Friday, August 31, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", August 29

- Fed's Treasuries holdings: $778.3bn (-$2.6bn)
- Other central banks' Treasuries holdings: $1,205.4bn (-$13.5bn) (*)
- Other central banks' agency securities: $774.0 (+$6.4bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,757.7bn (-$9.6bn)

(*) Off-balance-sheet items

Is the boom in funding liquidity over? The August numbers certainly suggest so. August 2007 is by far the worst month on record in terms of our Global Dollar Liquidity measure (-$35.5bn). But wait a minute. Year-on-year comparisons are still strong: the 14.6% rate of growth is still indicative of a healthy, if not spectacular, rate of world economic growth. So what is going on? It is difficult to avoid the obvious conclusion: the global flight to quality is forcing central banks to sell a portion of their custody holdings at the New York Fed. There seems to be a worldwide mini-banking crisis going on, with talk that Barclays borrowed heavily at the Bank of England discount window, ongoing rumors about the health of the German banking system, and the less unexpected noise about Russian, Kazahk, and South American banks.

If credit spreads do not register a dramatic improvement today, my long-term model for risky assets (which combines changes in the Global Dollar Liquidity measure and in Moody's Baa spreads) will likely turn bearish ... Time to say goodbye to Macro Man's expected W-shaped recovery? (for which I voted, by the way)? Time to sell rallies?

Thursday, August 30, 2007

. Krishna Guha. "World economy confronted by paradox of liquidity", Financial Times

On June 29 I posted a review of the weekly Fed balance sheet under the title: "A Tale of two Liquidities". A week later, I followed up with a post on "The Liquidity Conundrum". The idea was (and still is) that funding liquidity was surging just as market liquidity was showing signs of ... collapsing. It took the Financial Times' Krishna Guha almost two months to discover this "paradox over liquidity":

In large parts of the financial system market liquidity is in scarce supply. The supply of credit is tightening and the price of credit is going up. But at the macroeconomic level, liquidity remains abundant. The world is still awash with savings as it has been for several years. One striking example: the giant current account surpluses of the oil exporters, China and other emerging markets, which represent surplus national savings.

Mr. Guha then quotes two distinguished academics, Mr. Ken Rogoff and Mr. Rajan, who both broadly agree with the "paradox". The MSM, it goes without saying, rarely cites the work of a mere blogger — even at the cost of being painfully late.

Wednesday, August 29, 2007

[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -30.3%]

Amid the confusion about global, funding, market, dark and endogenous liquidity, Lex is to be praised for a serious effort at providing some clarity. According to Lex, there are two important definitions: a "narrow" definition, provided by Lombard Street Research, and a "wishy-washy" bull market mélange that clarifies little. There is no way to avoid a lengthy quote:

[Liquidity is] the ease with which one can sell an asset at the expected price. The most liquid asset of all is cash ... A subsidiary part of this technical definition is that central banks can increase the liquidity of the banking system by lending more cash to it, as most did this week ... The real mess, however, lies with the rise of a second usage of "excess liquidity" as 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.

At best, bunching these phenomena into a bull market mélange clarifies little. At worst, it inadvertedly ventures into controversy - for example, whether central bank policy rates should be set in reference to asset prices as well as inflation is a deeply contentious question. Liquidity in its first, narrow,definition is an important economic concept. But in its more fashionable second usage, liquidity is too, well, wishy-washy, to be useful.

Monday, August 27, 2007

[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -25.1%]

On Friday I wrote a rather bearish piece on the latest weekly Fed balance sheet. Markets duly responded with spectacular ... rallies! Once more, I was reminded of the wisdom of Manuel Johnson & Robert Keleher, authors of the already aged, but wonderful book Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996). Johnson and Keleher taught me not to put too much trust in quantity indicators suchs a GDP, industrial production and monetary indicators. Instead, look at market price indicators — especially in times of financial stress.

To gauge the Fed's monetary stance, Johnson and Keleher selected three variables: the exchange rate, commodity prices, and the yield curve. Dollar-based liquidity is abundant in situations were the dollar falls, commodity prices rise and the yield curve steepens. That is exactly what was happening as the Fed published its balance sheet! Message to my readers: sorry for Friday's blunder. I'll be hard at work this week on a Market Price Approach Index to monetary policy. [Many thanks to T. McGee for his useful comments].

