25

- Fed's Treasuries holdings: $775.7bn (-$2.6bn)
- Other central banks' Treasuries holdings: $1,228.0bn (-$7.9bn) (*)
- Other central banks' agency securities: $690.1bn (+$10.0bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,693.8bn (-$0.5bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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Our Global Dollar Liquidity Measure has contracted for the first time in ... sixteen weeks! Central banks, including the Fed, sold Treasury securities rather aggressively during the week. A $10bn purchase of agency securities by one or more foreign central banks was not enough to compensate for this loss. The liquidity contraction, however, is only a tiny one: less than $500 million. (The long-term picture remains very positive for liquidity bulls).

As if mirroring this situation, our Endogenous Liquidity Index barely moved during the week. The rising VIX (until Thursday) put downward pressure on the ELI, but the move was compensated by the Goldman Sachs share price (all-time high) and by slightly lower CDS spreads. High-yield bond spreads and the carry trade factor remained largely unchanged. Will the markets quiet down for a while?

LIQUIDITY TALK. BLACKROCK TALKS LIQUIDITY ...

I found this Financial Times interview with BlackRock's Larry Fink very revealing. To summarize it from the global liquidity perspective, two main issues are addressed: [1] The lack of "contagion" from sub-prime woes; [2] Liquidity conditions. Here's a brief review.

[1] The lack of contagion from sub-prime woes. "I don't think it's a contagion and I don't think it's going to exasperate into something that is much more meaningful and more destructive to the overall housing market ... We're seeing fewer investors in subprime but that money needs to be put to work so they're going into other credit markets, and we've actually seen a tightening in those other credit markets because there's more money going in these areas, and so we've seen the actual opposite. Historically when we've seen one problem, we’ve seen an adjustment throughout the marketplace. We've seen no indication of that yet."

[2] Liquidity conditions. Is the lack of contagion due to the much vaunted risk dispersion achieved through CDS and other innovations? Or is it all down to, well, liquidity? Fink's answer: "We've had just vast liquidity. The global capital markets have flourished so well, and there's so much money sloshing throughout the world, people are looking for ways to invest. And so the risk we have throughout the world now is that not only are we trading credit, higher grade credits to lower grade credits with poor covenants; probably the greatest issue that's confronting the world's investors is we are trading liquidity for illiquidity". Note that Fink sees financial markets themselves —not central banks— as the key providers of liquidity.

LIQUIDITY TALK. ON DARK LIQUIDITY, ETC.

- On "dark" liquidity (*). Just when I thought I had heard enough about "endogenous, big, small, domestic, global, funding, and market" liquidity, I came across the notion of ... dark liquidity. Paul Temperton, director of the Financial Times Portfolio Academy, defines dark liquidity as "these pools of liquidity [that] will typically not be shown on conventional trading platforms provided by the stock exchanges or crossing networks". Dark liquidity, thus, belongs to the domain of "microeconomic" or "market" liquidity. Financial Times reporter Gillian Tett detects a recent "explosion of dark liquidity pools" in the United States.

The "darkest of dark liquidity", adds Tett, takes place inside investment banks' private networks. This "explosion" may well threaten the dominant position of stock exchanges worldwide. Investment Technology Group (ITG), for example, is marketing a trading platform aimed at improving "liquidity connectivity"; algorithms help to detect hidden sources of liquidity. Thus, hedge funds and other investors who, as Tett puts it, "like to stay in the shadows", can trade cheaper and without disturbing the share price.

(*) See Paul Temperton. "Trading with the help of guerrillas and snipers", Financial Times, March 19; Gillian Tett. "Equity investors show willing to come to the dark side", Financial Times, February 9; CASTrader. "The magic alpha of dark liquidity and partial diversity".
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- The trouble with "domestic" liquidity. I sometimes mention the stock of Treasury securities held by the Fed (a proxy for the monetary base) as "domestic liquidity", as opposed to Treasury and agency securities held by foreign central banks ("global liquidity"). Strictly speaking, this is incorrect. Domestic liquidity can be influenced by global factors, and vice-versa. (Remember 1998). The key thing, in my mind, is to always consider them in tandem. This otherwise arcane issue came back to my mind as I watched a CNBC interview with David Sowerby, chief market strategist at Loomis Sayles.

