LIQUIDITY TALK. THE MAESTRO & INFLATION EXPECTATIONS
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -29.1%]

Alan Greenspan & inflation expectations; Moody's & "liquidity risk"; Brad Setser on the first financial crisis of the 21st century; is the "super-cycle" alive?

[1] The Greenspan debate: inflation, relative prices, or the price level? In yesterday's Financial Times interview, Alan Greenspan linked "the rate of change of prices" to "the rate of change of globalization". Thus, as the process reaches its end, inflation expectations are bound to increase (in the long run, the Maestro sees a 4.5% inflation rate as a likely scenario). Harvard's Ken Rogoff and Princeton's Alan Blinder both disagree: globalisation does not lead to changing inflation expectations, but rather to a new set of relative prices (Rogoff) or to a lower price level (Blinder).

[2] The Greenspan debate (II). "Technically", says Blinder, "this [i.e. globalization] changes the world price level, not the inflation rate. But because this effect is spread out over many years, it looks like a lower inflation rate". While Rogoff thinks that "the parameters are changing", Blinder appears to embrace the very bullish super-cycle thesis: "We are only beginning to exploit the opportunities for global economic integration in services".

[3] Moody's & "liquidity risk". The Financial Times's star reporter and editor Gillian Tett was on to something when she wrote, on September 6, that credit rating agencies would soon focus on liquidity risk: "The agency [i.e. Moody's] is looking at measures of so-called 'liquidity' and 'market value' risk that could be issued alongside credit ratings, which indicate the risk that an instrument will default".

[4] Brad Setser on the first financial crisis of the 21st century. Long and very interesting post by Brad Setser on the crisis in credit markets. Referring to central banks' liquidity injections aimed at SIVs, Brad writes: "Call it a twentieth-century solution to a twenty-first century problem. The central banks lend to the banks and the banks decide who else gets credit".

[5] Bullish outlook from the Asian Development Bank. From Bloomberg: "Developing Asian economies will expand faster than estimated in 2007 and 2008, and are expected to be able to weather any U.S. slowdown and turmoil in global credit markets, the Asian Development Bank said Monday. Growth in Asia excluding Japan and Australia is predicted to be 8.3 percent this year.The region will expand 8.2 percent in 2008, faster than an earlier forecast of 7.7 percent, according to the ADB". I pay a lot of attention to bullish arguments about a more "balanced" global economy: if true, volatility readings should come down -- which would be good news in terms of the Endogenous Liquidity Index.

REINTERMEDIATION & THE CREDIT SLOWDOWN
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -29.1%]

I don't pretend to know a whole lot about the analytics of Special Investment Vehicles (SIVs), Asset Backed Commercial Paper (ABCP) and Basel II. My numbers, however, show that the likelihood of a significant, protracted and global credit contraction continues to increase. Thus I was intrigued by two pieces that dwell on the impact of "re-intermediation" on the availability and cost of credit. Reintermediation is an euphemism for the absorption of conduits and SIVs into commercial banks' balance sheets (*). Thus Morgan Stanley's Richard Berner writes:

Reintermediation promotes a pro-cyclical credit contraction in three ways. First, credit concerns triggered liquidity backstops for conduits and SIVs, forcing a shift from a funding source that requires no capital to one that does. Inherently, that reduces leverage in the financial system. Second, in classic, pro-cyclical fashion, banks are raising the cost of new liquidity and credit facilities. Finally, and more controversial in terms of the analysis, courtesy of the move to Basel II, this shift to put riskier assets on bank balance sheets will boost future capital requirements for some European banks.

David Malpass, the usually bullish Bear, Stearns economist, expresses a similar opinion:

Bank balance sheets are expanding in connection with LBOs, SIVs, asset-backed commercial paper, and the breakdown in the securitization process (through which underwriters could sell their exposure). As banks make room for the new exposure, we expect tightness in other areas of their balance sheets, one of the disruptions facing economic growth.

(*) The arguments presented are based on Charles Goodhart. "Capital, not liquidity, is the problem", Financial Times (September 14): "... in the longer term the underlying problem will become capital availability, not funding problems and certainly not cash liquidity. Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks’ risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis". See also William Chambers: "Basel II requirements will strenghten the financial system", Financial Times (September 18).

