Wednesday, November 26, 2008

[Latest Endogenous Liquidity Index: -60.6%; Latest Global Dollar Liquidity measure: +39.6%]

Does the rally have legs? That's the key question, my friends. More than anything else, the rally that started on Friday is about valuation. Forget all the brouhaha about Mr. Obama's appointees. On that score, stocks still look cheap. Having said that, the real legs of the rally are represented by ... credit spreads. Here, things look rather hellish, I must say. The legs of the rally are very weak. At 586 bps, Moody's Baa ten-year spreads trade at all-time highs — again. If, by early next week, spreads have not declined by at least 40bps, I'll be donning my bear costume. [Federal Reserve: Selected Interest Rates]

Tuesday, November 25, 2008

[Latest Endogenous Liquidity Index: -63.9%; Latest Global Dollar Liquidity measure: +40.1%]

Interesting piece by John Muellbauer in today's Financial Times (*). Mr. Muellbauer's idea is to globalize the 1997-1998 unorthodox HKMA solution to the financial crisis. Back then, the Hong Kong Monetary Authority successfully intervened in asset markets, buying stocks from short-sellers in what turned out to be a very profitable trade. Now, says the author, the HKMA solution has to be global in scope: "Since no country is exempt, international co-ordination is needed and made easier because of the obvious common interest". Mr. Muellbauer is adamant about the nature of his plan: it is "reversible, self-financing and immediately applicable", as was the case in Hong Kong ten years back.

International co-ordination will avoid the policy being seen as a sign of weakness or panic at the individual country level, with costs to currencies and government bond markets. The incentive structure for central banks to join such concerted action is less likely to create free rider problems than is the case for fiscal policy. Any central bank considering such action has an incentive not to delay since the potential profitability is likely to be lower for late participants, given that asset prices will generally be bid up in the process.

(*) John Muellbauer: "The world’s central banks must buy assets", Financial Times.

Monday, November 24, 2008

[Latest Endogenous Liquidity Index: -65.9%; Latest Global Dollar Liquidity measure: +40.1%]

I'm a big fan of the Market Price Approach to monetary policy, as outlined in 1996 by Manuel Johnson and Robert Keleher (*). Largely relying on the work of Swedish economist Knut Wicksell, their recipe is deceptively simple: watch a trifecta of market-based indicators — the shape of yield curve, commodity prices and exchange rates. If the yield curve gets steeper and steeper, and commodity prices increase sharply, and the currency falls apart, then a central bank has an obvious inflation problem on its hands. [By the way, I'm collecting data to build a Market-Price-Approach Liquidity Index!]

Right now, we're in a crisis — and the blame game is in full swing. Some people seem to think that the 1% fed funds rate of 2003 was the key culprit (in terms of the housing boom and the subsequent collapse). Although I tend to symphatize with that view, I've been around long enough to know that bubbles are incredibly complex phenomena. Along with monetary policy considerations, many additional factors intervene: innovation waves, structural economic shifts, and plain old human nature with its inseparable greed and fear elements. Enough said — here's some intellectual ammo on the subject of rates and bubbles:

[1] Fed vice-chairman Donald Kohn. To his credit, Mr. Kohn does not dodge the bullet. "How might these monetary policy actions have fueled speculation?", he asks, rhetorically. His answer: maybe; but then again, it's more complex than that. "In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the Great Moderation back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions". [Donald L. Kohn: "Monetary Policy and Asset Prices Revisited", Federal Reserve Board]

[2] Jim Grant. The Financial Times'' John Authers reviews Mr. Market Miscalculates by James Grant: "As early as 2004, he wrote about how the 1 per cent Fed Funds rate, with which the Greenspan Fed battled the perceived threat of deflation, had “transformed the borrowing patterns of the clientele of the northeast region of Washington Mutual”. WaMu has now passed into history as the biggest US bank failure on record". With such juicy passages in mind, Mr. Authers concludes that Grant's volume "may well be the most perceptive book on the current financial crisis yet published". [John Authers: "Profit from prophesies of doom", Financial Times] [Grant's Interest Rate Observer]