Friday, August 24, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", August 22

- Fed's Treasuries holdings: $780.9bn (-$14.7bn)
- Other central banks' Treasuries holdings: $1,218.8bn (-$25.3bn) (*)
- Other central banks' agency securities: $767.6 (+$6.7bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,767.3bn (-$33.1bn)

(*) Off-balance-sheet items

We all knew it: this week's Fed balance sheet was going to be an eventful one. But while we were expecting improved liquidity conditions (thanks in part to the rediscovered discount window), what we got instead came as a shock: the biggest weekly fall ever in our Global Dollar Liquidity measure. The $33 bn collapse came as a result of a double whammy: foreign CBs sold as much as $25bn in Treasuries, and the Fed itself turned restrictive (-$14.7bn). In the event, the net amount borrowed at the discount window came in at a modest $1.27bn.

What is going on? Given the extent of the damage, we cannot entirely rule out the possibility of a "1997-1998 style" global banking crisis. (I know, I know: I recently wrote that this was not Asia redux). Here's a possible transmission mechanism: somewhere in the world, Mr. X worries about the solvency of his bank. He wants physical euros and U.S. dollar notes, which he buys from his bank. The bank now turns to the central bank, which has to sell a portion of its custody holdings at the New York Fed. As a result (and assuming that Mr. X has many imitators worldwide), the Global Dollar Liquidity measure registers a sharp fall.

There you have it. This is roughly what happened in Asia-Rusia ten years ago. Could it happen in 2007, courtesy of the global sub-prime mess? That's not my central scenario. But I'll keep a vigilant eye on credit spreads and on the next weekly Fed balance sheet.

Thursday, August 23, 2007

[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -28.2%]

Ken Fisher is at it again. As a keen observer of credit spreads myself (I view them as a key "tell" on risky assets), I am very interested in his analysis. On the subject of the rising TED spread, which he labels "cash hoarding", he is adamant: "It's what happened late in the 1998 correction or after the 1987 crash. I can't find it ever having happened early in a bear market. That hoarded cash won't stay in T-Bills for long".

Mr. Fisher's bullish case rests mostly on his analysis of credit spreads. Basically, he says two things: (1) spreads that widened the most "have fallen back" since late july; (2) about a third of the widening came from falling T-Note rates, as opposed to rising corporate bond yields. While my numbers seem to tell a slightly less bullish story, I fully agree with the view that the sort of action that we saw recently is more consistent with a bottom than with a top.

Wednesday, August 22, 2007

[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -30.6%]

Macro Man, the author of the outstanding homonymous financial blog, has just written a long post on global liquidity conditions. He is kind enough to link to the Global Liquidity Blog, in regard to my critique of M2 as a liquidity indicator. I made that point in a comment to an April 2007 post by Bill Luby:

I don't pay much attention to M2 and M3 because they include too many variables, a fact that may lead to grave mistakes. Thus I will always remember 1998: M2 & M3 were surging, and monetarist members of the FOMC (Bill Poole and the Cleveland Fed president, whose name I just forgot) were calling for an increase in the Fed funds target. The trouble was, M2 and M3 were surging not because the Fed funds target was too low, but because of ... flight-to-quality buying resulting from the "Asian-Russian" financial meltdown.

Because M2 and M3 included money-market funds, such behavior was understandable. Other measures of liquidity, however, were on the verge of ... collapsing! (like my very own Dollar Liquidity Measure). In the end, the Fed duly lowered the fed funds target -- thus avoiding the banking crisis that M2 and M3 enthusiasts were about to unleash.

The larger point, of course, is that funding liquidity remains very robust as we speak. The way I see it, liquidity analysts will have to come to terms with the fact that market liquidity can turn on a dime, even as "macro" liquidity remains ample. This, of course, is the liquidity conundrum that we are witnessing ... right now.

Tuesday, August 21, 2007

[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -31.3%]

While talking to my broker in New York City, the conversation was interrupted a couple of times by clients who wanted out of the firm's flagship money-market fund, and into ... T-Bills! "The ones who are really scared", my broker told me, "are all Wall Street types: traders, fund managers, etc". On the other hand, Main Street types (businesspeople, managers) are completely unperturbed. So who's right: nervous Wall Street, or happy Main Street? I'd say Main Street's right — but I'd like to see spreads fall a bit more. Meanwhile, here's some stuff I've been reading:

- Macro Man and a fine piece on the TED spread. ("Bills right now are trading like dot-coms", adds Brad Setser).

- The Chinese central bank raises key interest rates. More bad news? Not necessarily: it may even reinforce the view, championed by Morgan Stanley's Stephen Jen, that the G7 is not the only source of growth and demand. (Plus: Beijing opens up markets).

- The German banking system in a "not uncritical situation" overall. (Plus: Deutsche Bank taps the discount window).

