Thursday, May 31, 2007

[Latest Global Dollar Liquidity Measure: +14.16% annual growth rate; latest Endogenous Liquidity Index: +13.14%]

According to Forbes' Rich Karlgaard, "The bottomless pool of liquidity around the world is the business story of 2007. It drives everything. Low borrowing rates. High stock prices. Buybacks. Hedge fund growth. The private equity boom". The business story of the year! You bet! That's why I write the Global Liquidity Blog! While "always bullish", Rich has some doubts about the sustainability of the liquidity boom. He therefore asks readers to comment on two views.

The not-so-bullish case is presented by Alan Ruskin, chief international strategist at RBS Greenwich Capital. The decidedly bullish case is penned by Marc Chandler of Brown Brothers Harriman and by Jim Glassman of JP Morgan. (For the record, I strongly favor the bullish view— but I'll keep an eye on the Global Dollar Liquidity Measure and on the Endogenous Liquidity Index).
[Latest Global Dollar Liquidity Measure: +14.16% annual growth rate; latest Endogenous Liquidity Index: +13.14%]

To understand how credit markets work and how interest rates are set, the first thing to do is to dump academic textbooks. Instead, read material written by people actively involved in markets. My preferred article is already 19 years old: "Determinants of interest rates", by Horace W. Brock (Euromoney, 1988). Absolutely fantastic in its realism and simplicity. When contemplating today's credit markets from a global liquidity perspective, one tends to focus on the supply of loanable resources. But what about the demand side of the equation?

To the best of my knowledge, there are four major arguments to explain the tepid pace of credit demand worldwide. [1] Long-term inflation expectations under control; [2] Improving state of public finances worldwide; [3] Poor governance in developing countries; [4] Wikinomics and the iPod economy. Looking for signs of change in this blissful state of affairs, Bank Credit Analyst raises the possibility of a global capex boom that "would place upward pressure on real borrowing rates". Interesting stuff.

Wednesday, May 30, 2007

[Latest Global Dollar Liquidity Measure: +14.16% annual growth rate; latest Endogenous Liquidity Index: +11.79%]

There is a healthy debate going on at the European Central Bank over the relevance of M3 as an indicator of future inflation trends. According to Financial Times' Ralph Atkins, "some ECB insiders have suggested that the usefulness of such data has been undermined by innovation and the complexity of financial markets, and that the monetary pillar will eventually be merged into the ECB's general analysis of the real economy".

Here at the Global Liquidity Blog we tend to agree with the view that M3 will become increasingly ... irrelevant. The further the euro acts as an international reserve currency, the less the value of M3 as an inflation barometer. As more countries move to the euro as an international reserve asset, purely "domestic" monetary indicators —such as M3— are bound to loose relevance. Rember 1998 in the U.S.

Tuesday, May 29, 2007

. Buttonwood. "Painting by numbers", The Economist

A friend of mine, a keen art collector, reflects on the parallel course of Wall Street and the art market and informs me that Marc Rothko's White Center recently fetched $ 73 million, while Andy Warhol's Green Car Crash changed hands for a cool $72 million in November. On this very issue, The Economist quotes Jeremy Grantham of GMO, a fund-management group: "From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it's bubble time". The newspaper's conclusion is not a reassuring one:

One way of looking at high art prices is as part of a global wave of liquidity that is pushing up asset prices everywhere ... A variant of the same argument is that high art prices reflect the increasing number of rich people from all parts of the world. Russian and Chinese millionaires, along with hedge-fund and private-equity managers, have run out of houses to buy and yachts to launch, and would like to display their wealth on their walls.

Friday, May 25, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", May 23

- Fed's Treasuries holdings: $780.0bn (+4.2bn)
- Other central banks' Treasuries holdings: $1,221.7bn (-$3.0bn) (*)
- Other central banks' agency securities: $723.0bn (+$7.8bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,724.8bn (+$8.9bn)

(*) Off-balance-sheet items.