[3] Gerald P. O'Driscoll Jr. This is by far the most Wicksellian piece of all: "With a commodity standard in place, the government would also have price signals that would alert it to the formation of a bubble. Why? Because the price of the commodity would be continuously traded in spot and futures markets. Excessive easing by the Fed would be signaled by rising prices for the commodity. In recent years, Fed officials have claimed that they cannot know when an asset bubble is developing. With a commodity standard in place, it would be clear to anyone watching spot markets whether a bubble is forming. What's more, if Fed officials ignored price signals, outflows of commodity reserves would force them to act against the bubble". Very interesting, although I doubt that such a mechanism would completely "avoid bubbles". [Gerald P. O'Driscoll Jr.: "To Prevent Bubbles, Restrain the Fed", The Wall Street Journal]

[4] Richard Duncan. The author of The Dollar Crisis: Causes, Consequences, Cures is at it again: "Between unnaturally depressed interest rates and the buying spree by Fannie and Freddie, US property prices surged. The US housing bubble followed the ill-fated Nasdaq bubble. However, the inflation of the US housing market was one bubble too far. When it imploded, the global financial system was hurled into crisis, leaving the 21st century version of Anglo-American financial capitalism discredited". [Richard Duncan: "Bring back link between gold and dollar", Financial Times]

(*) Manuel Johnson & Robert Keleher. Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

Friday, November 21, 2008

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

- Fed's Treasuries holdings + loans: $1,473.4bn (-$11.5bn)
- Other central banks' Treasuries holdings: $1,609.9bn (+$1.9bn) (*)
- Other central banks' agency securities: $891.2 (-$8.7bn) (*)
- Global Dollar Liquidity Measure: $3,974.4bn (-$18.3bn)

(*) Off-balance-sheet items

After five hectic weeks, a sense of normalcy is a welcome sign. The weekly Fed balance sheet has seen historic changes over the last couple of months. It has been amazing. Really. That's why I welcome the last installment, with its more normal variations. The Global Dollar Liquidity measure declines by $18.3bn, as the transitory character of some Fed operations kicks in, and as foreign CBs sell (quite understandably, one would imagine) some of their Fannie and Freddie positions. Having said that, the phenomenal year-on-year growth rates illustrate the sheer magnitude of central banks' commitment to ease policy at all costs. Thus, the Global Dollar Liquidity measure posts a +40.1% rate of increase, while my proxy for the monetary base increases by a mind-boggling ... 83.3%!

On the monetary policy front, note the aggressive stance adopted by the Swiss National Bank, shaving a full 100 bps off its target for the libor rate, now at 0.5%-1.5%. The resulting weakness of the Swiss franc is another symptom (IMHO) of a coming rally in risky assets.

Thursday, November 20, 2008

[Latest Endogenous Liquidity Index: -65.8%; Latest Global Dollar Liquidity measure: +39.6%]

A rally is in sight. When valued against the Goldilocks/Stagflation index, the S&P500 trades now at the cheapest level ... ever! This is due to the collapse of ten-year inflation breakevens, courtesy of the phenomenal rally in Treasuries. The last time something like this happened, we duly got a 15% rally on the S&P500. Blood on Wall Street: a rally in sight.

Tuesday, November 18, 2008

[Latest Endogenous Liquidity Index: -64.2%; Latest Global Dollar Liquidity measure: +39.6%]

Although I understand what a double bottom is, I am not a big fan of technical analysis. Having said that, there are some technicians I listen to. One is Nicole Elliott, of Mizuho Corporate Bank in London. Really impressive! Nicole is very bearish on risky assets right now. She's been consistently right on euro/yen and on the S&P500, and she sees yet more downside in the coming months. Today on CNBC Europe (I can' t find the video link), she said something that any endogenous liquidity watcher would immediately understand: "There's no money out there; people are desperate to sell all peripheral assets". [Mizuho Technical Analysis]

Monday, November 17, 2008

[Latest Endogenous Liquidity Index: -64.6%; Latest Global Dollar Liquidity measure: +39.6%]

- A new all-time low. My Endogenous Liquidity Index, which comprises CDS spreads, cash bond spreads, volatility indicators and others closed on Friday at a new all-time low. The index is now 64.6% below its November 2007 levels. This situation is remarkable, especially when you realize that macroeconomic liquidity —as measured by the size of the Fed's balance sheet— has never been more abundant. The private sector's furious deleveraging process goes hand in hand with an equally furious re-leveraging effort by central banks.

