Friday, February 29, 2008

. Federal Reserve: "Factors Affecting Reserve Balances", February 27

- Fed's Treasuries holdings: $776.7bn (-$2.2bn)
- Other central banks' Treasuries holdings: $1,270.3bn (+$6.2bn) (*)
- Other central banks' agency securities: $871.2 (+$5.1bn) (*)
- Global Dollar Liquidity Measure: $2,918.1bn (+$9.0bn)

(*) Off-balance-sheet items

Market liquidity remains under stress, with both CDS spreads and cash bond spreads toying with recent highs. Global "funding" or "macroeconomic" liquidity, on the other hand, is still healthy, thanks to the ongoing recycling of emerging economies' surplus dollars into US treasury and agency securities. Believe or not, February 2008 marks the 63th month in a row with the Global Dollar Liquidity growing at an annual rate of 10% or more. This is, of course, unprecedented. Note, too, that the sharp fall in the stock of Treasury securities held by the Fed has been arrested by the much steeper yield curve resulting from the FOMC's strong medicine. Good news for euro-based investors!

Wednesday, February 27, 2008

[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -43.7%]

Rachel Lomax, Deputy Governor for Monetary Policy at the Bank of England, was certain to make headlines with her speech at the Institute of Economic Affairs (*). According to Lomax, "this must surely be the largest ever peacetime liquidity crisis". Now, that's a statement! And she added, for good measure: "There may be more shocks to come". Aside from the journalistic excitement created by these lines, and bearing in mind that Ms. Lomax does not deal with the still booming macroeconomic global liquidity, the really important part of the speech deals with the outlook for inflation expectations and their impact on monetary policy:

If people put their trust in the regime, or a ‘credible central bank’, they are unlikely to revise their expectations about future inflation much, especially if the nature of the current situation is well and honestly explained, including how long it will take inflation to return to target. But if they forecast future inflation using simple rules of thumb based on past actual inflation rates, anything that dislodges inflation from target will affect what people use as their best forecast for future inflation ... In the context of the current outlook, the real risk facing the Committee is that a further period of above target inflation, prompted by a cost shock over which it has no immediate control, will lead people to revise their expectations about future inflation, and to act accordingly. This will make it more costly to bring inflation back to target.

Interesting stuff indeed. I guess well' have to closely watch ... inflation breakevens.

(*) Speech (pdf); Bank of England asbstract; Angela Monaghan: "BoE fears largest ever peacetime liquidity crisis", The Telegraph

Tuesday, February 26, 2008

. Frederic S. Mishkin: "The Federal Reserve's Tools for Responding to Financial Disruptions", February 15

Federal Reserve Board governor Frederic Mishkin does a useful job here. The main point is the detailed discussion of the Term Auction Facility, announced on December 12. This new instrument, described as one of the "tools for supporting market liquidity", is aimed at providing credit to eligible borrowers for a term "substantially longer than overnight":

Despite the Federal Reserve's provision of liquidity through open market operations and the discount window, strains in term funding markets persisted and became particularly elevated in early December in response to year-end pressures. The magnitude of these strains can be gauged using the spread between Libor--that is, the London interbank offered rate--and the overnight indexed swap (OIS) rate at the same maturity, because the OIS rate reflects the average overnight interbank rate expected over that maturity but is not subject to pressures associated with credit and liquidity risks to the same degree as Libor.

As shown in chart 2, the one-month and three-month Libor-OIS spreads were at low levels through the month of July but increased markedly in August and early September at the onset of the financial market turmoil.6 The one-month spread declined during the fall but rose sharply again toward the end of the year. In association with these wider spreads, liquidity in term bank funding markets deteriorated substantially.

To address these pressures, the Federal Reserve introduced a new policy tool called the Term Auction Facility (TAF).7 With this tool, the Federal Reserve auctions a pre-announced quantity of credit to eligible borrowers for a term substantially longer than overnight; thus far, each auction has involved a term of one month. As with primary credit, a depository institution is eligible to participate in a TAF auction if the bank is judged to be in generally sound financial condition, and a wide variety of collateral can be used to secure the loan. The minimum bid rate for each auction is established at the OIS rate corresponding to the maturity of the credit being auctioned.

