WEEKLY FED BALANCE SHEET REVIEW. FINALLY SOME DECENT NUMBERS!
. Federal Reserve: "Factors Affecting Reserve Balances", September 26

- Fed's Treasuries holdings: $783.6bn (+$9.5bn)
- Other central banks' Treasuries holdings: $1,214.8bn (+$3.9bn) (*)
- Other central banks' agency securities: $780.4 (+$3.9bn) (*)
- Global Dollar Liquidity Measure: $2,778.9bn (+$17.3bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
__________________

After six weeks of misery, the weekly Fed balance sheet finally produces a set of decent numbers. Our Global Dollar Liquidity measure registers a $17.3bn increase, the best performance in 17 weeks. While the quality of the change leaves much to be desired —repo operations account for more than half of the increase— it is worth noting that borrowings at the discount window are back at their pre-crisis levels (i.e., almost non-existing).

In terms of the Global Dollar Liquidity measure, September closes at a 13.6% annual rate of growth, signalling a strong, if unspectacular, rate of global economic growth. Note also that, despite talk of the Fed "inundating" markets with excess liquidity, the stock of Treasury securities held by the U.S. central bank (a proxy for the monetary base) is growing at the rather modest rate of ... 2.5%, a six-month low. Will dollar bulls take note?

LIQUIDITY ROUNDUP. ENDOGENOUS LIQUIDITY AT A TWO-MONTH HIGH!
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -15.9%]

Endogenous Liquidity at a two-month high; the dollar & bond yields; Russian liquidity squeeze.

[1] Surging Endogenous Liquidity! Our index, designed to capture trends in market liquidity through market-based indicators, surged 2% yesterday, closing at a two-month high. Lower CDS and cash bond spreads, declining volatility and rising share prices of financial innovators indicate increasing risk appetite and leverage. So far, the index has acted mostly as a coincident indicator for risky assets. Still, it remains a valuable tool when monitoring divergence/convergence trends with respect to funding liquidity.

[2] Marc Chandler on the dollar & bond yields. Brown Brothers Harriman's Mark Chandler disputes the notion that aggressive Fed easing (on September 18) actually aggravated the U.S. inflation picture. His key argument: European yields increased too. In other words, falling bond prices on the heels of the FOMC anouncement may simply reflect "the loss of the safe-haven bid for bonds". Interesting!

[3] Mansoor Modi-huddin on the dollar & bond yields. Buried in page 34 of today's Financial Times, there is a strinkingly similar explanation by Mansoor Modi-huddin of UBS: "Paradoxically, [last weeks's aggressive 50 basis points interest rate cut from the Federal Reserve, by reinvigorating markets around the globe] may have made it easier for other central banks to continue with their tightening cycle, putting downward pressure on the dollar via yield differentials".

[4] More Russian liquidity troubles. In Moscow, FT reporter Catherine Belton reports that "A senior Russian banker warned on Wednesday of debt defaults as the liquidity squeeze in Russia tightened following the global credit crunch and interbank lending rates climbing to a two-year high" ("Russian liquidity trouble starts to boil"). Read the whole story. Events in Eastern Europe make it more urgent to create a ... Euro Global Liquidity Measure!

[5] Credit derivatives volume at $45 trillion. From the Wall Street Journal's Market Beat site: The credit derivatives sector "expanded by almost a third in the same period to a notional outstanding volume of $45.46 trillion, from $34.42 trillion at the end of 2006. This nevertheless takes a little off the pace the industry has seen so far. Last year, according to ISDA, the notional volume of credit derivative contracts outstanding more than doubled ... The derivatives market’s continued expansion is testimony to what has become its central role in capital markets, particularly during the liquidity crisis of the past couple of months, according to ISDA Chief Executive Officer Robert Pickel. "We expect this strong volume to continue over the 2007 second half, as privately negotiated derivatives have provided liquidity and functioned efficiently through the recent market volatility," he said.

[6] Jim O'Neill, the trade deficit and ... global liquidity. Jim O'Neill, the Goldman Sachs economist, reckons that the U.S. trade position may be on the verge of a spectacular improvement, a fact that would have many consequences for investors. Already, writes O'Neill, "Chinese retail sales are contributing as much to the world as the US". Michael Pettis worries about the impact of the vanishing US surplus in terms of global liquidity conditions: "As I said in an earlier post I believe that the recycling of the US trade deficit has been the main factor underpinning the recent globalization cycle. If so, and when the current cycle ends, if history is any indication the adjustment from the insanely happy days of too much liquidity (with its attendant surge in risk appetite) to a more “normal” level of liquidity will be a very difficult one ..." Maybe. But then again, volatility indicators would probably recede, and liquidity would assume a different shape.

