LIQUIDITY ANALYSIS. THE BANK OF ENGLAND REPORT
. Bank of England. Financial Stability Report, April 2007, issue No. 21

I'll be mostly out today, so no real posting. Liquidity watchers, however, have their hands full with the lavishly illustrated Financial Stability Report published last week by the Bank of England. Funding liquidity, market liquidity, liquidity risk, contingency liquidity, cross-border liquidity, liquidity standards, the carry trade: all these issues are discussed in detail. Enjoy!

WEEKLY FED BALANCE SHEET REVIEW. FIRST CONTRACTION IN SIXTEEN WEEKS (AND A TINY ONE AT THAT)
. Federal Reserve: "Factors Affecting Reserve Balances", April 25

- Fed's Treasuries holdings: $775.7bn (-$2.6bn)
- Other central banks' Treasuries holdings: $1,228.0bn (-$7.9bn) (*)
- Other central banks' agency securities: $690.1bn (+$10.0bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,693.8bn (-$0.5bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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Our Global Dollar Liquidity Measure has contracted for the first time in ... sixteen weeks! Central banks, including the Fed, sold Treasury securities rather aggressively during the week. A $10bn purchase of agency securities by one or more foreign central banks was not enough to compensate for this loss. The liquidity contraction, however, is only a tiny one: less than $500 million. (The long-term picture remains very positive for liquidity bulls).

As if mirroring this situation, our Endogenous Liquidity Index barely moved during the week. The rising VIX (until Thursday) put downward pressure on the ELI, but the move was compensated by the Goldman Sachs share price (all-time high) and by slightly lower CDS spreads. High-yield bond spreads and the carry trade factor remained largely unchanged. Will the markets quiet down for a while?

LIQUIDITY TALK. BLACKROCK TALKS LIQUIDITY ...

I found this Financial Times interview with BlackRock's Larry Fink very revealing. To summarize it from the global liquidity perspective, two main issues are addressed: [1] The lack of "contagion" from sub-prime woes; [2] Liquidity conditions. Here's a brief review.

[1] The lack of contagion from sub-prime woes. "I don't think it's a contagion and I don't think it's going to exasperate into something that is much more meaningful and more destructive to the overall housing market ... We're seeing fewer investors in subprime but that money needs to be put to work so they're going into other credit markets, and we've actually seen a tightening in those other credit markets because there's more money going in these areas, and so we've seen the actual opposite. Historically when we've seen one problem, we’ve seen an adjustment throughout the marketplace. We've seen no indication of that yet."

[2] Liquidity conditions. Is the lack of contagion due to the much vaunted risk dispersion achieved through CDS and other innovations? Or is it all down to, well, liquidity? Fink's answer: "We've had just vast liquidity. The global capital markets have flourished so well, and there's so much money sloshing throughout the world, people are looking for ways to invest. And so the risk we have throughout the world now is that not only are we trading credit, higher grade credits to lower grade credits with poor covenants; probably the greatest issue that's confronting the world's investors is we are trading liquidity for illiquidity". Note that Fink sees financial markets themselves —not central banks— as the key providers of liquidity.

LIQUIDITY TALK. ON DARK LIQUIDITY, ETC.

- On "dark" liquidity (*). Just when I thought I had heard enough about "endogenous, big, small, domestic, global, funding, and market" liquidity, I came across the notion of ... dark liquidity. Paul Temperton, director of the Financial Times Portfolio Academy, defines dark liquidity as "these pools of liquidity [that] will typically not be shown on conventional trading platforms provided by the stock exchanges or crossing networks". Dark liquidity, thus, belongs to the domain of "microeconomic" or "market" liquidity. Financial Times reporter Gillian Tett detects a recent "explosion of dark liquidity pools" in the United States.

The "darkest of dark liquidity", adds Tett, takes place inside investment banks' private networks. This "explosion" may well threaten the dominant position of stock exchanges worldwide. Investment Technology Group (ITG), for example, is marketing a trading platform aimed at improving "liquidity connectivity"; algorithms help to detect hidden sources of liquidity. Thus, hedge funds and other investors who, as Tett puts it, "like to stay in the shadows", can trade cheaper and without disturbing the share price.

(*) See Paul Temperton. "Trading with the help of guerrillas and snipers", Financial Times, March 19; Gillian Tett. "Equity investors show willing to come to the dark side", Financial Times, February 9; CASTrader. "The magic alpha of dark liquidity and partial diversity".
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- The trouble with "domestic" liquidity. I sometimes mention the stock of Treasury securities held by the Fed (a proxy for the monetary base) as "domestic liquidity", as opposed to Treasury and agency securities held by foreign central banks ("global liquidity"). Strictly speaking, this is incorrect. Domestic liquidity can be influenced by global factors, and vice-versa. (Remember 1998). The key thing, in my mind, is to always consider them in tandem. This otherwise arcane issue came back to my mind as I watched a CNBC interview with David Sowerby, chief market strategist at Loomis Sayles.

According to Sowerby, the Federal Reserve will soon have to ease monetary policy in order to "improve growth rates in the monetary aggregates". Sowerby does have a point: the stock of Treasury securities held by the Fed is growing at a tepid 2.6% rate. However, IMHO, he misses the larger point: global dollar liquidity is booming (+19.8%). Overall liquidity conditions remain very robust. There is no need for the Fed to act.

LIQUIDITY TALK. A SHARP FALL IN OUR "ELI"

- A sharp fall in our "Endogenous Liquidity Index". Our preliminary ELI fell 2,1% yesterday on the heels of the VIX (which surged 8%). CDS and high yield bond spreads also pulled the index lower, while the "carry trade" factor was unchanged (no news on policy rates). Only the Goldman Sachs share price —trading at a new all-time high— provided some support.

- Jim Griffin: Liquidity conditions "lush". ING's Jim Griffin quotes Kenneth Heebner, the "highly regarded manager of the CGM Realty Fund", who told Bloomberg that U.S. home prices will fall “at least 20%” this year. Says Griffin: "In liquidity conditions this lush, with six handle conventional mortgage rates, it is difficult for me to imagine such a calamity".

- Glenn Reynolds: Beware of "a turn in the global liquidity tide". Glenn Reynolds, the head of CreditSights, tells the Financial Times that "none of the major developed economies is immune to a turn in the global liquidity tide". For example, much of Germany's export growth "has been driven by the boom in China and elsewhere in the global economy, which itself has been due in large part to generous global liquidity conditions. The lagged impact of monetary tightening by the world’s major central banks is already beginning to hurt the US housing market, but in time it will also have a general dampening effect on Germany’s major export markets". Clearly, Mr. Reynolds thinks that G7 central banks are the key drivers of global liquidity growth.

- Brad Setser & Reserve growth. Brad Setser worries about the stunning growth of central bank reserves in 2007, which he deems unsustainable. This is something that liquidity bulls have to keep in mind. I used to worry myself whenever the rate of growth of Treasury and agency securities held at the New York Fed by foreign central banks would surpass 20%. (It is now at 18.9%). Nothing serious happened, however, between October 2003 and January 2005, when we reached ... 34%! Thus, I worry less now — but I'll definitely keep an eye on Mr. Setser's blog.

- Steen Jakobsen's blog: don't miss it. Steen Jakobsen, executive director at Saxo Bank, discusses trading ideas in his blog. In a post published this morning, he takes a look at falling real estate prices in Spain and warns readers: "... at extremes EVERYTHING is correlated". A very useful blog indeed!

LIQUIDITY TALK. MOODY'S ON GLOBAL LIQUIDITY
. FT Alphaville: "Moody's blames globalisation for tight credit spreads".