Monday, August 20, 2007

[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -32.5%]

The Good. [1] Friday's very sharp rebound in CDX indices. [2] The virtual collapse in inflation expectations: the spread between 10-year Treasuries and inflation-indexed notes trades at 221 basis points, the lowest on record. [3] The Fed will ease. [4] Islamic finance: Arcapita, the Bahrain-based Islamic investment firm buys Germany's HT Toplast for more than $1bn; according to the Financial Times, the deal "adds weight to predictions that Islamic investors would be less affected than traditional equity houses by the recent turmoil in debt markets". [5] China re-affirms dollar's global reserve status: the new lender of last resort? [6] Gillian Tett's superb coverage of the liquidity crisis.

The Bad. [1] Economic slowdown ahead. Merrill Lynch's David Rosenberg cuts 2008 estimates: +1.5% GDP growth (down from +2.3%); operating earnings seen at $92, down from $97. (My favorite market-based indicator of global growth, the platinum-gold ratio, is showing weakness). [2] The VIX refuses to trade significantly lower. [3] Clearing the backlog will take time: $300 bn of lending commitments that banks cannot sell on (FT's Richard Beales). [4] Monday morning quarterbacks: Intelligence Capital Limited's Avinash Persaud: "The crash of 2007-2008 need not have occurred".

The Ugly. [1] Special Investment Vehicles. Gillian Tett: "[banks] have promised to provide credit lines to other institutions with subrprime exposure, such as mortgage lenders or special investment vehicles." SIVs may be the reason why money markets are not functioning properly. [2] Quant funds.

Friday, August 17, 2007

[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -34.6%]

Smart move from the Federal Reserve, lowering the discount rate from 6.25% to 5.75%. (See communiqué 1 and 2). Next Thursday, we'll pay close attention to the weekly balance sheet for signs of movements at the discount window. So far, very little is happening there: there are only $271 million outstanding in direct loans to banks. In other words: today's move looks largely symbolic, as the key Fed funds rate remains at 5.25%. Symbolic, but smart — very smart.

On a completely unrelated issue, namely the China-Bear Stearns link-up talk, it looks like China is destined to act as the new ... lender of last resort! Technically, I should say "owner" of last resort. However, if money markets were to calm down following a move in that direction, China would in effect be acting as the indirect lender of last resort. Just think about it.
. Federal Reserve: "Factors Affecting Reserve Balances", August 15

- Fed's Treasuries holdings: $796.6bn (+$17.9bn)
- Other central banks' Treasuries holdings: $1,244.0bn (-$3.9bn) (*)
- Other central banks' agency securities: $760.9bn (+$2.3bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,800.4bn (+$16.2bn)

(*) Off-balance-sheet items

Yesterday's weekly Fed balance contains lots of information. Let us review it carefully, because it may be important. The first thing to note is a new all-time high in our Global Dollar Liquidity measure: $2,8 trillion. The annual rate of change is back above 15%, courtesy of the Federal Reserve's injection of liquidity. The best way to look at it is through the dramatic weekly increase in bank reserves held at the Fed (a component of the monetary base). This item grew by more than $18bn to $23.9bn. Needless to say, such a move occurs only at fairly rare intervals — September 2001 is a case in point.

Now let me speculate about what is going on with foreign CBs. We know that the Brazilian central bank and others continue to accumulate Treasury and agency securities at a blistering pace (see Brazil's new record). So why has the amount of Treasuries held in custody at the New York Fed declined by almost $10bn over the last month? My take is that China's diversification policy is gaining momentum. This would seem to fit nicely with yesterday's rumors about Bear Stearns selling part of the company to the Chinese. Now, ladies and gentlemen, if this is indeed the case, it's nothing short of ... revolutionary!

Thomas Barnett & globalization 2.0
My favorite global political analyst is Tom Barnett, author of the bestselling book The Pentagon's New Map. War and Peace in the Twenty First Century (Putnam, 2004). [See his fast-paced blog]. According to Barnett, today's globalization is not, er, your uncle's globalization. More and more, it is shaped by the so-called New Core players: China, India, Russia, Brazil, etc. Recently, Tom came up with an interesting analysis of global liquidity. (Actually, it is a short review of Michael Pettis: "Sovereign Wealth to the Rescue: Massive global reserves will chase the bears back to their dens," Wall Street Journal, 9 August 2007). His take: "The key thing is keeping the money on the table". Isn't what the Bear Stearns talk is all about? [Warning: Barnett's optimism can be infectious].

Thursday, August 16, 2007

[Latest Global Dollar Liquidity Measure: +14.9% annual growth rate; latest Endogenous Liquidity Index: -36.0%]

- The always relevant Bank Credit Analyst warns that "this week’s bout of illiquidity in money markets is an important sign that subprime-related stress has crossed the line from being a sector-specific event, to a source of systemic risk".

