WHILE TALKING TO MY BROKER ...
[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -31.3%]

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

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

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

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

THE GOOD, THE BAD & THE UGLY
[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -32.5%]

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

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

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

TWO QUICK THOUGHTS ON THE FED AND ... CHINA
[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -34.6%]

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

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

WEEKLY FED BALANCE SHEET REVIEW. FROM CHINA WITH LOVE: WELCOME TO GLOBALIZATION 2.0
. Federal Reserve: "Factors Affecting Reserve Balances", August 15

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

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

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

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

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

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

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

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

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

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

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

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

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

ENTER THE NARROWING TRADE DEFICIT (LONG-TERM BULLISH SIGNAL UNDER THREAT?)
[Latest Global Dollar Liquidity Measure: +14.9% annual growth rate; latest Endogenous Liquidity Index: -29.6%]

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

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

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

CENTRAL BANKS, RULES & DISCRETION. I'M LOVIN'IT!
[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -28.1%]

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

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

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

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

TAKING A SHORT BREAK ... BACK ON MONDAY ... MOST IMPORTANT PIECE OF NEWS: THE COLLAPSE IN INFLATION EXPECTATIONS, COURTESY OF THE INVERTED YIELD CURVE ... "COMBO MODEL" (FUNDING + MARKET LIQUIDITY) STILL BULLISH, BUT GETTING CLOSER TO LONG-TERM NEUTRAL SIGNAL (WATCH MOODY´S BAA SPREADS)... STILL A WATCHFUL OPTIMIST HERE ... CHEERS.

WEEKLY FED BALANCE SHEET REVIEW. ANOTHER STRONG SHOWING (WITH SOME QUESTION MARKS)
. Federal Reserve: "Factors Affecting Reserve Balances", August 1

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

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

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

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

THIS IS NOT ASIA REDUX
[Latest Global Dollar Liquidity Measure: +15.7% annual growth rate; latest Endogenous Liquidity Index: -23.0%]

As a keen watcher of credit spreads, I don't pretend to downplay the seriousness of the crisis in creditland. Estimations for corporate profits and global economic growth will most certainly have to be revised downwards. But this is not 1998 redux, as some are suggesting (sorry, no link). Back in September 1998, our Global Dollar Liquidity measure was all but collapsing: -4.7%. It is +15.7% now.

WEEKLY FED BALANCE SHEET REVIEW. FUNDING LIQUIDITY IS UP (BUT WHO CARES?)
. Federal Reserve: "Factors Affecting Reserve Balances", July 25

- Fed's Treasuries holdings: $778.1bn (-$3.6bn)
- Other central banks' Treasuries holdings: $1,253.3bn (+$1.8bn) (*)
- Other central banks' agency securities: $749.7bn (+$5.2bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,781.0bn (+$3.4n)

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

Foreign central banks continue to buy Treasury and agency securities: they added a further $7bn to their accounts. Meanwhile, the renewed inversion of the yield curve means that the 5.25% Fed funds rate is likely to take its toll on domestic liquidity conditions (-$3.6bn). All in all, "funding" liquidity remains strong, with the annual rate of growth of our preferred measure at a 30-month high (+15.7%). But who cares about funding liquidity anyway? All the action is in "market" liquidity.

Here, the meltdown is taking epic proportions. Our still preliminary Endogenous Liquidity Index is down 21%! All major components are weak: CDS and other credit spreads, volatility measures, and measures of financial innovation. Still, the Moody's Baa spread (the key spread in my long-term models) is unchanged vs. July 2006. Am I missing something here?

TRADING RANGE SCENARIO STILL IN THE CARDS ...
[Latest Global Dollar Liquidity Measure: +15.6% annual growth rate; latest Endogenous Liquidity Index: -15.0%]

Sorry for the lack of posting ... Not always easy from a distance ... Trading range scenario still in the cards ... A further 35 basis points to go on the Baa spread before Liquidity Combo Model (funding + market liquidity) turns officially bearish ... Looks very unlikely to me ... Yield curve's renewed inversion signals lower inflationary pressures ahead ... Markets doing the Fed's job ...

TRAVELLING! BACK ON TUESDAY OR WEDNESDAY!

WEEKLY FED BALANCE SHEET REVIEW. 24 UP, 5 DOWN
. Federal Reserve: "Factors Affecting Reserve Balances", July 18

- Fed's Treasuries holdings: $781.6bn (-$0.2bn)
- Other central banks' Treasuries holdings: $1,251.5bn (+$6.5bn) (*)
- Other central banks' agency securities: $744.5bn (+$0.6bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,777.6bn (+$6.9bn)

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

Twenty-nine weekly Fed balance sheets have been published so far this year. In as much as 24 of them, our Global Dollar Liquidity measure has shown gains. In fact, we're growing at a 15.6% annual rate, the fastest pace since January 2005. Liquidity bears do not seem to pay attention to these facts. Rather, they tend to concentrate on market liquidity. Admittedly, things do not look pretty in parts of credit-land. Richard Bernstein, chief investment strategist at Merril Lynch, mentions the L-word no less than 13 times in his very bearish comments on market liquidity [HT: Robert].

Now, as a keen watcher of credit spreads myself, I will concede that expectations of corporate earnings will have to be downgraded sooner or later if spreads continue to surge. But let's not forget one thing: while we are witnessing the greatest episode of wealth creation in the history of civilization, long-term interest rates are toying with ... what? 5%? Analyze that!

KEN FISHER & CREDIT SPREADS
[Latest Global Dollar Liquidity Measure: +15.5% annual growth rate; latest Endogenous Liquidity Index: -5.5%]

Very interesting piece by Ken Fisher. I am in a hurry right now, so no time to analyze in detail. The message is: watch credit spreads! Yes, they have been rising over the last couple of weeks. But year-on-year measures tell a more bullish story. I agree — but I'll keep an eye on those pesky spreads.

RISING CREDIT SPREADS ...
[Latest Global Dollar Liquidity Measure: +15.5% annual growth rate; latest Endogenous Liquidity Index: -3.0%]

Increasing funding liquidity and decreasing credit spreads: the ideal scenario to run with the bulls. But now credit spreads are rising: should we worry about risky assets? My (very simple) long-term models tell me not to worry — yet.