While May 2007 was not the strongest month on record in terms of liquidity growth, it was a pretty decent one. Central banks globally added $31bn to their holdings, as measured by custodial data and the Fed's own balance sheet. Our Global Dollar Liquidity Measure is growing at a 14.16% annual rate, the strongest showing since ... March 2005. Not bad!

Thursday, May 24, 2007

[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +12.68%]

The New Bretton Woods framework is the key to understand global liquidity conditions. That's clearly the idea behind this Financial Times article by Alan Ruskin, chief international strategist at RBS Greenwich Capital. Mr. Ruskin highlights what we have called in a recent report the risk of "explosive liquidity dynamics". Here's how it works. Brazil decides to check the appreciation of the real by buying U.S. dollar-denominated bonds. Stock market analysts applaud the move, as it is sure to lead to stronger corporate profits. Hedge funds buy Brazilian stocks — and the currency. The Brazilian real appreciates. The central bank steps in, buying up Treasuries. More global liquidity is created, more hedge funds invest, and the process starts all over again.

On the growth incentives behind this scheme, check out this post by Dani Rodrik [HT: Brad Setser]. By the way, it's worth rememberting that Dooley, Folkerts-Landau and Garber always considered the New Bretton Woods scheme a second best development strategy. It would be better, of course, if developing countries would beef-up their financial systems, strenghten property rights, and generally improve governance. But herein lies a paradox: the more successful they become at playing the FX reserves game, the less they care about good governance. Argentina is a case in point: maybe I'll write about that next week.

Wednesday, May 23, 2007

[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +13.17%]

Our expermiental, untested, preliminary Endogenous Liquidity Index is reaching new highs. The index is designed to capture the impact of changes in the supply of laonable resources in the credit market resulting from financial innovation, the "Great Moderation" of the business cycle, and the carry trade. Check out the Credit Derivatives & Liquidity section of the blog for lots of info (*).

(*) Latest links: PIMCO's Robert Mead on "Demystifying the Structured Credit Jargon and Identifying the Opportunities", and the Atlanta Fed conference on "Credit Derivatives: Where's the Risk?"

Tuesday, May 22, 2007


[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +11.25%]

Am I a perma (liquidity) bull? Judging from a number of recent e-mails, this must be the impression readers get from the Global Liquidity Blog. My answer, however, is always the same: I'm just trying to measure the beast. When I say that the current liquidity boom is unprecedented, it's for a reason. Previously, our Global Liquidity Measure had never grown north of 10% for fully 54 months in a row. Voilà. I hope this settles the issue. (I'll be glad to report about the next liquidity downturn as soon as it materializes).

Meanwhile, there are some very respectable growling credit- and liquidity bears out there:

- John Plender & the next 'savage downturn'. The Financial Times economist doesn't buy the argument that "structured products uniformly enhance market efficiency". Instead, he warns, "collapsing standards will now stretch out the credit cycle while ensuring the delayed downturn will be more savage when the defaults finally happen". Ironically enough, the "mispricing of credit" is driven by the illiquidity of CDOs and CLOs, which limits the scope for marking to market.

- Steve Previes & the 'global liquidity bubble'. The Jefferies International strategist told CNBC Europe that markets face a "global liquidity bubble", with key central banks pouring too much money into financial markets. "There's a situation of excessive liquidity, with too much money chasing too few deals".

- Gillian Tett & the 'bubble-like conditions in the credit markets'. Over an expensive lunch with a "senior banker", the Financial Times' capital markets worries about extraordinary "bubble-like conditions in the credit markets". Tett does not sound very convincing when she mentions the pattern of the business cycle: even the very cautious Bank of England's Financial Stability report all but concedes that the nature of the business cycle has been permanently altered. The real problem is whether institutions are becoming "more cavalier about lending risk", as Tett puts it. As Machiavelli said, "Perché un uomo che sia consueto a procedere in uno modo, non si muta mai". Human nature does not change ...

