Friday, December 28, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", December 26

- Fed's Treasuries holdings: $775.0bn (-$13.4bn)
- Other central banks' Treasuries holdings: $1,226.2bn (+$1.6bn) (*)
- Other central banks' agency securities: $830.2 (+$7.0bn) (*)
- Global Dollar Liquidity Measure: $2,831.4bn (-$4.5bn)

(*) Off-balance-sheet items

As the year draws to an end, one question remains unanswered: will the dichotomy between strong funding liquidity and weak market liquidity persist? Let me put it this way: what could cause my trusted long-term model for risky assets to flash a "buy" signal? (The model combines the rate of change of the inverse of the Moody's Baa spread and the rate of change of the Global Dollar Liquidity measure; it finds itself in mildly bearish territory since August). The math shows that spreads would need to fall about 70 bps; alternatively, funding liquidity would need to explode (+37%). None of this portrays a likely scenario, even with central banks easing aggressively. My own guess is that my model has become skewed to the bearish side, because it does not adequately reflect (among other components of market liquidity) the growing impact of the "Great Moderation" of the business cycle. Here, the VIX and other volatility indicators have a key role to play — and their recent performance is indeed encouraging. Bottom line, my friends: while I'm busy re-calibrating my models, I just don't see how risky asset markets could break out of their 2007 trading range any time soon.

Thursday, December 27, 2007

[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -28.5%]

Years spent at emerging markets trading desks have taught me a lesson that I am not about to forget: the availability of credit depends crucially on the stability of property rights — which in turn depends on the existence of political ... checks and balances. In Iceland, the credit market is three times the size of the GDP; in Argentina, it barely reaches 12% of GDP. Iceland regularly features among the top-ten countries in terms of judicial independence, freedom of the press, connectivity and central bank autonomy (see data). Meanwhile, the quality of Argentina's governance ranks below that of stalwarts Pakistan, Nigeria and Madagascar. In order for credit to flourish, power needs to be fragmented. In that spirit, I have selected the 2007 events/firms/products that have made a positive contribution in terms of credit creation and checks & balances.

[1] Goldman Sachs. Financial Times reporters writing on the saga of Goldman Sachs have uncovered one of the key secrets of the firm: its governance structure, especially in terms of risk management. "The culture of partnership", writes John Plender, "which entails a high degree of mutual surveillance in the common interest, still survives in spite of Goldman's status as a listed company". The key phrase here is: mutual surveillance. That's the very definition of ... checks and balances! In another FT piece on Goldman, we learn that the back-office is considered a prestigious place to work. Insiders call it the Federation — yet another allusion to the notion of checks and balances. And if this wasn't enough, consider the recent Michael Skapinker piece on Chuck Prince and Stan O'Neal. These guys behaved in almost authoritarian ways, something that (presumably) will not happen at Goldman Sachs. [John Plender: "Market insight: Goldman offers example of governance", Financial Times] [Ben White: "Man in the News: David Viniar", Financial Times] [Michael Skapinker: "Silencing the dissenters can end your career", Financial Times]

[2] The euro. In a remarkable speech at the 2004 Bundesbank Lecture, former Fed chairman Alan Greenspan said: "... if other currencies, such as the euro, emerge to share the dollar's role as a global reserve currency, that process, too, is likely to be benign". The Maestro was alluding to the diffusion of "current imbalances", a.k.a the U.S. current account deficit. In other words: the euro acts as a check on the propensity of the United States to over-use the dollar as the key international reserve asset. Far from being a bearish factor in terms of global credit creation, the surging euro is a ... balancing factor! [Alan Greenspan: "Globalization", Bundesbank Lecture, 2004]

[3] Sovereign Wealth Funds. SWFs are increasingly acting as a key element in terms of the global credit markets. Let me quote, on this subject, Richard Gnodde, co-CEO of Goldman Sachs International: "We have one global economy, but it is increasingly powered by multiple engines, with multiple sources of demand and liquidity ... This emergence of new flows and new actors from new models of capitalism reflects a natural diversity of social and economic practices that is in no way incompatible with the process of globalisation". More diversity, less risk. [Richard Gnodde: "A role for new actors in the global economy", Financial Times]

[4] Islamic finance. "Islamic finance takes off", writes Thomas Barnett, in my view the top globalization expert. He adds: "An estimated 300 Islamic banks hold half a trillion in assets. About 7-8 years ago, when Malaysia started pushing this crazy notion, there was no Islamic finance to speak of. Now it grows at more than 10% a year, and you’ve got Citigroup, HBC, Deutsche Bank and Asian giants all chasing this pie". Again: more diversity, less risk. [Thomas P.M. Barnett: " Islamic finance takes off"]

Friday, December 21, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", December 19

- Fed's Treasuries holdings: $788.4bn (+$6.0bn)
- Other central banks' Treasuries holdings: $1,224.6bn (-$4.0bn) (*)
- Other central banks' agency securities: $823.3 (+$11.6bn) (*)
- Global Dollar Liquidity Measure: $2,836.3bn (+$13.6bn)

(*) Off-balance-sheet items

[1] Decent numbers! After several weeks in the doldrums, the weekly Fed balance sheet finally manages to produce a set of decent numbers. The Global Dollar Liquidity measure surges on the back of renewed central bank activity — both domestically and internationally. Note also the pick up in lending through the discount window, now at levels not seen since the September 2001 terrorist attacks. The annual rate of growth of the Global Dollar Liquidity measure recovers somewhat, to 12.7% from 12.4%. But look at the growth rate of securirties held by the Federal Reserve itself: only 1.5%. Dare I say it? Dollars are ... scarce! There you have it.