LIQUIDITY TALK
[Latest Global Dollar Liquidity Measure: +15.5% annual growth rate; latest Endogenous Liquidity Index: -1.2%]

- Liquidity & CNBC's Trillion Dollar Survey. According to CNBC's survey, "Liquidity is the strongest factor influencing the stock market right now". More than 26% of those surveyed see "market liquidity" as the key factor. That's pretty interesting: our own measures of market liquidity aren't quite as bullish.
___________

- Boeing, Caterpillar & Volatility. Fascinating piece by John Gapper. Here's the key part: "The 787 is remarkable for the degree to which Boeing has outsourced production around the world. Boeing itself is responsible for about 10 per cent by value –– tail fin and final assembly. The rest is done by 40 partners, with the wings built in Japan, the carbon composite fuselage in Italy and the US and the landing gear in France".

Boeing has ceased to call itself a manufacturing company; instead, it now sees itself as a systems aggregator, whatever that means. Now take Caterpillar. Weak U.S. demand due to the housing slump? No problem: let's open a Component Manufacturing Campus in Wuxi, China. What do Boeing's and Caterpillar's actions tell us about the expected volatility of the business cycle?
___________

- Cisco Systems: productivity & the business cycle. There are a number of theories pretending to explain the "Great Moderation" of the business cycle. In the late 1990s, it was all about how digital networks helped companies better manage their inventories, thus leading to a smoother cycle. (By the way, I believe it's true: look at this amazing chart).

Enter John Chambers. In this interview, the Cisco CEO tells the Financial Times that "The introduction of consumer-driven web 2.0 technologies into businesses is set to usher in a new phase of productivity growth that could surpass that achieved during the late-1990s internet boom". Again: what does that tell us about the expected volatility of the business cycle?
___________

- China to buy Ginnie Mae paper? What a story (Bloomberg). Just as the U.S. budget situation appears to be improving, the housing market slumps. No problem: just ask the Chinese to buy up those Ginnie Mae-guaranteed bonds.

WEEKLY FED BALANCE SHEET REVIEW. UP, BUT NO BY MUCH
. Federal Reserve: "Factors Affecting Reserve Balances", July 11

- Fed's Treasuries holdings: $781.8bn (-$3.8bn)
- Other central banks' Treasuries holdings: $1,245.0bn (+$4.4bn) (*)
- Other central banks' agency securities: $744.0bn (+$2.5bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,770.7bn (+$3.1bn)

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

The weekly Fed balance sheet shows a rather modest (+$3.1bn) gain in our Global Dollar Liquidity measure. Foreign Central banks continue to show more appetite for Treasuries than for agency securities, which probably reflects the lure of higher yields. The weekly gains may be subdued, but July is nonetheless the 56th month in a row with our measure growing north of 10% in annual terms. As Barry Ritholtz would put it: un-frickin-believable.

VOLATILITY AND CREDIT SPREADS
[Latest Global Dollar Liquidity Measure: +15.5% annual growth rate; latest Endogenous Liquidity Index: -5.5%]

The Endogenous Liquidity Index was essentially flat yesterday, but its components were not. CDS spreads again went sharply up, but volatility measures sold-off quite dramatically. There's a lesson here, at least for me. The "Great Moderation" of the business cycle —for which volatility indicators act as a proxy— matters at least as much as credit spreads. More on that soon.

IMPLOSION! EXPLOSION!
[Latest Global Dollar Liquidity Measure: +15.5% annual growth rate; latest Endogenous Liquidity Index: -5.1%]

Our Endogenous Liquidity Index suffered yesterday its sharpest one-day fall since inception: -6.0%! All components registered losses: the "Great Moderation" indicator (as measured by the VIX and other volatility measures), CDS spreads and credit spreads in general, and measures of financial innovation. Implosion!

Meanwhile, foreign central banks continue to buy Treasury and agency securities at increasing rates. (See our last weekly report and this post by Brad Setser, who doesn't rule out the possibility that total emerging market reserve growth could "easily be in the $500-600b range for the first half of the year -- or $1,000 to $1,200b annualized"). Explosion!

With global liquidity both exploding and imploding, I remain true to the trading-range scenario for risky assets. Is there any money to be made? According to the Financial Times:

A $2bn fund run by New York's Paulson & Co was the single best-performing fund, rising 39.95 per cent after fees in June thanks to its dedicated bets against subprime mortgages – loans to less credit-worthy homeowners. Other hedge funds following similar strategies produced returns as high as 27.5 per cent in the month, while another manager has tripled investor money this year, according to investors.

Nice!

DANCIN' LIQUIDITY!
[Latest Global Dollar Liquidity Measure: +15.5% annual growth rate; latest Endogenous Liquidity Index: +2.0%]

This is, hands down, the liquidity story du jour. Chuck Prince, the Citigroup CEO, tells the Financial Times that he feels confident enough to dismiss fears that the music is about to stop for the cheap credit-fuelled buy-out boom, declaring that Citigroup is "still dancing". And he adds: "...the party [will] end at some point but there [is] so much liquidity at the moment it would not be disrupted by the turmoil in the US subprime mortgage market".

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing ... The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don't think we're at that point ... The way big Wall Street banks and large hedge funds [have] been picking up troubled subprime mortgage lenders [is] an example of how "liquidity rushes in" to fill the gap as others spot a buying opportunity.

LIQUIDITY TALK
[Latest Global Dollar Liquidity Measure: +15.5% annual growth rate; latest Endogenous Liquidity Index: -0.8%]

- The CDO Put at work, again. According to the Daily Institutional Investor, HSBC is in the early stages of marketing "a managed synthetic corporate collateralized debt obligation to Asian investors called Maple Hill II. The deal was structured in New York, contains largely European and U.S. investment-grade underlying and is getting global distribution. Seven-and-a-half-year and 10-year notes are available and the deal is managed by U.S.-based Babson Capital".