Monday, May 21, 2007


[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +12.27%]

The New Bretton Woods proposition, the key factor in the current liquidity boom, is sometimes misunderstood as an instance of (misguided) support for the Bush administration. In reality, it is much more than that. Having lived myself in "emerging" countries, it is perfectly clear to me that the key to understand the phenomenon is the high cost of capital resulting from weak property rights. These countries are thus virtually forced to compete à la Chinese: by systematically undervaluing their currencies and accumulating dollar-denominated FX reserves.

Look at the China-Blackstone deal. According to the Financial Times, "China's decision to buy a stake in Blackstone's IPO rather than in one of its buy-out funds, which are more volatile and risky, is a sign of Beijing's cautious approach to private equity". Let me get this straight: the Chinese do not trust the solidity of ... their own financial markets! And there's more. According to Thomas Barnett, Iran is studying the ... Chinese model. Here, readers of Dooley, Folkerts-Landau and Garber will recognize one their key insights: many more countries are likely to join in!

Meanwhile, down in Buenos Aires, Fed governor Randall Kroszner tells it like it is:

The financial systems in many developing nations are relatively weak and are not effective at directing saving toward appropriate investment projects. That failing leads to inadequate investment, particularly if business activity is further impeded by inadequate property rights and faulty regulations. As a result, excess saving flows to countries with better financial systems.

Businesses in many emerging-market economies face a multitude of hurdles. Red tape, rigid regulations, and weak legal systems impede the formation of businesses, their ongoing operation, and their confidence in having their contracts enforced without long and costly litigation. Accordingly, governments in these countries could greatly improve the environment for domestic capital formation by simplifying business regulations, strengthening property rights, including the rights of creditors, and improving contract enforcement.

Friday, May 18, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", May 16

- Fed's Treasuries holdings: $775.8bn (-$0.8bn)
- Other central banks' Treasuries holdings: $1,224.7bn (-$3.3bn) (*)
- Other central banks' agency securities: $715.2bn (+$12.1bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,715.8bn (+$8.1bn)

(*) Off-balance-sheet items.

It's business as usual in terms of the weekly Fed balance sheet. While the Fed's balance sheet barely moved —courtesy of the inverted yield curve—, foreign central banks eagerly snapped up $12bn in agency securities. At $715bn, the stock of such custody holdings is at a new all-time high. Overall liquidity growth is strong: our Global Dollar Liquidity Measure is growing at a 13.85% annual rate. Business as usual!

The Endogenous Liquidity Index surged 2.08%, spurred (mostly) by falling high-yield bond spreads. Meanwhile, the Goldilocks/Stagflation indicator appears to be moving decidedly in favor of Goldilocks, as the platinum/gold ratio reaches 2 (strong global growth), and the spread between plain and inflation-indexed Treasuries falls (decreasing inflation expectations).

Thursday, May 17, 2007

. Morgan Stanley Global Economic Forum

[Latest Global Dollar Liquidity Measure: +13.95% annual growth rate; latest Endogenous Liquidity Index: +9.35%]

Morgan Stanley's Stephen Jen discusses the current situation of "ample global liquidity", which he dubbs "Pillar 1" of the bullish case for risky assets:

Pillar 1. Ample global liquidity. This ‘real’ liquidity arises from a mismatch between world savings and investment rates. World capex has surprisingly been too low to absorb all available savings. Annually, there are some US$800 billion worth of ‘excess savings’ from oil exporters and Asian exporters to chase after assets.

