LIQUIDITY TALK. THE GLOBAL LIQUIDITY BOOM: "THE" BUSINESS STORY OF THE YEAR!
[Latest Global Dollar Liquidity Measure: +14.16% annual growth rate; latest Endogenous Liquidity Index: +13.14%]

According to Forbes' Rich Karlgaard, "The bottomless pool of liquidity around the world is the business story of 2007. It drives everything. Low borrowing rates. High stock prices. Buybacks. Hedge fund growth. The private equity boom". The business story of the year! You bet! That's why I write the Global Liquidity Blog! While "always bullish", Rich has some doubts about the sustainability of the liquidity boom. He therefore asks readers to comment on two views.

The not-so-bullish case is presented by Alan Ruskin, chief international strategist at RBS Greenwich Capital. The decidedly bullish case is penned by Marc Chandler of Brown Brothers Harriman and by Jim Glassman of JP Morgan. (For the record, I strongly favor the bullish view— but I'll keep an eye on the Global Dollar Liquidity Measure and on the Endogenous Liquidity Index).

LIQUIDITY ANALYSIS. BANK CREDIT ANALYST ON RISING BOND YIELDS
[Latest Global Dollar Liquidity Measure: +14.16% annual growth rate; latest Endogenous Liquidity Index: +13.14%]

To understand how credit markets work and how interest rates are set, the first thing to do is to dump academic textbooks. Instead, read material written by people actively involved in markets. My preferred article is already 19 years old: "Determinants of interest rates", by Horace W. Brock (Euromoney, 1988). Absolutely fantastic in its realism and simplicity. When contemplating today's credit markets from a global liquidity perspective, one tends to focus on the supply of loanable resources. But what about the demand side of the equation?

To the best of my knowledge, there are four major arguments to explain the tepid pace of credit demand worldwide. [1] Long-term inflation expectations under control; [2] Improving state of public finances worldwide; [3] Poor governance in developing countries; [4] Wikinomics and the iPod economy. Looking for signs of change in this blissful state of affairs, Bank Credit Analyst raises the possibility of a global capex boom that "would place upward pressure on real borrowing rates". Interesting stuff.

LIQUIDITY TALK. THE ECB & M3
[Latest Global Dollar Liquidity Measure: +14.16% annual growth rate; latest Endogenous Liquidity Index: +11.79%]

There is a healthy debate going on at the European Central Bank over the relevance of M3 as an indicator of future inflation trends. According to Financial Times' Ralph Atkins, "some ECB insiders have suggested that the usefulness of such data has been undermined by innovation and the complexity of financial markets, and that the monetary pillar will eventually be merged into the ECB's general analysis of the real economy".

Here at the Global Liquidity Blog we tend to agree with the view that M3 will become increasingly ... irrelevant. The further the euro acts as an international reserve currency, the less the value of M3 as an inflation barometer. As more countries move to the euro as an international reserve asset, purely "domestic" monetary indicators —such as M3— are bound to loose relevance. Rember 1998 in the U.S.

LIQUIDIY TALK. LIQUIDITY AND THE BOOMING ART MARKET
. Buttonwood. "Painting by numbers", The Economist

A friend of mine, a keen art collector, reflects on the parallel course of Wall Street and the art market and informs me that Marc Rothko's White Center recently fetched $ 73 million, while Andy Warhol's Green Car Crash changed hands for a cool $72 million in November. On this very issue, The Economist quotes Jeremy Grantham of GMO, a fund-management group: "From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it's bubble time". The newspaper's conclusion is not a reassuring one:

One way of looking at high art prices is as part of a global wave of liquidity that is pushing up asset prices everywhere ... A variant of the same argument is that high art prices reflect the increasing number of rich people from all parts of the world. Russian and Chinese millionaires, along with hedge-fund and private-equity managers, have run out of houses to buy and yachts to launch, and would like to display their wealth on their walls.