- Jim Griffin, ING Investment advisor, does not worry too much about falling market liquidity: "The economic context is robust if not booming". The next big thing to worry about, however, is ... funding liquidity! "In fact", says Griffin, "those official reserves have become so great as perhaps to constitute the next new big thing when this credit spasm passes". I agree.

- Crossborder Capital, a.k.a, has a report out on "The Subprime Credit Crunch and the New 'New' Yield Curve" (subscribers only).

- Check out the latest Fed money market operations at the New York Fed's website.

- Lou Crandall of RH Wrightson & Associates on yet another paradox of diversification: "The problem now is, everybody’s got a small piece, but those pieces are actually big enough to pull some players under, which means the fact that the risks are so diffuse in the system means everybody is a suspect, and that's the flip side of what we saw as the strength".

- PIMCO's Mark Kiesel outlines the firm's credit markets strategy: "One opportunity may be in the bank loan market, which has re-priced significantly, and specifically in the credit default swap market which references bank loans". Can credit spreads widen much more?

- The Economist mentions "indiscriminate selling ... in order to realise cash". See also the analysis of the turmoil in money markets: "Cash-rich banks will hoard their money if they fear that the inter-bank market will cease to function". Finally, the Buttonwood column delves into the paradoxes of "diversified" financial markets.

Wednesday, August 15, 2007

[Latest Global Dollar Liquidity Measure: +14.9% annual growth rate; latest Endogenous Liquidity Index: -29.6%]

What a shame! Liquidity-wise, we are witnessing the most exciting times ever, and yet the Global Liquidity Blog is almost silent! I'll do my best to post more frequently over the coming weeks, if only to review some of the excellent material published in newspapers and blogs. Today, I wanted to briefly discuss the U.S. June trade data and its implications in terms of global liquidity conditions. (See, as always, the detailed analysis by Brad Setser). Arguably, the trade deficit has been one of the key drivers of funding liquidity.

As foreign CBs re-cycled part of their surplus into the U.S. credit markets, interest rates were kept (artificially?) low for ... years! In that respect, the evidence from the last weekly Fed balance sheet is not very encouraging: our Global Dollar Liquidity measure fell by $9.8bn and the annual rate of growth declined sharply to 14.9%. Is our measure already responding to what seems to be a narrowing trade gap?

Long-term bullish signal under threat
One of my most trusted, long-term indicators for risky assets is the simplest thing you can imagine: it just adds the rate of growth of the Global Dollar Liquidity measure to the rate of growth of the inverse of the Moody's Baa spread. In other words, it combines funding and market liquidity. Only rarely does it signal changes. The last bullish signal was flashed in January 2003, with the S&P500 at 855.7. As things stand now, it would seem that we are pretty close to the end of the bull cycle. A sharp fall in funding liquidity (3% or more), a further rise in the Moody's Baa spread (to 200 bps or more) —or a combination of both— would do the job.

Monday, August 13, 2007

[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -28.1%]

Back from a short summer break, I see a lot of confusion among journalists (and even among some market strategists) with regard to central banks' liquidity injections. Decades ago, central banks abandoned their money supply targets in favor of short-term interest rate targets. This is the key to understand what is happening right now. Central banks are simply ... playing by the rules! If, for wathever reason, short-rates deviate significantly from their targets, central banks have the duty to step in. (Yes, Virginia: the duty).

They will add liquidity if market rates increase above the target (which is what they are doing); they will withdraw liquidity if rates go down below the target. It is largely a mechanical operation. No politics, no moral hazard considerations involved! Admittedly, it does not happen often. But when it happens, either you apply the rules, or the system breaks down altogheter. Take a look at the Fed August 10 communiqué:

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

This is a cristal-clear explanation of a fairly mechanical point. Again: no discretionary moves, no politics, no conspiracy theories, no moral hazard issues. Just a bunch of people playing by the rules. I'm lovin'it!

Wednesday, August 8, 2007


Friday, August 3, 2007

. Federal Reserve: "Factors Affecting Reserve Balances", August 1

- Fed's Treasuries holdings: $783.1bn (+$5.2bn)
- Other central banks' Treasuries holdings: $1,252.2bn (-$1.1bn) (*)
- Other central banks' agency securities: $757.8bn (+$8.0bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,793.2bn (+$12.1n)

(*) Off-balance-sheet items.

The first August weekly Fed balance sheet contains mixed news. At first sight, the $12bn increase in our Global Dollar Liquidity measure would seem like very good news indeed. Below the surface, however, we note two things: [1] A large portion of the increase is due to the Fed itself; [2] The annual rate of growth took a beating (from +15.7% to 15.1%), reflecting tougher comparisons (just like corporate earnings).

Meanwhile, our Endogenous Liquidity Index, at -23.7%, is only slightly above last Friday's all-time low.