According to Sowerby, the Federal Reserve will soon have to ease monetary policy in order to "improve growth rates in the monetary aggregates". Sowerby does have a point: the stock of Treasury securities held by the Fed is growing at a tepid 2.6% rate. However, IMHO, he misses the larger point: global dollar liquidity is booming (+19.8%). Overall liquidity conditions remain very robust. There is no need for the Fed to act.

LIQUIDITY TALK. A SHARP FALL IN OUR "ELI"

- A sharp fall in our "Endogenous Liquidity Index". Our preliminary ELI fell 2,1% yesterday on the heels of the VIX (which surged 8%). CDS and high yield bond spreads also pulled the index lower, while the "carry trade" factor was unchanged (no news on policy rates). Only the Goldman Sachs share price —trading at a new all-time high— provided some support.

- Jim Griffin: Liquidity conditions "lush". ING's Jim Griffin quotes Kenneth Heebner, the "highly regarded manager of the CGM Realty Fund", who told Bloomberg that U.S. home prices will fall “at least 20%” this year. Says Griffin: "In liquidity conditions this lush, with six handle conventional mortgage rates, it is difficult for me to imagine such a calamity".

- Glenn Reynolds: Beware of "a turn in the global liquidity tide". Glenn Reynolds, the head of CreditSights, tells the Financial Times that "none of the major developed economies is immune to a turn in the global liquidity tide". For example, much of Germany's export growth "has been driven by the boom in China and elsewhere in the global economy, which itself has been due in large part to generous global liquidity conditions. The lagged impact of monetary tightening by the world’s major central banks is already beginning to hurt the US housing market, but in time it will also have a general dampening effect on Germany’s major export markets". Clearly, Mr. Reynolds thinks that G7 central banks are the key drivers of global liquidity growth.

- Brad Setser & Reserve growth. Brad Setser worries about the stunning growth of central bank reserves in 2007, which he deems unsustainable. This is something that liquidity bulls have to keep in mind. I used to worry myself whenever the rate of growth of Treasury and agency securities held at the New York Fed by foreign central banks would surpass 20%. (It is now at 18.9%). Nothing serious happened, however, between October 2003 and January 2005, when we reached ... 34%! Thus, I worry less now — but I'll definitely keep an eye on Mr. Setser's blog.

- Steen Jakobsen's blog: don't miss it. Steen Jakobsen, executive director at Saxo Bank, discusses trading ideas in his blog. In a post published this morning, he takes a look at falling real estate prices in Spain and warns readers: "... at extremes EVERYTHING is correlated". A very useful blog indeed!

LIQUIDITY TALK. MOODY'S ON GLOBAL LIQUIDITY
. FT Alphaville: "Moody's blames globalisation for tight credit spreads".

The Financial Times' Alphaville Blog, always a must-read, reviews the paper "Why Is Credit Risk Priced So Low? A Perspective on Global Liquidity", by Moody's economist Pierre Cailleteau (*). According to the review, “the paper dismisses the global liquidity explanation as somewhat circular, saying 'the fact that the demand for financial assets increases at a higher pace than the supply is more a symptom than a cause.'” Instead, says Moody's, investors ought to ask why the expected risk-adjusted returns on financial investments are perceived to be higher than the funding cost, even as the major world central banks have tightened interest rates.

“The answer”, adds Alphaville, “rests with the assymetrical nature of globalisation. In Moody's words, 'The core of the explanation lies in the interaction between the deepening of financial integration on the one hand, and differences in the financial completeness of world economies on the other.'” (Our Global Dollar Liquidity Measure, by the way, tries to capture just that). The reviewer then asks: What could go wrong? According to Cailleteau, there are three key risks out there: (a) An adverse surprise on inflation; (b) A sharp decline in oil prices; (c) A dramatic change in Asian foreign exchange policies.