"The portfolio references 136 high quality global corporate credits with a 10% cap in high-yield credits". Interestingly enough, Asia appears to be the source of demand: "... there has been consistent demand for this type of deal, particularly from Japan and Korea. She added that HSBC also has a lot of new Asian accounts from places such as China, Philippines, Thailand and Malaysia looking to get into structured credit, and who look to this sort of product for its diversity and relatively high yield".
_________________

- PIMCO's Tomoya Masanao on global liquidity. From a global liquidity point of view, this piece contains three interesting elements. [1] The changing face of the New Bretton Woods: "Currency reserves in China and other Asian countries have been a very important factor in containing risk premiums in the financial markets. These countries have been using their reserves to buy U.S. Treasuries and other high quality bonds in an effort to maintain currency pegs versus the U.S. dollar ... This evolution [i.e. investing in riskier assets via "sovereign wealth funds"] is already occurring and will accelerate over our secular horizon".

"This evolution, coupled with our global growth outlook, suggests a positive environment for riskier assets, notably stocks, real estate and commodities. That environment is unfortunately not very positive for high quality bond markets like U.S. Treasuries". [2] Towards a more balanced global business cycle? "One important change in our outlook is simply that we recognize global aggregate demand is becoming less U.S.-centric and that domestic demand in emerging markets is continuing and accelerating, which in turn is feeding growth, particularly in Europe and Japan".

"We now believe that global aggregate demand will be less dependent on U.S. consumption because of the growth in emerging markets. As the emerging markets become an increasingly important driver of global aggregate demand, the rest of the world will benefit from emerging market growth, particularly Japan and European countries". [3] The recognition of endogenous liquidity. "A second factor that led us to a different conclusion this year is the recognition that the higher asset prices, tighter credit spreads and lower bond yields we have experienced in the last three to five years have eased financial conditions globally. This global liquidity has largely offset central bank tightening in developed countries like the U.S".
_________________

- Bennet Sedacca on global liquidity & M3. Bennet Sedacca and a confession: "I couldn't have said better myself ... the market has been driven by excess global liquidity". After this promising start, Mr. Sedacca surprises with a mention of the now-defunct M3 monetary measure. I have written about this a couple of times already, but let me take the opportunity to repeat one of the key "commandments" of liquidity watchers: M2 and M3 are not liquidity measures. Moreover: they sometines act as indicators of il-liquidity — remember 1998 in the U.S.

WEEKLY FED BALANCE SHEET REVIEW. THE LIQUIDITY CONUNDRUM
. Federal Reserve: "Factors Affecting Reserve Balances", July 4

- Fed's Treasuries holdings: $785.5bn (+$8.1bn)
- Other central banks' Treasuries holdings: $1,240.7bn (+$9.0bn) (*)
- Other central banks' agency securities: $741.5bn (-$2.1bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,767.7bn (+$15.1bn)

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

Another week, another sharp increase in our Global Dollar Liquidity measure. Central banks added more than $15bn to their collective balance sheets, thus contributing to the 15.5% annual rate of growth of funding liquidity — the highest since January 2005. To be sure, the quality of the increase leaves a lot to be desired: the Fed is the biggest contributor (reflecting, perhaps, a seasonal pattern). Note too, foreign CBs' unusual choice of Treasury securities over agency bonds — probably a consequence of higher yields.

Meanwhile, the "liquidity conundrum" is only intensifying, as market liquidity refuses to improve. Our Endogenous Liquidity Index is down 2.5%, reflecting higher credit spreads. In my view, a bullish solution to the conundrum is more likely than not. Inflation expectations continue to moderate, and global economic growth is as strong as ever (*). In the meantime, a trading range scenario should not come as a huge surprise to liquidity watchers.

(*) According to Geraud Charpin, head of European credit strategy at UBS quoted by the Financial Times's Alphaville blog, the sell-off in the CDS market is not being driven by fundamentals: "The sell-off in the market right now is purely technical: macroeconomic numbers have been pretty good and investors expect Q2 corporate earnings to be strong. Essentially, it's all about financial market deleveraging and adjustment rather than macroeconomic fears".

TRADING RANGE AHEAD?
[Latest Global Dollar Liquidity Measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -1.6%]

Strong funding liquidity tells me not to short risky assets; weak market liquidity tells me not to buy aggressively. Trading range ahead?

LIQUIDITY TALK. THE CDO PUT AT WORK?
[Latest Global Dollar Liquidity Measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -1.6%]

According to the Daily Institutional Investor, Wachovia has structured a synthetic collateralized debt obligation for PIMCO, the first deal the firm has led for the manager. "The $750 million CDO, called Bayshore Synthetic CDO 2007-01, is made up of 115 corporate credit-default swaps. Bayshore is being rated by Moody's Investors Service and Standard & Poor's ... The deal is being marketed globally, with the bulk of synthetic CDO liabilities generally now being placed in Asia".

According to Daily Institutional Investor, the deal is a remarkable one because PIMCO "does not issue into the CDO market as frequently as other large managers". I'd bet that Accrued Interest will reflect upon this piece and all the irony it contains. More to the point, could this be the start of the CDO Put? CDS spreads, after all, are rising.

LIQUIDITY TALK. THE GLOBALIZATION OF MICRO-FINANCE!
[Latest Global Dollar Liquidity Measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -4.0%]

A few months ago I read about Kiva's website, which enables pretty much anybody to lend to an entrepreneur in the developing world. It turns out that microfinance, according to this excellent Financial Times article by Joanna Chung (*), is "quickly becoming a popular corner of the capital markets as more investment banks and investors see the business of providing small loans to low-income individuals in poor countries as potentially profitable as well as a powerful tool for development".

To my great surprise, Morgan Stanley (together with Swiss company Blue Orchard) has just issued the first microfinance Collateralized Debt Obligation in a deal worth more than $100 million. According to Ms. Chung, Standard & Poor's "expects to rate an additional two to three microfinance CDO transactions and around 25 MFIs in the coming months, with CDO issuance levels potentially reaching $500m by the end of 2007".

Absolutely fantastic!

(*) Joanna Chung. "Calls for ratings framework amid surge in microfinance", Financial Times.

LIQUIDITY TALK. BOND RALLY?
[Latest Global Dollar Liquidity Measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -4.6%]

James Cramer asks investors to "recognize the bond rally" as a bullish sign. I'm not persuaded. Treasuries may be rallying, but corporates are not: spreads are rising.