- Misleading readings on inflation expectations? Liquidity @ Financial Times. Mike Pond, an inflation-linked bond strategist at Barclays Capital, says: "A lot of people call the move in nominal Treasuries [without the inflation indexing] a flight to quality. But it is really a flight to liquidity. Tips have the same credit as nominals, but the nominals are indeed much more liquid". Very interesting! In other words: take the message from inflation breakevens with a grain of salt. Liquidity considerations, short squeezes, supply disruptions and even hurricanes can affect the information value of any market-based indicator. You just have to know it. [John Dizard: "Weirdly, Tips yields point to deflation", Financial Times]

Friday, November 14, 2008

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

- Fed's Treasuries holdings + loans: $1,484.9bn (+$97.0bn)
- Other central banks' Treasuries holdings: $1,608.0bn (+$20.3bn) (*)
- Other central banks' agency securities: $899.9 (-$6.6bn) (*)
- Global Dollar Liquidity Measure: $3,992.9bn (+$110.6bn)

(*) Off-balance-sheet items

My rather crude, but trusted and battle-tested long term buy/sell indicator for risky assets simply adds two rates of growth: that of the Global Dollar Liquidity measure, and that of the inverse of the Moody's Baa spread. It has been in bearish territory since August 2007. Given the phenomenal increase in the size of the Fed's balance sheet, it's time to take a fresh look at the numbers. After all, the Global Dollar Liquidity measure is growing at an astonishing 39.6% annual rate. Things seem to be improving at the margin: the indicator is now at its less bearish point since November 2007. Still, we need as much as 124 bps of improvement in the Moody's Baa spread to get a new bullish signal.

Thursday, November 13, 2008

[Latest Endogenous Liquidity Index: -62.1%; Latest Global Dollar Liquidity measure: +37.7%]

Today's Financial Times features an article by James Flaherty, Canada's finance minister, about the beauty of being ... boring. "Canadians by nature are prudent", says Mr. Flaherty. And he adds: "Our financial system has been characterized as unexciting. Canada's regulatory regime ensures that stability and efficiency are balanced". Very interesting indeed! I decided to put Canada's famed prudence to the test. More to the point, I checked the data from Bank of Canada to get a sense of the shape of the yield curve, the ultimate wicksellian criterium of a prudent monetary policy. All in all, Mr. Flaherty's views seem to be backed by the evidence. The yield on the 10-year benchmark bond now trades at a prudent 1.65 times the target for the overnight rate (vs. a record and far-from-prudent 3.66 times in the U.S.)

Wednesday, November 12, 2008

[Latest Endogenous Liquidity Index: -60.1%; Latest Global Dollar Liquidity measure: +37.7%]

"Public liquidity is an imperfect substitute for private liquidity", says Fed Governor Kevin Warsh. (When it comes to liquidity issues, Mr. Warsh is one of the Fed's most eloquent speakers -- see his well-crafted March 2007 speech on "Martket Liquidity: Definitions and Implications"). But what does he really mean? If I understand him correctly, Mr. Warsh points to excessive central bank liquidity (in the past) as the key culprit of the current mess:

More consequentially, we should recognize that Fed-supplied liquidity is a poor substitute for private-sector-supplied liquidity. When liquidity flows among private-sector participants, the players can more judiciously assess risk and reward, more adroitly learn from the recent turmoil to strengthen the resiliency of credit intermediation, and more ably allocate capital to its most productive uses in the real economy. Moreover, Fed-provided liquidity should not be mistaken for capital.

I take Mr. Warsh's words as an endorsement of the usefulness of my very own ... Endogenous Liquidity Index!