The introduction of the TAF was announced on December 12 in conjunction with related announcements by the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank (Board of Governors, 2007c).8 The first two auctions were held on December 17 and 20, for amounts of $20 billion each, and were very well subscribed: A large number of banks participated in each auction, and the total value of bids was about three times as large as the amount of credit auctioned. The resulting interest rate in both cases was about 50 basis points above the minimum bid rate but well below the one-month Libor rate prevailing in financial markets at that time. In recent weeks, the Federal Reserve has conducted three more auctions (most recently, last Monday) for amounts of $30 billion each. The spread over the minimum bid rate was about 7 basis points for the January 14 auction, 2 basis points for the January 28 auction, and 15 basis points for the February 11 auction; these spreads were much lower than in December, apparently reflecting some subsequent easing in the pressures on banks' access to term funding.

The TAF appears to have been quite successful in overcoming the two problems with conventional discount window lending. Thus far, the TAF appears to have been largely free of the stigma associated with borrowing at the discount window, as indicated by the large number of bidders and the total value of bids submitted.9 Furthermore, because the Federal Reserve was able to predetermine the amounts to be auctioned, the open market desk has faced minimal uncertainty about the effects of the operation on bank reserves; hence, the TAF has not hampered the Federal Reserve's ability to keep the effective federal funds rate close to its target.

Isolating the impact of the TAF on financial markets is not easy, particularly given other recent market developments and the evolution of expectations regarding the federal funds rate. Nonetheless, the interest rates in term markets provide some evidence that the TAF may have had significant beneficial effects on financial markets. As can be seen in chart 2, term funding rates have dropped substantially relative to OIS rates: The one-month spread exceeded 100 basis points in early December but has dropped below 30 basis points in recent weeks--though still above the low level that prevailed before the onset of the financial disruption last August.

Monday, February 25, 2008

. Tobias Adrian & Hyun Song Shin. "Liquidity, Monetary Policy and Financial Cycles", New York Fed Current Trends in Economics and Finance, Vol. 14, No.1, January-February 2008

Henry B. kindly directs my attention to this very interesting piece by Tobias Adrian and Hyun Song Shin. The authors propose of a new definition of financial market liquidity, one that seeks to adequately reflect the nature of the new market-based financial system. The need to come up with a revised definition of liquidity responds to what the authors call "the rapid move toward a market-based financial system in recent years [that has] accelerated the trend toward greater reliance on nontraditional, non-deposit-based funding and toward greater use of the interbank market, the market for commercial paper, and asset-backed securities".

Adrian and Song Shin define liquidity as "The growth rate of financial intermediaries' balance sheets", that is to say "the growth rate of the stock of collateralized lending", or —even more precisely— "the growth rate of outstanding repurchase agreements". They detect a pattern whereby financial intermediaries "increase their leverage during booms and reduce it during downturns". Financial institution leverage is thus pro-cyclical. Unsurprisingly, they find a direct link between the growth of repos and the easing/tightening of monetary policy. While I tend to agree with their analysis, the fact remains that the indicator suggested by Adrian and Song Shin remains a quantity —not a market-based!— indicator. This is the great paradox of this otherwise very enticing piece (*).

(*) Interestingly enough, the VIX index —a truly market-based indicator— is singled out by the authors as the key indicator of "shifts in risk appetite". For a magnificent discussion of the relative merits of market-based indicators relative to quantity indicators, see the already aged, but still immensely valuable book by Manuel Johnson & Robert Keleher. Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

Friday, February 22, 2008

. Federal Reserve: "Factors Affecting Reserve Balances", February 20

- Fed's Treasuries holdings: $778.9bn (+$23.6bn)
- Other central banks' Treasuries holdings: $1,264.1bn (-$2.6bn) (*)
- Other central banks' agency securities: $866.2 (+$19.9bn) (*)
- Global Dollar Liquidity Measure: $2,909.1bn (+$40.9bn)

(*) Off-balance-sheet items

What a difference a week makes! After last week's across-the-board declines, the latest Fed balance sheet manages to produce very robust gains. First, let me discount the increase in the Fed's own stock of Treasury holdings: ever since the central bank started its special liquidity program, the accounts have become more difficult to interpret. Thus, "Federal Reserve Credit" registers a normal increase, while the (rather misterious) "Other Federal Reserve Assets" plunge by more than $15bn.

Having said that, the data are unambiguously positive. Foreign central banks' holdings of agency securities have reached a new all-time high ($866bn), reflecting the still very positive mood of investors in the emerging world. Because they desire to invest more in their own countries, they sell dollars to their (commercial) banks, which forces the local central bank to increase the amount of securities held under custody at the Federal Reserve Bank in New York. As Fed Governor Kevin Warsh says, "liquidity is confidence".