LIQUIDITY ROUNDUP. PIMCO V. BRETTON WOODS II
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -17.7%]

PIMCO & the Bretton Woods II system; a contrarian view on the dollar; reflation vs. inflation; a look at our Endogenous Liquidity Index.

[1] PIMCO against the Bretton Woods II system. PIMCO Bonds's "Renegade Economics: The Bretton Woods II Fiction", by Chris P. Dialynas and Marshall Auerback, is a truly amazing piece of economic reasoning. Yes, we all know that the system has many drawbacks, that it fosters speculation, that is stimulates the carry trade, etc, etc. However, I can't help but remaining a bit suspicious whenever a bond firm calls for "Japan-style zero interest rate policy [ZIRP] for the U.S. in combination with strategic and iterative fiscal tightening".

[2] A contrarian view on the dollar. Saxo Bank's Steen Jakobsen contends that "US fixed income is extremely cheap in currency adjusted basis" and that "EURUSD was .8600 in 2000... now 1.4200 ??? I remember distinctly how NO ONE wanted EURO then, this is the same US moment".

[3] Morgan Stanley's Richard Berner: more Fed easing ahead. Berner notes that while financial conditions have eased somewhat, money markets are not free from stress: "Between July 2006 and June 2007, the spread between fed funds and three-month LIBOR averaged 11.3 bp; that spread peaked at 83 bp last week and is currently 45 bp. Moreover, spreads between the rates banks are charging their customers and LIBOR and between credit market rates and LIBOR are also wider than two months ago". On the inflation front, adds Berner, the theme is "reflation rather than inflation".

[4] Daily Endogenous Liquidity watch. Another quiet day in terms of our Endogenous Liquidity Index, which closed unchanged. The VIX and CDS spreads are playing cat and mouse, thereby offsetting each other. The index is now down 17.7% for the year (it reached an all-time low on August 18, at -35.1%).

LIQUIDITY ROUNDUP. CAN MARKETS BECOME 'TOO LIQUID'?
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -17.9%]

Can markets become too liquid?; the Saudis & the dollar; monetary policy & the carry trade; a look at our Endogenous Liquidity Index. [More updates expected ...]

[1] Can markets become too liquid? Yes, says Fed governor Kevin Warsh. Warsh is the author of a very interesting piece on global liquidity ("Market Liquidity: Definitions and Implications", March 5, 2007), in which he famously stated that "liquidity is confidence". Confidence, however, can be fleeting: "Confidence can beget complacency. If, in liquid times, investors in structured products become complacent, they may not understand fully the value of the underlying assets. High levels of confidence, perhaps even complacency, were also observable in the behavior of many financial intermediaries".

[2] Cumberland Advisors on the dollar & the Saudis. Rumors that the Saudi Arabian Monetary Authority (SAMA) was about to drop the peg of its currency to the US dollar triggered the recent dollar sell-off, according to Cumberland Advisors. (See David Kotok: "The Euro, the Dollar & the Saudis"). Is rising global inflation beginning to undermine the New Bretton Woods arrangement? (In May, Kuwait dropped the dollar peg). We'll see. In the meantime, Mr. Potok doesn't foresee a massive move out of dollar, but rather "some progressive diversification out of US dollar assets into other currencies in an orderly way". His target for dollar-euro: 1.50-1.60.

[3] Monetary policy uncertainty & the carry trade. Writing in today's Financial Times, Lehman Brothers' James McCormick makes an interesting point about monetary policy and the outlook for the carry trade ("Currency lessons learned since the upheaval"): "... the global economy is turning down for the first time in several years at a time when economic optimism is high, and monetary policy uncertainty is on the rise after a prolonged period of near certainty of outcomes. Neither trend seems particularly supportive of a sustained carry-trade rally". Carry-traders tend to feel safe when they have strong convictions about the direction of monetary policy.

[4] Daily Endogenous Liquidity watch. Our Endogenous Liquidity Index barely moves (+0.1%). The rise in the VIX and other volatility indicators offsets modest declines in CDS spreads and in high yield bond spreads. The index is now down 17.9% for the year (it reached an all-time low on August 18, at -35.1%).

[5] Supply Siders on the Fed. The Club for Growth held an online symposium with supply-side economists on the FOMC decision to slash short-term rates. With the predictable exception of Larry Kudlow, supply siders generally consider, as Brian Wesbury puts it, that "Cutting rates was unnecessary. More importantly, it increased the longer-term risks to economic growth from inflation and future Fed tightening" [HT: Rich Karlgaard].