[2] The VIX & the mini-rally. Is the current mini-rally in stocks sustainable? Remember the last attempt to get past 1525 on the S&P500. The VIX did not collaborate: its refusal to trade through 20 sounded the death knell of the rally. Given the dreadful signals sent by credit spreads (Moody's Baa spreads are still toying with four-year highs), the VIX offers the only glimmer of hope in terms of "endogenous liquidity". Watch it carefully!

Thursday, December 20, 2007

[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -32.3%]

Über-bear David Roche has just coined the term "New Monetarism". His aim is to "properly define" the notion of liquidity in order to highlight "the potentially disastrous outlook for the global economy and financial markets". "What is liquidity?", he asks rhetorically. Sadly, his answer does nothing to alleviate the confusion: "To redefine liquidity under what I call New Monetarism, one must add, to the traditional definition of broad money, all the credit being created and moved off banks' balance sheets and onto the balance sheets of nonbank financial intermediaries. This new form of liquidity changed the very nature of the credit beast". As the Lex Column would say, Mr. Roche's views provide yet another example of a "catch-all phrase to denote, variously, loose central bank policy rates, broad money supply growth, aggressive lending to private equity, yen borrowing and even the growth of debt derivative products". In Mr. Roche' usage, "liquidity is too, well, wishy-washy, to be useful". [David Roche: "The Global Money Machine", Yale Global Online]

Wednesday, December 19, 2007

[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -33.1%]

The New York Fed-Princeton Liquidity Conference; M2 & liquidity conditions; William Dudley on the TIPS market; record platinum prices.

[1] Liquidity, an increasingly popular topic! Liquidity issues are making headlines. Today's FT carrries a front-page headline about the ECB's liquidity injections. Last week, the Federal Reserve Bank of New York organized a "Liquidity Conference" together with Princeton University. At the Global Liquidity Blog we welcome this sudden popularity! In his introductory remarks, New York Fed president and CEO Timothy Geithner uttered the L-Word no less than ... 19 times! Describing the current situation in money markets, Mr. Geithner points to factors that tend both to reduce the supply and to increase the demand for funds: "Financial institutions faced a sharp drop in demand for a range of assets, impairing the securitization market as a source of funding. And a substantial amount of these illiquid assets were held in vehicles with implicit or explicit liquidity guarantees provided by banks. This produced a large unexpected increase in demand for funding from banks at the same time banks confronted a reduced capacity to raise financing. As market participants have adjusted to what has been a very acute change in expectations about economic and credit risk, they have become more cautious in how they use their liquidity and capital". [Timothy Geithner: "Restoring Market Liquidity in a Financial Crisis", New York Fed] [The Second New York Fed — Princeton Liquidity Conference]

[2] James Picerno: M2 & liquidity. James Picerno, the editor of the Capital Spectator blog, is at it again. Analyzing trends in M2, he warns readers about the risks of "excess liquidity" created by the Fed. As I have written many times here, M2 is not a liquidity measure. The Fed has little control over M2. Moreover, in times of financial stress, strong M2 growth is a sure sign that liquidity is actually ... decreasing! Flight-to-quality buying of money market funds may artificially inflate M2, just as the monetary base —a true liquidity indicator— may show signs of faltering. This is what happened in 1998. The turmoil led to a memorable debate within the FOMC. While monetarist members led by Jerry Jordan and William Poole argued for increases in the Fed funds rate, "internationalists" such as chairman Alan Greenspan made the case for a rate cut. In the event, Greenspan prevailed and the central bank lowered the Fed funds target — a move that was instrumental in avoiding a major banking crisis. The "monetary multiplier" is a notion that needs to be applied with a considerable degree of caution, especially if the currency in question is also an international reserve asset. Indeed, to the extent that a lower Fed funds rate eases the flight-to-quality stress (and the consequent rush to buy money-market funds), it may well lead to ... less M2 growth! [James Picerno: "Stable prices won't come cheap", Capital Spectator]

[3] William Dudley on the TIPS market. William Dudley, the former Goldman Sachs economist now at the New York Fed, analyzes the Treasury Inflation-Protected Securities market. Key point: "... the 5-year, 5-year forward breakeven inflation measure is a very important part of the monetary policymaking process. Without a TIPS market, this tool would be unavailable and I think it would be safe to say that monetary policy would suffer as a consequence. How much is this tool worth? Of course, it is very difficult to say. Perhaps, we would flatter ourselves and think that we could do just as well without such a market-based, real-time measure of inflation expectations. But I doubt it. After all, inflation expectations, when untethered, are very difficult to re-anchor. TIPS help make it easier to keep inflation expectations firmly in check". [William Dudley: "Reflections on the Treasury Inflation-Protected Securities Market", New York Fed]

[4] Platinum prices at a record high. Platinum hit a record $1,519/oz yesterday. As readers of this blog know, we closely follow the platinum-gold ratio as a key indicator of global economic growth. [Chris Flood: "Platinum jumps to record of $1,519", Financial Times]

Tuesday, December 18, 2007

[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -33.3%]

Stocks not expensive; liquidity @ Financial Times

[1] On market corrections. Not all market corrections are created equal: this truism has been particularly useful in 2007. As one would expect in a trading range environment, rallies in risky assets prices have been followed by sharp corrections. The key question to ask, in my mind, is the following: what happens both in terms of economic growth and inflation expectations as the market corrects? When the S&P500 sold-off in the second week of November, our market-based "Stagflation-Goldilocks" indicator duly followed suit. There was little value in stocks even as they fell in price. By this same measure, the current correction is an altogether different animal. Ten-year inflation breakevens are relatively well behaved, and the platinum-gold ratio has just reached a two-month high, signalling strong global growth. The S&P500 doesn't look particularly expensive here.