Thursday, February 21, 2008

[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -45.4%]

[1] Notes yielding less than Bunds. When it comes to the dollar, I fully understand the bearish case and the very negative sentiment that surrounds the greenback. But why are ten-year notes yielding less than Bunds? Speaking on CNBC, an economist at an investment bank sees this as yet another bearish sign for the dollar (yields are lower in the U.S. because growth is weaker, etc). I beg to disagree. The higher Bund yield may be a sign of decreasing relative confidence in ... the euro.

[2] Checks and balances ... again. Readers of this blog are familiar with one of my key convictions: the cost of capital is lower in countries with political checks and balances. There is a micro side to this largely macro story: as I pointed out in December, the success of Goldman Sachs is largely due to its "culture of partnership which entails a high degree of mutual surveillance in the common interest", as John Plender puts it. I'm glad to know that Paul Strebel, Professor at IMD, makes a similar point:

In an industry that can bring down the whole economy and one with technically complex products, the board should include leadership checks and balances, plus a critical mass of industry experts, as at Goldman Sachs and Credit Suisse, who are independent enough to shape management's risk appetite and if necessary tame it by raising the red flag.

Is Prof. Strebel reading the blog?

[3] More stagflation talk. Every now and then, journalists are kind enough to direct our attention to the "growing risk of stagflation" (*). Now, I take this issue rather seriously — that's why I follow the market-based "Goldilocks-Stagflation" indicator. While the indicator took a beating yesterday on the back of higher inflation breakevens and some profit taking in the platinum market, it still confidently points to strong global economic growth with subdued inflation expectations. What a crazy world.

(*) Krishna Guha, Daniel Pimlott & Michael Mackenzie: "New Jump in prices raises worry of US stagflation", Financial Times

Wednesday, February 20, 2008

[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -46.5%]

Today's Financial Times carries a rather gloomy piece by Martin Wolf. Mr. Wolf summarizes the ultra-bearish case as presented by economist Nouriel Roubini of RGE Monitor (*). Now, is there a bearish case to be made from the global liquidity perspective? You bet there is. Let me show you the results of backtesting a very simple model that combines elements of both macroeconomic and market liquidity. Whenever the sum of the rate of change of the Global Dollar Liquidity measure and the rate of change of the inverse of Moody's Baa spread is positive (negative), the "model" says be bullish (bearish).

- June 1997: Bullish. S&P500 at 885.14
- January 1998: Bearish. S&P500 at 980.28
- September 1999: Bullish. S&P500 at 1282.71
- October 2000: Bearish. S&P500 at 1429.71
- October 2001: Bullish. S&P500 at 1139.45
- January 2002: Bearish. S&P500 at 1130.20
- February 2002: Bullish. S&P500 at 1106.73
- May 2002: Bearish. S&P500 at 1067.14
- September 2002: Bullish. S&P500 at 815.28
- October 2002. Bearish. S&P500 at 885.77
- Januayr 2003. Bullish. S&P500 at 855.70
- August 2007. Bearish. S&P500 at 1473.99

(*) An earlier version of this post contained a harsh, and poorly documented, comment on Mr. Roubini as a forecaster. I am now withdrawing that comment: I want to focus on liquidity conditions — ad hominem remarks have no place in this blog. My apologies [Agustin].

Friday, February 15, 2008

. Federal Reserve: "Factors Affecting Reserve Balances", February 13

- Fed's Treasuries holdings: $75530bn (-$2.2bn)
- Other central banks' Treasuries holdings: $1,266.7bn (-$0.5bn) (*)
- Other central banks' agency securities: $846.2 (-$4.2bn) (*)
- Global Dollar Liquidity Measure: $2,822.0bn (-$6.9bn)

(*) Off-balance-sheet items

The weekly Fed balance sheet shows modest, but across-the-board declines. All components of the Global Dollar Liquidity measure are down: the Fed's own stock of Treasury securities, foreign central banks holdings of Treasuries, and foreign central banks holdings of agency securities. This is a very rare occurrence indeed! Most striking of all, the "domestic" (*) component is now down for two months in a row. The last time we had back-to-back contractions in this proxy of the monetary base was in ... December 2000/January 2001!