AN EXCENTRIC INDEX MAKES A COMEBACK
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -28.2%]

I still remember this piece from the May 1996 issue of The Economist: "The erection index (a humorous look at the relation between the size of the largest skyscrapers and world stock markets)". If I remember well, the author opined that bear markets always followed the erection of the largest skycrapers. The piece was written before the official inauguration of the Kuala Lumpur Towers on October 1, 1996. Six months later, a devastating bear market took hold in Asia, eventually creating the conditions for both the Russian default and the LTCM collapse in the second half of 1998.

Judging from this new piece, the erection index is bound to make a ... spectacular comeback! In Shanghai, a "topping-out ceremony" recently took place for the world's third-tallest building -- the 101-storey, 492-metre Shanghai World Financial Center. But there's more. Here's the Foreign Policy blog: "For sheer absurdity, though, nothing tops Burj Dubai, already the world's tallest building at an estimated 545.7 meters" (see the photo taken last Friday).

As Cassandra would say, all of this surely "just smacks of classical overconfidence" (*).

(*) According to Bloomberg TV this morning, the construction of the Shard Tower in London has been suspended.

LIQUIDITY TALK
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -28.8%]

[1] Bank Credit Analyst on the credit crunch. The top-notch Canadian consultant reviews the situation in credit-land and concludes: "So far there is no evidence to suggest that the credit and liquidity crunch is over". This is also what my numbers show. Chapeau to the stock market!

[2] Fortis Investments on the credit market /stock market decoupling. William De Vijlder mentions three reasons: (a) the rise in credit spreads may reflect a temporary illiquidity premium; (b) equities have remained the "liquid asset class" so there is no reason to incorporate an illiquidity premium; (c) the equity market did not become as overvalued as credit. Very interesting indeed!

[3] Merrill Lynch: credit markets 'remain challenging'. According to MarketWatch, Merrill Lynch & Co. (MER) in a filing Friday said credit-market conditions have continued to "remain challenging" in the third quarter and that it has made fair-value valuation adjustments to some of its exposures. The company didn't provide further details on the adjustments in the filing.

[4] Standard & Poor's on emerging markets. The Financial Times quotes an S&P report on liquidity and emerging markets: "If tighter liquidity conditions intensify, Latvia, Iceland, Bulgaria, Turkey and Romania would top the list of countries most at risk of repercussions due to their greater inflows to finance current account deficits". Would investors in these countries rush to buy euros, as Asians bought dollars ten years ago?

[5] Flight to quality in hedge fund land? The Financial Times reports that SAC Capital raised $1bn two weeks ago, thus "underscoring the demand for the most successful funds even during difficult times". But investors in hedge funds, adds the FT, said smaller funds might suffer as a result. Says Ken Kinsey-Quick, head of Thames River Capital: "A lot of investors are going to be saying get out of anything small".

[6] Gillian Tett: credit rating agencies & liquidity risk. The star FT editor writes: "I expect credit rating agencies to come under fire. These agencies have always insisted that their ratings only measure the likely default rates of instruments or institutions, not their liquidity risk or market values".

[7] Nick Ferguson: credit crunch not over. The Daily Institutional Investor quotes the chairman of private equity group SGV Capital: "These things usually last longer rather than shorter, and that those predicting a quick end to the credit crunch are wrong. Investor willingness to back leveraged buyouts will remain subdued and funding will be more expensive ... I think the appetite will come back, but it'll be less than it was, and spreads will be higher".

[8] Vladimir Putin on liquidity conditions in Russia. From DII: "Russian authorities don't exclude the possibility of providing liquidity to Russian banks if necessary," President Putin said during a visit to Australia. In an attempt to alleviate the tighter liquidity, the Central Bank of Russia (CBR) injected a large amount of cash into the market by buying securities under repurchase agreements last month. The CBR also started earlier in August the first major purchase of rubles since 2002 to stop the ruble's depreciation against the dollar and the Euro.

[9] Jim Paulsen & "super-liquidity". The Wells Capital Management chief strategist does not buy the "liquidity crisis" story. "Everyone keeps saying this is a liquidity crisis. But I don't buy that," says Paulsen. "There has been superliquidity, and I still see lots of evidence of that ... If monetary restraint or illiquidity is not causing this crisis, monetary ease alone will not solve it. The good news, however, is we need only alter an attitude or emotion (such as confidence), which could happen quickly".