The Financial Times' Alphaville Blog, always a must-read, reviews the paper "Why Is Credit Risk Priced So Low? A Perspective on Global Liquidity", by Moody's economist Pierre Cailleteau (*). According to the review, “the paper dismisses the global liquidity explanation as somewhat circular, saying 'the fact that the demand for financial assets increases at a higher pace than the supply is more a symptom than a cause.'” Instead, says Moody's, investors ought to ask why the expected risk-adjusted returns on financial investments are perceived to be higher than the funding cost, even as the major world central banks have tightened interest rates.

“The answer”, adds Alphaville, “rests with the assymetrical nature of globalisation. In Moody's words, 'The core of the explanation lies in the interaction between the deepening of financial integration on the one hand, and differences in the financial completeness of world economies on the other.'” (Our Global Dollar Liquidity Measure, by the way, tries to capture just that). The reviewer then asks: What could go wrong? According to Cailleteau, there are three key risks out there: (a) An adverse surprise on inflation; (b) A sharp decline in oil prices; (c) A dramatic change in Asian foreign exchange policies.

(*) Paper presented at a conference on Corporate and Structured Default Research for Basel II and Credit Risk Strategies, London, April 19.

WEEKLY FED BALANCE SHEET REVIEW. THE LONG, LONG, LONG LIQUIDITY BOOM
. Federal Reserve: "Factors Affecting Reserve Balances", April 18

- Fed's Treasuries holdings: $778.3bn (+$3.7bn)
- Other central banks' Treasuries holdings: $1,235.9bn (-$0.2bn) (*)
- Other central banks' agency securities: $680.1bn (+$4.8bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,694.3bn (+$8.3bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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Out of the sixteen weekly Fed balance sheets reported so far in 2007, fifteen have yielded an increase in our Global Dollar Liquidity Measure. We are clearly witnessing the greatest liquidity boom on record, with our own measure growing north of 10% for fully ... 53 months in a row. While nobody knows how long this will last, I can't help but agree with investor Ken Fisher: when it comes to liquidity conditions, "We live in a unique period of history".

Meanwhile, our still untested and preliminary Endogenous Liquidity Index is up 1.6% on the week. The index was spurred by the Goldman Sachs share price and by CDS spreads, with junk bond spreads and the VIX acting as a drag.

LIQUIDITY TALK. ON THE NEW BRETTON WOODS, Mr. TRICHET & FINANCIAL INNOVATION

Brad Setser & the New Bretton Woods.
. Brad Setser: Latin America joins Bretton Woods 2 (Big Time)

Brad Setser detects a renewed willingness, within Latin American economic policy circles, to avoid sharp episodes of currency appreciation. (See my post on this issue here). The thing to keep in mind is that these countries are not ... Scandinavian countries. If Denmark can compete in the global economy despite the high cost of its labor force, it's because its top-quality governance leads to stable property rights and therefore to a low cost of capital. Meanwhile, the quality of governance in Latin America is deteriorating day by day — the "domestic" cost of capital is definitely not falling. Therefore, these countries need to stick to the New Bretton Woods proposition.
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Mr. Trichet & Financial Innovation.
. Keynote address by Jean-Claude Trichet, President of the ECB at the 22nd Annual General Meeting of the International Swaps and Derivatives Association

Interesting speech by the ECB president on the impact of Credit Default Swaps on liquidity conditions. I am preparing a more detailed post on this issue. Here are some quotes:

... technological innovations have significantly enhanced the ability of banks to grant credit ... Credit derivatives could therefore make the economy, and thus monetary policy, increasingly sensitive to credit market movements ... Price discovery in the credit derivatives market reduces the risk of mispricing loans ... Banks are moving from the traditional “buy-and-hold” model to the “originate-and-distribute” model, whereby they distribute portfolios of credit risks and assets to other market players ... Indeed, some evidence from the United States, based on individual loan data, supports the idea that banks are increasing the supply of credit as they obtain additional credit protection through credit derivatives.

LIQUIDITY ANALYSIS. A VERY, VERY, VERY PRELIMINARY "ENDOGENOUS LIQUIDITY INDEX"
. Endogenous liquidity: the madness continues

Our preliminary —and rudimentary, temporary, untested, 1.0— version of an Endogenous Liquidity Index (ELI) eased 0.32% yesterday. The VIX and junk bond spreads pulled the index down, while CDS spreads and the Goldman Sachs share price provided some support. Still, the index is up a healthy 8.42% with respect to March 30. As Gary Kaminsky, a Neuberger Berman asset manager, just said on CNBC: "Liquidity will put a floor under asset prices". Indeed.

LIQUIDITY TALK. LIQUIDITY AS "A RISK-SEEKING STATE OF MIND"
. Paul McCulley on PIMCO's Cyclical Outlook and Investment Strategy.

PIMCO economist Paul McCulley discusses the world economy and casually defines liquidity in a way that combines "funding liquidity" and "market liquidity":

At the end of the day, liquidity isn’t about money stock growth, but a risk-seeking state of mind. In other words, liquidity isn’t about money on the sidelines per se, but rather about the risk appetite of those on the sidelines. And when risk appetite turns, no amount of liquidity on the sidelines matters, particularly when a crowd gathers there. This is the essence of modern day finance. The human condition is, in the end, momentum-driven, not value-driven.

This is exactly the reason why we pay attention not only to our own Global Liquidity Measure, but to CDS spreads, the VIX index, the Goldman Sachs share price, etc.

LIQUIDITY TALK. KEN FISHER, AGAIN.
. Ken Fisher. "Stocks Never This Cheap", Forbes Digital Rules

- Ken Fisher, again. "All around the world", says the investor, "earning yields--defined as E/P (earnings over price) --are higher than 10-year government bond yields. For the American S&P index, the E/P is 6.7%. Compare that to the cost of borrowing. The average S&P company can borrow money at 5.8% pre-tax, or about 3.8% after-tax." Fisher is prompt to add that this highly abnormal situation ("We live in a unique period of history") has lasted already for 54 months. Remarkably, our own Global Liquidity Measure is growing at more than 10% for ... 53 months in a row. This, too, is quite unique.

- Geithner on funding and market liquidity. Timothy Geithner, the New York Fed president and CEO, tries to inject a dose of rationality into the debate about the "current period of exceptional liquidity". He defines funding liquidity as the "availability of credit or the ease with which institutions can borrow or take on leverage". Market liquidity, in turn, is referred to as "the ease with which market participants can transact, or the ability of markets to absorb large purchases or sales without much effect on prices". The two concepts, adds Geithner, "are closely related and are often mutually reinforcing". This is exactly what is happening right now.

- Argentine reserves at record level. According to the Financial Times, Argentina's reserves reached a record level of $47.4bn. True to its tradition as the boom-and-bust country par excellence, Argentina is firing on all cylinders, systematically undervaluing its currency and accumulating dollar reserves at full speed. Once the music stops, it will not be a pretty picture.

- Norway to lift equities exposure. Norway's government pension fund, with $300bn under management, is about to lift its exposure to global equity markets from 40% to 60%. According to the Financial Times: "In a significant reassessment of the fund’s attitude towards risk, it also announced on Friday that it would bolster investments in smaller listed companies, may invest in real estate and will also in coming years consider investments in private equity and hedge funds".

- Egypt & the New Bretton Woods. Egypt is increasingly marketing itselft as an export hub. In authoritarian countries, the cost of capital is high because property rights are naturally unstable. China's solution has been to systematically undervalue its currency (and to accumulate foreign reserves) in order export its way out of economic paralysis. Its success is attracting more and more would-be imitators — which bodes well for global liquidity conditions in the long run.

