BEN BERNANKE ON GLOBAL IMBALANCES
[Global Dollar Liquidity: +11.9%; Endogenous Liquidity Index: +24.9%; bullish]

Ben Bernanke on Global Imbalances (*). Overall, Mr. Bernanke aims to downplay the argument according to which QE is exacerbating competitiveness problems caused by hot money flows — particularly in emerging economies. Here's my takeaway:

. The cost of capital & property rights. Note the link: "... capital flows from emerging markets to advanced economies will tend to be directed to the safest and most liquid assets, of which, these researchers argue, there is a relative shortage in emerging markets."

. Global flows & changes in behavior. This is what Jacques Rueff had predicted all along: "The preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that 'transformed' risky loans into highly rated securities. Remarkably, even though a large share of new U.S. mortgages during the housing boom were of weak credit quality, financial engineering resulted in the overwhelming share of private-label mortgage-related securities being rated AAA."

. The US's responsibility. "These findings are not to be read as assigning responsibility for the breakdown in U.S. financial intermediation to factors outside the United States. Instead, in analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves". Note the reference to "risk-management deficiencies among financial institutions". No checks and balances, baby!

. Argentina & Brazil. Although not explicitely named by Mr. Bernanke, these two countries provide a vivid illustration of the problems caused by sudden capital inflows: "The maintenance of undervalued currencies by some countries [read: Argentina] has contributed to a pattern of global spending that is unbalanced and unsustainable, as those countries that have allowed their exchange rates to be determined primarily by market forces [read: Brazil] have seen their competitiveness erode relative to countries that have intervened more aggressively in foreign exchange markets.

(*) Ben S. Bernanke: "Global Imbalances: Links to Economic and Financial Stability", At the Banque de France Financial Stability Review Launch Event, Paris, France, February 18, 2011.
_________

TRAVELLING SOUTH ... BE BACK ON FRIDAY ... THE STORY REMAINS THE SAME: VALUATION GENERALLY OK, BUT CREDIT SPREADS WILL CHECK RALLIES

LIQUIDITY NEWS. RATE REDUCTIONS EVERYWHERE!
[Latest Endogenous Liquidity Index: -64.9%; latest Global Dollar Liquidity measure: +40.3%]

As expected, central banks deliver on the interest rate front. But will it work? Not if demand for bank reserves continues to weaken. When demand for bank reserve collapses, central banks may indeed destroy liquidity, even as they lower their target for the short rate. This happened in Japan in the early 1990s. It's called the liquidity trap. Look at the comments on inflation: are we in the midst of a global liquidity trap?

. The RBNZ sets the tone. The Reserve Bank of New Zealand reduces the Official Cash Rate (OCR) from 6.5 percent to 5.0 percent. Note the comment: "Inflation is abating here and overseas". [RBNZ]

. The Riksbank: a leading indicator. The Swedish CB slashes rate in a dramatic move. The Riksbank often leads other CBs in terms of monetary policy. "The Executive Board of the Riksbank has decided to cut the repo rate by 1.75 percentage points to 2 per cent". Again: "A lower interest rate path ..." [Riksbank]

. The Old Lady moves again! The Bank of England reduces the Bank rate by a full 100 bps to 2.00%! According to the Committee: "... measures of inflation expectations fell back sharply". [BoE]

. The laggard. The ECB takes the main refinancing operations of the Eurosystem to 2.50%, own from 3.25% [ECB]

DAILY TWITTER-LIKE POSTS ON GLOBAL LIQUIDITY ...
[Latest Endogenous Liquidity Index: -65.6%; latest Global Dollar Liquidity measure: +40.3%]

. A resilient market as credit spreads widen. The market is showing some resilience here in the face of surging credit spreads. At 612 bps, the Moody's Baa spread trades at record highs — a sure sign that corporate earnings are collapsing as we speak. [Selected Interest Rates]

