Tuesday, June 26, 2007

[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: -2.4%]

Bombarded from all sides, our Endogenous Liquidity Index has finally turned negative. The rising VIX, surging CDS- and credit spreads, the Goldman Sachs share price: all components register sharp falls. (A narrower, time-tested version based on Moody's spreads still shows healthy year-on-year gains). Clearly, we are witnessing a contraction in the supply of loanable resources in markets for corporate borrowers. Morgan Stanley's Richard Berner sums up the situation:

... the recent repricing of risk has tightened financial conditions, and the renewed turmoil in subprime mortgages will probably make lenders still more risk averse. Financial conditions represent the channels through which changes in interest rates, asset prices, and the availability of credit affect economic activity. ... Increased uncertainty about the economic and financial environment has increased term premiums and volatility in financial markets ...The resulting backup in risk-free yields, combined with slowing — and more uncertain — growth in corporate profits, is challenging stock prices.

Note the link between volatility, risk premia, corporate profits and stock prices. That's precisely the kind of analysis that we try to provide here. I still think that the combination of strong funding liquidity and the CDO Put has the potential to turn things around. (More on the CDO Put here; see also Bloomberg's detailed account of the ongoing Bear Stearns saga).

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