LIQUIDITY TALK. CDOs DOMINATE THE LIQUIDITY DEBATE
[Latest Global Dollar Liquidity Measure: +14.6% annual growth rate; latest Endogenous Liquidity Index: -4.6%]

Another day, another drop in our Endogenous Liquidity Index. Once again, all components showed weakness: CDS spreads, cash bond spreads, volatility measures, financial innovation measures. While most of the talk is about CDOs containing asset-backed securities, one has to wonder about the fate of the so-called synthetic CDOs, as CDS spreads continue to climb.

- The FT's Tony Jackson on CDS, CDOs & derivatives. Rightly focuses on synthetic CDOs. "[Credit derivatives] will still be in demand for their original function of hedging risk. They may be less so as a means of blindly assuming risk in the hunt for yield".

- Bloomberg's Mark Pittman on the CDO debâcle. Contains lots of quotes from angry- and bearish fund managers. "We remain nervous about the end of the week, when many leveraged investors in the CDO markets will have to mark down their positions, debt strategists at Barclays Capital in New York said in a June 28 report".

- Morgan Stanley's Richard Berner on the turn in the credit cycle. "The turn in the credit cycle has begun", writes Mr. Berber in this interesting piece. He then asks, rhetorically: "Could this so-far orderly renormalization now morph into an ugly credit crunch that would slam the brakes on the economy and corporate leverage?"

- Bank Credit Analyst feeling less pessimistic. Canada-based BCA acknowledges the increase in quality spreads, but concludes that "the shakeout in sub-prime debt is not over, but may now be contained to lower quality securities, with less risk of a contagion into credit spreads and the banking sector".

WEEKLY FED BALANCE SHEET REVIEW. A TALE OF TWO "LIQUIDITIES"
. Federal Reserve: "Factors Affecting Reserve Balances", June 27

- Fed's Treasuries holdings: $777.4bn (-$4.0bn)
- Other central banks' Treasuries holdings: $1,231.7bn (+$0.7bn) (*)
- Other central banks' agency securities: $743.6bn (+$7.5bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,752.6bn (+$4.2bn)

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

All quiet on the "funding liquidity" front! Foreign central banks were active in the U.S. credit markets, buying more than $8bn in Treasury and agency securities. This was more than enough to compensate for the Federal Reserve's restrictive stance. All in all, our Global Dollar Liquidity measure gained a rather modest $4.2bn. However, the annual rate of growth, at 15.6%, is the highest since February 2005.

Not all is quiet on the "market liquidity" front, though. Credit spreads are still rising; share prices of financial "innovators" (GS, BX) are under pressure; volatility indices refuse to re-visit recent lows. This is a tale of two "liquidities": strong funding liquidity vs. weak market liquidity. What will give? With oil prices hovering around $70/barrel, the need to recycle petro-dollars will soon become pressing. In the meantime, range-bound equity markets make a lot of sense.

LIQUIDITY ANALYSIS. NICE RALLY — BUT SPREADS ARE STILL RISING
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: -1.8%]

Risky assets rallied nicely yesterday. Thanks to a sharp fall in the VIX, our Endogenous Liquidity Index recovered strongly. But we're not out of the woods yet: that's the message conveyed by credit spreads. Even previously dormant European and Japanese CDS spreads are up!

LIQUIDITY TALK. BILL GROSS GETS EMOTIONAL
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: -5.3%]

Concerns about subprime loans have re-emerged, and Bill Gross is bearish once again. That's fine: it's a free country. Anybody has the right to change his or her mind. What got my attention was the article's high degree of emotional intensity. (See for yourself). "Currently", writes Mr. Gross, " 7% of subprime loans are in default. The percentage will grow and grow like a weed in your backyard tomato patch. Now I, the curmudgeon of credit, am as sure of this as I am that the sun will set in the west".

Point taken. I will just say this: I have yet to see a recession with the Global Dollar Liquidity measure growing at 14%-plus rates.

LIQUIDITY TALK. CHARLES DUMAS: LIQUIDITY UNDER THREAT!
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: -5.3%]

Interesting and timely piece by Charles Dumas, chief economist at Lombard Street Research. Mr. Dumas analyzes the possibility of an "implosion of liquidity". That is certainly what our Endogenous Liquidity Index is suggesting: it fell another 2.4% yesterday on the heels of the surging VIX and rising credit spreads. Here's Dumas:

Banks' capital is about to be slashed, and with it excess liquidity in the global system ... Suppose the CDOs held by banks were valued at “market” rather than “model” levels (a fancy new euphemism for illusionary historic book values). Their capital would turn out to be lower. Preservation of capital ratios against loans would require fewer loans: liquidity would have imploded ... A bunch of hedge funds may have problems, but that is the tip of the iceberg for "Titanic" Wall Street. Who holds the toxic tranches? Answer: the originating banks and syndicating investment banks for the most part ... [The] much-trumpeted shift of credit risk off balance sheets was less than met the eye.

Given what's happening with credit spreads, there's little doubt that we are witnessing, at least to some degree, the scenario described by Mr. Dumas. But then Mr. Dumas himself acknowledges that "liquidity is a complex thing". And that leads to an interesting question: why does he omit the (still booming) funding liquidity?

LIQUIDITY TALK. ENDOGENOUS ... IL-LIQUIDITY!
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: -2.4%]

Bombarded from all sides, our Endogenous Liquidity Index has finally turned negative. The rising VIX, surging CDS- and credit spreads, the Goldman Sachs share price: all components register sharp falls. (A narrower, time-tested version based on Moody's spreads still shows healthy year-on-year gains). Clearly, we are witnessing a contraction in the supply of loanable resources in markets for corporate borrowers. Morgan Stanley's Richard Berner sums up the situation:

... the recent repricing of risk has tightened financial conditions, and the renewed turmoil in subprime mortgages will probably make lenders still more risk averse. Financial conditions represent the channels through which changes in interest rates, asset prices, and the availability of credit affect economic activity. ... Increased uncertainty about the economic and financial environment has increased term premiums and volatility in financial markets ...The resulting backup in risk-free yields, combined with slowing — and more uncertain — growth in corporate profits, is challenging stock prices.