WEEKLY FED BALANCE SHEET REVIEW. ROCK'N ROLL!
. Federal Reserve: "Factors Affecting Reserve Balances", April 11

- Fed's Treasuries holdings: $774.5bn (-$2.0bn)
- Other central banks' Treasuries holdings: $1,236.1bn (+$15.8bn) (*)
- Other central banks' agency securities: $675.3bn (+$2.9bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,685.9bn (+$16.7bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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In late 2004, a number of central banks toned down their purchases of Treasury and agency securities. Worried about the build-up of domestic inflationary pressures, they suddenly let their currencies appreciate against the greenback. If I am not mistaken, the central banks of Brazil, Russia, Turkey and Mexico led the charge (I am sure Brad Setser knows all the details). Interestingly enough, the central bank of Argentina took the other side of the trade: it received strict orders from the finance ministry not to let the peso appreciate under any circumstances.

Eventually, Argentina's strategy paid handsome dividends: the economy grew at a much faster clip than Brazil's or Mexico's. (On the inflation front, however, the picture is not quite as rosy). The current wave of central bank purchases of Treasuries and agency securities seems to indicate a renewed willingness to avoid any damaging currency appreciation in a number of emerging countries. Already in April, foreign central banks have bought as much as $25bn in Treasuries, and about $6bn in agency securities. The New Bretton Woods proposition is alive and well. Global liquidity growth is strong — very strong.

LIQUIDITY ANALYSIS. A COMMENT ON VOLATILITY & LIQUIDITY
. Bill Luby. "Volatility and Liquidity: A First Look", Vix and More

Bill Luby, who was kind enough to mention my blog in a recent post, encourages "any lurking monetarists and others with thoughts on liquidity and volatility to chime in". Here are some quick thoughts. Reading through Fed governor Kevin Warsh's excellent piece on Market Liquidity, it appears that the Federal Reserve does indeed see a link between volatility and liquidity:

Researchers have documented the so-called "Great Moderation" in which the U.S. economy has achieved a marked reduction in the volatility of both real gross domestic product (GDP) and core inflation over the past twenty years or so. In theory, reduced volatility, if perceived to be persistent, can support higher asset valuations--and lower risk premiums--as investors require less compensation for risks about expected growth and inflation ... Others have pointed to the low levels of stock market volatility in recent months as indicative of pressures from excess liquidity [1].

Thus, the "Great Moderation" of the business cycle —for which the VIX index can be seen as a proxy— expands the supply of loanable resources at every level of the interest rate. This, in my view, is the key link between volatility and liquidity. There is no need to dig deep into M2 or M3 [2].

[1] Fed vice-chairman Donald Kohn is a bit more skeptical: "... the relationship between financial market volatility and the volatility of macroeconomic variables such as GDP is not well understood".

[2] M2 and the now-defunct M3 measures are not liquidity measures. Says Warsh: "I doubt, however, that traditional monetary aggregates can adequately capture the form and structure of liquidity many observe in the financial markets today". See also my comment to Bill's post.

WEEKLY FED BALANCE SHEET REVIEW. A STRONG START IN APRIL
. Federal Reserve: "Factors Affecting Reserve Balances", April 4

- Fed's Treasuries holdings: $776.5bn (+$0.9bn)
- Other central banks' Treasuries holdings: $1,220.4bn (+$9.5bn) (*)
- Other central banks' agency securities: $672.4bn (+$3.5bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,669.2bn (+$13.9bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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The first weekly Fed balance sheet for the new month contains goods news for liquidity bulls. Our Global Dollar Liquidity Measure is growing at a 13.2% rate, the strongest showing in 26 months. Following hints by Fed officials and market participants about "the liquidity that the market itself creates", I find myself concocting an Index of Intrinsic Liquidity designed to capture the impact of financial innovation on the supply of loanable resources.

The index combines measures of bond spreads (soon to be replaced by CDS spreads), market volatility, the carry trade (as measured by the spread between short rates in Japan and the US), and ... the Goldman Sachs share price (as a proxy for financial innovation). Preliminary results show that "intrinsic liquidity", despite sharp setbacks in February and March, is still growing at a healthy rate. All in all, not a bad picture for risky assets.

LIQUIDITY ANALYSIS. NEW ZEALAND & GLOBAL LIQUIDITY
. Alan Bollard. "Easy money — global liquidity and its impact on New Zealand", speech to the Wellington Chamber of Commerce.

The BIS publishes an interesting paper by Alan Bollard, Governor of the Reserve Bank of New Zealand. According to Bollard, global liquidity has "increased dramatically over recent years", reflecting three key factors: (1) a surplus of saving relative to investment in the East-Asian and oil exporting countries; (2) financial innovation and the arrival of "new players"; (3) the carry trade.

Bollard notes that the sheer magnitude of "the flow of increased global liquidity", by paving the way to further financial innovation, has led to ... even more liquidity!

LIQUIDITY TALK. LOTS OF LIQUIDITY TALK!
. PIMCO

So much things to do, so much things to read ... Liquidity watchers have their hands full with the incessant flow of articles, essays, indices and innovations. Here's some of the stuff I've been reading lately:

- Bill Gross' April Investment Outlook is out. Always a must-read, Bill Gross writes in his April Outlook that we will soon have to face the consecuences of "the 1% Fed Funds financing train of 2003". Pay attention to what lenders —not central banks— do: "It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses". Indeed.

- Willem Buiter: A hard landing in China? Prof. Buiter rightly sees China and India as key players in the global liquidity game — more so than G7 central banks: "Both India and China are in the terminal stages of a credit boom. So there will be a cyclical slowdown in both countries. If the monetary and fiscal authorities act in time (they appear to be well behind the curve in both countries) and if they have the right instruments and the political will and freedom to use them (doubtful in both countries) the credit boom can end with a whimper. A hard landing seems more likely, however".

- About the IMF Liquidity Measure. Take a look at page 5 of this report, in which the IMF displays what it calls its "Liquidity Measure". The term "measure" is more appropiate than our own "index", because it deals directly with money and credit figures. The IMF indicator is identical to Merrill Lynch's and closely resembles our own Global Dollar Liquidity Index. The IMF, however, takes the monetary base as a proxy for "domestic" liquidity; we prefer the stock of Treasury securities in the Fed's balance sheet. (We do this is in order not to mix apples and oranges, and also to avoid sharp Y2K-like swings). One last comment: the IMF compares its Liquidity Measure to the VIX index — just as Todd Harrison does.

- PIMCO's Clarida on Petro-Dollars and Credit Spreads. PIMCO's Global Strategic Advisor Richard Clarida argues that a decline in oil prices and a subsequent drain of petro-dollars would cause credit spreads to widen, because "there is evidence to suggest that the petro surpluses have been allocated much more into spread product than have the surpluses of the oil importers [like China]".

LIQUIDITY TALK. BILL RHODES BEARISH ON GLOBAL LIQUIDITY
. William Rhodes. "A market correction is coming, this time for real", Financial Times

Citibank's Bill Rhodes is full of praise for the performance of the world economy during the past few years. However, developments on the liquidity front are likely to signify the end of the "Goldilocks economy":

... much of the good news has come as a result of extraordinary levels of liquidity pouring into opportunities around the globe. To a large extent this is due to the Federal Reserve's expansionary monetary policies early in the decade and the US administration's fiscal stimulus. The yen carry trade has also facilitated the buoyant expansion of investments and leverage evident everywhere today. The low spreads, the tremendous build-up of liquidity, the reach for yield and the lack of differentiation among borrowers have stimulated both dynamic growth and some real concerns.

Thus the main culprit, on the upside, is the Federal Reserve. On the downside, however, it is investors and lenders who are likely to cause liquidity to decelerate: "As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface". Rhodes concludes with a pessimistic outlook. "Against that background", he adds, "I believe that over the next 12 months a market correction will occur and this time it will be a real correction".

Towards the end of the piece, concerns about liquidity resurface. This time, the focus is on market liquidity:

The primary worry of many who make or regulate the market is not inflation or growth or interest rates, but instead the coming adjustment and the possible destabilising effect these new players could have on the functioning of international markets as liquidity recedes. It is also possible that they could provide relief for markets that face shortages of liquidity.