[2] Liquidity @ Financial Times: ECB emergency measures. According to the FT, the ECB announced last night that it would offer "unlimited funds at below market interest rates in a special operation to head off a year-end liquidity crisis" (I can't find the link to the ECB website). Appartently, funds injected today will be "mopped up" later on by the central bank. [Ralph Atkins & al: "ECB steps up fight to safeguard liquidity", Financial Times]

[3] Liquidity @ Financial Times: credit creation & vehicular finance. Amid the sometimes sensless gyrations in financial markets, it pays to read articles that put it all in context. As a fan of Joseph Schumpeter (who thought that innovation went hand in hand with 'credit creation'), I was struck by this timely piece on vehicular finance: "... in the past decade, this financial model has changed radically. On the one hand, banks have increasingly started to sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans into bonds; at the same time, regulatory reforms have permitted the banks to reduce the amount of capital that they need to hold against the danger that borrowers default. The net consequence is that the western financial system embraced what Paul Tucker (BoE), has described as the age of 'vehicular finance'. This system has given banks huge incentives to pass on their loans to new vehicles, either by creating these themselves or by sponsoring outside fund managers to run them. The role of such entities in creating credit has increased vastly in the past three years. For example, the asset-backed commercial paper market, which supplies the lion’s share of funding to SIVs and conduits in the form of cheap, short-term cash, saw a step-change in growth at the end of 2004. The volumes of such paper in issue had fluctuated between $600bn and $700bn for at least four years; at the market’s peak this summer they stood at almost $1,200bn". [Gillian Tett & Paul J. Davies: "Out of the shadows. How banking's hidden system broke down", Financial Times]

Monday, December 17, 2007

[Latest Global Dollar Liquidity measure: +12.4% annual growth rate; latest Endogenous Liquidity Index: -31.9%]

Kudos to Brad Setser! Economist Richard Iley, who holds sharply different views on the US current account, is 'guest-blogging' at RGE Monitor (*). I have always felt that large current account deficits could be treated with benign neglect provided that: (a) property rights remain stable; (b) productivity gains persist. In the event, this is largely the case in the U.S. According to Mr. Iley: "The obsession with ‘official’ inflows into the US seemingly arises from two controversial conclusions. First, that central bank purchases are somehow special, if not outright ‘abnormal’".

"Flowing on this is the usually tacit but sometimes explicit assumption that central bank purchases may prove more ephemeral or footloose than more inherently normal private capital flows. Both assumptions are highly dubious ... The lesson of recent years has been that foreign demand for US assets – both private and ‘official’ – appears more structural and hence more sustainable than anyone thought ... the marginal productivity of holding dollars appears to be higher than most economists believed".

Read the whole thing!

(*) Richard A. Iley & Mervyn K. Lewis. Untangling the US Deficit. Evaluating Causes, Cures and Global Imbalances. (Cheltenham: Edward Elgar, 2007).

Friday, December 14, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", December 12

- Fed's Treasuries holdings: $782.4bn (-$8.1bn)
- Other central banks' Treasuries holdings: $1,228.6bn (+$2.9bn) (*)
- Other central banks' agency securities: $811.7 (+$0.7bn) (*)
- Global Dollar Liquidity Measure: $2,822.7bn (-$4.6bn)

(*) Off-balance-sheet items

For the first time since mid-September, banks are borrowing at the discount window. The weekly Fed balance sheet registers a $2.7bn increase in "primary credit", a sure sign that the discount window has indeed re-opened. But is it not a case of "too little, too late?" Overall, the stock of Treasury holdings at the central bank shows a sharp $8.1bn decline, a reflection (IMHO) of the bizarre shape of the yield curve, with the Fed funds rate target still above the ten-year note yield. The annual rate of growth of the Global Dollar Liquidity measure takes another hit: at 12.4%, the situation still qualifies as a "funding liquidity boom". But if current trends persist, it will not be long before we see sub-10% growth rates. This may be the message sent by a slightly stronger dollar, although some commodities markets —especially in the grains complex— are still "dancin' in liquidity".

Thursday, December 13, 2007

[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -31.9%]

Bank Credit Analyst & the yield curve; liquidity @ Financial Times

[1] It's the yield curve, stupid! Bank Credit Analyst, the top-notch Canadian consultant, makes a good point about Fed policy: what matters is the yield curve. BCA's starting point is the swap curve, as defined by "the spread between the 5-year swap rate (a proxy for the rate that banks lend at) and the 6-month libor rate (a proxy for bank funding costs)", which "is at its most inverted level in the history of the series". They conclude: "The Fed likely needs to dramatically steepen the swap curve as occurred in the early 1990s and early 2000s, in order to facilitate a healing process". The spread between the ten-year note and the Fed funds (the measure I follow) is inverted since ... june 2006! Clearly, more work needs to be done. [Bank Credit Analyst:"What Can The Fed Do?"]