Note the link between volatility, risk premia, corporate profits and stock prices. That's precisely the kind of analysis that we try to provide here. I still think that the combination of strong funding liquidity and the CDO Put has the potential to turn things around. (More on the CDO Put here; see also Bloomberg's detailed account of the ongoing Bear Stearns saga).

LIQUIDITY TALK. GLOBAL LIQUIDITY & THE "CDO PUT"
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: +1.6%]

Interesting debate at the Wall Street Journal about the reasons behind the recent jump in bond yields. (An issue discussed repeatedly in this blog). Both James Hamilton and Mark Zendi dismiss the inflation-expectations explanation, largely because "the inflation-protected TIPS yields are up just like the nominal." All right. Prof. Hamilton then presents the bullish case: higher demand for credit from the private sector fuelled the rise in yields. There is, however, a serious problem with the way the case is presented. Mr. Hamilton says his views were confirmed by the subsequent strong performance of the equity market. In other words: his hypothesis can only be confirmed/denied after the facts.

I strongly favor the more ex-ante spreads-based approach. It's a bit more risky, but it can be useful from a trading perspective. Now, it is becoming increasingly clear that something has changed since last week. Surging CDS spreads point to a contraction in the supply of loanable resources — a much more bearish proposition in terms of risky assets (Our Endogenous Liquidity Index is almost flat!). Here's Mark Zendi:

Behind the higher rates is slowly evaporating global liquidity. This is most evident in tighter monetary policies across much of the globe. Central banks ranging from the European Central Bank to the Chinese Central Bank are in the midst of a series of tightening moves ... I also believe, however, that next year as global liquidity continues to dry up, long-term rates will resume climbing. Equilibrium 10-year Treasury yields are closer to 6%. In other words, this is the rate that should prevail in the long-run abstracting from the vagaries of the business cycle and the effects of shifting global liquidity.

So where do we go from here? To become "officially" bearish, I want to see declines in both the Global Dollar Liquidity measure and in the Endogenous Liquidity Index. This is clearly not the case with the Global Dollar Liquidity measure. But will investors in the CDO market panic, sending credit spreads even higher? Take a look at this fascinanting piece about the so-called "CDO Put":

Basically, the CDO put, as I'm using it, refers to the fact that wider credit spreads result in making CDO creation easier. Thus a minor widening event will be met with increased CDO issuance, thus creating a back-stop to spreads.

Increased CDO issuance! A back-stop to spreads! I agree with this fairly bullish view, if only because funding liquidity will need to be deployed. Credit spreads are likely to be the key "tell" going forward.

WEEKLY FED BALANCE SHEET REVIEW. A RECOVERY, AND A NEW RECORD
. Federal Reserve: "Factors Affecting Reserve Balances", June 20

- Fed's Treasuries holdings: $781.4bn (+$2.3bn)
- Other central banks' Treasuries holdings: $1,231.0bn (+$4.3bn) (*)
- Other central banks' agency securities: $736.1bn (+$7.4bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,748.4bn (+$14.0bn)

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

Following two weeks of setbacks, our Global Dollar Liquidity measure rebounded to a new record high of $2,748bn. All the components showed gains, but foreign central banks led the charge with combined purchases of treasuries and agency securities totalling $11.7bn. The 14.5% annual growth rate means that June is the 55th month in a row with a 10% or more rate of growth. As readers of this blog know, this is ... unprecedented.

A word on our wild Endogenous Liquidity Index: the Bear Stearns CDO saga is putting upward pressure on CDS spreads, thus taming the index (now up by only 5.9%).

LIQUIDITY TALK. NOT SO FAST! (AN INCREDIBLY HONEST MARKET)
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +5.9%]

It doesn't matter if you are bullish or bearish: either way, the market is ... incredibly honest. Price discovery has never been so cheap. Need to know about credit spreads in order to forecast corporate profits? Check out the Markit site. Looking for a market-based proxy to the "Great Moderation" of the business cycle? Take a look at the VIX, the V-DAX and other similar indices. I am convinced that success in this market is largely a matter of learning the language of market-based indicators.

Yesterday, just as I was "declaring victory" about my bullish interpretation of the recent bond market rout, surging CDS spreads suddenly sent a clear message: "Not so fast!"

LIQUIDITY TALK. LOTS OF LIQUIDITY TALK!
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +10.6%]

- A brief review (*). This is a stimulating essay, especially because the authors admit that their previous views on global liquidity covered just one aspect of the phenomenon, namely the "monetary policy cycle". I went through exactly the same process until I decided to tackle things like financial innovation, the Great Moderation, the carry trade, etc. It's nice to see serious people making a serious effort at integrating the various parts of the global liquidity puzzle. I especially enjoyed the part on the Great Moderation of the business cycle, with lots of interesting charts and a specific mention to real-time inventory management, one of the key elements of the Great Moderation. There is no mention of the great factor behind the surge in Asian purchases of U.S. fixed-income assets: the New Bretton Woods proposition.

IMHO, understanding BWII is the key to the global liquidity boom. China and other emerging economies are systematically accumulating Treasuries as part of a development strategy based on the recognition that their own financial systems (and property rights in general) are too weak. Thus, they need to act as an exporting periphery. According to Dooley, Folkerts-Landau and Garber, we are still relatively early in the process, as more countries and regions are likely to join in (Iran? Africa?) The part about financial innovation is too short. Furthermore, there is no link to the ... Great Moderation. If the key impact of CDS and credit transfer markets is the dispersion of credit risk, then the relationship becomes apparent: the credit cycle becomes smoother, leading to less volatile GDP growth and inflation rates.