WEEKLY FED BALANCE SHEET REVIEW. JUST SWAPPIN' ...
. Federal Reserve: "Factors Affecting Reserve Balances", March 28

- Fed's Treasuries holdings: $775.6bn (+$2.3bn)
- Other central banks' Treasuries holdings: $1,210.8bn (-$6.6bn) (*)
- Other central banks' agency securities: $668.9bn (+$10.5bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2,655.4bn (+$6.1bn)

(*) Off-balance-sheet items.
agustin_mackinlay@yahoo.com
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The only remarkable feature of last week's Fed weekly balance sheet is the fact that foreign central banks continue to swap Treasuries for agency securities. A year ago, holdings of agency securities made up 38% of the assets held in custody at the Federal Reserve Bank of New York. Now, they represent ... 55% of the total. Meanwhile, our Global Dollar Liquidity Index grows at a 12.3% annual rate, the fastest pace since August 2005.

LIQUIDITY TALK. THE FED, LIQUIDITY, AND THE MARKET PRICE APPROACH
. Donald L. Kohn. "Asset-Pricing Puzzles, Credit Risk, and Credit Derivatives", Conference on Credit Risk and Credit Derivatives, Washington, D.C. March 22, 2007.

Just over a decade ago, former Fed officials Manuel "Manley" Johnson and Robert Keleher published a book that added enormously to the global liquidity debate: Monetary Policy. A Market Price Approach (Westport, Connecticut: Quorum Books, 1996). According to the authors, globalization makes it almost irrelevant for the Fed to rely on quantity indicators such as GDP, employment, industrial production and monetary aggregates. Market prices such as the foreign exchange value of the dollar, the shape of the yield curve and commodity prices provide more timely and useful information.

For obvious reasons, the book has aged. The fast pace of financial innovation during the past decade means that more and/or different market prices require attention. But Johnson & Keleher's key insight appears to be more useful than ever — here's Fed vice-chairman Donald Kohn speaking at a conference on Credit Risk and Credit Derivatives:

... the staff at the Federal Reserve puts considerable effort into research on asset prices and into reporting the results of that research to policymakers. One reason we do so is to try to understand the expectations that households, businesses, and market participants have about the future. Expectations are critical to understanding the economy and developments in the financial system. Of course, we look at a great deal of data from the nonfinancial side of the economy, such as gross domestic product (GDP) growth, the unemployment rate, and changes in the prices of goods and services.

It's almost as if —within the Fed's hierarchy— GDP and other quantity indicators have been relegated to a distant second place behind ... asset prices. This challenges us "liquidity watchers" to pay more attention to credit derivatives. No problema. Meanwhile, here's some more liquidity talk from the Federal Reserve:

- Fed Governor Randall Kroszner on "Recent Innovations in Credit Markets". CDSs and CDOs have enhanced the transparency and liquidity of the credit markets. This is an important piece of the global liquidity puzzle: thanks to lower transaction costs and better risk diversification, the supply of loanable resources registers a permanent increase, thereby leading to lower long-term interest rates.

- The structured credit market & the supply of loanable resources. Adam Ashcraft and Joao Santos (Federal Reserve Bank of San Francisco) discuss the impact of structured credit markets on the overall credit market. They find evidence that "CDS trading helps borrowers issue syndicated loans more frequently and take on more leverage relative to a matched sample of untraded firms, consistent with an increase in credit supply".

- Timothy Geithner on "Credit Markets Innovations and Their Implications". Not to be undone, New York Fed president and CEO Tim Geithner discusses "the latest wave of credit market innovations". What is the main factor behind the so-called Great Moderation of the business cycle? Digital networks? Low inflation expectations? Nope, says Geithner. It's all down to financial innovation.

- Charles Plosser on the shape of the yield curve. Philadelphia Fed president Charles I. Plosser debates the shape of the yield curve. Here are the two key points: "On average, I expect the yield curve to be flatter than at comparable points in previous business cycles. While this flattening of the yield curve puts pressure on banks’ interest income, given the amount of financial innovation in the industry, banks will be able to adjust".

LIQUIDITY TALK. KEN FISHER: PRIVATE EQUITY & THE GLOBAL LIQUIDITY BOOM
. Charles Duhigg. "Cheap debt takes the fear out of making a deal", International Herald Tribune.

I watched yesterday's Squawk Box Europe Ken Fisher interview with interest. According to Fisher, the private equity boom will continue as long as the large spread between the cost of debt financing and the return on equity persists. Late last year, Fisher was quoted by the International Herald Tribune:

"Right now, debt is so cheap that you can borrow and buy another company for less than it would cost to build something yourself," Fisher said. "And that's not going to change until the stock market goes up significantly, or bond rates increase. Banks and insurance companies are eager to lend at today's going rates. As long as bond buyers think the future is rosier than stock buyers, there's going to be lots of deals."

From my perspective, the really interesting part was Fisher's comment about the unusually long period of abnormal discrepancies between the cost of debt financing and the return on equity capital: 54 months. Fisher was prompt to add that this had never happened before. Amazingly enough, we are about the enter the 54th month in a row in which our own Global Liquidity Index grows at a 10% (or more) annual rate. This too has never happened before.

LIQUIDITY ANALYSIS. "WIKINOMICS" & THE CREDIT DEMAND CONUNDRUM
. "Q&A with the CEO of Lego", Monocle

The key "mystery" of the current global economic expansion is, without a doubt, the low level of long-term interest rates. A year ago, the governor of the Bank of England, Mervyn King, addressed the issue in a speech at a dinner for Kent Business Contacts. Among the causes of low interest rates, King singled out the tepid pace of credit demand: "... business investment in the developed economies has been weak in recent years for reasons we do not fully understand".

For reasons we do not fully understand? How interesting! A couple of years ago, an article by economist-investor Thomas Nugent caught my attention, because it provided a clue to this phenomenon. This is the key quote:

What is interesting is that, with a booming economy, business-loan demand is falling, not rising. This is not your father’s traditional economic expansion. Productivity is mitigating the need for bank borrowing. To see this, think about the notion of infinite operating leverage whereby business technology is, in effect, “taking over.” Higher sales-GDP from applications can be considered “pure productivity” that doesn’t tax resources or drive up prices.

If Apple Computer sells more songs over the Internet, people are simply downloading more songs at a buck a song. This transaction has neither fixed nor variable expenses and therefore adds to GDP as pure productivity gains. This type of activity increases GDP without price pressure. It’s pure productivity, and it brings into question the entire rationale for expectations that the Fed will be raising interest rates just because GDP is growing (at least until more evidence accumulates of potential labor-market tightness).

This is much more realistic than it sounds. In fact, it may be the only way to explain the simultaneous drop in credit demand and in credit spreads that took place between 2002 and 2006. The issue came back to my mind as I listened to a Q&A session by journalist Tyler Brûlé with Jørgen Vig Knudstorp, CEO of Danish firm Lego. (Brûlé's new journalistic venture is called Monocle). Knudstorp, describing the amazing turn-around in the fortunes of the company, says:

We completely changed the way we run the business. We really involve users to an extreme degree ... They even decide their own products ... We are not involved in the design process ... We have become more virtual ... We have open-sourced the company and it does not take a lot of investment to generate a lot of cash.

In other words: by "open-sourcing" the company, Lego needs to invest considerably less. This is innovation at its best, and it goes a long way in explaining the weakness in business-loan demand. Wikinomics, anyone?