WEEKLY FED BALANCE SHEET REVIEW. ANOTHER LACKLUSTER PERFORMANCE
. Federal Reserve: "Factors Affecting Reserve Balances", September 12

- Fed's Treasuries holdings: $778.7bn (-$3.0bn)
- Other central banks' Treasuries holdings: $1,207.1bn (-$0.1bn) (*)
- Other central banks' agency securities: $774.2 (+$1.2bn) (*)
- Global Dollar Liquidity Measure: $2,760.0bn (-$1.9bn)

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

Another week, another lackluster performance from a global liquidity point of view. The $1.8bn increase in bank borrowing at the discount window is about the only interesting piece of news. Is liquidity fatigue setting in? Judging from the annual rate of growth of our Global Dollar Liquidity measure (+13.4%, a six-month low), this appears indeed to be the case.

LIQUIDITY TALK
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -30.0%]

- Big Ben & the savings glut. Ben Bernanke on the savings glut: "My reading of recent developments is that although some of the details have changed, the fundamental elements of the global saving glut remain in place. Most important, the emerging-market countries and oil producers remain large net suppliers of financial capital to global markets" [See Brad Setser's comprehensive review]. Dr. Bernanke is right, of course: custody and agency holdings are still growing at a healthy rate (+18.3%). But things appear to be changing at the margin — tonight we get the new weekly Fed balance sheet.

- Bank Credit Analyst on gold prices. "The precious metals complex (especially gold) is sniffing out more plentiful liquidity conditions". That's also the message sent by the energy complex, by the falling dollar and by the steeper Treasury curve.

- The Bank of England & liquidity conditions. Macro Man quotes the stoic BoE governor Mervyn King: "The provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future."

- On the futility of pumping liquidity. In a letter to the Financial Times, Robert Matthews, the chief economist of Wood Cottage Group argues that "the happy process of central banks implementing a sharply upwardly sloping yield curve" by "pumping liquidity into the system" may not work this time around. This is because "off-balance sheet mistakes" are likely to be marked to market immediately, i.e. not "over a period of four to five years".

- Liquidity as a figure of speech. From Alex J. Pollock, Resident Fellow, AEI, again to the Financial Times: "In short, liquidity is about group belief in the solvency of counterparties and the reliability of prices, reminding us that 'credit' and 'credo' have the same root. When no one is sure who is broke, and there is high uncertainty about prices, we will discover that liquidity has vanished, however plentiful it may recently have seemed".

NICE GAINS ... IN DOLLAR TERMS
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -31.3%]

The U.S. market opens with strong gains ... in a currency that is increasingly acting as a third-world currency. (See Macro Man's take). Meanwhile, here's some stuff I've been reading: [1] PIMCO's Paul McCulley on the "real" and "shadow" banking system ("... there is a mighty gulf between the Fed's liquidity cup and the shadow banking system's parched liquidity lips"); [2] Lombard Street Research's Diana Choyleva on the hype surrounding Sovereign Wealth Funds; [3] Philly Fed's Charles Plosser on the distinction between short-liquidity injections and changes in the Fed funds rate.

WHAT WOULD SCHUMPETER SAY?
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -31.4%]

Steen Jakobsen, the cautious Saxo Bank fund manager, recently mentioned Joseph Schumpeter, writing: "Destruction of capital is the name of the game". Instinctively, I went back to my bookshelf, and to one of my most prized possessions: a 1951 edition of the Encyclopaedia Britannica. Volume 4 contains a long article by Schumpeter on "Capitalism". I don't have it right now with me, so let me quote it from Thomas McCraw's recent biography (*):

"A society is called capitalist if it entrusts its economic process to the guidance of the private businessman. This may be said to imply, first, private ownership of nonpersonal means of production … second, production for private account, i.e., production by private initiative for private profit." He went on to say that a third element is "so essential to the functioning of the capitalist system" that it must be added to the other two. This third element is the creation of credit.

The core ethos of capitalism looks constantly ahead and relies on credit and launching new ventures. From the Latin root credo—"I believe" —credit represents a wager on a better future. The entrepreneurs and consumers who make these bets often care little about the past and have scant patience with the present. They undertake innovative projects and make expensive purchases (houses, for example) that require far greater resources than those lying at hand. In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations.

Are we about to witness a period of destruction of capital, on the heels of a phenomenal wave of financial innovation? If funding and market liquidity indicators continue to deteriorate, this is a distinct possibility.

(*) Prophet of Innovation: Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007 (read the prologue).