. Hugh Hendry: bullish on government bonds. Eclectica Asset Management's Hugh Hendry is always a highly entertaining guest over at CNBC Europe. Mr. Hendry looks at inverted yield curves a sure sign of danger in terms of riksy assets. He now thinks that US equities "could remain in the doldrums" for another 15 ... years! [Steve Johnson: "Bold hedge fund star says stellar performance no longer enough", Financial Times]

. The UK & the euro. Denmark's prime minister and central bank chief both recently stated that the key lesson from the financial crisis was that the country had to join the euro. The ECB, after all, represents a very large source of liquidity. Is the United Kingdom now thinking in similar terms? [BBC News: "No 10 denies shift in euro policy"]

SOME TWITTER-LIKE POSTS ON GLOBAL LIQUIDITY ...
[Latest Endogenous Liquidity Index: -66.3%; latest Global Dollar Liquidity measure: +40.3%]

. Credit spreads I. The Moody's Baa spread trades at 601 bps. Difficult to feel too bullish about risky assets with such level of credit spreads. [Selected Interest Rates]

. Credit spreads II. Blackrock's Owen Murfin warns: the information-value of credit spreads is distorded (and undermined) by liquidity considerations, i.e. people being forced to sell corporates. I know that already: market-based indicators are not perfect. But they are doing a heck of a job all the same. [Sophia Grene: "Bond spread not as scary as it first seems", Financial Times]

. Liquidity & checks and balances. Countries with political checks and balances have the best credit systems. The same principle operates at a micro-economic level. Citigroup had no independent risk analysis system in place. What a mess! [Eric Dash & Julie Creswell: "Citigroup Saw No Red Flags Even as It Made Bolder Bets", The New York Times]

. Ben Bernanke on private credit markets. "The Federal Reserve's liquidity programs ... have not yet returned private credit markets to normal functioning". Now that's an understatement! (The Endogenous Liquidity Index is now 66.3% below last year's level). [Ben Bernanke: "Federal Reserve Policies in the Financial Crisis"]

. RBA cuts rates. The Reserve Bank of Australia cuts its target for the cash rate by 100 bps, down to 4.25%. Good news! [RBA]

LIQUIDITY NEWS. THE LEGS OF THE RALLY
[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]
_______

LIQUIDITY NEWS. GLOBALIZING THE HKMA SOLUTION
[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.

LIQUIDITY NEWS. ON RATES & BUBBLES: LOTS OF MATERIAL!
[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).

LIQUIDITY WATCH. A WELCOME RETURN TO NORMALCY
. 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
agustin_mackinlay@yahoo.com
_________________

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.

LIQUIDITY NEWS. A RALLY IS IN SIGHT!
[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.

LIQUIDITY NEWS. NICOLE ELLIOTT ON CNBC ... VERY BEARISH!
[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]

LIQUIDITY NEWS. ENDOGENOUS LIQUIDITY AT A NEW ALL-TIME LOW
[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]
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LIQUIDITY WATCH. AN IMPROVING SITUATION -- BUT STILL NO LONG-TERM BULLISH SIGNAL
. 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
agustin_mackinlay@yahoo.com
_________________

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.

MONTEARY POLICY. PRUDENCE, CANADIAN STYLE
[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.)

LIQUIDITY NEWS. KEVIN WARSH: PRIVATE & PUBLIC LIQUIDITY
[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!

LIQUIDITY NEWS. A 15% GDP CONTRACTION?
[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]
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- 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]
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LIQUIDITY NEWS. THE TED SPREAD AT ONE-AND-A-HALF MONTH LOWS
[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.

LIQUIDITY WATCH. THE MADNESS CONTINUES
. 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
agustin_mackinlay@yahoo.com
_________________

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.

LIQUIDITY NEWS. A TALE OF TWO CENTRAL BANKS
[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%].