LIQUIDITY ROUNDUP. THE 'CREDIT WILDFIRE' HYPOTHESIS
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -18.0%]

The "Credit Wildfire" hypothesis; long liquidity cycles; improved Endogenous Liquidity Index. [More updates expected ...]

[1] The Credit Wildfire hypothesis. Jack Malvey, global fixed income strategist at Lehman Brothers, has written an important piece on the credit crisis. The current episode, according to Malvey, is "far from the greatest credit contraction of all time". In fact, he calls it a mere 'Credit Wildfire', a garden variety crisis with three important features: (i) it does not last long (three months on average); (ii) it ends with decisive action from central banks; (iii) it signals the "mature phase of business cycles". Fascinating stuff: read it all.

[2] Michael Pettis on globalization cycles & liquidity. Guest-blogging at Brad Setser's blog, Michael Pettis, professor of Finance at Peking University's Guanghua School of Management, writes about long-term liquidity cycles: " ... globalization cycles are driven largely by new developments or structural changes in the financial system that cause a significant increase in global liquidity and a concomitant increase in risk appetite ... These liquidity cycles were never smooth sailing but were often interrupted by sometimes shockingly severe crises ... Some well-known examples might be the Overend Gurney Crisis in 1866, the Panic of 1907, or the 1976 Peso Crisis and, I am willing to bet, the sub-prime mortgage crisis of 2007". According to Pettis, the current long cycle will end when the U.S. current account finally adjusts.

[3] Improving Endogenous Liquidity Index. Courtesy of Bernanke & Co., our Endogenous Liquidity Index has just registered its sharpest weekly gain since inception: +14.4%! All components went up: CDS and cash bond spreads, volatility readings, measures of financial innovation. The Index trades at at two-month high.

WEEKLY FED BALANCE SHEET REVIEW. UNINSPIRING
. Federal Reserve: "Factors Affecting Reserve Balances", September 19

- Fed's Treasuries holdings: $774.1bn (-$4.6bn)
- Other central banks' Treasuries holdings: $1,211.0bn (+$3.9bn) (*)
- Other central banks' agency securities: $776.5 (+$2.3bn) (*)
- Global Dollar Liquidity Measure: $2,761.6bn (+$1.6bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
__________________

Yet another uninspiring weekly Fed balance sheet. Our Global Dollar Liquidity measure barely moves, as the impact of a still restrictive Fed (a week before the change in the Fed funds rate) is compensated by foreign CBs returning to the Treasury and agency market. At +13.4%, the annual rate of growth still signals an expanding global economy, but at a markedly slower pace.

LIQUIDITY ROUNDUP. IS IT 1998 REDUX? OR IS 2001 AGAIN?
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -21.4%]

1998 or 2001?; PIMCO & the UK fixed-income market; a look at our "Goldilocks/Stagflation" indicator. [More updates expected ...]

[1] Is it 1998 redux? Or is it 2001 again? The very busy Krishna Guha asks himself, rhetorically: Are we in a 1998-style situation, or rather in a 2001 style-situation? The 1998-like scenario would see risky assets fly for many months, until central banks engineer a new round of monetary tightening. Tom Graff of Accrued Interest is in that camp. On the other hand, a 2001 style situation would see falls in asset prices followed by a "sustained rate-cutting cycle", where rates could fall below 4%. That would be Todd Harrison's position. The Minyanville CEO is wary of encouraging folks to "climb aboard the Rally Express," because "I’ve seen that movie before (in 2000) and a lotta folks never made it out of the theater".

[2] PIMCO Bonds on the UK fixed-income market. According to PIMCO's Myles Bradshaw, the UK economy will experience a significant slowdown as "higher mortgage rates and debt-service costs are occurring against a backdrop of tepid income growth". His conclusion: "Consumers will see higher interest rates as fixed-rate mortgages roll off and as mortgage spreads widen. Tepid income growth and debt-servicing costs near record highs mean consumers have little to cushion them against higher interest rates. Facing this storm, the U.K. economy is likely to slow down and grow below trend. The silver lining: This bodes well for U.K. fixed income".

[3] A look at our "Goldilocks/Stagflation" indicator. Our market-based "Goldilocks/Stagflation" indicator comprises the platinum/gold ratio (numerator) and the 10y/10y inflation breakevens (denominator). A strong showing is indicative of a Goldilocks scenario, whereas a falling number describes the nightmarish Stagflation scenario. It currently trades a 0.79, a four-month low. On the heels of the credit crisis, the platiunm/gold ratio has declined from 2.01 to 1.81, reflecting —quite logically— slower global economic growth. On the other hand, inflation breakevens, although still relatively low, have risen sharply over the last couple of sessions. All in all, the message is: risky assets have become significantly more expensive.