(*) Strictly speaking, the adjective "domestic" is a bit of a misnomer here. The Fed destroys liquidity whenever it defends a target for the fed funds rate that is too high relative to the demand for bank reserves. The weakness in the demand for bank reserves, in turn, may reflect both domestic and international factors.

Thursday, February 14, 2008

[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -46.2%

[1] Hail to the VIX! I am a big fan of market-based volatility indicators: the VIX, the VXN, the RVX, the V-DAX and others. (For all things VIX, see Bill Luby's blog — he's now analyzing the VXV, the new kid in town). The VIX is the key market proxy of the "Great Moderation" of the business cycle hypothesis, a key element in terms of endogenous liquidity. Here, the message is pretty clear: the Great Moderation is alive and well. The global economy is incredibly diverse; its multiple sources of demand and liquidity all but negate the possibility of a worldwide economic depression à la 1930s [VIX and more]

[2] Main Street v. Wall Street — again (Liquidity @ Financial Times). Don't miss this piece by Francesco Guerrera et al., which highlights the divergent views of (bearish) economists and (bullish) business people. One sentence summarises it well: "... economists are from Mars and businesspeople are from Venus". This is precisely what we are seeing at the Global Liquidity Blog: while credit markets are weak, world economic growth is strong. [Francesco Guerrera, James Politi & Aline van Duyn: "Full steam ahead?", Financial Times]

[3] The FT & "Liquidity reform" (Liquidity @ Financial Times). The L-word is mentioned no less than 15 times in this somewhat confusing FT editorial comment. The key part: "Most regulatory regimes today are far too simplistic: they must evolve to become complex simulations that test which events, from closure of the asset-backed bond market to a currency crisis, would put liquidity stress on a bank, and whether they are properly insured against it. Regulators also need to co-operate: a bank may seem illiquid in one country, but have mountains of cash waiting in another". [Financial Times: "Liquidity reform"]

Wednesday, February 13, 2008

[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -46.0%]

First, the good news. Surging platinum prices and well-behaved ten-year inflation breakevens have taken the market-based "Goldilocks-Stagflation" indicator to an all-time high of 0.93 (*). In addition, the latest Fed balance sheet reveals a $6.5bn increase in the Global Dollar Liquidity measure, driven by foreign central bank purchases of Treasury securities. The global economy is growing strongly!

At the same time, however, credit spreads continue to surge, which tends to portend bad news in terms of corporate earnings. Higher CDS- and cash spreads have pushed the Endogenous Liquidity Index to a new ... all-time low! I will fully admit it: (a) I find these market/economy conditions somewhat perplexing; (b) I have some catching up to do in terms of reading. I hope to come up with something interesting soon! Meanwhile, the extended trading range scenario is likely to prevail.

(*) Platinum-Gold = 1943/1906 = 2.14. Ten-year inflation breakevens = note yield - TIIPS yield = 230 bps. Goldilocks-Stagflation = 2.14/2.30 = 0.93.

Thursday, February 7, 2008

[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -45.4%]

Not seen since March 2003: the Moody's Baa spread relative to 10-year Treasuries trades at just over 300 bps. Watch out for a massive blow to corporate earnings.

Wednesday, February 6, 2008

[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -44.6%]

Surely the most intriguing element of the Fed's balance sheet is the sharp contraction in the stock of Treasury securities held by the central bank. This reliable proxy of the monetary base is down 1.7% from January 2007 — the first monthly contraction since ... January 2001! The only way to make sense of the incredible shrinking monetary base, in my view, is to consider the odd shape of the yield curve (ten-year note yield vs. fed funds rate target). A year and a half of inversion has taken its toll on high-powered money. When demand for credit weakens and demand for bank reserves follows suit, there are only two equilibrium points: (a) the Fed announces a new, lower target for the fed funds rate; (b) the Fed contracts the supply of bank reserves by selling bonds.

Clearly, alternative (b) was the path chosen by Bernanke and Co. until very recently. Believe it or not, there is an ongoing dollar ... scarcity! With the latest FOMC move, which took the fed funds rate all the way down to 3%, the yield curve has recovered its normal shape. One last issue remains to be mentioned: do trends in the monetary base matter at all? From the persective of the Global Liquidity Blog, the answer is clearly: yes — and a lot. Shrinking base money completely justifies the aggressive easing of monetary policy. And don't rule out additional steps!