LIQUIDITY NEWS ...
[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]
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- 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]
__________

LIQUIDITY WATCH. THE MOST SUCCESSFUL FED MOVE SO FAR?
[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!
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- 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".

LIQUIDITY ANALYSIS. WHEN IT COMES TO LIQUIDITY, SIZE MATTERS
[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.

LIQUIDITY WATCH. WHAT A MESS!
. Federal Reserve: "Factors Affecting Reserve Balances", October 30

- Fed's Treasuries holdings + loans: $1,233.9bn (+$50.5bn)
- Other central banks' Treasuries holdings: $1,571.2bn (+$15.9bn) (*)
- Other central banks' agency securities: $915.0 (-$8.4bn) (*)
- Global Dollar Liquidity Measure: $3,290.4bn (+$58.0bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

The weekly Fed balance sheet is a complete mess. (Other words that come to my mind: chaos, confusion, anarchy). New items are being added every week. And we're talking hundreds of billions of dollars. Literally. My new Global Dollar Liquidity measure, which (hopefully) reflects the impact of all recent liquidity programs, now reaches almost $3.3 trillion. The numbers are trully mind-boggling. Monthly average figures (not displayed here) show a 46.5% increase in my proxy for the monetary base. Think about it: prior to the Lehman Brothers collapse, we were dealing with a 2.6% contraction. This is by far the greatest balance sheet expansion in the history of the Federal Reserve Bank. The Global Dollar Liquidity is growing at the phenomenal rate of 29.6% per annum. Totally unheard of!

Ladies and gentlemen, it's not that complicated after all: the massive delevarging efforts by the private sector are being matched by an equally massive releveraging process from G7 central banks. Keynesian economics, anyone?

LIQUIDITY ANALYSIS. A TRULY HISTORIC AGREEMENT; THE TROUBLE WITH "HELICOPTER BEN"
[Latest Endogenous Liquidity Index: -65.5%; Latest Global Dollar Liquidity measure: +28.7%]

- A truly historic agreement! Yesterday's swap lines agreement between the Fed, Banco Central do Brasil, Banco de México, Bank of Korea and Singapore's Monetary Authority is a historic event. As any reader of Thomas Barnett's books on globalization would instantly recognize, these facilities confirm the inescapable reality of today's economic and financial connectivity. The message for commodity-exporting countries is clear: you can benefit from global trade flows, provided that you recognize the risks and that you play by the rules. Look at the list of CBs included in the "swap club": the Reserve Bank of Australia, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Reserve Bank of New Zealand, the Norges Bank, the Sveriges Riksbank, and the Swiss National Bank. These are all independent central banks, which makes the inclusion of Banco de Mexico and Banco Central do Brasil all the more impressive. Henrique Meirelles, the Banco Central do Brasil chairman, waisted no time in putting forward the importance of the agreement: "O acordo é importante pela inclusão formal do Brasil com outras economias relevantes do globo". [Banco do Brasil: "Nota à imprensa"; Federal Reserve: "Press Release"]
__________

- The trouble with "Helicopter Ben". Remember Ben Bernanke's recent remarks at the Economic Club of New York? The thing that caught my attention was his response to a question on ... financial bubbles. In essence, Mr. Bernanke seemed to suggest that bubbles pop up whenever bank regulation fails. In other words: they have little to do with monetary policy itself. This was a clever answer, since we all know that it was the then Fed vice-chairman who in 2003 argued forcefully for a 1% fed funds rate. Now "Helicopter Ben" is at it again. I know, I know: in times of crisis, you just throw prudence to the wind. My point is, if you want to avoid a permanent spike in long-term rates, you need a monetary policy rule-set. And what is the FOMC's rule-set? I dunno. [Ben Bernanke: "Stabilizing the Financial Markets and the Economy", Federal Reserve]
_________

