Wednesday, June 20, 2007

[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +10.6%]

- A brief review (*). This is a stimulating essay, especially because the authors admit that their previous views on global liquidity covered just one aspect of the phenomenon, namely the "monetary policy cycle". I went through exactly the same process until I decided to tackle things like financial innovation, the Great Moderation, the carry trade, etc. It's nice to see serious people making a serious effort at integrating the various parts of the global liquidity puzzle. I especially enjoyed the part on the Great Moderation of the business cycle, with lots of interesting charts and a specific mention to real-time inventory management, one of the key elements of the Great Moderation. There is no mention of the great factor behind the surge in Asian purchases of U.S. fixed-income assets: the New Bretton Woods proposition.

IMHO, understanding BWII is the key to the global liquidity boom. China and other emerging economies are systematically accumulating Treasuries as part of a development strategy based on the recognition that their own financial systems (and property rights in general) are too weak. Thus, they need to act as an exporting periphery. According to Dooley, Folkerts-Landau and Garber, we are still relatively early in the process, as more countries and regions are likely to join in (Iran? Africa?) The part about financial innovation is too short. Furthermore, there is no link to the ... Great Moderation. If the key impact of CDS and credit transfer markets is the dispersion of credit risk, then the relationship becomes apparent: the credit cycle becomes smoother, leading to less volatile GDP growth and inflation rates.

(*) Stephen Gallagher & Aneta Markowska: "Global liquidity cycle ebbing", Eco Insight, June 6.

- Steen Jakobsen on spreads. Saxo Bank's Steen Jakobsen notes that "something is wrong in high credit land". He mentions the ABX index and the latest Bear Stearns hedge fund troubles. As I look at the spreads component in my Endogenous Liquidity Index, I note the jump in CDS- and high-yield spreads. But this bearish piece of news is almost exactly offset by the ... collapsing VIX!

- The Martin Wolf article. "Unfettered finance is fast reshaping the global economy", yesterday's Financial Times article by Martin Wolf, has created a bit of a sensation. Rich Karlgaard, who writes one my favorite blogs, is one of the enthusiasts: "Terrific piece. Read it. Save it. Read it again every now and then". I'm a bit underwhelmed, although I admit that it provides a good summary of many current developments. Here's Mr. Wolf on global liquidity:

Yet there is also a shorter-term explanation for the explosive recent growth in finance: today’s global savings and liquidity gluts. Low interest rates and the accumulation of liquid assets, not least by central banks around the world, has fuelled financial engineering and leverage. How much of the recent growth of the financial system is due to these relatively short-term developments and how much to longer-term structural features will be known only when the easy conditions end, as they will.

- Bank Credit Analyst on the bond market. "The recent bond market rout has not caused a sharp correction in risky assets, a sign this bond collapse is not restrictive but reflective of vigorous global growth". So says Bank Credit Analyst. Bingo! This is the idea we favored all along: the recent rise in bond yields reflects increased demand for credit, not a sudden fall in the supply of loanable resources. [Nonetheless, I will keep an eye on those pesky spreads].

- "Accrued Interest": a blog on the bond market. Take a look at this interesting blog [HT: Brad Setser]. The author imagines a LTCM-like episode in the context of today's markets. Not a pretty picture:

1) A large number of investors in higher quality CDO tranches (A and AA) are burned by sub-prime defaults.2) This causes a re-pricing of CDO spreads, and causes a drastic slow-down in deal flow.3) In turn, this eliminates the "CDO Put" in the credit market. This is where any widening of credit spreads made forming new CDO's that much more attractive, thus creating a back-stop for spreads generally. If the CDO market disappears, even temporarily, this "put" is gone.

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