[2] Liquidity @ Financial Times: good coverage! The FT provides good coverage of the coordinated central bank action to ease the liquidity situation. Prof. Willem Buiter (whose lectures I attended a long time ago) is quoted about moral hazard: "Prof. Buiter said the concern about moral hazard was overplayed: Moral hazard, schmoral hazard". [Chris Giles: "Co-ordinated action attracts praise", Financial Times]

Wednesday, December 12, 2007

[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -32.8%]

- The globalization of liquidity provision. The Federal Reserve, together with the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank is announcing measures "designed to address elevated pressures in short-term funding markets". Welcome to the globalization of liquidity provision! From the press release: "By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress". Well done! [Federal Reserve Board press release][ECB press release]

- Liquidity @ Financial Times: Martin Wolf. The FT's international economist makes some good points about the credibility of what he dubbs the Anglo-Saxon model of transactions-orientated financial capitalism: "Not for a long time will people listen to US officials lecture on the virtues of free financial markets with a straight face". This is what he has to say on liquidity: "What, more precisely, should a central bank do when liquidity dries up in important markets? Equally, the crisis suggests that liquidity has been significantly underpriced". These are all interesting points. Not so long ago, however, Mr. Wolf used to refer to the global economic landscape as a "new Golden Era". Perhaps we should discount both his earlier bullishness and his current bearishness. The credit squeez is not a "turning point for the world". [Martin Wolf: "Why the credit squeeze is a turning point for the world", Financial Times]

- The trading range asserts its rights. The S&P500 almost made it to 1525! In retrospect, I should have noted the VIX's refusal to trade below 20 as a warning sign (memo to self: keep better track of such divergences — they can be very useful!). Anyway, it was a wild ride: a gain of almost 8% in little more than two weeks. Bravo! The FOMC communiqué turned out to be the perfect excuse to take profits, especially when you realize that the Moody's Baa spread continues to forge ahead. At 259 bps, it now trades at levels not seen since March 2003 — and that does not bode well in terms of corporate profits. The trading range scenario is asserting its rights again. Having said that, what strikes me is the fact that the S&P500 —when valued against the "Goldilocks-Stagflation" index— does not look particularly expensive. We continue to see relatively strong global economic growth, and well-behaved inflation breakevens.

Tuesday, December 11, 2007

[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -28.7%]

- Liquidity @ Financial Times: liquidity & transparency. Larry Tabb makes a good point about the lack of transparency in the OTC debt market: "So what would happen if by fiat – or, more likely, by some government act – the asset-backed (or other OTC) market were to become listed overnight? Liquidity would dry up and pricing would be more volatile. The reason OTC markets tend to be OTC is that there is not enough liquidity provided by 'the general market' to enable buyers and sellers to execute without the aid of large-broker capital". [Larry Tabb: "Market insight: Transparency would muddy OTC waters", Financial Times]

- Endogenous Liquidity watch. Our Endogenous Liquidity Index is up 12.9% since its November 26 low. This stellar performance was led by the falling VIX; I view it as a sign that the "Great Moderation" of the business cycle is alive and well. Spreads on Credit Default Swaps and on high yield bonds are also sharply lower. But note the discrepancy with Moody's Aaa and Baa spreads, which continue to surge. What is going on? Long-time spreads watcher Ken Fisher is not worried: according to Forbes' Rich Karlgaard, Mr. Fisher emphasized the (bullish) fact that "Triple-A-rated companies can borrow at lower rates than they could six months ago". (This is true). Note, also, the very bullish fall in 10-year inflation breakevens (225 bps), which are fast approaching late August lows. Here, the FOMC will likely have an impact. [Rich Karlgaard: "Three Bulls Walk Into A Forbes Cruise", Forbes Digital Rules]

- Liquidity @ Financial Times: Bullish Pictet Asset Management. John-Paul Smith, chief strategist at Pictet Asset Management, describes himself as a value-based investor with a strong contrarian streak. I like that — and I like his views on the dollar and on commodities. Mr. Smith thinks the dollar will recover "once investors realise that the long-term prognosis for the US economy is actually very good, as evidenced by its high productivity and positive demographic trends". On the subject of commodities, he thinks that the "intellectual foundations of the commodity boom are pretty shaky", and that "there is a tendency over the very long-term of real commodity prices to decline". Given the not-so-hot rate of growth of the Global Dollar Liquidity measure, and the related collapse in US monetary base growth, I tend to agree with Mr. Smith. [John-Paul Smith: "Investors should shut their ears to the bears", Financial Times]

Monday, December 10, 2007

[Latest Global Dollar Liquidity measure: +12.7% annual growth rate; latest Endogenous Liquidity Index: -30.0%]

Brad Setser on global reserves; Cumberland Advisors on the FOMC meeting.

[1] Brad Setser on global reserves (i): no free lunch! Don't miss this post by Brad Setser, who discusses discusses JP Morgan's Bernhard Eschweiler's views on central bank diversification (he wrote in the FT: ): "The idea that central banks are undermining the dollar makes neither sense nor is there evidence in the data. The principle mistake that many commentators make is the assumption that central banks can separate the currency allocation of reserves from their exchange rate objectives. In practice, this is often not the case, especially for the large surplus economies in Asia as well as the oil-exporting countries. These countries all follow some sort of dollar standard, whether it is an outright peg or a dirty float. So, when they intervene to prevent their currencies from appreciating against the dollar, they get mostly – or even exclusively – dollars (also because most of their trade and capital flows are dollar denominated). However, it is difficult to sell those dollars back to the market without causing renewed dollar weakness and, thus, trigger new interventions. Some small central banks may get away with it, but not the group of large reserve holders. There is no free lunch: if you shadow the dollar you also have to hold it". [Brad Setser: "Are central banks diversifying away from the dollar?", RGE Monitor]