- Endogenous Liquidity daily watch. The Endogenous Liquidity Index improves modestly (+0.65%) on the heels of falling CDS spreads — especially Emerging Market spreads, as commodities rally and the dollar falls. Inflation breakevens are rebounding somewhat, and I suspect that they will move further up in coming days (they are still close to all-time lows, though). On a spot basis, the recent slight improvement in the 3-month TED spread is now history: we're back at 373 bps. The real worry, in my opinion, is the credit spreads situation. The 10-year Moody's Baa spread refuses to back down. That, my friends, is a sure sign of trouble in terms of corporate earnings. [Selected Interest Rates]
_________

LIQUIDITY NEWS ...
[Latest Endogenous Liquidity Index: -65.8%; Latest Global Dollar Liquidity measure: +28.7%]

- The Fed cuts rates. The FOMC lowers the fed funds target to 1.00% from 1.50%; in a related action, the Board of Governors unanimously approves a 50-basis-point decrease in the discount rate to 1.25%. [Communiqué]

- Two new swap lines. The Fed announces the establishment of temporary reciprocal currency arrangements (a.k.a swap lines) with the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore. (A similar announcement was made yesterday with respect to the Reserve Bank of New Zealand.)

- Norway's central bank lowers key rate from 5.25% to 4.75%. From the communiqué: "There is now unusually high uncertainty surrounding economic developments ahead. An overall assessment of the outlook and the balance of risks suggests that it is now appropriate to reduce the key policy rate by 0.50 percentage point. Weight is given to moving forward the reduction in the key policy rate so that lending rates for households and businesses can gradually be reduced".

- The People's Bank of China cuts one-year lending rate from 6.93% to 6.66%. From Bloomberg: "This cut was driven by the slowdown in the third quarter and the likelihood that the U.S. and other central banks will cut rates,'' said Xing Ziqiang, an economist at China International Capital Corp. in Beijing". Coordinated rate cuts, anyone?

LIQUIDITY ANALYSIS. A NEW HIGH FOR THE GOLDILOCKS/STAGFLATION INDEX (IF YOU CAN BELIEVE IT)
[Latest Endogenous Liquidity Index: -65.8%; Latest Global Dollar Liquidity measure: +28.7%]

- The TED spread & credit spreads. Pointing to the slightly lower TED spread, CNBC's Steve Liesman keeps talking about "improving credit markets" conditions. Wrong, in my opinion. Money markets are not credit markets. Take a look at the 10-year Moody's Baa spread: at 560 bps, it trades at an all-time high. This is hardly what you would expect in the context of "improving credit markets". [Selected Interest Rates]
________

- Don't cry for me, Argentina (again). Argentine policymakers just don't get it. If you destroy property rights, credit markets will respond in kind. The supply of loanable resources is all but collapsing; interest rates are skyrocketting in Buenos Aires and beyond. Ladies and gentlemen: checks and balances do matter. The arbitrary exercise of government power generally results in very high long-term (real) interest rates. The great Montesquieu said as much in The Spirit of the Laws. Now just ask Vladimir Putin and Nestor Kirchner. [Financial Times: "Argentine own goal"]
__________

- The Goldilocks/Stagflation Index at a new high (if you can believe it). Inflation expectations are collapsing at a much faster rate than economic growth: that's the message behind the new high in my Goldilocks/Stagflation Index. With the denominator (ten year-inflation breakevens) at such an impressive all-time low (77 bps), even the lackluster performance of the numerator (the platinum-gold ratio) cannot impede the index to reach new highs. Does that really matter? When valued against the Goldilocks/Stagflation Index, the S&P500 trades at a new all-time low. If credit spreads would collaborate (not a sure bet, by any means), the ensuing rally would be —as a well-known CNBC commentator recently put it— "jaw-dropping".
________

LIBERTÉ, EGALITÉ, LIQUIDITÉ!

Just when the most impressive liquidity crisis in recent memory makes headlines everywhere, the editor of the Global Liquidity Blog finds himself incredibly busy with a number of different projects. Plus, I'll be in Paris for the Easter week-end. In other words, no blog until next Tuesday. Liberté, egalité, liquidité!