LIQUIDITY TALK. EVERYBODY TALKS ABOUT LIQUIDITY!
. Federal Reserve

Bloggers, Fed officials, economists, journalists, investors: everybody is talking about global liquidity! And not only in the US: the French central bank and a Dutch business magazine are joining in. Here are some of the more relevant pieces — I will be discussing some of them in detail during the week:

- The Cleveland Fed & liquidity. "Liquidity ... Lately, I’ve been hearing people say that the world is awash in liquidity", writes Mark Sniderman in comments published in the Cleveland Fed's Economic Trends newsletter. Sniderman is the third Fed official to discuss the L-Word in March (see Kroszner and Warsh on global liquidity).

- Liberté, égalité, liquidité. The French central bank (not the ECB) is worried about the impact of excessive liquidité on asset prices. There is no mention either of the so-called Asian savings glut, nor of "petro-dollars": Banque de France sees the problem only from the perspective of central bank liquidity.

- An entrepreneur-blogger on global liquidity. Blogger/entrepreneur Fabrice Grinda discusses global liquidity, the yield curve, and the prospects for a US recession. Petro-dollars, according to Grinda, have become the key source of global liquidity (for a similar perspective, see this PIMCO study).

- Global liquidity: a myth? Economist John Hussman debunks the "global liquidity myth". Hussman makes an important point: foreign central banks' purchases of US bonds represent "money that has already been spent – goods and services that have already been deployed". Thus, they do not represent "money in the sidelines". Excellent! (However, IMHO, they do have an impact on US interest rates — more on that during the week).

- Standard Life on global liquidity. The UK insurance company derives its investment outlook from "global liquidity" indicators provided by an "independent research consultancy". Interesting! At present, monetary conditions are "their tightest since 2002, but not yet unduly tight". Good point: in late 2004, a number of central banks decided to let their currencies appreciate in order to fight domestic inflationary pressures, thus accumulating less US bonds.

- A Dutch business magazine discusses global liquidity. Citing the above-mentioned piece by the French central bank, Peter Hendriks wonders whether "excessive liquidity in the market" means that "too much money is a dangerous thing" ("Veel goedkoop geld gevaarlijk", FEM Business).

WEEKLY FED BALANCE SHEET REVIEW. DOMESTIC CONTRACTION, GLOBAL BOOM
. Federal Reserve: "Factors Affecting Reserve Balances", March 21

- Fed's Treasuries holdings: $773.4bn (-$2.9bn)
- Other central banks' Treasuries holdings: $1,217.4bn (+$3.7bn) (*)
- Other central banks' agency securities: $658.4bn (+$12.4bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2,649.2bn (+$13.2bn)

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

The global liquidity boom, as defined by an annual increase of 10% or more in our Global Dollar Liquidity Index, is about to enter its 54th month. This is unprecedented. Already in 2007, foreign central banks have added almost $100bn in Treasury and agency securities. Remarkably, the global liquidity boom takes place in the midst of a rather sharp contraction of domestic liquidity — no doubt courtesy of the inverted yield curve. The stock of Treasuries held by the Federal Reserve, a proxy for the monetary base, is growing at a 2.2% annual rate, the weakest since January 2001.

Bank reserves held by the Fed appear to be trending down, a reflection of both sophisticated reserve management tools and lower levels of credit demand. The dollar, meanwhile, fails to rally despite its growing "domestic" scarcity. One can only wonder what will happen to the greenback as the yield curve normalizes and domestic liquidity is replentished.

LIQUIDITY TALK. LIQUIDITY AS A "DOUBLE-EDGED SWORD"
. Kudlow's Money Politics

On the Larry Kudlow show yesterday, short-seller Doug Kass warned market bull Jason Trennert: "Liquidity is a double-edged sword". Kass' warning is an important one. But how do we know when too much liquidity is being created? Take central bank liquidity. In G7 countries, with well-developped financial markets, markets themselves provide the answer. A look at the shape of the yield curve, the exchange rate, commodity prices and bond spreads provides more than enough information.

But what about non-OECD suppliers of global liquidity such as BRICs, Mexico, Turkey, Argentina? The lack of local currency bond markets means that there is no yield curve to speak of. My favorite indicator here is the Fed's stock of custody holdings, a key component of our own Global Dollar Liquidity Index. This figure, published every Thursday as an off-balance item to the Fed's weekly balance sheet, has an excellent track-record as a warning sign of excess central bank liquidity in emerging markets. Here, increasing "dollarized" liquidity means increasing confidence, as investors dump dollars held as a store of value and conduct business in their own currencies.

In order to assert that an excess of dollarized central bank liquidity is upon us, one should see and abrupt fall in the value of the dollar (against foreign currencies and gold), a normalization of the yield curve and a falling stock of custody holdings. Right now, the picture is mixed, but tilted in favor of ... stock market bulls.

LIQUIDITY ANALYSIS. THE DEMOCRATIZATION OF CAPITAL
. Chicago Mercantile Exchange

The Milken Institute's 2006 Capital Access Index is out. It measures the degree of "democratization of capital", i.e. the ease with which entrepreneurs get access to financing. Looking at the top and bottom positions, one obvious conclusion comes to mind: entrepreneurs get better access to finance in countries where property rights are stable and the rule of law prevails. Countries with high savings rates but weak property rights, like China, are an important piece of the global liquidity puzzle. As these countries take steps to solidify property rights, we are likely to see more moderate inflows into our own markets.

This is one of the reasons why we are witnessing, right now, an impressive move ―led by the Chicago futures exchanges― to "democratize" access to capital ... within the United States. Coming right after the Housing Futures and Options, the Chicago Mercantile Exchange plans to launch Credit Index Event contracts in the second quarter of 2007. Meanwhile, encouraged by the success of the VIX, the Chicago Board of Options Exchange has just announced a new benchmark index for selling volatility.

More endogenous liquidity is coming our way.

LIQUIDITY TALK. MORGAN STANLEY'S STEPHEN JEN, LIQUIDITY BULL
. Stephen Jen. "Currencies: March Madness", Morgan Stanley

"Global liquidity is likely to remain abundant", writes Morgan Stanley's FX economist Stephen Jen. Reserve growth is the key source of global liquidity:

Global official reserves are massive, and still growing. The world’s official reserves have just breached the US$5 trillion mark (US$5,130 billion, to be exact, for gross reserves and US$5,078 billion for the currency component). The world’s official reserves are growing at roughly US$75-80 billion a month, with China accounting for about 30% of these increases. While oil exporters and the Asian countries have roughly the same absolute size aggregate C/A surpluses (around US$400 billion a year), so far the Asian countries have accumulated these balance of payments (BoP) surpluses in the form of official reserves, while the oil exporters tend to channel their export proceeds into SWFs. In any case, compared to the total official reserves that prevailed at end-2005 of US$4,175 billion, the world’s official reserves have risen by close to US$1 trillion in a little more than a year: this is a major increase.

On the other hand, Jen seems to agree with Mohamed El-Erian's views on endogenous liquidity:

The 'real' sources (i.e., the world’s savings-investment surplus) of global liquidity remain robust: the Asian countries and the oil exporters continue to generate some US$800 billion worth of combined current accout surplus. Global long-term interest rates, as a result, have remained near a generational low. Unless 'endogenous money' collapses due to risk retrenchment, which I don’t believe will happen, global liquidity conditions could quickly rebound to support new risk-taking.

[HT: Brad Setser].

LIQUIDITY TALK. THE END OF THE "LIQUIDITY PARTY"?

Jim Rogers & the end of the "liquidity party".
. "Top investor sees U.S. property crash", Reuters

From a Reuters interview with star investor Jim Rogers: "This is the end of the liquidity party ... Some emerging markets will go down 80 percent, some will go down 50 percent. Some will most probably collapse. When you have a financial crisis, it reverberates in other financial markets, especially in those with speculative excess," he said.