[2] Brad Setser on global reserves (ii): diversification vs. sales. In the more informal comments section, Mr. Setser outlines his own views: "I define diversification as reducing the $ share of your reserves (Russia, early 2006 = clear example). Market folks tend to define it as sale of dollars, whether to meet an existing portfolio benchmark or to meet a new (higher) portfolio benchmark for euros/ pounds. And this year -- given the increased scale of reserve growth -- there clearly has been more $ sales even if there hasn't been much diversification. Russia is an interesting example: by virtue of having diversified in 2006 (in the sense of reducing the $ share of their reserve portfolio), they were in a position where they had to sell a lot of $ to buy euros and pounds to meet their benchmarks when capital inflows into russia picked up and russian reserve growth accelerated. no further diversification, but a lot larger $ sales". Excellent! In other words: central banks can act as large dollar sellers, even without diversifiying in terms of their portfolio benchmarks.

[3] Brad Setser on global reserves (iii): the hidden data. If central banks continue to accumulate dollar reserces, as Brad suggests, why has this failed to show up in US data? "Mr. Eschweiler argues that China hasn't been able to reduce the dollar share of its reserves, and may even be increasing the dollar share. The US data, of course, doesn't show such an increase, but as Eschweiler notes, the US data doesn't capture Chinese purchases from banks in Europe and Asia". Color me a skeptic on that one. The New York Fed custody data has seen aenemic growth over the last couple of months. Meanwhile, market liquidity is faltering. Maybe —just maybe— less bullish investors in emerging markets are slowly increasing their own holdings of dollars as a precautionary move. Keep an eye on the dollar exchange rate vis-à-vis the emerging market currencies. This could become a key tell here.

[4] Cumberland Advisors on the FOMC meeting. David Kotoc expects a 25 basis points cut, but thinks 50 would be more appropiate: "The place to look for significant policy changes is in the Discount Window rules and rate decision on December 11. We think the Fed will lower the Discount Window Rate by 25 basis points more than the Federal Funds Rate. The rules for using the “window” may be liberalized again as has been repeatedly done during this turmoil period. In addition the Fed will approve lengthening the term of repurchase agreements. That is another form of easing ... Why do we believe the Fed should drop the Fed Funds rate by 50 and the Discount rate by more than 50? Simply put: that is what it will take to get the London Inter-bank interest rate (LIBOR) to clear transactions between banks at an interest rate which reflects some return to normal credit spreads. Current US dollar LIBOR rates are higher than the Discount Window rate. They have induced some banks to obtain funds from the Discount Window as we saw in last Thursday’s reserve report. The Fed saw it, too. They published it. They know that LIBOR is not clearing well. They also know that half of the total world’s finance is tied to LIBOR ($150 trillion including derivatives according to Jim Bianco’s estimate). The Fed knows it must change this and the risk of recession and contagion grow every single day that they fail to do so". [David Kotoc: "The Fed & December 11th Meeting Outcome", Cumberland Advisors]

Friday, December 7, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", December 5

- Fed's Treasuries holdings: $790.5bn (-$3.3bn)
- Other central banks' Treasuries holdings: $1,225.7bn (+$0.4bn) (*)
- Other central banks' agency securities: $811.0 (+$4.8bn) (*)
- Global Dollar Liquidity Measure: $2,827.3bn (+$2.0bn)

(*) Off-balance-sheet items

[1] Weekly Fed balance sheet watch: an early December surprise. I haven't missed a single weekly Fed balance sheet for the last ... eleven years! In other words: I only need a brief glance at the numbers to get a sense of what's coming. Then, I duly put the data into an Excel sheet for an extensive massage session. As soon I saw the latest numbers, I knew that the annual rate of change of the Global Dollar Liquidity measure would take a hit — a big one. At 12.7%, it is the lowest since March. Moreover, the stock of Treasury securities held by the Federal Reserve —a proxy for the monetary base— has all but collapsed. Its annual rate of growth (+1.9%) is the lowest since ... January 2001! The good news is that another rate cut is now firmly in the cards. And there may be some trades here: long dollar against the majors, and short commodities ...

[2] Credit Default Swaps & liquidity conditions [Liquidity @ Financial Times]. The collapse in market liquidity has taken its toll on Credit Default Swaps, widely seen as "one of the most liquid corners of the derivatives markets". While the market for single-name CDS is "almost totally illiquid in Europe", even benchmark CDS indices are seeing lower volumes. As I read this FT piece, I note that, over the last two sessions, CDS spreads have narrowed considerably more than spreads on cash bonds. Along with the anemic VIX, this has helped the Endogenous Liquidity Index, which is now down "only" 29.7%. [Sarah O'Connor: "Credit default swaps in treacherous waters", Financial Times]

Thursday, December 6, 2007

[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -31.6%]

The trading range scenario; Bill Gross on quality spreads; liquidity @ Financial Times; the Bank of England eases!