Cheers,

Agustin.

LIQUIDITY NEWS. WILD RUMORS, WEAK DOLLAR
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -50.6%]

There are all sorts of rumors out there about hedge funds, and even about some big financial institution going under. The liquidity crisis, apparently, is fast becoming a ... solvency crisis! Here's my two cents on the rumors: I don't believe them. I trully think that the new market-based, securitization-driven financial market has succeeded in diversifying credit risk. Of course, we are only now becoming aware of the phenomenal downside: a spectacular information crunch, whereby nodody really knows the extent of the damage sustained by one's credit counterparties.

Overall, the Fed's liquidity operations are well designed. But perhaps Mr. Bernanke should be more explicit about his goal: to solve the liquidity puzzle while not giving the impression that he stamps his signature on mere American ... pesos.

LIQUIDITY NEWS. THE "TAF" INCREASE IS A SMART MOVE
[Latest Global Dollar Liquidity measure: +11.3% annual growth rate; latest Endogenous Liquidity Index: -50.6%]

[1] The TAF increase: a smart move! On Friday, the Federal Reserve announced that the amounts outstanding in the Term Auction Facility (TAF) would be increased to $100 billion. In a separate move, the Fed will initiate "a series of term repurchase transactions that are expected to cumulate to $100 billion". These are smart moves, reminiscent of the European Central Bank's recent liquidity policies. The aim is to provide liquidity without altering the target rate of the fed funds. For most of 2007, Fed policy has been rather restrictive: fed funds traded above Treasury market rates, and monetary base growth was very weak. Now, the triple combination of a steeper yield curve, rising commodity prices and a faltering dollar is signalling that the fed funds rate is fast approaching an appropiatley accomodative level. The Fed needs to be more creative. The TAF increase is a smart move. [Press release]

[2] Panic in credit-land! The Moody's Baa spread has reached 335bp, a level not seen since January 2003. And the Credit Default Swap market is in turmoil. On Friday, the iTraxx Japan 80 index traded at 155bp, a 30bp increase in just one session! According to the Financial Times, "Institutions that lapped up credit risk products in recent years – many financing their purchases through borrowing – are scrambling to reduce their exposure following heavy losses ... The spread widening is so severe, you’re seeing a rise in borrowing rates across the board for everybody except top-quality governments. It’s affecting both the price and availability of credit". We'll be closely watching the U.S. investment grade CDS market, now trading at 178bp over Libor. A move above 200bp, according to Bank of America, "could trigger a jump towards 220bp". Meanwhile, Cumberland Advisors's David Kotok sees the current panic as an opportunity: "My negative and disagreeable email is approaching the peak levels I last saw in 2000. Then we were buying 6% tax-free bonds while investors were selling them to buy Cisco and Microsoft at 100 times earnings". [Robert Cookson: "Credit derivatives turmoil strikes", Financial Times] [David Kotok: "J'ai Peur", Cumberland Advisors]

LIQUIDITY WATCH. WHO CARES ABOUT 'MACRO' LIQUIDITY WHEN MARKET LIQUIDITY IS EVAPORATING?
. Federal Reserve: "Factors Affecting Reserve Balances", March 5

- Fed's Treasuries holdings: $789.6bn (+$12.9bn)
- Other central banks' Treasuries holdings: $1,280.6bn (+$10.3bn) (*)
- Other central banks' agency securities: $869.4 (-$1.8bn) (*)
- Global Dollar Liquidity Measure: $2,939.6bn (+$21.5bn)