WEEKLY FED BALANCE SHEET REVIEW. A STRONG CLOSE IN MAY
. Federal Reserve: "Factors Affecting Reserve Balances", May 23

- Fed's Treasuries holdings: $780.0bn (+4.2bn)
- Other central banks' Treasuries holdings: $1,221.7bn (-$3.0bn) (*)
- Other central banks' agency securities: $723.0bn (+$7.8bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,724.8bn (+$8.9bn)

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

While May 2007 was not the strongest month on record in terms of liquidity growth, it was a pretty decent one. Central banks globally added $31bn to their holdings, as measured by custodial data and the Fed's own balance sheet. Our Global Dollar Liquidity Measure is growing at a 14.16% annual rate, the strongest showing since ... March 2005. Not bad!

LIQUIDITY TALK. STILL MORE ON THE "NEW BRETTON WOODS"
[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +12.68%]

The New Bretton Woods framework is the key to understand global liquidity conditions. That's clearly the idea behind this Financial Times article by Alan Ruskin, chief international strategist at RBS Greenwich Capital. Mr. Ruskin highlights what we have called in a recent report the risk of "explosive liquidity dynamics". Here's how it works. Brazil decides to check the appreciation of the real by buying U.S. dollar-denominated bonds. Stock market analysts applaud the move, as it is sure to lead to stronger corporate profits. Hedge funds buy Brazilian stocks — and the currency. The Brazilian real appreciates. The central bank steps in, buying up Treasuries. More global liquidity is created, more hedge funds invest, and the process starts all over again.

On the growth incentives behind this scheme, check out this post by Dani Rodrik [HT: Brad Setser]. By the way, it's worth rememberting that Dooley, Folkerts-Landau and Garber always considered the New Bretton Woods scheme a second best development strategy. It would be better, of course, if developing countries would beef-up their financial systems, strenghten property rights, and generally improve governance. But herein lies a paradox: the more successful they become at playing the FX reserves game, the less they care about good governance. Argentina is a case in point: maybe I'll write about that next week.

ENDOGENOUS LIQUIDITY AT A NEW ALL-TIME HIGH
[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +13.17%]

Our expermiental, untested, preliminary Endogenous Liquidity Index is reaching new highs. The index is designed to capture the impact of changes in the supply of laonable resources in the credit market resulting from financial innovation, the "Great Moderation" of the business cycle, and the carry trade. Check out the Credit Derivatives & Liquidity section of the blog for lots of info (*).

(*) Latest links: PIMCO's Robert Mead on "Demystifying the Structured Credit Jargon and Identifying the Opportunities", and the Atlanta Fed conference on "Credit Derivatives: Where's the Risk?"

LIQUIDITY TALK. GROWLING CREDIT- AND LIQUIDITY BEARS

[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +11.25%]

Am I a perma (liquidity) bull? Judging from a number of recent e-mails, this must be the impression readers get from the Global Liquidity Blog. My answer, however, is always the same: I'm just trying to measure the beast. When I say that the current liquidity boom is unprecedented, it's for a reason. Previously, our Global Liquidity Measure had never grown north of 10% for fully 54 months in a row. Voilà. I hope this settles the issue. (I'll be glad to report about the next liquidity downturn as soon as it materializes).

Meanwhile, there are some very respectable growling credit- and liquidity bears out there:

- John Plender & the next 'savage downturn'. The Financial Times economist doesn't buy the argument that "structured products uniformly enhance market efficiency". Instead, he warns, "collapsing standards will now stretch out the credit cycle while ensuring the delayed downturn will be more savage when the defaults finally happen". Ironically enough, the "mispricing of credit" is driven by the illiquidity of CDOs and CLOs, which limits the scope for marking to market.

- Steve Previes & the 'global liquidity bubble'. The Jefferies International strategist told CNBC Europe that markets face a "global liquidity bubble", with key central banks pouring too much money into financial markets. "There's a situation of excessive liquidity, with too much money chasing too few deals".

- Gillian Tett & the 'bubble-like conditions in the credit markets'. Over an expensive lunch with a "senior banker", the Financial Times' capital markets worries about extraordinary "bubble-like conditions in the credit markets". Tett does not sound very convincing when she mentions the pattern of the business cycle: even the very cautious Bank of England's Financial Stability report all but concedes that the nature of the business cycle has been permanently altered. The real problem is whether institutions are becoming "more cavalier about lending risk", as Tett puts it. As Machiavelli said, "Perché un uomo che sia consueto a procedere in uno modo, non si muta mai". Human nature does not change ...