[1] No way out of the trading range. Almost everywhere, central banks are adding liquidity — and not only for lame year-end reasons. Slowly but surely, inflation expectations are receding: the dollar is a tad stronger; oil and gold prices have eased somewhat; ten-year inflation breakevens are back at the very reasonable level of 230 bps. The VIX is running out of gas. According to Jim Cramer, the price discovery mechanism is working again inside the financial world. That's the good news. Now for the bad news — rising quality spreads. At 254 bps, the Moody's Baa spread trades at four-year highs: this is a warning sign in terms of the outlook for corporate earnings. I still think that, on valuation grounds, a 1525 target is on the cards for the S&P500. But if spreads do not improve, look for the trading range scenario to assert its rights again.

[2] Bill Gross on spreads & the Fed. It took longer than usual, but Bill Gross' December investment outlook is out. Mr. Gross dwells on the overlooked situation in terms of quality spreads: "Fed ease has lowered Treasury yields, but for the rest of the market—the segment that influences the bottom line of U.S. corporations, homeowners, and consumers—not much has changed. Those that claim that the current cycle of Fed ease will inevitably—and shortly—lead to vigorous economic growth do not really have their ears to the ground or their eyes on their Bloomberg screens. The Fed needs to bring Fed Funds levels down steadily and significantly more in order to counteract the contraction of the shadow banking system which has imposed, and will continue to require, higher risk premiums for non-Treasury securities in an increasingly risky financial environment". The PIMCO manager is looking for a 3.00%/3.50% target for the Fed funds rate. [Bill Gross: "The Shadow Knows", PIMCO Investment Outlook]

[3] More stagflation talk [Liquidity @ Financial Times]. This time from Barclays Capital's Tim Bond: "The outlook for financial markets in 2008 is not encouraging ... The US economy is heading the way, having already entered a stagflationary phase". Really? Our own market-based "Goldilocks-Stagflation" indicator is trading at levels not seen since October. While the platinum-gold ratio continues to recover, ten-year inflation breakevens have not been this low in a month-and-a-half. The stagflation hypothesis merits serious consideration: that's the reason why I follow a such an array of exotic indicators. But its proponents need to do a better job at explaining why long-term Treasury paper yields less than 4%, even as inflation is (supposedly) about to take off. [Tim Bond: "Financial assets owners need to get their heads out of the sand", Financial Times]

[4] The Bank of England eases! From the communiqué: "The Bank of England’s Monetary Policy Committee today voted to reduce the official Bank Rate paid on commercial bank reserves by 0.25 percentage points to 5.5% ... conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead". [Bank of England: "Bank of England Reduces Bank Rate by 0.25 Percentage Points to 5.5%"]

Wednesday, December 5, 2007

[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -33.0%]

Just do it!; Sotheby's as a liquidity tell; the complete index of Checks & Balances.

[1] Central banks to the rescue. Can they afford it? Yes — that was the clear message sent yesterday by Bank of Canada: "Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further". Note that US problems are mentioned! The financial system is truly a global marketplace, and the BoC has the courage to acknowledge it. Can the BoE and the ECB take a similar step? Their inverting yield curves (ten-year sovereigns relative to central bank policy rates) and the strength of their currencies (especially the euro) are the key "tells" here. And the message is pretty clear: Just do it! [Bank of Canada: "Bank of Canada lowers overnight rate target by 1/4 percentage point to 4 1/4 per cent"]

[2] Sotheby's stock price as a liquidity indicator. At the Global Liquidity Blog we view the Goldman Sachs stock price as a proxy for financial innovation. Thomas Tan thinks that BID can be seen as an indicator of global liquidity: "It could be used as a gauge to measure hot money and liquidity flowing around the world. The argument: when super rich people have too much money to burn, they will bid up the prices of expensive art sales by setting one record after another". [Thomas Tan: "Sotheby's (Falling) Stock as a Market Indicator", Seeking Alpha]

[3] The complete Index of Checks & Balances. The are four results for each country: Fraser Institute's grades on judicial independence, Freedon House's grades on freedom of the press, the WEF's grades on network readiness, and the Index of Checks & Balances. The US continues to lose ground in terms of judicial independence (courtesy of the "War on Terror"); all of the Nordic countries make it to the top-ten; China's poor results sharply improve when Hong Kong is included:

- New Zealand [8.9, 8.7, 6.9, 8.5]; Netherlands [9.0, 8.9, 6.3, 8.4]; Norway [8.9, 9.0, 6.4, 8.4]; Denmark [8.8, 9.0, 6.6, 8.4]; Germany [9.2, 8.4, 5.6, 8.3]; Iceland [8.4, 91, 7.0, 8.3]; Australia [8.8, 8.1, 6.7, 8.2]; Finland [8.6, 9.1, 6.1, 8.2]; Switzerland [8.6, 8.9, 6.2, 8.2]; Sweden [8.1, 9.0, 7.0, 8.1].

- United Kingdom [8.7, 8.1, 6.1, 8.1]; Ireland [8.6, 8.5, 5.1, 7.9]; Israel [8.9, 7.2, 4.8, 7.7]; Hong Kong [8.2, 7.1, 6.6, 7.7]; Canada [7.9, 8.2, 6.4, 7.7]; Austria [8.1, 7.9, 5.5, 7.5]; Portugal [7.8, 8.6, 5.4, 7.5]; Luxemburg [7.4, 8.9, 5.6, 7.3]; Japan [7.6, 8.0, 5.8, 7.3]; Malta [7.2, 8.2, 6.8, 7.3].

