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]

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