(*) Paper presented at a conference on Corporate and Structured Default Research for Basel II and Credit Risk Strategies, London, April 19.

WEEKLY FED BALANCE SHEET REVIEW. THE LONG, LONG, LONG LIQUIDITY BOOM
. Federal Reserve: "Factors Affecting Reserve Balances", April 18

- Fed's Treasuries holdings: $778.3bn (+$3.7bn)
- Other central banks' Treasuries holdings: $1,235.9bn (-$0.2bn) (*)
- Other central banks' agency securities: $680.1bn (+$4.8bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,694.3bn (+$8.3bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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Out of the sixteen weekly Fed balance sheets reported so far in 2007, fifteen have yielded an increase in our Global Dollar Liquidity Measure. We are clearly witnessing the greatest liquidity boom on record, with our own measure growing north of 10% for fully ... 53 months in a row. While nobody knows how long this will last, I can't help but agree with investor Ken Fisher: when it comes to liquidity conditions, "We live in a unique period of history".

Meanwhile, our still untested and preliminary Endogenous Liquidity Index is up 1.6% on the week. The index was spurred by the Goldman Sachs share price and by CDS spreads, with junk bond spreads and the VIX acting as a drag.

LIQUIDITY TALK. ON THE NEW BRETTON WOODS, Mr. TRICHET & FINANCIAL INNOVATION

Brad Setser & the New Bretton Woods.
. Brad Setser: Latin America joins Bretton Woods 2 (Big Time)

Brad Setser detects a renewed willingness, within Latin American economic policy circles, to avoid sharp episodes of currency appreciation. (See my post on this issue here). The thing to keep in mind is that these countries are not ... Scandinavian countries. If Denmark can compete in the global economy despite the high cost of its labor force, it's because its top-quality governance leads to stable property rights and therefore to a low cost of capital. Meanwhile, the quality of governance in Latin America is deteriorating day by day — the "domestic" cost of capital is definitely not falling. Therefore, these countries need to stick to the New Bretton Woods proposition.
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Mr. Trichet & Financial Innovation.
. Keynote address by Jean-Claude Trichet, President of the ECB at the 22nd Annual General Meeting of the International Swaps and Derivatives Association

Interesting speech by the ECB president on the impact of Credit Default Swaps on liquidity conditions. I am preparing a more detailed post on this issue. Here are some quotes:

... technological innovations have significantly enhanced the ability of banks to grant credit ... Credit derivatives could therefore make the economy, and thus monetary policy, increasingly sensitive to credit market movements ... Price discovery in the credit derivatives market reduces the risk of mispricing loans ... Banks are moving from the traditional “buy-and-hold” model to the “originate-and-distribute” model, whereby they distribute portfolios of credit risks and assets to other market players ... Indeed, some evidence from the United States, based on individual loan data, supports the idea that banks are increasing the supply of credit as they obtain additional credit protection through credit derivatives.

LIQUIDITY ANALYSIS. A VERY, VERY, VERY PRELIMINARY "ENDOGENOUS LIQUIDITY INDEX"
. Endogenous liquidity: the madness continues

Our preliminary —and rudimentary, temporary, untested, 1.0— version of an Endogenous Liquidity Index (ELI) eased 0.32% yesterday. The VIX and junk bond spreads pulled the index down, while CDS spreads and the Goldman Sachs share price provided some support. Still, the index is up a healthy 8.42% with respect to March 30. As Gary Kaminsky, a Neuberger Berman asset manager, just said on CNBC: "Liquidity will put a floor under asset prices". Indeed.

LIQUIDITY TALK. LIQUIDITY AS "A RISK-SEEKING STATE OF MIND"
. Paul McCulley on PIMCO's Cyclical Outlook and Investment Strategy.