(*) Stephen Gallagher & Aneta Markowska: "Global liquidity cycle ebbing", Eco Insight, June 6.
_____________

- Steen Jakobsen on spreads. Saxo Bank's Steen Jakobsen notes that "something is wrong in high credit land". He mentions the ABX index and the latest Bear Stearns hedge fund troubles. As I look at the spreads component in my Endogenous Liquidity Index, I note the jump in CDS- and high-yield spreads. But this bearish piece of news is almost exactly offset by the ... collapsing VIX!
_____________

- The Martin Wolf article. "Unfettered finance is fast reshaping the global economy", yesterday's Financial Times article by Martin Wolf, has created a bit of a sensation. Rich Karlgaard, who writes one my favorite blogs, is one of the enthusiasts: "Terrific piece. Read it. Save it. Read it again every now and then". I'm a bit underwhelmed, although I admit that it provides a good summary of many current developments. Here's Mr. Wolf on global liquidity:

Yet there is also a shorter-term explanation for the explosive recent growth in finance: today’s global savings and liquidity gluts. Low interest rates and the accumulation of liquid assets, not least by central banks around the world, has fuelled financial engineering and leverage. How much of the recent growth of the financial system is due to these relatively short-term developments and how much to longer-term structural features will be known only when the easy conditions end, as they will.
____________

- Bank Credit Analyst on the bond market. "The recent bond market rout has not caused a sharp correction in risky assets, a sign this bond collapse is not restrictive but reflective of vigorous global growth". So says Bank Credit Analyst. Bingo! This is the idea we favored all along: the recent rise in bond yields reflects increased demand for credit, not a sudden fall in the supply of loanable resources. [Nonetheless, I will keep an eye on those pesky spreads].
____________

- "Accrued Interest": a blog on the bond market. Take a look at this interesting blog [HT: Brad Setser]. The author imagines a LTCM-like episode in the context of today's markets. Not a pretty picture:

1) A large number of investors in higher quality CDO tranches (A and AA) are burned by sub-prime defaults.2) This causes a re-pricing of CDO spreads, and causes a drastic slow-down in deal flow.3) In turn, this eliminates the "CDO Put" in the credit market. This is where any widening of credit spreads made forming new CDO's that much more attractive, thus creating a back-stop for spreads generally. If the CDO market disappears, even temporarily, this "put" is gone.

LIQUIDITY TALK. MALCOM KNIGHT ON LIQUIDITY CONDITIONS
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +10.4%]

In this very interesting speech, Malcom Knight, General Manager of the BIS, analyzes the situation of "ample growth in global liquidity and generalised compression of risk spreads". He reviews two hypotesis about the "recent benign conditions in financial markets": (a) monetary policy; (b) the global saving-investment imbalance and the related increase in foreign exchange reserves. The end-game is different in each case. If you believe that G7 monetary policy has been the driving force behind the global liquidity boom, then the end is nigh:

... if monetary policy has played a dominant role, the rise in inflation that has been observed recently in many countries and the likelihood of a further tightening of global monetary conditions suggest that the current episode of low interest rates and tight spreads could end quickly. This could have an adverse impact on interest rate sensitive sectors of the economy and lead to a withdrawal of liquidity from precisely those markets that have benefited the most from low interest rates.

By contrast, "saving-investment imbalances evolve slowly over time". In othe words: expect the observed changes in yields and spreads to be reversed only gradually. And this is precisely where things get interesting:

... a further prolonged period of low interest rates and tight spreads of the sort that is implied by the saving-investment hypothesis risks encouraging even more leveraging in the short to medium term. The further build-up of global foreign exchange reserves could have similar implications. This suggests that the current episode of ample liquidity may be longer, involve a continued build-up of positions, and have an even more uncertain resolution than one might at first have expected.

LIQUIDITY ANALYSIS. NOT ALL RATE RISES ARE CREATED EQUAL
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +9.4%]

Mid-way through the recent bond market sell-off, I discussed the meaning of rising yields with Macro Man. He elegantly summed up my position with the sentence: "Not all rate rises are created equal". My point was that interest rates can change for a variety of reasons. As the great Horace W. Brock taught us almost 20 years ago, long-term interest rates change whenever new information alters the behavior of those who demand and/or supply loanable resources in the credit market (*). When discussing the valuation of risky assets, this simple insight can be very useful.

If interest rates increase because participants get new —and very bullish— information about the state of the global economy, the impact on risky assets is not necessarily negative. Demand for credit increases at every level of the interest rate as firms rush to borrow funds to take advantage of the expected increase in profitability. Now, interest rates can go up for seemingly "bad" reasons as well: reduced foreign capital inflows, rising inflation expectations and budget deficits, etc. (a bearish proposition in terms of risky assets).

In my discussion with Macro Man, I argued that spreads can go a long way in telling us why interest rates change. Narrowing CDS and high-yield bond spreads, plus decreasing inflation expectations usually tell a bullish story. In the event, this is largely what happened: the stock market took off despite higher interest rates. Poring over my spreadsheets again this morning, my impressions are more mixed. Year-on-year, spreads still tell a distinctly bullish story. In the short term, however, it would be nice if inflation expectations spreads would again decline towards the 2.30%/2.35% range.

(*) Horace W. Brock. "Determinants of interest rates", Euromoney, 1988. The Financial Times's Tony Jackson, for expample, seems to take it for granted that bond yields went up because of reduced foreign capital flows. There is an element of truth in that: our Global Dollar Liquidity measure shows declines for two weeks in a row. But spreads were painting a rosier picture.

LIQUIDITY ANALYSIS. "ENDOGENOUS LIQUIDITY" TAKES CENTER STAGE
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +9.7%]

When Mohamed El-Erian mentioned the notion of "endogenous liquidity, the liquidity that the market itself creates", it dawned on me that one could design an index to try and capture changes in the supply of loanable resources derived from financial innovation and from the "Great Moderation" of the business cycle (the two are related, by the way). The result has been our Endogenous Liquidity Index. The ELI includes a number of CDS and high-yield spreads, the VIX, a measure of the carry trade (through short-rate spreads), and ... the Goldman Sachs share price.

While more work needs to be done in terms of CDS spreads and volatility indicators, I am quite confident that such indices will become more and more popular. There is a reason why: as Manuel Johnson and Robert Keleher taught us over ten years ago, globalization and innovation will only increase the value of market-based indicators (*). It was thus with pleasure that I read about Saxo Bank's Steen Jakobsen, "hard at work at designing [a] new monetary index, which includes today's new 'liquidity' generators, credit derivatives and similar structures". Good!