- Belgium [7.0, 8.9, 4.9, 7.0]; Estonia [7.1, 8.4, 5.0, 6.9]; United States [6.6, 8.4, 6.5, 6.9]; France [6.8, 7.9, 4.3, 6.5]; Cyprus [7.0, 7.8, 3.8, 6.5]; India [8.2, 6.3, 1.5, 6.5]; South Africa [7.6, 7.3, 1.9, 6.4]; Costa Rica [6.9, 8.2, 3.0, 6.4]; Singapore [7.0, 3.4, 6.5, 6.2]; Slovenia [5.9, 8.0, 4.7, 6.1].

- Uruguay [6.6, 7.2, 2.6, 5.9]; Namibia [7.1, 7.0, 1.2, 5.9]; Botswana [7.2, 6.5, 1.3, 5.9]; Malaysia [7.2, 3.5, 4.1, 5.8]; Taiwan [5.1, 8.0, 5.8, 5.8]; South Korea [5.2, 7.0, 6.1, 5.7]; Jamaica [5.4, 8.3, 4.0, 5.7]; Maurice [6.1, 7.4, 2.8, 5.7]; Ghana [6.7, 7.2, 1.0, 5.7]; Kuwait [7.0, 4.4, 2.8, 5.6].

- Greece [5.6, 7.2, 3.6, 5.5]; Hungary [5.4, 7.9, 3.4, 5.5]; Czech Republic [4.7, 8.0, 4.8, 5.4]; UAE [6.3, 3.5, 3.9, 5.3]; Chile [4.8, 7.4, 4.3, 5.2]; Latvia [4.6, 8.1, 3.7, 5.1]; Spain [4.5, 7.9, 3.9, 5.1]; Jordan [6.5, 3.9, 1.9, 5.1]; Trinidad & Tobago [5.3, 7.4, 1.9, 5.0]; Slovakia [4.3, 8.0, 4.2, 5.0].

- Egypt [6.4, 3.9, 1.5, 4.9]; Thailand [5.7, 5.0, 2.2, 4.9]; Italy [4.3, 6.5, 4.7, 4.8]; Tunisia [6.8, 1.7, 1.9, 4.8]; Poloand [4.2, 7.9, 3.1, 4.7]; Lithuania [4.0, 8.2, 3.2, 4.7]; Turkey [5.3, 5.2, 2.1, 4.6]; Malawi [5.9, 4.5, 0.9, 4.6]; Mali [4.4; 7.6; 0.9; 4.3]; Mexico [4.4, 5.2, 2.5, 4.2].

- Tanzania [4.9, 5.0, 1.0, 4.1]; Dominican Republic [4.2, 6.3, 1.7, 4.1]; Croatia [3.7, 6.1, 3.2, 4.1]; Uganda [4.6, 4.8, 1.0, 3.9]; Philippines [3.9, 6.0, 1.7, 3.9]; Colombia [4.4, 3.9, 2.2, 3.9]; Algeria [4.6, 3.9, 1.5, 3.8]; Morroco [4.1, 3.9, 2.1, 3.7]; Sri Lanka [4.2, 4.2, 1.1, 3.6]; Bahrain [4.1, 2.8, 2.7, 3.6].

- Brazil [3.0, 6.1, 2.6, 3.5]; Romania [3.1, 5.6, 2.7, 3.5]; Senegal [3.5, 5.6, 1.2, 3.5]; Bulgaria [2.5, 6.7, 3.1, 3.5]; Guatemala [3.8, 4.2, 1.5, 3.4]; El Salvador [3.1, 5.7, 1.7, 3.3]; Pakistan [3.8, 3.9, 1.3, 3.3]; Nigeria [3.6, 4.6, 1.2, 3.3]; Madagascar [3.3, 5.1, 0.9, 3.2]; Vietnam [4.1, 2.1, 1.5, 3.2].

- Bolivia [2.5, 6.7, 1.2, 3.1]; China [3.9, 1.7, 2.0, 3.1]; Kenya [3.3, 4.2, 1.2, 3.0]; Argentina [2.0, 5.5, 3.5, 3.0]; Indonesia [3.0, 4.2, 1.6, 3.0]; Macedonia [2.4, 5.1, 2.4, 2.9]; Panama [2.4, 5.7, 1.8, 2.9]; Ukraine [2.6, 4.7, 1.8, 2.9]; Albania [2.4, 5.0, 1.9, 2.8]; Mozambique [2.5, 5.7, 0.8, 2.8].

- Angola [3.1, 3.5, 0.8, 2.7]; Azerbaijan [3.0, 2.7, 1.8, 2.7]; Zambia [2.9, 3.6, 1.0, 2.7]; Honduras [2.4, 4.8, 1.2, 2.6]; Ecuador [1.9, 5.9, 1.5, 2.6]; Peru [1.6, 6.1, 2.2, 2.6]; Kahzakstan [2.9, 2.5, 1.3, 2.5]; Bangladesh [2.5, 3.2, 0.8, 2.3]; Russia [2.1, 2.8, 2.2, 2.2]; Armenia [2.1, 3.6, 1.2, 2.2].

- Georgia [1.9, 4.3, 1.2, 2.2]; Cameroon [2.1, 3.5, 0.9, 2.1]; Nicaragua [0.8, 5.6, 1.0, 1.8]; Paraguay [1.1, 4.3, 1.0, 1.7]; Tchad [1.3, 2.7, 0.7, 1.5]; Zimbabwe [1.1, 1.0, 1.3, 1.1]; Venezuela [0.3, 2.8, 1.9, 1.1]; Haiti [0.2, 3.2, 1.2, 1.0].