Rogers adds: "You can't believe how bad it's going to get before it gets any better," the prominent U.S. fund manager told Reuters by telephone from New York. "It's going to be a disaster for many people who don't have a clue about what happens when a real estate bubble pops. Right now, there is huge speculative excess in emerging markets around the world. There will be a lot of money coming out of emerging markets".

Pretty straightforward stuff. (HT: Big Picture).
_____________

"The lion is tame": Myron Scholes on Risk & Liquidity
. Holman W. Jenkins, Jr. "Risk Manager A Nobel laureate says learning can be costly", The Wall Street Journal.

Risk is "a lion", says Myron Scholes in this Wall Street Journal interview. "Right now we're quiet because the lion is tame, and maybe it's the central bankers of the world who are keeping it tame." But this very quietness creates a dangerous state of affairs ― it attracts even more risk-takers: "My belief is that because the system is now more stable, we'll make it less stable through more leverage, more risk taking." Thus Scholes on macro-economic liquidity. But what about micro-economic liquidity?

In chaotic times, speculators (who are business people, in Mr. Scholes's view, providing liquidity services to the market) doubt their models. They want to reassess. In today's ever more globalized and complex economy, "the information set is huge, it's gigantic." As a result, "decision time becomes elongated" and speculators hold back their capital just when their services are most in demand. The lack of liquidity itself then becomes a factor in asset pricing, leading to swift, sharp drops in values.

LIQUIDITY ANALYSIS. "ENDOGENOUS LIQUIDITY": THE MADNESS CONTINUES
. Financial Times. Mohamed El-Erian interview

The endless talk about "brimming reservoirs of liquitidy", "liquidity boom", "big and small liquidity" is getting a bit out of hand, I am afraid. The Economist was on to something when it wondered "whether the term [liquidity] has any real meaning". And now comes Mohamed El-Erian, the head of Harvard Management Company, who oversees more than $30 bn in assets. El-Erian coins yet a new term ― "Endogenous liquidity":

I think that if this were normal conditions, the Fed would be looking to cut rates. The economy is slowing. The housing market is under pressure. The corporate sector is not spending. However I think that policy makers are increasingly aware of the source of endogenous liquidity, the liquidity that the market itself creates. Private equity is a perfect example, where a dollar that comes out of the public market, becomes $4 or $5 when it goes back in, through the private equity mechanism. So, I think that policy makers will wait for unambiguous evidence that the economy is slowing, before they move, lest they contribute to excess liquidity.

Like it or not, this "liquidity madness" is here to stay. People are desperately looking for new paradigms in a world of globalized capital markets, where the only sure bet seems to be that measures of domestic liquidity are fast becoming irrelevant.

WEEKLY FED BALANCE SHEET REVIEW. BUSINESS AS USUAL
. Federal Reserve: "Factors Affecting Reserve Balances", March 15

- Fed's Treasuries holdings: $776.3bn (+$0.7bn)
- Other central banks' Treasuries holdings: $1,213.7bn (+$3.9bn) (*)
- Other central banks' agency securities: $646.0bn (+$7.5bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2,636.1bn (+$12.1bn)

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

It's business as usual on the global liquidity front. While "domestic" liquidity barely moves (courtesy of the inverted yield curve), foreign central banks continue to accumulate Treasuries and agency securities. Our own Global Dollar Liquidity Index is growing at a 11.9% annual rate ― sharply down from the September 2004 "insane" +22.8% peak, but still above +10% for the 53th month in a row.

LIQUIDITY ANALYSIS. "BIG LIQUIDITY" V. "SMALL LIQUIDITY"
. CNBC

Squawk Box just aired an interview with Jack Ablin, chief investment officer at Harris Private Bank. Ablin mentioned two kinds of liquidity: "big liquidity" and "small liquidity". The former refers to investment flows from the global economy, driven by external deficits and by demographics. The latter refers to more microeconomic issues, specific to individual markets. According to Ablin, "big liquidity" trumps "small liquidity" ― risky assets will continue to benefit from huge waves of investment flows.

To my mind, the real issue is: what determines the shape of the yield curve? If "big liquidity" is the key element, then the credit markets are simply responding to an increase in the supply of loanable resources ― a healthy development. On the other hand, if long-term rates reflect a sharp fall in demand for credit, then a 5.25% bank rate will cause a lot of pain. Watch credit spreads and ... the monetary base.

LIQUIDITY ANALYSIS. ONE (VERY) BAD LIQUIDITY INDICATOR
. Andrew Balls. "What Has Changed, What Has Not Changed, and What We are Doing", PIMCO.

As Fed governor Randall S. Kroszner recently wrote, "the use of the term liquidity spans a wide variety of meanings". You only need to check out PIMCO's (magnificent) web site to understand this. Andrew Balls, for one, presents a couple of "money-based measures of global liquidity" (based on M2 and M3, that is). These measures can hardly be called "global" indicators. Remember 1998: domestic liquidity was increasing in the US, but only as a result of an explosive demand for money market funds (flight-to-quality buying).

Global dollarized liquidity, meanwhile, was on the verge of collapse ― as the Asian currency crisis forced other central banks to sell Treasuries. Eventually, the Fed eased. Had the FOMC based its forecast on M2 and M3 (as some monetarist members of the committee argued at that time), a full blown domestic banking crisis would have erupted. Memo to Mr. Balls: forget about M2 and M3 as meaningful global liquidity indicators.

LIQUIDITY ANALYSIS. THE GOLDMAN SACHS SHARE PRICE AS A LIQUIDITY "TELL"
. Mark Kiesel. "U.S. Credit Perspectives: A New Era", PIMCO Bonds

In a recent note on the so-called "new sources of liquidity", PIMCO's Mark Kiesel highlights the role of financial innovation in what he calls the "global liquidity boom". Remarkably, Kiesel tells investors to focus on Goldman Sachs' share price [NYSE: GS] as a key liquidity "tell":

New pools of capital are also seeking out alternative investments. This trend has fueled significant growth in the financial advisory services industry for mergers and acquisitions, as well as investment management. Not surprisingly, Goldman Sachs has benefited tremendously from these secular changes in the financial markets. Goldman Sachs is not only one of the largest global advisory firms in the world, but it is also the largest manager of hedge fund assets. It is a primary beneficiary of the growth in collateralized debt obligations (CDOs) and credit derivatives, which have acted to expand liquidity in the credit markets through disintermediation and innovation. Goldman Sachs has aggressively moved into private equity capital fund raising, and reportedly just raised $19 billion through a new fund. The firm's stock is a reflection of today's global liquidity boom.

During yesterday's session, not long after midday, trader Todd Harrison actually acted on this insight:

I have, so you know, nibbled a bit on some puts with a stop level through GS $210. Either GS is gonna pull the tape higher or the weight of the world will pull it lower. Not advice, natch, just sharing my process with hopes that it helps yours.

He had been quoted by the Wall Street Journal on this very issue:

One might think that I'm smarting after being quoted in the WSJ saying "what happens in Goldman's shares on any given day is a good indicator of what's happening in the market," just in time for this chasm (GS up, tape down). But au contraire, Mon Frere, I think that is that very reason the market is still afloat. No other stock in the universe would have this much "pull" and it's a testament to the mojo therein.