WEEKLY FED BALANCE SHEET REVIEW. MIXED NEWS AT BEST
. Federal Reserve: "Factors Affecting Reserve Balances", September 5

- Fed's Treasuries holdings: $781.7bn (+$3.4bn)
- Other central banks' Treasuries holdings: $1,207.2bn (+$1.8bn) (*)
- Other central banks' agency securities: $773.0 (-$1.0bn) (*)
- Global Dollar Liquidity Measure: $2,761.9bn (+$4.2bn)

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

The first weekly Fed balance sheet for the month of september is out — and it contains mixed news at best. The good news is that, for the first time in two weeks, our Global Dollar Liquidity measure registers an increase (+4.2bn). The bad news concerns the annual rate of growth: it tumbled from 14.6% in August to just 13.4%, pushing my trusted long-term "model" for risky assets further into bearish territory. In a sense, the problem with the Global Dollar Liquidity is not unlike the situation faced by corporate earnings: tough —very tough— comparisons. In order for the rate of growth to continue above 10% in the months ahead, central banks will have to buy ... lots of securities!

Bearish thoughts, however, need to be kept in check by the wisdom of the Market Price Approach (*). The dollar is weak, commodity prices are strong, the Treasury yield curve is steepening: none of this heralds a significant dollar liquidity contraction. Are foreign central banks simply beefing up their SWFs? Is global liquidity assuming a different shape? Questions, questions.

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

OFFICIALLY BEARISH, BUT ...
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -29.3%]

The verdict is known: by the slightest of margins, the interest rate data published by the Federal Reserve has pushed my trusted, long-term model for risky assets into bearish territory (*). Consequently, I find myself in a "sell the rallies" mood. A couple of caveats: the margin is so slight, that the most probable scenario, IMHO, is a protracted range-trading environment rather than an outright bear market. (By the way, this is what I had forecast in early July, with good results in terms of the Dow and the Nasdaq, but definitly not in terms of the S&P500).

Second caveat: Credit Default Swaps have become the norm in terms of credit spreads analysis; in other words: models that rely on Moody's spreads may be a thing of the past. We'll see.

(*) The "model" adds the rate of change of the inverse of the Moody's Baa spread to the rate of change of the Global Dollar Liquidity Measure. Until this morning, the last sign was a "buy", flashed out in January 2003.

THE OLD LADY & THE MONEY MARKET CRUNCH
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -27.7%]

Liquidity watchers and analysts are abuzz with the situation in the money markets. Gillian Tett, the very able Financial Times reporter, describes the crisis as a "frantic scramble for liquidity". She mentions the L-word no less than six times in today's piece [HT: Robert]. Steen Jakobsen, the rather bearish Saxo Bank fund manager, writes: "Destruction of capital is the name of game ... In all my life as a trader I have never seen anything like this. The stock market is in a total denial, the fixed income in near panic".

The most interesting statement came from the Bank of England, which raised its aggregate reserves target for the next month in a move to lower the overnight London interbank lending rate. However, according to the Financial Times, the Old Lady stressed "the move was not intended to bring down the three-month Libor rate, which hit a nine-year high of 6.8 per cent ... The persistent widening in the spread between interbank rates and the central bank’s policy rates reflected the difficulty in valuing risk and not a lack of liquidity, the Bank said".

The Daily Telegraph quotes the BoE's statement:

Spreads have risen significantly in all major financial markets since August 9, reflecting the difficulty in valuing a variety of asset-backed instruments, which has reduced liquidity in those instruments and also in term money markets. The source of these problems does, therefore, not lie in a lack of central bank liquidity.

Wow! This is getting really interesting.

LIQUIDITY ANALYSIS. QATAR, THE EFFECTIVE FED FUNDS RATE & THE GLOBAL DOLLAR LIQUIDITY MEASURE
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -28.7%]

Consider, first, this Reuters piece: "The Qatar Investment Authority (QIA), the energy exporter's $50 billion sovereign wealth fund, said on Monday it was diversifying away from the weakening U.S. dollar by investing more in Asia". Consider, then, the effective Fed funds rate over the second week of August (consistently below the 5.25% target). Get the picture? On the one hand, foreign CBs are accumulating less Treasury securities; on the other hand, the Fed has to withdraw liquidity in order to re-establish its Fed funds target. No wonder our Global Dollar Liquidity measure tanked in August.