[4] Forget the 1990s! Forget the 2000s! The 1970s are ... baaaack! Richard Bove, over at Punk Ziegel, says the Fed actions are reminiscent of the ... 1970s! That's right, the 1970s: soaring inflation rates, a highly politicized Fed, a falling dollar and surging commodity prices. The aggressiveness of the Federal Reserve —unmatched by other central banks— will result in higher, not lower, long-term interest rates. The higher cost of capital will be particularly detrimental to U.S. broker-dealers.

LIQUIDITY ROUNDUP. HELICOPTER BEN DELIVERS
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -23.3%]

Helipcopter Ben delivers; a sharp rebound in our Endogenous Liquidity Index; predictable Bears; the Old Lady & Northern Rock.

[1] Helicopter Ben delivers — and then some. Good move by Bernanke & Co! (FOMC statement). Our Endogenous Liquidity Index registers its largest one-day upside move, spurred by sharp falls in CDS and bond spreads, and especially by the collapse in volatility indicators. Upward moves in market-based indicators of financial innovation (particulary the Goldman Sachs share price) also helped. Note, too, that the move by the FOMC marginally reduces the attractivenes of the carry trade, as the spread between U.S. and Japanese policy rates falls.

[2] Are there long-term credibility issues in terms of the Fed? Sure. That's the message conveyed by the dollar, commodity prices, and the steepening yield curve. Predictably —perhaps all too predictably— Marc Faber and Jim Rogers are already talking about the coming recession.

[3] To bail out, or not to bail out. Little by little, information on the Northern Rock saga becomes available. According to the Financial Times, the Bank of England "refused [to widen the types of collateral it would accept], arguing that this would promote moral hazard by protecting banks and their shareholders from the consequences of their risk-taking". Appropiately enough, the newspaper concludes that regulators "need to develop new measures and new tests" to capture liquidity risk.

[4] Accrued Interest's scenario. Interesting ideas from the fixed-income blogger: "I'd like to see the Fed follow the 1998 playbook. Cut 75-100bps to prevent the liquidity crisis from expanding. Let banks get back into a position to make new loans to good borrowers, be that individuals or corporations. Don't cut so much that the bad banks don't feel the pain, because we need the bad loans wrung out. Then when the market has made clear that it's strong enough to walk on its own, start hiking again".

LIQUIDITY TALK. THE MAESTRO & INFLATION EXPECTATIONS
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -29.1%]

Alan Greenspan & inflation expectations; Moody's & "liquidity risk"; Brad Setser on the first financial crisis of the 21st century; is the "super-cycle" alive?

[1] The Greenspan debate: inflation, relative prices, or the price level? In yesterday's Financial Times interview, Alan Greenspan linked "the rate of change of prices" to "the rate of change of globalization". Thus, as the process reaches its end, inflation expectations are bound to increase (in the long run, the Maestro sees a 4.5% inflation rate as a likely scenario). Harvard's Ken Rogoff and Princeton's Alan Blinder both disagree: globalisation does not lead to changing inflation expectations, but rather to a new set of relative prices (Rogoff) or to a lower price level (Blinder).

[2] The Greenspan debate (II). "Technically", says Blinder, "this [i.e. globalization] changes the world price level, not the inflation rate. But because this effect is spread out over many years, it looks like a lower inflation rate". While Rogoff thinks that "the parameters are changing", Blinder appears to embrace the very bullish super-cycle thesis: "We are only beginning to exploit the opportunities for global economic integration in services".

[3] Moody's & "liquidity risk". The Financial Times's star reporter and editor Gillian Tett was on to something when she wrote, on September 6, that credit rating agencies would soon focus on liquidity risk: "The agency [i.e. Moody's] is looking at measures of so-called 'liquidity' and 'market value' risk that could be issued alongside credit ratings, which indicate the risk that an instrument will default".

[4] Brad Setser on the first financial crisis of the 21st century. Long and very interesting post by Brad Setser on the crisis in credit markets. Referring to central banks' liquidity injections aimed at SIVs, Brad writes: "Call it a twentieth-century solution to a twenty-first century problem. The central banks lend to the banks and the banks decide who else gets credit".