PIMCO economist Paul McCulley discusses the world economy and casually defines liquidity in a way that combines "funding liquidity" and "market liquidity":

At the end of the day, liquidity isn’t about money stock growth, but a risk-seeking state of mind. In other words, liquidity isn’t about money on the sidelines per se, but rather about the risk appetite of those on the sidelines. And when risk appetite turns, no amount of liquidity on the sidelines matters, particularly when a crowd gathers there. This is the essence of modern day finance. The human condition is, in the end, momentum-driven, not value-driven.

This is exactly the reason why we pay attention not only to our own Global Liquidity Measure, but to CDS spreads, the VIX index, the Goldman Sachs share price, etc.

LIQUIDITY TALK. KEN FISHER, AGAIN.
. Ken Fisher. "Stocks Never This Cheap", Forbes Digital Rules

- Ken Fisher, again. "All around the world", says the investor, "earning yields--defined as E/P (earnings over price) --are higher than 10-year government bond yields. For the American S&P index, the E/P is 6.7%. Compare that to the cost of borrowing. The average S&P company can borrow money at 5.8% pre-tax, or about 3.8% after-tax." Fisher is prompt to add that this highly abnormal situation ("We live in a unique period of history") has lasted already for 54 months. Remarkably, our own Global Liquidity Measure is growing at more than 10% for ... 53 months in a row. This, too, is quite unique.

- Geithner on funding and market liquidity. Timothy Geithner, the New York Fed president and CEO, tries to inject a dose of rationality into the debate about the "current period of exceptional liquidity". He defines funding liquidity as the "availability of credit or the ease with which institutions can borrow or take on leverage". Market liquidity, in turn, is referred to as "the ease with which market participants can transact, or the ability of markets to absorb large purchases or sales without much effect on prices". The two concepts, adds Geithner, "are closely related and are often mutually reinforcing". This is exactly what is happening right now.

- Argentine reserves at record level. According to the Financial Times, Argentina's reserves reached a record level of $47.4bn. True to its tradition as the boom-and-bust country par excellence, Argentina is firing on all cylinders, systematically undervaluing its currency and accumulating dollar reserves at full speed. Once the music stops, it will not be a pretty picture.

- Norway to lift equities exposure. Norway's government pension fund, with $300bn under management, is about to lift its exposure to global equity markets from 40% to 60%. According to the Financial Times: "In a significant reassessment of the fund’s attitude towards risk, it also announced on Friday that it would bolster investments in smaller listed companies, may invest in real estate and will also in coming years consider investments in private equity and hedge funds".

- Egypt & the New Bretton Woods. Egypt is increasingly marketing itselft as an export hub. In authoritarian countries, the cost of capital is high because property rights are naturally unstable. China's solution has been to systematically undervalue its currency (and to accumulate foreign reserves) in order export its way out of economic paralysis. Its success is attracting more and more would-be imitators — which bodes well for global liquidity conditions in the long run.

WEEKLY FED BALANCE SHEET REVIEW. ROCK'N ROLL!
. Federal Reserve: "Factors Affecting Reserve Balances", April 11

- Fed's Treasuries holdings: $774.5bn (-$2.0bn)
- Other central banks' Treasuries holdings: $1,236.1bn (+$15.8bn) (*)
- Other central banks' agency securities: $675.3bn (+$2.9bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,685.9bn (+$16.7bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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In late 2004, a number of central banks toned down their purchases of Treasury and agency securities. Worried about the build-up of domestic inflationary pressures, they suddenly let their currencies appreciate against the greenback. If I am not mistaken, the central banks of Brazil, Russia, Turkey and Mexico led the charge (I am sure Brad Setser knows all the details). Interestingly enough, the central bank of Argentina took the other side of the trade: it received strict orders from the finance ministry not to let the peso appreciate under any circumstances.

Eventually, Argentina's strategy paid handsome dividends: the economy grew at a much faster clip than Brazil's or Mexico's. (On the inflation front, however, the picture is not quite as rosy). The current wave of central bank purchases of Treasuries and agency securities seems to indicate a renewed willingness to avoid any damaging currency appreciation in a number of emerging countries. Already in April, foreign central banks have bought as much as $25bn in Treasuries, and about $6bn in agency securities. The New Bretton Woods proposition is alive and well. Global liquidity growth is strong — very strong.