LIQUIDITY ANALYSIS. PIMCO BONDS & "PETRO-LIQUIDITY" (THE END OF THE "NEW BRETTON WOODS"?)
. Ramin Toloui. "Petrodollars, Asset Prices, and the Global Financial", PIMCO Bonds

PIMCO's Ramin Toloui dissects the dynamics of petro-dollar flows and their impact on global financial markets. Since 2001, oil exporters have poured about $1 trillion into world financial markets. Accordingly, a clear understanding of how these flows operate has become a key element in the outlook for global liquidity, financial markets, and the so-called New Bretton Woods arrangement. Here's a brief overview of Tolouis's main points:

- Governments of oil-producing countries have become the largest source of global savings, having surpassed Asia in 2005. They added $500bn to global financial markets in 2006 alone;

- While their combined current account surplus amounted to only 1/5th of the US current account deficit in 2001, it now represents as much as 2/3ds of the world's largest economy's external deficit;

- Savings from oil producing countries are highly concentrated; only three countries make up the lion's share of petro-dollar flows: Russia, Saudi Arabia and Norway;

- The bulk of petro-dollar savings takes the form of central bank reserves: nearly 80% of the their cumulative surpluses from 2002-2005 were used to build up central bank reserves. The "explosion" is such that even with oil prices at $50/barrel, these countries would channel as much as $300bn into global markets annualy;

- There is evidence to support the view that central bank reserves are being diversified away from the US Treasury market, into bank deposits and / or into other currencies, notably the euro. For example, Russia's reserves are growing, but its holdings of Treasuries remain flat.

- Middle East accounts tend to diversify much more aggressively than their Asian counterparts. This may lead to sustained levels of M&A activity, ongoing downward pressure on credit spreads, and less investment flows into the US Treasury market. This last point, in turn, raises doubts over the sustainability of the New Bretton Woods system.

LIQUIDITY ANALYSIS. THE YIELD CURVE & LIQUIDITY CONDITIONS (GREENSPAN'S EXPLANATION)
. Alan Greenspan. "Technological innovation and the economy", remarks before the White House Conference on the New Economy, Washington, D.C. April 5, 2000

While foreign central banks continue to act as the key providers of global dollar liquidity, the "domestic" scene is dominated by the restrictive stance of the Federal Reserve. The stock of Treasury securities held by the Fed ―the main counterpart to the monetary base on the asset side― is growing at 2.25%, the lowest rate since ... January 2001. The shape of the yield curve is the key "tell" here ― as the Maestro himself told us in an April 2000 speech. There is no way to avoid a lenghty quote:

As our experience over the past century and more attests, such surges in prospective investment profitability carry with them consequences for interest rates, which ultimately are part of the process that balances saving and investment in a noninflationary economy. In these circumstances, rising credit demand is almost always reflected in an increase in corporate borrowing costs and that has, indeed, been our recent experience, especially in longer-dated debt issues. Real interest rates on corporate bonds have risen more than a percentage point in the past couple of years. Home mortgage rates have risen comparably. The Federal Reserve has responded in a similar manner, by gradually raising the federal funds rate over the past year. Certainly, to have done otherwise--to have held the federal funds rate at last year's level even as credit demands and market interest rates rose--would have required an inappropriately inflationary expansion of liquidity. It is difficult to imagine product price levels remaining tame over the longer haul had there been such an expansion of liquidity. In the event, of course, inflation has remained largely contained.

Back then, Greenspan was referring to a normal yield curve, with long-term yields solidly above the Fed funds target. But the same reasoning applies to today's situation ― with the opposite conclusions. To the extent that it reflects a decreasing demand for bank reserves, an inverted yield curve must lead to one of the following scenarios: (a) the Fed validates the new equilibrium (and lower) target; (b) the Fed destroys bank reserves (by selling bonds in the open market) to keep its current target intact. In that case, the mechanics of an inverted yield lead to an automatic contraction of (domestic) liquidity.

LIQUIDITY TALK. MORE FED TALK!
. Randall S. Kroszner: remarks on "Liquidity and Monetary Policy" to the U.S. Monetary Policy Forum, Washington, D.C.March 9, 2007

On March 5 Fed board governor Kevin Warsh gave a presentation on "Market Liquidity: Definitions and Implications". (See our review here). Now Randall S. Kroszner, another board member, discusses "Liquidity and Monetary Policy". This appears to be the critical issue at the moment. As Kroszner says: "A quick search of LexisNexis turned up 2,795 separate articles in the past six months alone that mentioned the word 'liquidity' in the context of its abundance in financial markets. The use of the term liquidity in these articles spans a wide variety of meanings--perhaps 2,795 of them! "

Unlike Warsh's piece, Kroszner's is a rather disappointing lecture on the role played by inflation expectations in the credit markets. Yes, lower inflation expectations lead to an increase in the supply of loanable funds and thus to lower long-term interest rates. We all know that. Mr. Kroszner then adds: "Explanations of these phenomena should have an international component". Fine: but where's the international component in his analysis? What is the role played by the dollar as the key international reserve currency? Why do foreign governments invest in such a massive scale in the US bond market? Is it all down to inflation expectations?

LIQUIDITY ANALYSIS. "THE ECONOMIST" & GLOBAL LIQUIDITY
. Buttonwood. "We all fall down", The Economist

Buttonwood reflects on the recent market turmoil and notes: "There is a healthy debate about how to measure this liquidity, or indeed whether the term has any real meaning" (*). It then cites JPMorgan estimates:

... most people agree that the savings surpluses in Asia and the oil exporters have played an important part in fuelling financial markets. JPMorgan estimates that global liquidity increased by $3.9 trillion between 2002 and 2006, of which around 50% came from Asia and 40% from the oil producers. The bulk of this money went at first into risk-free assets such as Treasury bills and bonds. That drove down the yield on such assets. So other investors were then naturally tempted to look elsewhere for higher returns.

Our own Dollar Liquidity Index yields a much lower figure: about $1.3 trillion between 2002 and 2006. JPMorgan must be considering US bond purchases not only by central banks, but by other official sources and by private investors as well.

(*) See also, by The Economist, "Liquidity, liquidity everywhere".

LIQUIDITY TALK. IS GOLDMAN PREPARING FOR A "LIQUIDITY DROUGHT"?
. Financial Times

- Goldman Sachs & the "inevitable liquidity drought". David Wighton, writing for the Financial Times' Corporate Finance supplement, reveals that Goldman Sachs has been quietly "taking advantage of cheap long-term funding to extend the maturities of its debt with unusually relaxed covenants". Wighton also quotes a Citigroup banker: "Now is the time to prepare for less certain capital availability".

- Central banks & hedge funds. In a letter to the Financial Times, former IMF-economist Vito Tanzi warns about the dangers of central banks investing in hedge funds, as some did (with disastrous consequences) before and during the Asian currency/LTCM crisis. This is likely to happen, according to Tanzi, if "the US keeps injecting more liquidity in the international financial system". OK, except that the Federal Reserve is not running a lax monetary policy.

- The BIS on global liquidity (*). Malcom D. Knight, General Manager of the Bank for International Settlements, assesses "the evolving nature of financial risk" and warns against the danger of complacency. He admits, however, that we may be witnessing long-term, structural shifts involving the very notion of "liquidity":

We may be witnessing a progressive change in the characteristics of business fluctuations, in a new environment defined by liberalised financial markets, globalisation and central bank anti-inflation credentials. Indeed, market participants often refer quite aptly to the loose notion of "ample liquidity", in the sense of low financing costs and easy access to credit or funding liquidity.

(*) Malcom D. Knight. "Now you see it, now you don't: risk in the small and in the large", Keynote address at the Eighth Annual Risk Management Convention of the Global Association of Risk Professionals, 27-28 February 2007.

LIQUIDITY TALK. GEORGE SOROS ON GLOBAL LIQUIDITY
. Chrystia Freeland & James Politi. "George Soros interview", Financial Times

The Financial Times interviews George Soros, and the legendary investor talks ... liquidity! Soros adds little to the current debate, but the very simplicity of his views makes them worth pondering. On the yen carry trade, Soros says:

... the fact that the yen is basically interest free and a lot of money is coming from borrowing and a lot of Japanese money going abroad. And the yen was weakening so a lot of people got into that trade and there’s a little bit of a shake-up going on ... I mean the appreciation of the yen shows that there is a shake-out.