[5] Bullish outlook from the Asian Development Bank. From Bloomberg: "Developing Asian economies will expand faster than estimated in 2007 and 2008, and are expected to be able to weather any U.S. slowdown and turmoil in global credit markets, the Asian Development Bank said Monday. Growth in Asia excluding Japan and Australia is predicted to be 8.3 percent this year.The region will expand 8.2 percent in 2008, faster than an earlier forecast of 7.7 percent, according to the ADB". I pay a lot of attention to bullish arguments about a more "balanced" global economy: if true, volatility readings should come down -- which would be good news in terms of the Endogenous Liquidity Index.

REINTERMEDIATION & THE CREDIT SLOWDOWN
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -29.1%]

I don't pretend to know a whole lot about the analytics of Special Investment Vehicles (SIVs), Asset Backed Commercial Paper (ABCP) and Basel II. My numbers, however, show that the likelihood of a significant, protracted and global credit contraction continues to increase. Thus I was intrigued by two pieces that dwell on the impact of "re-intermediation" on the availability and cost of credit. Reintermediation is an euphemism for the absorption of conduits and SIVs into commercial banks' balance sheets (*). Thus Morgan Stanley's Richard Berner writes:

Reintermediation promotes a pro-cyclical credit contraction in three ways. First, credit concerns triggered liquidity backstops for conduits and SIVs, forcing a shift from a funding source that requires no capital to one that does. Inherently, that reduces leverage in the financial system. Second, in classic, pro-cyclical fashion, banks are raising the cost of new liquidity and credit facilities. Finally, and more controversial in terms of the analysis, courtesy of the move to Basel II, this shift to put riskier assets on bank balance sheets will boost future capital requirements for some European banks.

David Malpass, the usually bullish Bear, Stearns economist, expresses a similar opinion:

Bank balance sheets are expanding in connection with LBOs, SIVs, asset-backed commercial paper, and the breakdown in the securitization process (through which underwriters could sell their exposure). As banks make room for the new exposure, we expect tightness in other areas of their balance sheets, one of the disruptions facing economic growth.

(*) The arguments presented are based on Charles Goodhart. "Capital, not liquidity, is the problem", Financial Times (September 14): "... in the longer term the underlying problem will become capital availability, not funding problems and certainly not cash liquidity. Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks’ risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis". See also William Chambers: "Basel II requirements will strenghten the financial system", Financial Times (September 18).

AN EXCENTRIC INDEX MAKES A COMEBACK
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -28.2%]

I still remember this piece from the May 1996 issue of The Economist: "The erection index (a humorous look at the relation between the size of the largest skyscrapers and world stock markets)". If I remember well, the author opined that bear markets always followed the erection of the largest skycrapers. The piece was written before the official inauguration of the Kuala Lumpur Towers on October 1, 1996. Six months later, a devastating bear market took hold in Asia, eventually creating the conditions for both the Russian default and the LTCM collapse in the second half of 1998.

Judging from this new piece, the erection index is bound to make a ... spectacular comeback! In Shanghai, a "topping-out ceremony" recently took place for the world's third-tallest building -- the 101-storey, 492-metre Shanghai World Financial Center. But there's more. Here's the Foreign Policy blog: "For sheer absurdity, though, nothing tops Burj Dubai, already the world's tallest building at an estimated 545.7 meters" (see the photo taken last Friday).

As Cassandra would say, all of this surely "just smacks of classical overconfidence" (*).

(*) According to Bloomberg TV this morning, the construction of the Shard Tower in London has been suspended.

LIQUIDITY TALK
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -28.8%]

[1] Bank Credit Analyst on the credit crunch. The top-notch Canadian consultant reviews the situation in credit-land and concludes: "So far there is no evidence to suggest that the credit and liquidity crunch is over". This is also what my numbers show. Chapeau to the stock market!

[2] Fortis Investments on the credit market /stock market decoupling. William De Vijlder mentions three reasons: (a) the rise in credit spreads may reflect a temporary illiquidity premium; (b) equities have remained the "liquid asset class" so there is no reason to incorporate an illiquidity premium; (c) the equity market did not become as overvalued as credit. Very interesting indeed!

[3] Merrill Lynch: credit markets 'remain challenging'. According to MarketWatch, Merrill Lynch & Co. (MER) in a filing Friday said credit-market conditions have continued to "remain challenging" in the third quarter and that it has made fair-value valuation adjustments to some of its exposures. The company didn't provide further details on the adjustments in the filing.

[4] Standard & Poor's on emerging markets. The Financial Times quotes an S&P report on liquidity and emerging markets: "If tighter liquidity conditions intensify, Latvia, Iceland, Bulgaria, Turkey and Romania would top the list of countries most at risk of repercussions due to their greater inflows to finance current account deficits". Would investors in these countries rush to buy euros, as Asians bought dollars ten years ago?