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

WEEKLY FED BALANCE SHEET REVIEW. TWO IN A ROW
. Federal Reserve: "Factors Affecting Reserve Balances", June 13

- Fed's Treasuries holdings: $779.1bn (-$6.5bn)
- Other central banks' Treasuries holdings: $1,226.7bn (-$3.2bn) (*)
- Other central banks' agency securities: $728.7bn (+$3.1bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,734.4bn (-$6.7bn)

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

For the second week in a row, our Global Dollar Liquidity Measure shows a contraction. Most of the damage was caused by repo operations totalling $8bn. Custodial data show that central banks were mostly quiet during the week, swapping some holdings of treasuries for agency securities. Officially, the liquidity boom is intact: the annual rate of growth of our liquidity measure is still solidly above 10%.

The collapse of the VIX over the last couple of sessions has greatly benefited the Endogenous Liquidity Index, which shows a healty 9.7% rate of growth. However, it is worth noting that the recovery in risky assets is not accompanied by falling spreads: CDS and high-yield bond spreads are mostly unchanged, while inflation expectations spreads continue to slowly grind higher.

LIQUIDITY TALK. SOME WORDS OF WISDOM AMID THE BOND ROUT
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: +6.1%]

It pays to read Jim Griffin (here) and Bank Credit Analyst (here and here). The message, in a nutshell: the yield curve is normalizing. Big deal. (OK: it happened a bit faster than usual). Meanwhile, the VIX is taking a toll on our Endogenous Liquidity Index. Spreads are rising a bit, but they remain very tight. The platinum/gold ratio trades at 2 again (strong global economy). What, me worry?

LIQUIDITY ANALYSIS. THE DEFEAT OF THE YIELD CURVE
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: +8.4%]

The yield curve is finally normalizing. When it became deeply inverted in August 2006, I briefly went bearish on risky assets. A sudden collapse in the demand for bank reserves, I reasoned, would force the Fed to sell treasuries — thus putting and end to the liquidity boom. But foreign CBs kept on buying U.S. bonds. Far from retreating, global dollarized liquidity gained more and more ground. In the new global context, the yield curve suddenly mattered less. Score one for the "It's Different This Time" (IDTT) crowd.

LIQUIDITY ANALYSIS. THE IMF & CUSTODIAL RESERVE HOLDINGS
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: +7.7%]

Brad Setser, the doyen of reserve analysis, has repeatildy highlighted the numerous drawbacks of the New York Fed custodial data. They tend to underestimate the true size of central banks' dollar holdings. But I remain a fan nonetheless: they have served me well over the years. Apparently, the IMF likes them too:

In recent years, the investment of a large share of these reserves into U.S. treasuries and agencies has contributed to the low yields in fixed-income markets. To measure this, we look at the growth of official international reserves held at the U.S. Federal Reserve system.

See figure 1.32 on page 40.

LIQUIDITY TALK. RECENT NEWS ...
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: +7.7%]

- Morgan Stanley's Richard Berner assesses financial conditions following the recent market correction. This piece is particularly interesting, because Mr. Berner reviews one by one the elements of the global liquidity boom: the mix of global savings, credit spreads and —last but not least— the impact of financial innovation on the "Great Moderation".

- From Bloomberg: China's trade surplus soars 73% in May from a year earlier to $22.45 billion, state-run news agency Xinhua reports, citing data from the customs bureau. See also Brad Setser's take on the surprising April U.S. trade data.

- The Federal Reserve releases its weekly balance sheet, with its important annexes. Our Global Dollar Liquidity measure contracts slightly.

- PIMCO's Bill Gross shakes up the bond market. In an interview published in the firm's website, the investor detects a change at the margin in the behaviour of "reserve nations": the China-Blackstone deal means that central banks are likely to do less recycling. "To the extent that that stops at the margin—an example being China now investing $3 billion in Blackstone, a private equity firm—we have to factor that into our equation in terms of the attractiveness of bonds".

- An article on Lloyd C. Blankflein, the CEO of Goldman Sachs (Jenny Anderson: "Goldman Runs Risks, Reaps Rewards", The New York Times). Mr. Blankflein describes himself as "cautiously optimistic about the current market". And he adds: "... to be successful in this business, you have to have a degree of risk tolerance".

- The Reserve Bank of New Zealand raises its target for the the Official Cash Rate from 7.75% to 8.00%. Says Governor Alan Bollard: "Had we not increased the OCR this year, it is likely that the inflation outlook would now be looking uncomfortably high".

- The European Central Bank raises its short-term rate target from 3.75% to 4.00%. As usual, Mr. Trichet mentions the L-Word: "... liquidity in the euro area [is] ample".

- Interesting speech by Federal Reserve Board Governor Kevin Warsh on "Financial Intermediation and Complete Markets". Lots of references to liquidity issues: Mr. Warsh is a keen global liquidity watcher.

- Sebastian Becker, of Deutsche Bank Research, publishes an essay on "Global liquidity 'glut' and asset price inflation. Fact or fiction?" I'll review it during the week.

LIQUIDITY TALK. BILL LUBY'S WISDOM ON THE VIX
[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: +3.6%]

Three short posts by Bill Luby on the VIX will provide more information than an entire day with RealMoney: [1],[2] and [3].

WEEKLY FED BALANCE SHEET REVIEW. TESTING TIMES!
. Federal Reserve: "Factors Affecting Reserve Balances", June 6

- Fed's Treasuries holdings: $785.6bn (+2.3bn)
- Other central banks' Treasuries holdings: $1,229.9bn (-$1.5bn) (*)
- Other central banks' agency securities: $725.5bn (-$2.4bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,741.1bn (-$1.6bn)

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

Testing times for liquidity bulls! The latest Fed balance sheet contains lots of (potentially) useful information. First things first: there is a weekly contraction in our Global Dollar Liquidity measure. OK, it's only a tiny one (-$1.6bn), but as Bill Gross said in a interview that set the tone for Thursday's bond market rout, what counts is what happens ... at the margin! Foreign central banks sold about $4bn in treasuries and agencies. "We're not talking about a major overnight shift but at the margin", said Gross. We'll see.