Tuesday, November 11, 2008

[Latest Endogenous Liquidity Index: -60.7%; Latest Global Dollar Liquidity measure: +37.7%]

- A 15% GDP contraction? Liquidity @ Financial Times. As a big fan of credit spreads (the best forward-looking indicator in terms of corporate earnings), I try to pay attention to what people write on the subject. It turns out that, according to Barclay's "model of implied economic forecasts from credit spreads", the market is discounting "as much as a 15 per cent decline in real gross domestic product for the US next year". Now, that's what you'd call a recession! Barclay's strategists are convinced that credit markets are wrong, and that equities at current prices might present "the buying opportunity of a generation". Perhaps. But watch the Moody's Baa ten-year spread (my own key benchmark): at 550 bps, it simply refuses to yield (pun intended). Not a good sign. [John Authers: "Time to buy?", Financial Times]

- Hong-Kong, Argentina & the dollar peg. Hong-Kong celebrates 25 years of US dollar peg. Meanwhile, Argentina broke away from its own peg in late 2001. Pegging your currency to the dollar is no panacea: you can't avoid episodes of both deflation (1999-2001) and inflation (2005-2007). Hong-Kong is willing to pay the price: "Where else should we go?", asks Donald Tsang, HK's chief executive. In 2008, Argentina faces the specter of stagflation. Its GDP is one of the most volatile in the world; there are no monetary policy rules, no checks and balances, no nothing — the perfect recipe for an ultra-high cost of capital. And while Argentina scrambles to protect is pseudo-currency, the HKMA lowers its target for the base rate to 1.5%. [Tom Mitchell: "Hong Kong celebrates 25 years of US dollar peg", Financial Times]

Monday, November 10, 2008

[Latest Endogenous Liquidity Index: -60.9%; Latest Global Dollar Liquidity measure: +37.7%]

The spot TED spread, as measured with data from the Fed's daily "Selected Interest Rates", trades at 268 bps (a level not seen since September 16, when Lehman Brothers failed). Now, if only the good money market news would translate into equally good credit markets news. This, alas, is still not the case: the Moody's Baa spread trades at 550 bps, close to its recent highs.

Friday, November 7, 2008

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

- Fed's Treasuries holdings + loans: $1,388.0bn (+$154.1bn)
- Other central banks' Treasuries holdings: $1,587.8bn (+$16.6bn) (*)
- Other central banks' agency securities: $906.5 (-$8.5bn) (*)
- Global Dollar Liquidity Measure: $3,882.3bn (+$162.2bn)

(*) Off-balance-sheet items

When a key central bank states on its website that "the global banking system has experienced its most serious disruption for almost a century", you know that things look pretty scary. Presumably, in that context, you would do well to look at central banks' balance sheets with a grain of salt. You would assume, in other words, that some of the things they are doing are temporary in nature. Look at those incredible numbers from the last Fed weekly balance sheet. My proxy for the monetary base is increasing at a 75% annual rate in November. Let me say this again: SEVENTY-FIVE PERCENT! The Global Dollar Liquidity measure is growing at almost 38% (November 2008 vs. November 2007). Guys, it'd better be temporary. Trust me on this one.

Thursday, November 6, 2008

[Latest Endogenous Liquidity Index: -60.8%; Latest Global Dollar Liquidity measure: +29.6%]

Liquidity-wise, the news today is dominated by the policy moves from both the Bank of England and the European Central Bank. The Old Lady moved first, and she decided to surprise financial markets with a 150 bp cut. The Bank rate stands now at 3.00% [communiqué]:

Since mid-September, the global banking system has experienced its most serious disruption for almost a century. While the measures taken on bank capital, funding and liquidity in several countries, including our own, have begun to ease the situation, the availability of credit to households and businesses is likely to remain restricted for some time. As a consequence, money and credit conditions have tightened sharply.

The most serious disruption for almost a century! Now, that's seems to justify the audacity of the move! Now consider the ECB. Shortly after the BoE decision, many market participants thought that the Trichet Boys would go for a 75 bp, or even a 100 bp, cut. To no avail. The ECB opted for a tepid 50 bp move, taking the marginal lending facility to 3.75% [communiqué]. And here comes the interesting part. Guess what's happening to the euro/sterling cross? Actually, the pound is rallying. When FX markets react like that, it means that (nervous) investors are paying attention to asset markets in general, and not only to yields on short-term debt instruments.

[PS. The Swiss National Bank also announces a "relaxation of monetary policy", lowering the three-month Libor target range by 50 basis points to 1.5%–2.5%].