Readers of this blog know that, every Friday morning, we publish our own version of this "Pillar"; we call it Global Dollar Liquidity Measure. Now, Jen's "Pillar 3" caught my attention, because although he does not include volatility measures in his definition of liquidity, they do feature prominently in our own Endogenous Liquidity Index:

Pillar 3. Global de-coupling and positive growth prospects. Global de-coupling has effectively reduced overall financial risk, relative to a world powered by a single growth engine. Whether the US is in a refreshing mid-cycle slowdown, or cycle-terminating event is critical. This question, I believe, is more complicated than deciding on the US housing market’s fate. I see the global economy as healthy, with 2007 as the fifth consecutive year with global growth above 4.0%. The first phase of the globalization growth process entails a massive increase in world useable labor force and I believe we are at the tail-end. The second phase should entail a sharp increase in capital expenditures, infrastructure and production capacity. The expansion of labor and of capital should enhance the global economy’s potential growth rate. Risky assets, theoretically, should be in a secular bull market. Apparent financial bubbles are actually well supported by solid global economic fundamentals. Inevitable ‘frictions’ from the globalization process will be just minor irritants. From this broader perspective, discussion on global de-coupling is unhelpful. The cyclical risks to the global economy are inflation, and the likelihood of the global economy driving the US housing market rather than the other way around.

Wednesday, May 16, 2007

[Latest Global Dollar Liquidity Measure: +13.95% annual growth rate; latest Endogenous Liquidity Index: +7.76%]

. Bill Gross. "How We Learned to Stop Worrying (so much) and Love Da Bomb", PIMCO Bonds

Ladies and Gentlemen: this is by far the most important piece on global liquidity that I have read in a while. Bill Gross is telling us in no uncertain terms that the time has come to embrace all the elements of the global liquidity tide: the New Bretton Woods proposition, financial innovation and its wonders, the Great Moderation of the business cycle, and even ... the carry trade ("the dominant liquidity lever in today’s marketplace").

Among the many, many interesting conclusions to draw from this piece: (a) an excess of caution "has cost [PIMCO] some basis points"; (b) foreign CBs' purchases of U.S. bonds keep long-term rates down by as much as 50 basis points; (c) PIMCO will enter local-currency money markets in selected emerging economies.


Tuesday, May 15, 2007

[Latest Global Dollar Liquidity Measure: +13.95% annual growth rate]

. Rich Karlgaard. "The Economy's Trillion Dollar Question", Forbes - Digital Rules

The Trillion Dollar Question, according to Forbes' Rich Karlgaard, involves the current liquidity boom: is it sustainable? Does it reflect dangerously lax global monetary policies? The Financial Times' Lex column ponders similar questions:

Everywhere, financiers are holding their collective breath, waiting for the dreaded turn in the cycle. Even bank bosses are becoming more and more candid about the dangers. Bank of America’s Ken Lewis, talking about private equity, last week called for “a little more sanity in a period in which everyone feels invincible”.

Global liquidity conditions, the turn of the credit cycle: these are precisely the "trillion dollar questions" that we ask ourselves daily at the Global Liquidity Blog.

Monday, May 14, 2007


- David Malpass on Global Liquidity Conditions. Rich Karlgaard, who writes Forbes' Digital Rules blog, quotes Bear Stearns chief economist David Malpass on global liquidity conditions:

Globally, the impact of plentiful liquidity is reaching a crescendo, with stocks high, spreads narrow, growth strong, land prices booming and central banks flooded with dollars. We note the sharp contrast with 2001, when a shortage of dollar liquidity (strong and strengthening dollar, high real interest rates, low central bank dollar reserves, falling gold and commodity prices, rapidly shrinking U.S. profits) all spelled weakness.

- Steen Jakobsen on China & the New Bretton Woods. Saxo Bank's fund manager Steen Jakobsen tours Asia and realizes how vitally important the New Bretton Woods proposition is to China:

The rule of controlled peg, or Breton Woods II, as many prefer to call it inflates assets as the locals banks get FLOATED with domestic currencies which then goes into stock markets, fixed income, land and consumption through low rates, leverage debts ... The risk though being PBOC could be forced to move. The inflation numbers created some stir, and there is desperate needs deflate some of the bubble, but the Chinese have learned their lessons from the Japanese in the 1980s. Japan accepted to let their currency to go stronger and ever since they have been in deflation!