LIQUIDITY ANALYSIS. THE IRRESISTIBLE ALLURE OF THE NEW BRETTON WOODS

[Latest Global Dollar Liquidity Measure: +13.84% annual growth rate; latest Endogenous Liquidity Index: +12.27%]

The New Bretton Woods proposition, the key factor in the current liquidity boom, is sometimes misunderstood as an instance of (misguided) support for the Bush administration. In reality, it is much more than that. Having lived myself in "emerging" countries, it is perfectly clear to me that the key to understand the phenomenon is the high cost of capital resulting from weak property rights. These countries are thus virtually forced to compete à la Chinese: by systematically undervaluing their currencies and accumulating dollar-denominated FX reserves.

Look at the China-Blackstone deal. According to the Financial Times, "China's decision to buy a stake in Blackstone's IPO rather than in one of its buy-out funds, which are more volatile and risky, is a sign of Beijing's cautious approach to private equity". Let me get this straight: the Chinese do not trust the solidity of ... their own financial markets! And there's more. According to Thomas Barnett, Iran is studying the ... Chinese model. Here, readers of Dooley, Folkerts-Landau and Garber will recognize one their key insights: many more countries are likely to join in!

Meanwhile, down in Buenos Aires, Fed governor Randall Kroszner tells it like it is:

The financial systems in many developing nations are relatively weak and are not effective at directing saving toward appropriate investment projects. That failing leads to inadequate investment, particularly if business activity is further impeded by inadequate property rights and faulty regulations. As a result, excess saving flows to countries with better financial systems.

Businesses in many emerging-market economies face a multitude of hurdles. Red tape, rigid regulations, and weak legal systems impede the formation of businesses, their ongoing operation, and their confidence in having their contracts enforced without long and costly litigation. Accordingly, governments in these countries could greatly improve the environment for domestic capital formation by simplifying business regulations, strengthening property rights, including the rights of creditors, and improving contract enforcement.

WEEKLY FED BALANCE SHEET REVIEW. BUSINESS AS USUAL
. Federal Reserve: "Factors Affecting Reserve Balances", May 16

- Fed's Treasuries holdings: $775.8bn (-$0.8bn)
- Other central banks' Treasuries holdings: $1,224.7bn (-$3.3bn) (*)
- Other central banks' agency securities: $715.2bn (+$12.1bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,715.8bn (+$8.1bn)

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

It's business as usual in terms of the weekly Fed balance sheet. While the Fed's balance sheet barely moved —courtesy of the inverted yield curve—, foreign central banks eagerly snapped up $12bn in agency securities. At $715bn, the stock of such custody holdings is at a new all-time high. Overall liquidity growth is strong: our Global Dollar Liquidity Measure is growing at a 13.85% annual rate. Business as usual!

The Endogenous Liquidity Index surged 2.08%, spurred (mostly) by falling high-yield bond spreads. Meanwhile, the Goldilocks/Stagflation indicator appears to be moving decidedly in favor of Goldilocks, as the platinum/gold ratio reaches 2 (strong global growth), and the spread between plain and inflation-indexed Treasuries falls (decreasing inflation expectations).

LIQUIDITY TALK. STEPHEN JEN'S BULLISH "PILLARS"
. Morgan Stanley Global Economic Forum

[Latest Global Dollar Liquidity Measure: +13.95% annual growth rate; latest Endogenous Liquidity Index: +9.35%]

Morgan Stanley's Stephen Jen discusses the current situation of "ample global liquidity", which he dubbs "Pillar 1" of the bullish case for risky assets:

Pillar 1. Ample global liquidity. This ‘real’ liquidity arises from a mismatch between world savings and investment rates. World capex has surprisingly been too low to absorb all available savings. Annually, there are some US$800 billion worth of ‘excess savings’ from oil exporters and Asian exporters to chase after assets.

