Tuesday, September 25, 2007

[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].

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