[5] Flight to quality in hedge fund land? The Financial Times reports that SAC Capital raised $1bn two weeks ago, thus "underscoring the demand for the most successful funds even during difficult times". But investors in hedge funds, adds the FT, said smaller funds might suffer as a result. Says Ken Kinsey-Quick, head of Thames River Capital: "A lot of investors are going to be saying get out of anything small".

[6] Gillian Tett: credit rating agencies & liquidity risk. The star FT editor writes: "I expect credit rating agencies to come under fire. These agencies have always insisted that their ratings only measure the likely default rates of instruments or institutions, not their liquidity risk or market values".

[7] Nick Ferguson: credit crunch not over. The Daily Institutional Investor quotes the chairman of private equity group SGV Capital: "These things usually last longer rather than shorter, and that those predicting a quick end to the credit crunch are wrong. Investor willingness to back leveraged buyouts will remain subdued and funding will be more expensive ... I think the appetite will come back, but it'll be less than it was, and spreads will be higher".

[8] Vladimir Putin on liquidity conditions in Russia. From DII: "Russian authorities don't exclude the possibility of providing liquidity to Russian banks if necessary," President Putin said during a visit to Australia. In an attempt to alleviate the tighter liquidity, the Central Bank of Russia (CBR) injected a large amount of cash into the market by buying securities under repurchase agreements last month. The CBR also started earlier in August the first major purchase of rubles since 2002 to stop the ruble's depreciation against the dollar and the Euro.

[9] Jim Paulsen & "super-liquidity". The Wells Capital Management chief strategist does not buy the "liquidity crisis" story. "Everyone keeps saying this is a liquidity crisis. But I don't buy that," says Paulsen. "There has been superliquidity, and I still see lots of evidence of that ... If monetary restraint or illiquidity is not causing this crisis, monetary ease alone will not solve it. The good news, however, is we need only alter an attitude or emotion (such as confidence), which could happen quickly".

WEEKLY FED BALANCE SHEET REVIEW. ANOTHER LACKLUSTER PERFORMANCE
. Federal Reserve: "Factors Affecting Reserve Balances", September 12

- Fed's Treasuries holdings: $778.7bn (-$3.0bn)
- Other central banks' Treasuries holdings: $1,207.1bn (-$0.1bn) (*)
- Other central banks' agency securities: $774.2 (+$1.2bn) (*)
- Global Dollar Liquidity Measure: $2,760.0bn (-$1.9bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
__________________

Another week, another lackluster performance from a global liquidity point of view. The $1.8bn increase in bank borrowing at the discount window is about the only interesting piece of news. Is liquidity fatigue setting in? Judging from the annual rate of growth of our Global Dollar Liquidity measure (+13.4%, a six-month low), this appears indeed to be the case.

LIQUIDITY TALK
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -30.0%]

- Big Ben & the savings glut. Ben Bernanke on the savings glut: "My reading of recent developments is that although some of the details have changed, the fundamental elements of the global saving glut remain in place. Most important, the emerging-market countries and oil producers remain large net suppliers of financial capital to global markets" [See Brad Setser's comprehensive review]. Dr. Bernanke is right, of course: custody and agency holdings are still growing at a healthy rate (+18.3%). But things appear to be changing at the margin — tonight we get the new weekly Fed balance sheet.

- Bank Credit Analyst on gold prices. "The precious metals complex (especially gold) is sniffing out more plentiful liquidity conditions". That's also the message sent by the energy complex, by the falling dollar and by the steeper Treasury curve.

- The Bank of England & liquidity conditions. Macro Man quotes the stoic BoE governor Mervyn King: "The provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future."

- On the futility of pumping liquidity. In a letter to the Financial Times, Robert Matthews, the chief economist of Wood Cottage Group argues that "the happy process of central banks implementing a sharply upwardly sloping yield curve" by "pumping liquidity into the system" may not work this time around. This is because "off-balance sheet mistakes" are likely to be marked to market immediately, i.e. not "over a period of four to five years".

- Liquidity as a figure of speech. From Alex J. Pollock, Resident Fellow, AEI, again to the Financial Times: "In short, liquidity is about group belief in the solvency of counterparties and the reliability of prices, reminding us that 'credit' and 'credo' have the same root. When no one is sure who is broke, and there is high uncertainty about prices, we will discover that liquidity has vanished, however plentiful it may recently have seemed".