Note the positive contribution of "domestic" liquidity. This may reflect the changing shape of the yield curve, which is getting steeper day by day. (Bank reserves at the Fed are at a five-month high). Last but not least, our Endogenous Liquidity Index has fallen sharply, losing 8% in just two days, courtesy of the surging VIX and of rising CDS spreads. There you have it. The only thing that can be said in favor of liquidity bulls is that the Global Dollar Liquidity measure is growing at a (preliminary) 14.5% annual rate, the fastest pace since February 2005. Will it be enough to keep the equity bull market running? As Ronald Reagan famously said: "Trust, but verify".

LIQUIDITY TALK. TONY JACKSON & THE "IT'S DIFFERENT THIS TIME" CROWD
[Latest Global Dollar Liquidity Measure: +14.16% annual growth rate; latest Endogenous Liquidity Index: +8.6%]

I just came across this charming piece by the FT's Tony Jackson (I wish I could write with such wit). Mr. Jackson blasts the "it's different this time" crowd, whose members he duly labels IDTTs. According to Mr. Jackson, IDTTs are active in at least four fronts: corporate profits, global liquidity, commodity prices, and the UK housing market. The article provides an excellent opportunity to briefly assess some aspects of the current liquidity cycle.

When it comes to "Chinese savings, the yen carry trade, the surge in petrodollars and so on", Mr. Jackson tells readers that "most of those seem cyclical to me, or at least finite". Absolutely right! As a matter of fact, we are about to "celebrate" the tenth anniversary of the onset of the Asian currency crisis, when our Dollar Global Liquidity measure all but collapsed. In September 1998, at the end of the crisis, the stock of dollar-denominated bonds held by foreign central banks was declining by a staggering 12.6%!

In one respect, though, I have to disagree with Mr. Jackson when it comes to "Chinese savings". There is an element of IDTT in the current flow of global capital to the U.S.: the Dollar Global Liquidity measure is about to enter the 55th month in a row with a growth rate of 10% or more. This had never happened before. I wish I could say otherwise —I don't consider myself a member of the IDTT crowd— but that's what the numbers tell.

And then there's the issue of derivatives. Mr. Jackson takes a narrow one-to-one view. Yes, derivatives are a zero-sum game: you lose money/I make money. But consider the macro-economic impact of CDS. G7 central bankers, and even the IMF, agree on this point: credit risk is diversified as never before. Thanks at least in part to risk transfer markets, business cycles have become smoother. As the (very cautious) Bank of England recently put it, "less volatile collateral values promote steady credit, investment and growth rates". And this, ladies and gentlemen, is the very definition of ... liquidity!

LIQUIDITY TALK. GOVERNOR WARSH ON LIQUIDITY & FINANCIAL INNOVATION
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +13.0%]

Don't miss Governor Kevin Warsh's latest speech on liquidity and financial innovation. Back in March, his speech on liquidity was a hit with liquidity watchers (or al least with me!). Key themes: [1] liquidity-fueled financial innovation has made markets substantially more "complete": more risks are more readily priced and traded without significant diminution in value than in prior periods; [2] because of more complete markets, shocks to liquidity are less likely to become self-fulfilling and less likely to impose lasting damage.

Governor Warsh thus considers himself a "watchful optimist"; he pays tribute to the army of financial engineers who have "forever changed" the nature of financial intermediation.

LIQUIDITY TALK. TOBIAS LEVKOVICH ON GLOBAL LIQUIDITY, ETC.
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +13.1%]

In a Q&A session with Financial Times readers, the Citigroup U.S. equity strategist dismisses the idea of "excess liquidity" as a "poorly described term", adding that "Alan Greenspan once defined liquidity as being a function of confidence" (for a similar view, see Fed Governor Kevin Warsh's March speech). Tobias is bullish on U.S. stocks, but he's no raging bull. His S&P and Dow Jones targets are, respectively: 1,600 and 14,400 by year-end 2007, and 1,725 and 15,500 by mid-2008. Beyond that, he has "some profound concerns about margins for second half 2008, so we are being vigilant on the earnings front". (The U.S. presidential election is also a source of concern).

Meanwhile, Mohamed El-Erian, the president and chief executive of Harvard Management Company, dwells on the Second Best theory in the context of the New Bretton Woods model (see our recent post on that very issue here). Finally, Bill Luby warns: be careful out there!

LIQUIDITY TALK. WHY ARE SPREADS SO LOW?
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +14.6%]

In the context of an exchange of ideas with Macro Man about the meaning of higher interest rates, I ventured that spreads matter as much as levels when it comes to the valuation of risky assets. Now, every time I check the numbers, I am struck by the sheer collapse of spreads (between high-yield bonds and treasuries) over the last couple of years. Absolutely amazing! Spreads are the best forecasters of corporate profits. But why are they so low?

Let me briefly discuss one of the least understood aspects of the current liquidity boom: collateralized debt obligations or CDOs. This technology —it is not a "product"— provides "a way of creating high quality debt from average quality (or even low quality) debt" (*). Financial innovation is creating a huge demand for average and low quality debt; in other words: the supply of loanable resources continues to increase.

In 2006 alone, $450bn of CDOs have been issued, and as much as $460bn in synthetic CDOs (portfolios of CDS packaged as CDOs). How does that relate to the valuation of risky assets, beyond the immediate impact of lower financial costs? I don't really pretend to know, but I just don't feel like betting against the market.

(*) John Hull. Options, Futures and Other Derivatives (Sixth Edition). Prentice Hill, 2006, p. 517.

WEEKLY FED BALANCE SHEET REVIEW. A NEW RECORD IN MAY
. Federal Reserve: "Factors Affecting Reserve Balances", May 31

- Fed's Treasuries holdings: $783.3bn (+3.3bn)
- Other central banks' Treasuries holdings: $1,231.4bn (+$9.8bn) (*)
- Other central banks' agency securities: $727.9bn (+$4.9bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,742.6bn (+$17.9bn)

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

It's official: liquiditywise, May was the strongest month of the year. Our Global Dollar Liquidity Measure now tops $2,742 billion, a monthly increase of $48.9bn. The annual rate of growth (14.4%) is the highest since February 2005. Our Endogenous Liquidity Index, which combines measures of CDS spreads, volatility and the carry trade, continues to surge forward. Meanwhile, the "Goldilocks/Stagflation" indicator appears to stagnate somewhat, a slightly less bullish development.