Readers of this blog know that, every Friday morning, we publish our own version of this "Pillar"; we call it Global Dollar Liquidity Measure. Now, Jen's "Pillar 3" caught my attention, because although he does not include volatility measures in his definition of liquidity, they do feature prominently in our own Endogenous Liquidity Index:

Pillar 3. Global de-coupling and positive growth prospects. Global de-coupling has effectively reduced overall financial risk, relative to a world powered by a single growth engine. Whether the US is in a refreshing mid-cycle slowdown, or cycle-terminating event is critical. This question, I believe, is more complicated than deciding on the US housing market’s fate. I see the global economy as healthy, with 2007 as the fifth consecutive year with global growth above 4.0%. The first phase of the globalization growth process entails a massive increase in world useable labor force and I believe we are at the tail-end. The second phase should entail a sharp increase in capital expenditures, infrastructure and production capacity. The expansion of labor and of capital should enhance the global economy’s potential growth rate. Risky assets, theoretically, should be in a secular bull market. Apparent financial bubbles are actually well supported by solid global economic fundamentals. Inevitable ‘frictions’ from the globalization process will be just minor irritants. From this broader perspective, discussion on global de-coupling is unhelpful. The cyclical risks to the global economy are inflation, and the likelihood of the global economy driving the US housing market rather than the other way around.

[Latest Global Dollar Liquidity Measure: +13.95% annual growth rate; latest Endogenous Liquidity Index: +7.76%]

LIQUIDITY TALK. THE GLOBALIZATION OF PIMCO!
. Bill Gross. "How We Learned to Stop Worrying (so much) and Love Da Bomb", PIMCO Bonds

Ladies and Gentlemen: this is by far the most important piece on global liquidity that I have read in a while. Bill Gross is telling us in no uncertain terms that the time has come to embrace all the elements of the global liquidity tide: the New Bretton Woods proposition, financial innovation and its wonders, the Great Moderation of the business cycle, and even ... the carry trade ("the dominant liquidity lever in today’s marketplace").

Among the many, many interesting conclusions to draw from this piece: (a) an excess of caution "has cost [PIMCO] some basis points"; (b) foreign CBs' purchases of U.S. bonds keep long-term rates down by as much as 50 basis points; (c) PIMCO will enter local-currency money markets in selected emerging economies.

Rock'n'roll!

[Latest Global Dollar Liquidity Measure: +13.95% annual growth rate]

LIQUIDITY TALK. THE "TRILLION DOLLAR QUESTION"
. Rich Karlgaard. "The Economy's Trillion Dollar Question", Forbes - Digital Rules

The Trillion Dollar Question, according to Forbes' Rich Karlgaard, involves the current liquidity boom: is it sustainable? Does it reflect dangerously lax global monetary policies? The Financial Times' Lex column ponders similar questions:

Everywhere, financiers are holding their collective breath, waiting for the dreaded turn in the cycle. Even bank bosses are becoming more and more candid about the dangers. Bank of America’s Ken Lewis, talking about private equity, last week called for “a little more sanity in a period in which everyone feels invincible”.

Global liquidity conditions, the turn of the credit cycle: these are precisely the "trillion dollar questions" that we ask ourselves daily at the Global Liquidity Blog.

LIQUIDITY TALK. ON DAVID MALPASS, THE NEW BRETTON WOODS, ETC.

- David Malpass on Global Liquidity Conditions. Rich Karlgaard, who writes Forbes' Digital Rules blog, quotes Bear Stearns chief economist David Malpass on global liquidity conditions:

Globally, the impact of plentiful liquidity is reaching a crescendo, with stocks high, spreads narrow, growth strong, land prices booming and central banks flooded with dollars. We note the sharp contrast with 2001, when a shortage of dollar liquidity (strong and strengthening dollar, high real interest rates, low central bank dollar reserves, falling gold and commodity prices, rapidly shrinking U.S. profits) all spelled weakness.
_______________

- Steen Jakobsen on China & the New Bretton Woods. Saxo Bank's fund manager Steen Jakobsen tours Asia and realizes how vitally important the New Bretton Woods proposition is to China:

The rule of controlled peg, or Breton Woods II, as many prefer to call it inflates assets as the locals banks get FLOATED with domestic currencies which then goes into stock markets, fixed income, land and consumption through low rates, leverage debts ... The risk though being PBOC could be forced to move. The inflation numbers created some stir, and there is desperate needs deflate some of the bubble, but the Chinese have learned their lessons from the Japanese in the 1980s. Japan accepted to let their currency to go stronger and ever since they have been in deflation!
_______________

- Chris Dialynas on ... the New Bretton Woods. PIMCO's Chris Dialynas discusses the New Bretton Woods arrangement in the context of the firm's upcoming "secular forum":