NICE GAINS ... IN DOLLAR TERMS
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -31.3%]

The U.S. market opens with strong gains ... in a currency that is increasingly acting as a third-world currency. (See Macro Man's take). Meanwhile, here's some stuff I've been reading: [1] PIMCO's Paul McCulley on the "real" and "shadow" banking system ("... there is a mighty gulf between the Fed's liquidity cup and the shadow banking system's parched liquidity lips"); [2] Lombard Street Research's Diana Choyleva on the hype surrounding Sovereign Wealth Funds; [3] Philly Fed's Charles Plosser on the distinction between short-liquidity injections and changes in the Fed funds rate.

WHAT WOULD SCHUMPETER SAY?
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -31.4%]

Steen Jakobsen, the cautious Saxo Bank fund manager, recently mentioned Joseph Schumpeter, writing: "Destruction of capital is the name of the game". Instinctively, I went back to my bookshelf, and to one of my most prized possessions: a 1951 edition of the Encyclopaedia Britannica. Volume 4 contains a long article by Schumpeter on "Capitalism". I don't have it right now with me, so let me quote it from Thomas McCraw's recent biography (*):

"A society is called capitalist if it entrusts its economic process to the guidance of the private businessman. This may be said to imply, first, private ownership of nonpersonal means of production … second, production for private account, i.e., production by private initiative for private profit." He went on to say that a third element is "so essential to the functioning of the capitalist system" that it must be added to the other two. This third element is the creation of credit.

The core ethos of capitalism looks constantly ahead and relies on credit and launching new ventures. From the Latin root credo—"I believe" —credit represents a wager on a better future. The entrepreneurs and consumers who make these bets often care little about the past and have scant patience with the present. They undertake innovative projects and make expensive purchases (houses, for example) that require far greater resources than those lying at hand. In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations.

Are we about to witness a period of destruction of capital, on the heels of a phenomenal wave of financial innovation? If funding and market liquidity indicators continue to deteriorate, this is a distinct possibility.

(*) Prophet of Innovation: Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007 (read the prologue).

WEEKLY FED BALANCE SHEET REVIEW. MIXED NEWS AT BEST
. Federal Reserve: "Factors Affecting Reserve Balances", September 5

- Fed's Treasuries holdings: $781.7bn (+$3.4bn)
- Other central banks' Treasuries holdings: $1,207.2bn (+$1.8bn) (*)
- Other central banks' agency securities: $773.0 (-$1.0bn) (*)
- Global Dollar Liquidity Measure: $2,761.9bn (+$4.2bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
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The first weekly Fed balance sheet for the month of september is out — and it contains mixed news at best. The good news is that, for the first time in two weeks, our Global Dollar Liquidity measure registers an increase (+4.2bn). The bad news concerns the annual rate of growth: it tumbled from 14.6% in August to just 13.4%, pushing my trusted long-term "model" for risky assets further into bearish territory. In a sense, the problem with the Global Dollar Liquidity is not unlike the situation faced by corporate earnings: tough —very tough— comparisons. In order for the rate of growth to continue above 10% in the months ahead, central banks will have to buy ... lots of securities!

Bearish thoughts, however, need to be kept in check by the wisdom of the Market Price Approach (*). The dollar is weak, commodity prices are strong, the Treasury yield curve is steepening: none of this heralds a significant dollar liquidity contraction. Are foreign central banks simply beefing up their SWFs? Is global liquidity assuming a different shape? Questions, questions.

(*) Manuel Johnson & Robert Keleher. Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

OFFICIALLY BEARISH, BUT ...
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -29.3%]

The verdict is known: by the slightest of margins, the interest rate data published by the Federal Reserve has pushed my trusted, long-term model for risky assets into bearish territory (*). Consequently, I find myself in a "sell the rallies" mood. A couple of caveats: the margin is so slight, that the most probable scenario, IMHO, is a protracted range-trading environment rather than an outright bear market. (By the way, this is what I had forecast in early July, with good results in terms of the Dow and the Nasdaq, but definitly not in terms of the S&P500).

Second caveat: Credit Default Swaps have become the norm in terms of credit spreads analysis; in other words: models that rely on Moody's spreads may be a thing of the past. We'll see.

(*) The "model" adds the rate of change of the inverse of the Moody's Baa spread to the rate of change of the Global Dollar Liquidity Measure. Until this morning, the last sign was a "buy", flashed out in January 2003.

THE OLD LADY & THE MONEY MARKET CRUNCH
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -27.7%]

Liquidity watchers and analysts are abuzz with the situation in the money markets. Gillian Tett, the very able Financial Times reporter, describes the crisis as a "frantic scramble for liquidity". She mentions the L-word no less than six times in today's piece [HT: Robert]. Steen Jakobsen, the rather bearish Saxo Bank fund manager, writes: "Destruction of capital is the name of game ... In all my life as a trader I have never seen anything like this. The stock market is in a total denial, the fixed income in near panic".