Tuesday, December 4, 2007

[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -31.2%]

In April 2001, in the midst of the worst deflation episode in half-a-century, Argentina granted "special powers" to economic czar Domingo Cavallo. Mr. Cavallo promptly issued a decree to put an end to the dollar-based currency board, widely seen as an aggravating factor in terms of deflation. Many in Argentina were encouraged by the move: people thought that the euro would continue to fall, and that Mr. Cavallo's new scheme —a currency basket with both the dollar and the euro— would offer some relief to battered Argentine exporters. In early May, a local pension fund kindly requested my opinion on the matter. My answer was straightforward: "I can't predict what will happen to the euro, but I can predict one thing — Mr. Cavallo's scheme will collapse".

My Argentinean forecast turned out to be one my few 2001 winners. The way I saw it, the matter clearly transcended the economics of exchange-rate determination. Mr. Cavallo's so-called "super-powers" were at the root of the problem. If one individual has the power to arbitrarily modify the currency, then property rights are ... gone. Interest rates have to go up, because the supply of loanable resources in the credit market will shrink fast — very fast. Sadly, this is what happened in Argentina in 2001. I bring up this issue because I have just found an academic paper in which the authors contend that high inventory-to-sales ratios may be caused by ... weak judiciaries! [1]. Now, inventory-to-sales ratios provide one of the best ways to analyze the volatility of the business cycle, a key component of ... endogenous liquidity.

Thus, the general principle can be stated like this: the lack of political checks and balances leads to weak property rights, to smaller credit markets, and to a higher cost of capital. As the great James Madison said: "Where an excess of power prevails, property of no sort is duly respected. No man is safe in his opinions, his person, his faculties, or his possessions" [2]. I recently took the trouble to put together an "Index of Checks & Balances", made up by Fraser Institute's grades on judicial independence, Freedon House's grades on freedom of the press and the WEF's grades on network readiness. The ten top-countries are to ones in which one would expect to find the lowest cost of capital: New Zealand, The Netherlands, Norway, Denmark, Germany, Iceland, Australia, Finland, Switzerland and Sweden. Now get ready for the ten bottom countries: Russia, Armenia, Georgia, Cameroon, Nicaragua, Paraguay, Tchad, Zimbabwe, Venezuela and Haiti.

[1] Angara V. Raja, Hans-Bernd Schaefer: "Are Inventories a Buffer Against Weak Legal Systems?", Kyklos, Vol. 60, No. 3, 2007, 415-441.

[2] James Madison: "Property", 29 Mar. 1792, Papers 14: 266--68.

Monday, December 3, 2007

[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -30.6%]

Spreads are hurting; Malpass on liquidity conditions; liquidity @ Financial Times.

[1] Spreads are hurting. At 246 bps, the Moody's Baa spread relative to Treasuries trades at levels not seen since September 2003. At 135 bps (a 3 year-high), its Aaa cousing is faring a little better. Bear Stearns economist David Malpass discounts the negative implications of rising spreads: "Despite wider credit spreads relative to Treasuries, we note the relatively low interest rates in most credit markets". Does the evidence support that view? Not really — unless you factor in a slightly higher inflation rate. The fact is, quality spreads are rising across the board. Despite its horrendous track-record in terms of short-term market moves, my trusted long-term "Combo Model" for risky assets —which adds the rate of growth of the Global Dollar Liquidity measure to the inverse of the Moody's Baa spread— has entered its fourth consecutive month in bearish territory. The August and September signals were so weak that I suggested a trading-range scenario rather than an outright bear market (which turned out to be OK big picture-wise, especially in euro or gold terms). Now, spreads have become more stubborn; they refuse to back down; signals are becoming louder. Stay tuned.

[2] David Malpass on liquidity. Rich Karlgaard quotes Bear Stearns economist David Malpass on liquidity conditions: "Extra cash in the global financial system remains massive. The feeling of a credit crunch is coming more from the slowdown in velocity or turnover of money than from a scarcity of liquidity". In other words, Mr. Malpass is describing the five-month old dichotomy between strong funding liquidtity and weak market liquidity. [Rich Karlgaard: "Malpass: Slowdown, not Recession", Forbes Digital Rules]

[3] Brad Setser on China & the yen. Brad Setser on China's latest rumoured FX moves: "Put the latest from Stratfor and Yves Smith (Naked Capitalism) together, and it seems like China may be scaling back on its holdings of US treasuries in order to buy yen. Stratfor hints that China may have a policy of reducing its holdings of Treasuries; Smith argues that China is buying yen: My Asia sources tell me that China is willing to let the yuan appreciate only if the yen rises first, and they are actively buying yen to make sure that comes to pass". Interesting stuff. [Brad Setser: "China: selling Treasuries and buying yen?"]

[4] Liquidity @ Financial Times: the Stagflation debate. The stagflation debate has been going on for a while now. If I remember correctly, PIMCO's Paul McCulley embraced that scary notion back in 2005 (he has now moved to the deflation camp). In this solid FT piece, Krishna Guha reviews the main issues involved. The key question, well emphasized by Guha, is this: if inflation risks are are so high, why are long-term nonimal interest rates so low? To track 'stagflation', we have devised a market-based indicator: the "Goldilocks-Stagflation" indicator. The numerator is the platinum-gold spread (a gauge of goblal economic growth), and the denominator is the ten-year inflation breakeven (a proxy for inflation expectations). At 0.79, the "Goldilocks-Stagflation" indicator looks neither too hot nor too cold. [Krishna Guha: "Cooler yet the pressure rises", Financial Times]