The common presumption is that Bretton Woods II is in every country’s mutual interest to keep the globalization game going. But as this arrangement grows, it becomes more complicated and makes more people nervous ... From the U.S. standpoint, a revaluation is an obligation under Bretton Woods II, since it could help cure some of the imbalances or at least keep them from growing too large. But China has been very reluctant to let its currency appreciate significantly.
_______________

- Slow investment growth & global interest rates. Strong global liquidity growth increases the supply of loanable resources in the credit market. But other factors must be at work to explain the low level of long-term interest rates globally. Harvard University economist Ken Rogoff recently suggested that low levels of investment are a natural consequence of emerging economies' weak governance standards. This Financial Times article makes a similar point about investment (or the lack thereof) in oil-exporting countries:

Resource nationalism, which is limiting access for international oil companies, and the national oil companies’ failure to reinvest profits in production, are limiting outlay required to replace existing resources, which are being substantially depleted ... Robin West, chairman of PFC Energy said: "The concern is not that the world is running out of oil, but rather it is running out of oil production capacity". The PFC study shows political factors are limiting capacity increases in Mexico, Venezuela, Iran, Iraq, Kuwait and Russia.

WEEKLY FED BALANCE SHEET REVIEW. THE THIRD WEEKLY CONTRACTION
. Federal Reserve: "Factors Affecting Reserve Balances", May 9

- Fed's Treasuries holdings: $776.6bn (-$9.2bn)
- Other central banks' Treasuries holdings: $1,228.0bn (+$0.7bn) (*)
- Other central banks' agency securities: $703.1bn (+$3.6bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,707.7bn (-$4.9bn)

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

The week ends with a $4.9bn contraction in our Global Dollar Liquidity Measure. So far in 2007, this has happened on three occasions only. The main culprit: the Fed reverting a massive repo operation. Foreign central banks added about $4bn, mostly in agency securities. They now hold more than $700bn in agency bonds in custody at the New York Fed. Meanwhile, our Endogenous Liquidity Index did not fare any better (-0.94% on the week). While the carry trade factor remained unchanged, all other components dragged the index lower: CDS spreads, high-yield bond spreads, the VIX, and the Goldman Sachs share price.

The way I see it, the correction in risky assets that began yesterday could very well continue for some time. But I wouldn't get too excited with short positions: year-on-year growth rates (+13,95% for our Dollar Global Liquidity Measure) still suggest a heathy long-term liquidity situation.

LIQUIDITY ANALYSIS. ON KEN FISHER, PART III
. CNBC Street Smarts: Buyouts

Interviewed last night by Maria Bartiromo, investor Ken Fisher tells is like it is: "This market is uniquely ideal in modern history". According to Fisher, the unusually large gap between the after-tax earnings yield and bond yields has been in place for 55 months, something that "has never happened before". There is a reason why I keep mentioning Fisher every time he shows up for a CNBC interview: the liquidity boom, as captured by our own Global Dollar Liquidity Measure, has just entered its ... fifty-fourth month. This too has never happened before.

LIQUIDITY ANALYSIS. A MARKET-BASED "GOLDILOCKS-STAGFLATION" INDICATOR
. Barchart.com

Suppose that the best market-based indicator of global economic growth is the platinum/gold ratio [a], and that the best indicator of inflation expectations is the spread between the 10-year benchmark Treasury note and the current 10-year inflation-indexed note [b]. The [a]/[b] ratio is thus a "Goldilocks/Stagflation" indicator. What does it tell us right now? On the one hand, inflation expectations have increased somewhat in 2007. On the other hand, the global economy is growing strongly (platinum/gold ratio approaching 2).

At 0.81, our "Goldilocks/Stagflation" indicator looks neither too hot nor too cold. Based on past data, it would appear that the S&P500 has further room to run (about 5%) before getting seriously overvalued in terms of this "Goldilocks/Stagflation" indicator.