- Chris Dialynas on ... the New Bretton Woods. PIMCO's Chris Dialynas discusses the New Bretton Woods arrangement in the context of the firm's upcoming "secular forum":

The common presumption is that Bretton Woods II is in every country’s mutual interest to keep the globalization game going. But as this arrangement grows, it becomes more complicated and makes more people nervous ... From the U.S. standpoint, a revaluation is an obligation under Bretton Woods II, since it could help cure some of the imbalances or at least keep them from growing too large. But China has been very reluctant to let its currency appreciate significantly.

- Slow investment growth & global interest rates. Strong global liquidity growth increases the supply of loanable resources in the credit market. But other factors must be at work to explain the low level of long-term interest rates globally. Harvard University economist Ken Rogoff recently suggested that low levels of investment are a natural consequence of emerging economies' weak governance standards. This Financial Times article makes a similar point about investment (or the lack thereof) in oil-exporting countries:

Resource nationalism, which is limiting access for international oil companies, and the national oil companies’ failure to reinvest profits in production, are limiting outlay required to replace existing resources, which are being substantially depleted ... Robin West, chairman of PFC Energy said: "The concern is not that the world is running out of oil, but rather it is running out of oil production capacity". The PFC study shows political factors are limiting capacity increases in Mexico, Venezuela, Iran, Iraq, Kuwait and Russia.

Friday, May 11, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", May 9

- Fed's Treasuries holdings: $776.6bn (-$9.2bn)
- Other central banks' Treasuries holdings: $1,228.0bn (+$0.7bn) (*)
- Other central banks' agency securities: $703.1bn (+$3.6bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,707.7bn (-$4.9bn)

(*) Off-balance-sheet items.

The week ends with a $4.9bn contraction in our Global Dollar Liquidity Measure. So far in 2007, this has happened on three occasions only. The main culprit: the Fed reverting a massive repo operation. Foreign central banks added about $4bn, mostly in agency securities. They now hold more than $700bn in agency bonds in custody at the New York Fed. Meanwhile, our Endogenous Liquidity Index did not fare any better (-0.94% on the week). While the carry trade factor remained unchanged, all other components dragged the index lower: CDS spreads, high-yield bond spreads, the VIX, and the Goldman Sachs share price.

The way I see it, the correction in risky assets that began yesterday could very well continue for some time. But I wouldn't get too excited with short positions: year-on-year growth rates (+13,95% for our Dollar Global Liquidity Measure) still suggest a heathy long-term liquidity situation.

Thursday, May 10, 2007

. CNBC Street Smarts: Buyouts

Interviewed last night by Maria Bartiromo, investor Ken Fisher tells is like it is: "This market is uniquely ideal in modern history". According to Fisher, the unusually large gap between the after-tax earnings yield and bond yields has been in place for 55 months, something that "has never happened before". There is a reason why I keep mentioning Fisher every time he shows up for a CNBC interview: the liquidity boom, as captured by our own Global Dollar Liquidity Measure, has just entered its ... fifty-fourth month. This too has never happened before.

Wednesday, May 9, 2007


Suppose that the best market-based indicator of global economic growth is the platinum/gold ratio [a], and that the best indicator of inflation expectations is the spread between the 10-year benchmark Treasury note and the current 10-year inflation-indexed note [b]. The [a]/[b] ratio is thus a "Goldilocks/Stagflation" indicator. What does it tell us right now? On the one hand, inflation expectations have increased somewhat in 2007. On the other hand, the global economy is growing strongly (platinum/gold ratio approaching 2).

At 0.81, our "Goldilocks/Stagflation" indicator looks neither too hot nor too cold. Based on past data, it would appear that the S&P500 has further room to run (about 5%) before getting seriously overvalued in terms of this "Goldilocks/Stagflation" indicator.