LIQUIDITY ANALYSIS. A COMMENT ON VOLATILITY & LIQUIDITY
. Bill Luby. "Volatility and Liquidity: A First Look", Vix and More

Bill Luby, who was kind enough to mention my blog in a recent post, encourages "any lurking monetarists and others with thoughts on liquidity and volatility to chime in". Here are some quick thoughts. Reading through Fed governor Kevin Warsh's excellent piece on Market Liquidity, it appears that the Federal Reserve does indeed see a link between volatility and liquidity:

Researchers have documented the so-called "Great Moderation" in which the U.S. economy has achieved a marked reduction in the volatility of both real gross domestic product (GDP) and core inflation over the past twenty years or so. In theory, reduced volatility, if perceived to be persistent, can support higher asset valuations--and lower risk premiums--as investors require less compensation for risks about expected growth and inflation ... Others have pointed to the low levels of stock market volatility in recent months as indicative of pressures from excess liquidity [1].

Thus, the "Great Moderation" of the business cycle —for which the VIX index can be seen as a proxy— expands the supply of loanable resources at every level of the interest rate. This, in my view, is the key link between volatility and liquidity. There is no need to dig deep into M2 or M3 [2].

[1] Fed vice-chairman Donald Kohn is a bit more skeptical: "... the relationship between financial market volatility and the volatility of macroeconomic variables such as GDP is not well understood".

[2] M2 and the now-defunct M3 measures are not liquidity measures. Says Warsh: "I doubt, however, that traditional monetary aggregates can adequately capture the form and structure of liquidity many observe in the financial markets today". See also my comment to Bill's post.

WEEKLY FED BALANCE SHEET REVIEW. A STRONG START IN APRIL
. Federal Reserve: "Factors Affecting Reserve Balances", April 4

- Fed's Treasuries holdings: $776.5bn (+$0.9bn)
- Other central banks' Treasuries holdings: $1,220.4bn (+$9.5bn) (*)
- Other central banks' agency securities: $672.4bn (+$3.5bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,669.2bn (+$13.9bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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The first weekly Fed balance sheet for the new month contains goods news for liquidity bulls. Our Global Dollar Liquidity Measure is growing at a 13.2% rate, the strongest showing in 26 months. Following hints by Fed officials and market participants about "the liquidity that the market itself creates", I find myself concocting an Index of Intrinsic Liquidity designed to capture the impact of financial innovation on the supply of loanable resources.

The index combines measures of bond spreads (soon to be replaced by CDS spreads), market volatility, the carry trade (as measured by the spread between short rates in Japan and the US), and ... the Goldman Sachs share price (as a proxy for financial innovation). Preliminary results show that "intrinsic liquidity", despite sharp setbacks in February and March, is still growing at a healthy rate. All in all, not a bad picture for risky assets.

LIQUIDITY ANALYSIS. NEW ZEALAND & GLOBAL LIQUIDITY
. Alan Bollard. "Easy money — global liquidity and its impact on New Zealand", speech to the Wellington Chamber of Commerce.

The BIS publishes an interesting paper by Alan Bollard, Governor of the Reserve Bank of New Zealand. According to Bollard, global liquidity has "increased dramatically over recent years", reflecting three key factors: (1) a surplus of saving relative to investment in the East-Asian and oil exporting countries; (2) financial innovation and the arrival of "new players"; (3) the carry trade.

Bollard notes that the sheer magnitude of "the flow of increased global liquidity", by paving the way to further financial innovation, has led to ... even more liquidity!

LIQUIDITY TALK. LOTS OF LIQUIDITY TALK!
. PIMCO

So much things to do, so much things to read ... Liquidity watchers have their hands full with the incessant flow of articles, essays, indices and innovations. Here's some of the stuff I've been reading lately:

- Bill Gross' April Investment Outlook is out. Always a must-read, Bill Gross writes in his April Outlook that we will soon have to face the consecuences of "the 1% Fed Funds financing train of 2003". Pay attention to what lenders —not central banks— do: "It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses". Indeed.