(*) Off-balance-sheet items
agustin_mackinlay@yahoo.com
_________________

Who cares about funding (or macroeconomic) liquidity when market liquidity is all but collapsing? The answer: FX and commodity markets traders. They like what they see: foreign central banks desperately trying to avoid the unavoidable — namely, sharp interest rate increases in places like China, Russia and Argentina, to name but a few. We may be witnessing the last phase of extravagant moves in some of these markets. Meanwhile, our Endogenous Liquidity Index saw one of its worst days ever, as all components —including all CDS indices— fell sharply (a very rare occurrence).The ELI is now down more than 50% from a year ago! The hedge fund community, in particular, is feeling the heat. Peloton Partners, trying to pick the bottom in credit markets, is now out of the game. Carlyle Capital, which had geared up 32 times to buy a $22bn book a triple-A mortgages, is making headlines (for the wrong reasons, presumably).

To put it in perspective, here are a few quotes from analysts interviewed by the Financial Times: "The repricing of liquidity and credit lines to hedge funds will squeeze more credit funds out of business" (Huw van Steenis, Morgan Stanley); "... The most chaotic times in the credit markets since the Great Depression" (William O'Donnell, UBS); "There is an extreme lack of liquidity and markets are being moved by liquidation fears and margin calls" (Tom Di Galoma, Jefferies). There you have it. [Michael Mackenzie: "Hedge funds spark fixed income stress", Financial Times] [James Mackintosh: "Gloom set to worsen as threat of spiral grows", Financial Times].

LIQUIDITY NEWS. FREDERIC MISHKIN & DAVID RICARDO
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -47.3%]

In his discussion of the dynamics of inflation expectations, Federal Reserve Governor Frederic Mishkin discounts the current uptick in the spread between "nominal Treasuries" and TIPS as a reflection (in part) of "changes in ... the relative liquidity of TIPS and similar maturity nominal Treasuries". Hmmm ... Now let's not forget that Mr. Mishkin is referring to a market-based indicator here. He should, perhaps, show more respect for other market-based indicators. Long ago, Manuel Johnson and Robert Keleher taught us the following golden rule, partly based on the teachings of British economist David Ricardo (1772-1823): whenever a currency falls in terms of other currencies, AND in terms of gold, AND its yield curve gets steeper, AND commodity prices soar, there's no way to hide the ugly truth — there is indeed an inflation problem.

LIQUIDITY NEWS. CREDIT SPREADS TAKE CENTER STAGE
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -48.6%]

As I wrote yesterday, credit spreads are surging on a global basis. The Moody's Baa spread trades at a new five-year high of 322 basis points. Federal Reserve Governor Frederic Mishkin mentioned credit spreads on at least three occasions in his latest speech. First, he notes that corporate bond spreads are rising because investors are becoming "less willing to bear risk, more concerned about the valuations of a wide range of complex financial instruments, and more concerned about counterparty credit risk". He then notes that rising credit spreads point to a deterioration in "business sentiment" (translation: corporate profits will fall).

Finally, Mr. Mishkin notes, in the context of the housing market, that "a decline in house prices can increase the wedge between the default-free interest rate and the effective interest rate facing the homeowner. That is, in the eyes of the lenders, declining house prices diminish the quality of the borrowers' collateral, which effectively reduces the availability of credit to households that can be used to finance consumer purchases". Credit spreads, my friends, are taking center stage. Not a minute too soon! In today's Financial Times "Markets & Investing column", PIMCO's Bill Gross makes an important point about rising credit spreads:

Despite the rapid decline in Treasury yields, mortgage and corporate credit markets are not co-operating, producing aggregate price declines in total. Historically high levels of consumption as a percentage of gross domestic product are not being supported any more by leverageable assets that appreciate perpetually in price ... The American economy, so dependent on asset inflation of one sort or another, is now experiencing price deflation in all three major categories – real estate, stocks, and yes, bonds.

Even with the recent bout of price inflation in the Treasury market, rising credit spreads mean that the bond market as a whole is "deflating". While one could argue with the remark that the U.S. economy is "so dependent on asset inflation" —Bill Gross has a perma-bear-like tendency to sistematically discount the positive impact of business innovation on the economy— the point about price deflation in all three major categories is an important one.