Friday, May 4, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", May 2

- Fed's Treasuries holdings: $785.8bn (+$10.2bn)
- Other central banks' Treasuries holdings: $1,227.3bn (-$0.7bn) (*)
- Other central banks' agency securities: $699.5bn (+$9.4bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,712.6bn (+$18.8bn)

(*) Off-balance-sheet items.

The global liquidity boom, defined as a 10% or more annual rate of growth in our Global Dollar Liquidity Measure, has just entered its fifty-fourth month. To the best of my knowledge, this is unprecedented. Both the Fed and foreign central banks actively added to their portfolios. The Fed did so through unusually large repo operations. Foreign CBs bought more than $9bn in agency securities, leaving the stock of such custody holdings at a new record level, just below $700bn.

Meanwhile, our preliminary Endogenous Liquidity Index (ELI) fell 0.9% during the week, dragged down by slightly higher junk bond and CDS spreads. I'll take it as a mildly bearish short-term sign in an otherwise very supportive long-term liquidity environment.

Thursday, May 3, 2007

. Dan Carty. "Not so Golden Liquidity", Traders Insight

"Liquidity is the catch word of the day", complains Dan Carty. He goes on to suggest that people who talk about liquidity should at least be able to quantify it. I agree: that's what we do here every Friday morning! As for the rest of the piece, I have some doubts. Dan uses market-based indicators to arrive at a "liquidity demand model". Now, I happen to like market-based liquidity models myself (*). But are not market prices, by definition, always factoring in supply and demand?

(*) See the fast-aging but still wonderful book by Manuel Johnson & Robert Keleher. Monetary Policy. A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

Wednesday, May 2, 2007

. Gillian Tett & Chris Giles. "Traders urged to learn from subprime saga", Financial Times

Citing the recent Bank of England report on Financial Stability, Financial Times writers Gillian Tett and Chris Giles briefly discuss the issue of moral hazard in the context of the risk transfer mechanism through CDS and other innovations. "If banks think they can unload risk on to someone else", write Tett and Giles, "they may become more cavalier about making loans". Moral hazard, thus, may increase as the transfer of risk intensifies.

Not so fast, says Timothy Geithner, president and CEO of the New York Fed: "... the system as a whole may be less vulnerable to distorsions introduced by the moral hazard associated with the access that banks have to the safety net" (italics mine). In other words: as banks embrace the "originate-and-distribute" model, those moving to the "buy-and-hold" role may behave more cautiously because they do not have access to the safety net.

The two views are not necessarily incompatible. Moral hazard within banks may increase as a result of financial innovation, but it may well decrease in terms of the financial system as a whole (*).

(*) See Gillian Tett. "Hedge funds lead European leveraged lending", Financial Times: "American hedge funds and other non-bank credit investment groups now hold just over 50 per cent of all lending to risky European companies — pushing banks into a minority role in this sector for the first time".

Tuesday, May 1, 2007

. Jeremy Siegel. "Presenting the bullish case for equity valuations", Financial Times

Jeremy Siegel, professor of finance at the Wharton School, establishes the bullish case for equity valuations by arguing —among other things— that "the reduction in economic volatility should reduce the equity risk premium". Here's another the way to put it: lower macro volatility leads to an increase in the supply of loanable resources in the credit market, which (other things being equal) means lower long-term interest rates and higher equity valuations.

The recent Bank of England report on financial stability explains the process — "Less volatile collateral values promotes steady credit growth rates":

The stability of the economic environment may have encouraged the provision of more long-dated and subordinated finance because lenders are more confident that firms will not default as a result of sharp shocks. Loan payments are also being backloaded ... Even lowly rated firms are able to raise subordinated finance, with issuance of second-lien loans and mezzanine notes (which fall between equity and debt in a firm's capital structure) increasing over the past year.

Can we legitimately use the VIX as a proxy for macro volatility? It is an open question. Our own Endogenous Liquidity Index does just that — it fell as much as 4.8% yesterday as the VIX surged past 14.