Wednesday, November 5, 2008

[Latest Endogenous Liquidity Index: -58.5%; Latest Global Dollar Liquidity measure: +29.6%]

- Endogenous Liquidity Watch. The Endogenous Liquidity Index improves once again, courtesy of both the falling VIX and collapsing CDS spreads. As expected, ten-year inflation breakevens have deteriorated somewhat following the recovery in commodity prices. As a result, the Goldilocks/Stagflation Index retreats a bit, which makes equities less attractive at current levels. There are some encouraging signs in terms of junk bond spreads: the "New Junk" spread trades at 877 bps, down from the high of 1013 bps reached on September 21. Still, I am a bit skeptical about further S&P500 rallies if Moody's Baa spreads fail to collaborate. [KDP High Yield Daily Index]

- Denmark & the euro [Liquidity @ Financial Times]. Can Scandinavian countries afford to go it alone? The banking crisis highlights the pitfalls of monetary sovereignty in the age of ... connectivity. The Danish central bank has been forced to sell FX reserves and to raise interest rates twice to shore up the krone: "The spread between Danish interest rates and the ECB's was just 25 basis points in May; it is now at an all-time high of 175 basis points. This could widen further if the ECB cuts rates as expected by half a per cent on Thursday and the Danish central bank does not follow. The interest rate rises threaten to push housing prices down further, hurt consumer spending and depress an already stagnating economy". [Robert Anderson: "Danish PM seeks backing for euro referendum", Financial Times]

Tuesday, November 4, 2008

[Latest Endogenous Liquidity Index: -61.4%; Latest Global Dollar Liquidity measure: +29.6%]

- A very successful move by the Fed. I am more convinced than ever that the recent swap agreement between the Fed and the central banks of Brazil, Korea, Mexico and Singapore was nothing short of a brilliant stroke. Why do I say that? Because the Emerging Markets CDS has collapsed from 1056 bps on October 23 to 658 bps yesterday. I am reminded of an episode I read about a while back in Ron Chernow's The Warburgs: The Twentieth-Century Odyssey of a Remarkable Jewish Family (New York: Random House, 1993). In the Vienna of the late 1850s, a devastating panic in the banking sector is brought to an end by news that a train loaded with silver ingots (arranged by the Warburg family) is on its way from Germany. In the event, not an ounce of the silver was sold. The mere announcement of the incoming train was enough to calm the markets down. This is happening right now in some of the most important emerging markets. The swap lines have remained untouched, but the panic has receded. As a result, the Endogenous Liquidity Index continues to improve. Bravo!

- Liquidity @ Financial Times. Today's FT editorial comment stresses the need for fiscal stimulus as a crucial element of any strategy designed to get the world economy out of the "liquidity trap". There is something to be said in favor of this position. If a broad and prolonged recession puts permanent downward pressure on the demand for bank reserves, then CBs may find themseleves forced to destroy liquidity just to prevent their target rates from collapsing. This is what happened in Japan in the 1990s.

- Another stunning move Down Under. The Reserve Bank of Australia delivers another bold rate cut: -75 bps to a 5.25% target rate. From the communiqué: "International economic data have continued to point to significant weakness in the major industrial economies, and there have been further signs that China and other parts of the developing world are slowing as well. These conditions have contributed to further falls in world commodity prices".

Monday, November 3, 2008

[Latest Endogenous Liquidity Index: -65.3%; Latest Global Dollar Liquidity measure: +29.6%]

As the Belgian bank giant Fortis collapses, citizens of that country appreciate the bonheur of belonging to the eurozone. Had it not been for the euro, Belgium would have devalued and sharply increased interest rates — just as Iceland was forced to do. The banking and financial crisis is quickly changing perceptions. Across Europe, there is a bit of a scramble to join the euro. Politicians from Scandinavia to Eastern Europe, fearful of the abyss, are re-evaluating the wisdom of going it alone (Denmark, Sweden, Norway) or postponing structural reform (Hungary, Poland). Brazil and Mexico have secured a swap line from the Federal Reserve Bank. When it comes to liquidity conditions, size seems to matter after all (*).

(*) See the very good piece by Wolgang Münchau: "Now they see the benefits of the eurozone", Financial Times.