On global liquidity, Soros takes the view of classical economists ― the US current account deficit is the key driver of liquidity growth:

... you have got the slowdown in the US economy, the housing situation where you haven’t yet seen the total effect of the slowdown. It’s still halfway through. So will that actually result in a significant slowdown in consumer spending? That is yet to be seen because you have had mortgage equity withdrawals of nearly $900bn a year. Now it has fallen to $300bn and it basically will disappear. And that will affect consumer spending. Now, as the US slows down, the emerging markets are still going very strong, China and India, so you will actually go back to a more balanced economy with more growth abroad and correcting the deficit.

But that will see less liquidity in the market because it’s really the trading balance creating the same trillion dollars of Chinese reserves and similar amounts in other countries. That has actually fed this global liquidity splurge ... It will have an effect on the [Chinese stock] market and I don’t think that we are in any way nearer a crash. But it’s a warning crack ... But, on the other hand, they don’t want it to fall out of bed either so I think that you’ve had that sort of initial impulse and I think the Chinese market will be kept on an even keel, certainly until after the Olympics.

WEEKLY FED BALANCE SHEET REVIEW. LIQUIDITY BULLS IN CONTROL
. Federal Reserve: "Factors Affecting Reserve Balances", March 8

- Fed's Treasuries holdings: $775.5bn (-$1.5bn)
- Other central banks' Treasuries holdings: $1209.9bn (+$9.4bn) (*)
- Other central banks' other securities: $638.5bn (+$7.9bn) (*)
- Mackinlay's Global Dollar Liquidity Index: $2623.9bn (+$13.6bn)

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

The first weekly Fed balance sheet for the month of March reveals a $13.6bn increase in our Global Dollar Liquidity Index. Liquidity bulls are firmly in control. The data support the view that the shape of the yield curve is losing relevance as a liquidity "tell" in a globalized world. Yes, the stock of Treasury securities held by the Fed is growing rather slowly (+2.25%, the weakest rate since January 2001).

But compare this to the explosive rate of growth of non-Treasury securities held by foreign central banks. According to my estimates, they went from roughly $104bn in early 2001 to almost $639bn now. In that same period, Treasuries held by the Fed grew "only" by 43%. In other words: when it comes to global liquidity, Asia is the place that matters.

Mr. TRICHET & THE L-WORD
. Jean-Claude Trichet, President of the ECB, Frankfurt am Main, 8 March 2007

The European Central Bank raised its target for the key short-term rate from 3.50% to 3.75%, "in view of the upside risks to price stability over the medium term that we have identified through both our economic and monetary analyses". Mr. Trichet mentioned the L-word at least three times in his statement: "... money and credit growth [remain] vigorous, and liquidity in the euro area ample by all plausible measures ... Following several years of robust monetary growth, the liquidity situation in the euro area is ample by all plausible measures ... In an environment of ample liquidity..."

Remarkably, the decision was criticized by Banque de France. The French central bank published a report that raises "serious questions about the reliability of M3 growth as a pillar of the ECB's monetary policy strategy". (Mr Trichet said the ECB acted in part to curb the 9.8% rise in the M3 money supply, the highest since the creation of the euro.) The Daily Telegraph has more:

"The existence of a strong, stable, and predictable relation between money and prices in the euro area cannot be taken for granted," it said. The implication is that M3 data is causing the ECB to over-tighten.The policy revolt comes after repeated attacks on the ECB by French political leaders, who argue that rising rates are pushing up the euro, with dire effects for Airbus and France's car industry.

Aside from the obvious politics at play (general elections coming up in May), I think Banque de France does have a point. The more your currency becomes an international reserve asset, the less relevant the purely domestic monetary indicators. Remember 1998 in the US?

GOOD SPEECH BY PAULSEN IN SHANGHAI
. Prepared Remarks by Treasury Secretary Henry M. Paulson, Jr. on the Growth and Future of China's Financial Markets

Message from Treasury Secretary Hank Paulsen to the Chinese: you can become a part of the dynamic center of the world economy, instead of acting like a mere exporting periphery. To succeed, however, you need to modernize the financial system ― and strenghten property rights:

The global economy, which over the last several years has been as strong as any I have seen during my business lifetime – has been characterized by strong growth, low inflation, and high levels of liquidity... Deep, liquid, and efficient capital markets pave the way for prosperity, opportunity, and economic dynamism, while minimizing and diversifying risks ... Open, competitive, world-class financial markets are the backbone of stable and balanced growth. Markets connect money with ideas and ambition – which are the lifeblood of innovation and dynamism. They offer a diverse array of financing channels, providing for more innovation and a lower cost of finance.

Strong capital markets require strong property rights; a robust supervisory regime with clear, transparent rules which strike the appropriate balance to ensure market integrity while promoting the entrepreneurial spirit and innovation; sound accounting standards; strong corporate governance; strong financial institutions; objective, independent financial information, analysis, and research; a meaningful disclosure regime; and independent credit rating agencies ... One lesson I have learned over the years is that although perhaps not as easy politically, it is better to implement reforms during periods of economic strength.

JIM GRIFFIN ON THE "OPERATIONALLY RELEVANT YIELD CURVE"
. Jim Griffin. "Bank of Japan Stings Like A Butterfly", ING Investment Weekly

ING's Jim Griffin waxes lyrical over the irrelevance of the US credit market yield curve, and tells investors to focus on Japan instead:

So we follow the Fed obsessively, even though it has a recent record of not being able to move markets, while we blow off BoJ, which is where the operationally relevant global yield curve is anchored.

"LIQUIDITY BULLS" vs. "LIQUIDITY BEARS": THE NEW DEBATE ON WALL STREET
.CNBC

On Wall Street, it would seem, strategists are increasingly taking positions with regard to the liquidity controversy. Yesterday on CNBC, Joe Battipaglia, strategist at Ryan Beck & Co., cast himself as a liquidity bear. The Federal Reserve, says Big Joe, is on the verge of creating a credit crunch. Liquidity bears take their clues from Fed policy ― especially from the shape of the yield curve.

The other side was taken by Vince Farrell, market strategist at Scotsman Capital Management. Farrell argued that liquidity is still ample, given the impact of financial innovation, petro-dollars, and foreign central banks. (That said, he added, a "test of the recent lows" was in order). Liquidity bulls vs. liquidity bears: the new debate on Wall Street.

LIQUIDITY IS CONFIDENCE! (SO SAYS THE ... FEDERAL RESERVE)
. Kevin Warsh. "Market Liquidity: Definitions and Implications", remarks at the Institute of International Bankers Annual Washington Conference, Washington, D.C. March 5, 2007.

"Liquidity is confidence", says Fed Governor Kevin M. Warsh. Now, that's a statement. Warsh's speech is worth reading, because it provides an attempt at defining global liquidity in more than just monetary terms. In fact, Warsh's argument is based on a "loanable funds theory of interest-rate determination" (*). This is much simpler than it sounds: financial innovation, he implies, leads to an increase in the supply of loanable funds ― and thus to a lower cost of capital across the board.

Warsh is thus an unabashed liquidity bull. The conventional definition of liquidity ―in purely monetary terms― no longer holds: "Instead, market observers are more likely to be referring to liquidity in broader terms, incorporating notions of credit availability, fund flows, asset prices, and leverage".

As to the yield curve, its days as a recession predictor are all but over: "Thus, to the extent that low long-term Treasury yields and the negative slope of the yield curve reflects a lower term premium, rather than a lower expected short rate, it is less likely to signal future economic weakness". Interesting ―and important― stuff.

(*) Frank Jones & Benjamin Wolkowitz. "The Determinants of Interest Rates on Fixed-Income Securities", in Frank J. Fabozzi (ed.). The Handbook of Fixed Income Securities (Homewood, Ill., 1991).