[1] Frederic S. Mishkin: "Outlook and Risks for the U.S. Economy", Federal Reserve Board

[2] Bill Gross: "Urgent action needed to stave off rise of Bushville", Financial Times

LIQUIDITY NEWS. CDS SPREADS EXPLOSE GLOBALLY
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -48.5%]

[1] Credit spreads are surging globally. Most of the international CDS indices that I track are posting new highs in terms of spreads. Emerging markets appear to fare a touch better as of this writing. But take a look at Markit's iTraxx series. All of them, without exception, are trading at new highs in terms of spreads: Europe, Europe Crossover, Japan, Asia ex-Japan, Australia, and Japan 80. There is a whiff of panic in the air, as some spreads have surged more than 30% in just one session. Ladies and gentlemen: the credit spread explosion has gone global, no doubt about it.

[2] A Petrodollar tsunami? (Liquidity @ Financial Times). Morgan Stanley's Stephen Jen warns about the upcoming "petrodollar tsunami" that is likely to occur as oil trades at $100/barrel. Here's the key excerpt: "At $100 a barrel, the total proven reserves of the oil exporting countries is about $104,000bn – equivalent to the combined total value of publicly-traded equities and bonds in the world". Jen thinks that the tsunami has two broad implications in terms of financial markets: (a) equities will outperform bonds; (2) emerging market currencies are likely to gain both in terms of the dollar and the euro [Stephen Jen: "Petrodollar tsunami to hit euro and dollar", Financial Times]

LIQUIDITY NEWS. A NEW LOW FOR THE ENDOGENOUS LIQUIDITY INDEX
[Latest Global Dollar Liquidity measure: +11.9% annual growth rate; latest Endogenous Liquidity Index: -48.1%]

[1] Endogenous liquidity: a new low! Surging credit spreads on both CDS and cash bonds, the higher VIX, and plunging stock prices of financial innovators: all these factors are conspiring to send our Endogenous Liquidity Index to yet a new low (-48.1% year-on-year). The most worrying factor, in my mind, continues to be the path of the Moody's Baa spread. At 317 bps, it trades at highs not seen since February 2003. This provides a clear forecast in terms of corporate earnings: down!

[2] Bank Credit Analyst's own ... Goldilocks-Stagflation indicator! Since Friday, the Goldilocks-Stagflation indicator has competition: Bank Credit Analyst, the top-notch Canadian consultants, have launched their own indicator. Unlike our measure, which is market-based, BCA's is a quantity indicator: it results from computing stories that mention "goldilocks", "rising inflation" and "recession". See for yourself.

LIQUIDITY WATCH. BUSINESS AS USUAL: STRONG FUNDING LIQUIDITY, WEAK MARKET LIQUIDITY
. 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
agustin_mackinlay@yahoo.com
_________________

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!

LIQUIDITY NEWS. THE LARGEST EVER PEACETIME LIQUIDITY CRISIS?
[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

LIQUIDITY ANALYSIS. GOVERNOR MISHKIN ON THE TERM AUCTION FACILITY
. 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.

ESSAY REVIEW. A NEW DEFINITION OF LIQUIDITY: THE GROWTH RATE OF REPOS
. 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).

LIQUIDITY WATCH. WHAT A DIFFERENCE A WEEK MAKES!
. 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
agustin_mackinlay@yahoo.com
_________________

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".

LIQUIDITY NEWS
[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

LIQUIDITY NEWS. MARTIN WOLF & THE BEARISH CASE
[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].

LIQUIDITY WATCH. ACROSS-THE-BOARD DECLINES!
. 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
agustin_mackinlay@yahoo.com
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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.

LIQUIDITY NEWS
[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"]

LIQUIDITY ANALYSIS. THE LIQUIDITY CONUNDRUM INTENSIFIES
[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.