The most interesting statement came from the Bank of England, which raised its aggregate reserves target for the next month in a move to lower the overnight London interbank lending rate. However, according to the Financial Times, the Old Lady stressed "the move was not intended to bring down the three-month Libor rate, which hit a nine-year high of 6.8 per cent ... The persistent widening in the spread between interbank rates and the central bank’s policy rates reflected the difficulty in valuing risk and not a lack of liquidity, the Bank said".

The Daily Telegraph quotes the BoE's statement:

Spreads have risen significantly in all major financial markets since August 9, reflecting the difficulty in valuing a variety of asset-backed instruments, which has reduced liquidity in those instruments and also in term money markets. The source of these problems does, therefore, not lie in a lack of central bank liquidity.

Wow! This is getting really interesting.

LIQUIDITY ANALYSIS. QATAR, THE EFFECTIVE FED FUNDS RATE & THE GLOBAL DOLLAR LIQUIDITY MEASURE
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -28.7%]

Consider, first, this Reuters piece: "The Qatar Investment Authority (QIA), the energy exporter's $50 billion sovereign wealth fund, said on Monday it was diversifying away from the weakening U.S. dollar by investing more in Asia". Consider, then, the effective Fed funds rate over the second week of August (consistently below the 5.25% target). Get the picture? On the one hand, foreign CBs are accumulating less Treasury securities; on the other hand, the Fed has to withdraw liquidity in order to re-establish its Fed funds target. No wonder our Global Dollar Liquidity measure tanked in August.

Bottom line: [1] funding liquidity is not vanishing: it just has a different shape; [2] the Fed will ease.

LIQUIDITY TALK. LOTS OF MATERIAL!
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -28.7%]

- Two academic papers on markets & liquidity. [1] Markus K. Brunnermeier & Lasse Heje Pedersen: "Market Liquidity and Funding Liquidity", June 2007; [2] Ricardo J. Caballero & Arvind Krishnamurthy: "Collective Risk Management in a Flight to Quality Episode", August 2007. See a short review by The Economist's Buttonwood column:

In the past, liquidity crises have been solved by the emergence of a confident buyer with deep pockets, such as John Pierpont Morgan in 1907. But who could it be this time? Pension funds and insurance companies no longer have the flexibility, while hedge funds are facing tighter funding and the prospect of redemptions. That leaves the sovereign wealth funds of China and the Middle East. But even if they want to buy in bulk, do Western governments want to let them?
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- Jean-Pierre Mustier interview. The chief executive of SocGen's corporate and investment banking division talks to the Financial Times:

Mr Mustier reckons that credit conditions will normalise at around the level they were late in 2004. This means that private equity groups will be able to borrow to finance leveraged buy-outs, but at one or two multiples of cashflow less than the average level earlier this year, he says. Similarly, he believes that credit spreads for senior debt instruments will ultimately end up at about 60 basis points higher than they were at the market’s peak.
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- Jim Bianco on the Fed. The always sharp Jim Bianco told Bloomberg TV that the liquidity crisis would likely force the Federal Reserve to review the way it conducts monetary policy. Mr. Bianco suggested that, in order to avoid further episodes of "boom-and-bust" behaviour, procedural changes were needed. Mr. Bianco didn't elaborate, but I think he was hinting at the possibility of adopting a formal procedure to keep the Fed funds rate closer to market rates. (Many on Wall Street think that the 1% Fed funds rate in 2003-2004 is at the root of the current turmoil).
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- Ben Bernanke and the liquidity of home equity. In his Jackson Hole speech, Fed chairman Ben Bernanke dwelled on "the history of housing finance" in order to clarify "the interaction of housing, housing finance, and economic activity". The goal, ultimately, is to "better understand the behavior of the economy". This brief passage caught mi attention:

The increased liquidity of home equity may lead consumer spending to respond more than in past years to changes in the values of their homes; some evidence does suggest that the correlation of consumption and house prices is higher in countries, like the United States, that have more sophisticated mortgage markets.

In other words: liquidity analysts will have to revise their models to incorporate the effects of "the increased liquidity of home equity".
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- Blog Watch. [1] T. McGee on the carry trade; [2] Bill Luby on "echo volatility"; [3] Rich Karlgaard: "Liquidity Crisis or Credit Crunch?"; [4] Morgan Stanley on "soft decoupling" in AXJ (Asia ex-Japan); [5] F-Trader and a new blog: Futures Day Trading.