- Willem Buiter: A hard landing in China? Prof. Buiter rightly sees China and India as key players in the global liquidity game — more so than G7 central banks: "Both India and China are in the terminal stages of a credit boom. So there will be a cyclical slowdown in both countries. If the monetary and fiscal authorities act in time (they appear to be well behind the curve in both countries) and if they have the right instruments and the political will and freedom to use them (doubtful in both countries) the credit boom can end with a whimper. A hard landing seems more likely, however".

- About the IMF Liquidity Measure. Take a look at page 5 of this report, in which the IMF displays what it calls its "Liquidity Measure". The term "measure" is more appropiate than our own "index", because it deals directly with money and credit figures. The IMF indicator is identical to Merrill Lynch's and closely resembles our own Global Dollar Liquidity Index. The IMF, however, takes the monetary base as a proxy for "domestic" liquidity; we prefer the stock of Treasury securities in the Fed's balance sheet. (We do this is in order not to mix apples and oranges, and also to avoid sharp Y2K-like swings). One last comment: the IMF compares its Liquidity Measure to the VIX index — just as Todd Harrison does.

- PIMCO's Clarida on Petro-Dollars and Credit Spreads. PIMCO's Global Strategic Advisor Richard Clarida argues that a decline in oil prices and a subsequent drain of petro-dollars would cause credit spreads to widen, because "there is evidence to suggest that the petro surpluses have been allocated much more into spread product than have the surpluses of the oil importers [like China]".

LIQUIDITY TALK. BILL RHODES BEARISH ON GLOBAL LIQUIDITY
. William Rhodes. "A market correction is coming, this time for real", Financial Times

Citibank's Bill Rhodes is full of praise for the performance of the world economy during the past few years. However, developments on the liquidity front are likely to signify the end of the "Goldilocks economy":

... much of the good news has come as a result of extraordinary levels of liquidity pouring into opportunities around the globe. To a large extent this is due to the Federal Reserve's expansionary monetary policies early in the decade and the US administration's fiscal stimulus. The yen carry trade has also facilitated the buoyant expansion of investments and leverage evident everywhere today. The low spreads, the tremendous build-up of liquidity, the reach for yield and the lack of differentiation among borrowers have stimulated both dynamic growth and some real concerns.

Thus the main culprit, on the upside, is the Federal Reserve. On the downside, however, it is investors and lenders who are likely to cause liquidity to decelerate: "As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface". Rhodes concludes with a pessimistic outlook. "Against that background", he adds, "I believe that over the next 12 months a market correction will occur and this time it will be a real correction".

Towards the end of the piece, concerns about liquidity resurface. This time, the focus is on market liquidity:

The primary worry of many who make or regulate the market is not inflation or growth or interest rates, but instead the coming adjustment and the possible destabilising effect these new players could have on the functioning of international markets as liquidity recedes. It is also possible that they could provide relief for markets that face shortages of liquidity.

WEEKLY FED BALANCE SHEET REVIEW. JUST SWAPPIN' ...
. Federal Reserve: "Factors Affecting Reserve Balances", March 28

- Fed's Treasuries holdings: $775.6bn (+$2.3bn)
- Other central banks' Treasuries holdings: $1,210.8bn (-$6.6bn) (*)
- Other central banks' agency securities: $668.9bn (+$10.5bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2,655.4bn (+$6.1bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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The only remarkable feature of last week's Fed weekly balance sheet is the fact that foreign central banks continue to swap Treasuries for agency securities. A year ago, holdings of agency securities made up 38% of the assets held in custody at the Federal Reserve Bank of New York. Now, they represent ... 55% of the total. Meanwhile, our Global Dollar Liquidity Index grows at a 12.3% annual rate, the fastest pace since August 2005.