WEEKLY FED BALANCE SHEET REVIEW. THE LIQUIDITY BOOM ENTERS ITS 54TH MONTH!
. Federal Reserve: "Factors Affecting Reserve Balances", May 2

- Fed's Treasuries holdings: $785.8bn (+$10.2bn)
- Other central banks' Treasuries holdings: $1,227.3bn (-$0.7bn) (*)
- Other central banks' agency securities: $699.5bn (+$9.4bn) (*)
- Mackinlay's Global Dollar Liquidity Measure: $2,712.6bn (+$18.8bn)

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

The global liquidity boom, defined as a 10% or more annual rate of growth in our Global Dollar Liquidity Measure, has just entered its fifty-fourth month. To the best of my knowledge, this is unprecedented. Both the Fed and foreign central banks actively added to their portfolios. The Fed did so through unusually large repo operations. Foreign CBs bought more than $9bn in agency securities, leaving the stock of such custody holdings at a new record level, just below $700bn.

Meanwhile, our preliminary Endogenous Liquidity Index (ELI) fell 0.9% during the week, dragged down by slightly higher junk bond and CDS spreads. I'll take it as a mildly bearish short-term sign in an otherwise very supportive long-term liquidity environment.

LIQUIDITY TALK. "LIQUIDITY IS THE CATCH WORD OF THE DAY"
. Dan Carty. "Not so Golden Liquidity", Traders Insight

"Liquidity is the catch word of the day", complains Dan Carty. He goes on to suggest that people who talk about liquidity should at least be able to quantify it. I agree: that's what we do here every Friday morning! As for the rest of the piece, I have some doubts. Dan uses market-based indicators to arrive at a "liquidity demand model". Now, I happen to like market-based liquidity models myself (*). But are not market prices, by definition, always factoring in supply and demand?

(*) See the fast-aging but still wonderful book by Manuel Johnson & Robert Keleher. Monetary Policy. A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

LIQUIDITY TALK. RISK DIVERSIFICATION & MORAL HAZARD: TWO VIEWS
. Gillian Tett & Chris Giles. "Traders urged to learn from subprime saga", Financial Times

Citing the recent Bank of England report on Financial Stability, Financial Times writers Gillian Tett and Chris Giles briefly discuss the issue of moral hazard in the context of the risk transfer mechanism through CDS and other innovations. "If banks think they can unload risk on to someone else", write Tett and Giles, "they may become more cavalier about making loans". Moral hazard, thus, may increase as the transfer of risk intensifies.

Not so fast, says Timothy Geithner, president and CEO of the New York Fed: "... the system as a whole may be less vulnerable to distorsions introduced by the moral hazard associated with the access that banks have to the safety net" (italics mine). In other words: as banks embrace the "originate-and-distribute" model, those moving to the "buy-and-hold" role may behave more cautiously because they do not have access to the safety net.

The two views are not necessarily incompatible. Moral hazard within banks may increase as a result of financial innovation, but it may well decrease in terms of the financial system as a whole (*).

(*) See Gillian Tett. "Hedge funds lead European leveraged lending", Financial Times: "American hedge funds and other non-bank credit investment groups now hold just over 50 per cent of all lending to risky European companies — pushing banks into a minority role in this sector for the first time".

LIQUIDITY ANALYSYS. MORE ON LIQUIDITY & VOLATILITY
. Jeremy Siegel. "Presenting the bullish case for equity valuations", Financial Times

Jeremy Siegel, professor of finance at the Wharton School, establishes the bullish case for equity valuations by arguing —among other things— that "the reduction in economic volatility should reduce the equity risk premium". Here's another the way to put it: lower macro volatility leads to an increase in the supply of loanable resources in the credit market, which (other things being equal) means lower long-term interest rates and higher equity valuations.

The recent Bank of England report on financial stability explains the process — "Less volatile collateral values promotes steady credit growth rates":

The stability of the economic environment may have encouraged the provision of more long-dated and subordinated finance because lenders are more confident that firms will not default as a result of sharp shocks. Loan payments are also being backloaded ... Even lowly rated firms are able to raise subordinated finance, with issuance of second-lien loans and mezzanine notes (which fall between equity and debt in a firm's capital structure) increasing over the past year.

Can we legitimately use the VIX as a proxy for macro volatility? It is an open question. Our own Endogenous Liquidity Index does just that — it fell as much as 4.8% yesterday as the VIX surged past 14.

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
__________________

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
__________________

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.
_____________

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
__________________

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
__________________

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
__________________

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.