Bottom line: [1] funding liquidity is not vanishing: it just has a different shape; [2] the Fed will ease.

LIQUIDITY TALK. LOTS OF MATERIAL!
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -28.7%]

- Two academic papers on markets & liquidity. [1] Markus K. Brunnermeier & Lasse Heje Pedersen: "Market Liquidity and Funding Liquidity", June 2007; [2] Ricardo J. Caballero & Arvind Krishnamurthy: "Collective Risk Management in a Flight to Quality Episode", August 2007. See a short review by The Economist's Buttonwood column:

In the past, liquidity crises have been solved by the emergence of a confident buyer with deep pockets, such as John Pierpont Morgan in 1907. But who could it be this time? Pension funds and insurance companies no longer have the flexibility, while hedge funds are facing tighter funding and the prospect of redemptions. That leaves the sovereign wealth funds of China and the Middle East. But even if they want to buy in bulk, do Western governments want to let them?
_____________

- Jean-Pierre Mustier interview. The chief executive of SocGen's corporate and investment banking division talks to the Financial Times:

Mr Mustier reckons that credit conditions will normalise at around the level they were late in 2004. This means that private equity groups will be able to borrow to finance leveraged buy-outs, but at one or two multiples of cashflow less than the average level earlier this year, he says. Similarly, he believes that credit spreads for senior debt instruments will ultimately end up at about 60 basis points higher than they were at the market’s peak.
_____________

- Jim Bianco on the Fed. The always sharp Jim Bianco told Bloomberg TV that the liquidity crisis would likely force the Federal Reserve to review the way it conducts monetary policy. Mr. Bianco suggested that, in order to avoid further episodes of "boom-and-bust" behaviour, procedural changes were needed. Mr. Bianco didn't elaborate, but I think he was hinting at the possibility of adopting a formal procedure to keep the Fed funds rate closer to market rates. (Many on Wall Street think that the 1% Fed funds rate in 2003-2004 is at the root of the current turmoil).
_____________

- Ben Bernanke and the liquidity of home equity. In his Jackson Hole speech, Fed chairman Ben Bernanke dwelled on "the history of housing finance" in order to clarify "the interaction of housing, housing finance, and economic activity". The goal, ultimately, is to "better understand the behavior of the economy". This brief passage caught mi attention:

The increased liquidity of home equity may lead consumer spending to respond more than in past years to changes in the values of their homes; some evidence does suggest that the correlation of consumption and house prices is higher in countries, like the United States, that have more sophisticated mortgage markets.

In other words: liquidity analysts will have to revise their models to incorporate the effects of "the increased liquidity of home equity".
___________

- Blog Watch. [1] T. McGee on the carry trade; [2] Bill Luby on "echo volatility"; [3] Rich Karlgaard: "Liquidity Crisis or Credit Crunch?"; [4] Morgan Stanley on "soft decoupling" in AXJ (Asia ex-Japan); [5] F-Trader and a new blog: Futures Day Trading.

WEEKLY FED BALANCE SHEET REVIEW. THE BIGGEST MONTHLY FALL ON RECORD!
. Federal Reserve: "Factors Affecting Reserve Balances", August 29

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

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

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

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

THE FT DISCOVERS THE "PARADOX OVER LIQUIDITY" ... A BIT LATE
. Krishna Guha. "World economy confronted by paradox of liquidity", Financial Times

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

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

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

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

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

[Liquidity is] the ease with which one can sell an asset at the expected price. The most liquid asset of all is cash ... A subsidiary part of this technical definition is that central banks can increase the liquidity of the banking system by lending more cash to it, as most did this week ... The real mess, however, lies with the rise of a second usage of "excess liquidity" as catch-all phrase to denote, variously, loose central bank policy rates, broad money supply growth, aggressive lending to private equity, yen borrowing and even the growth of debt derivative products.

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

QUANTITY VS. MARKET PRICE INDICATORS
[Latest Global Dollar Liquidity Measure: +14.8% annual growth rate; latest Endogenous Liquidity Index: -25.1%]

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

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

WEEKLY FED BALANCE SHEET REVIEW. THE BIGGEST WEEKLY FALL ON RECORD!
. Federal Reserve: "Factors Affecting Reserve Balances", August 22

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

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

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

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

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

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

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

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

"MACRO MAN" & THE GLOBAL LIQUIDITY BLOG
[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -30.6%]

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

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

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

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

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".
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- 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".