Tuesday, February 5, 2008

[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -42.0%]

Henry, a.k.a. the Picky Investor, asked yesterday for background information on ... methodology. His question led me to think about penning a short history of the Global Dollar Liquidity measure. Also, I realized that it was a good time to launch an older project of mine, namely to "open-source" my liquidity indicators. By sharing the information, and by discussing the (numerous) shortcomings of all these measures, I hope to benefit from the interaction with readers. So let's begin with a short history of the GDL measure ...

I. - From Jacques Rueff to John Mueller
As a young international economist working at a boutique investment bank in the 1990s, I was puzzled (together with my boss, who happened to be the chairman of the bank) by the effects of the "Tequila" contagion in early 1995. After reading a Barron's piece by John Mueller, chief economist of Washington, D.C.-based consultants Lehrman, Bell, Mueller & Cannon, we decided to hire them for a couple of months. Mueller's (and Lehman's) insights were based on the writings of French economist Jacques Rueff (1898-1982). In the 1930s, Rueff had given birth to the notion of an international reserve currency. Later, as an advisor to French president Charles de Gaulle, he fought vehemently for the demise of the Bretton Woods System. In order to check the growing power of America, de Gaulle and Rueff urged Western Europe to dump the dollar as the key reserve asset. France was doing just that, with Banque de France buying huge amounts of physical gold against its massive greenback holdings [1].

Rueff's key insight was as simple as it was powerful: when countries invest the proceeds of their trade surplus into the credit markets of the deficit countries, they create a "double pyramid of credit". Interest rates are kept at artificially low levels, the (reserve) currency suffers from chronic overvalution, and dangerous financial bubbles arise. The "neo-Rueffians" at LBMC had created a proprietary measure of these flows, dubbed the World Dollar Base. Clients did not have access to LBMC's methodology. As soon as our contract expired, I decided to take matters into my own hands. Having lived in France as a child, I could read in French (I still can!) After digesting the first pages of Jacques Rueff's Le peché monétaire de l'Occident (Paris: Plon, 1971), I decided to set up my own "Rueffian" liquidity indicators ...

[To be continued]

[1] See Francis J. Gavin. Gold, Dollars, & Power. The Politics of International Monetary Relations 1958-1971 (Chapell Hill: The University of North Carolina Press, 2004).

Monday, February 4, 2008

[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -40.4%]

Hello everybody, I'm baaack! After a long summer break (I was in South America), I'm back in the saddle, trying to make sense of financial markets and liquidity indicators. Plugging in the numbers, here's what I see: business as usual. In other words: while funding liquidity is still relatively strong, market liquidity looks awful. Most of the damage is caused by surging credit spreads; volatility indicators, however, appear to behave in a way that is consistent with the "Great Moderation" of the business cycle thesis. Finally, and quite surprising, I note that my market-based "Goldilocks-Stagflation" indicator is trading at a ... 3-month high! In a nutshell: earnings will take a hit -- but the global economy still looks good. A recipe for an extended trading range?

[1] Funding liquidity is still strong. The Global Dollar Liquidity measure shows a 11.4% increase with respect to January 2007. That fits my definition of a "liquidity boom": a 10%-plus rate of growth. Moreover, January marks the 62th month in a row of this funding liquidity boom. There are no precedents for such an extended period of strong growth in central banks' dollar reserves.

[2] Market liquidity looks awful. At -40.4%, our Endogenous Liquidity Index is plumbing new lows. Within the index, however, we note two diverging trends. Volatility and financial innovation indicators (chiefly, the VIX index and the GS share price) are relatively well behaved. But credit spreads are hurting a lot. The Moody's Baa spread is approaching 300 bps, a five-year high. Not good in terms of corportate earnings!

[3] Surprising Goldilocks. At 1.94, the platinum-gold ratio (a market-based proxy for the world economy) trades at a six-month high. At 234 bps, ten-year inflation breakevens look reasonable, given the FOMC's aggressiveness. Thus the "Goldilocks-Stagflation" measure, which plots one indicator against the other, trades at a 3-month high. Against this background, stocks do not look particularly expensive, even after the recent rally.

[4] Long-term picture still bearish. On August 31, 2007, my trusted long-term model for risky assets went bearish. It combines the rate of growth of both the Global Dollar Liquidity measure and the inverse of the Moody's Baa spread. Because it does no take account of volatility indicators, the model may be unduly skewed to the bearish side. All in all, a very sharp fall in credit spreads (more than 100 bps) is required for the model to flash out a bullish signal.