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GGlloobbaallLLiiqquuiiddiittyyEEbbooookkItaintthethingsyoudontknowwhatgetsyouintotroubleitsthethingsyouknowforsurewhataintso.MarkTwain0.IntroductionGlobalLiquiditytheGLIsandtheM-ShapedInvestmentCycle1.TheQualityTheoryofMoneyTheBernankeDoctrineandtheRiseofGold2.LiquidityandtheShadowBankingSurge3.HowChinaControlsWorldInterestRates4.StyleSelectionvs.AssetAllocationTSSvs.TAA5.ConclusionLiquidityMakesTheWorldGoAroundABCDABCCalmTurbulenceSpeculationReboundDLiquidityCycleEconomicCycle 0.IntroductionGlobalLiquidityTheGLIsandtheM-ShapedInvestmentCycleThisE-bookpullstogetherseveralofourresearchthemesfromthelastdecade.OurstartingpointisGlobalLiquiditythatisthepoolofcashandcreditthatflowsthroughWorldfinancialmarkets.WehavetrackedthesecapitalflowsnowformorethantwodecadesandregularlysummarisethedatausingourGlobalLiquidityIndexesGLIs.ThisdataisdistributedthroughanExceladd-in.TheGlobalLiquidityIndexesGLIsarecomprehensivemonthlysurveysofcarefullyselectedvariablescompiledbyCrossBorderCapital.Theyprovideanadvanceindicatoroffinancialstressandofwhatwillhappentofinancialmarketsandtherealeconomybytrackingdataoncreditspreadscreditgrowthandleverageavailablefundingshadowbankingcross-borderflowsandCentralBankinterventionsacrosssome80countriesworldwide.TheGLIsareregularlyavailablewithin10workingdaysofeachmonthendandtypicallyleadfinancialmarketsandeconomiesbybetween612months.TheseIndexeshavebeencontinuouslyrefinedanddevelopedsincetheirinceptionintheearly1980s.SeeFigure1.Figure1GlobalLiquidityCycle1965-2014monthlynormalrange0-100Liquidityincludesfinancialintermediationbeyondthetraditionalbankingsystem.Structuralchangerendersonceusefulmoneysupplymeasurementout-dated.ThereforewedigdeeperintoflowoffundsstatisticstofindtherootsofthisnewliquidityamongtheshadowbankswholesalemoneymarketsandCentralBankbalancesheets.OuruseoftheflowoffundsaccountingsystemseeUSFederalReserveZ1Accountstieseverythingtogetherandenforcesconsistencybecausebalancesheetsmustbalancedeficitsmustbefundedanddebtcannotbeaccumulatedforever.WesplitLiquidityintoitsthreecomponents1CentralBankLiquidity2DomesticPrivateSectorLiquidityand3Cross-borderFinancialFlows.TheaggregatelevelofliquiditytendstoleadScandinavianBankingCrisisJapaneseTighteningUSSLCrisisSoaringCommoditiesUSCreditSqueezeSterlingCrisisPennCentralBankruptUSCommercialPaperCrisisUSFiscalSpendingBoomInflationaryBoomEndOfBrettonWoodsVolckerFedReaganElectionLDCDebtCrisisFailureofContinentalIllinoisPlazaAccordWeakUS1987CrashMexicoPesoCrisisEmergingMarketBoomBondCrashAsianCrisisRussianCrisisTechY2KEnronWorldcomUSSub-primeCrisisGSEsAIGBailoutNorthernRockBearStearnsLehmanFailureUKBanksNationalisationOPECIOPECIISurgingDollarJohnsonMattheyJapaneseBubbleBaringsCollapseArgentinaCrisis911RealEstateCommoditiesBoomLooseTightUSBankCrisisUKBankingCrisisStockMarketBoomGoldAssetMarketBoomBankingCrisisLouvreAccordRiskOnRiskOff65676971737577798183858789919395979901030507091113020406080100020406080100 reportedcorporateprofitsby18-20monthsandmeasuresofrealeconomicactivityby12-15months.Themomentumofaggregateliquiditytypicallyleadstheslopeoftheyieldcurvebyashorter3-6months.AndrelativeliquidityCentralBanklessPrivateSectorusuallyleadsexchangeratesbyaround6-9months.ThesethreerelationshipsareshownrespectivelyforprofitsgrowthontheMSCIDevelopedWorlduniversetheG20yieldcurveandtheUStrade-weighteddollarexchangerateinFigures2through4.Figure2GlobalLiquidityCycleandWorldCorporateEarningsGrowthFigure3GlobalLiquidityandtheG20YieldCurveDevelopedMarketsDomesticLiquidityIndexAdvanced20MonthsLHSEarningsGrowthYoYChg.RHSOverallLiquidityIndexLHSYieldCurveBasisPointsRHS7577798183858789919395979901030507091113020406080100-200-1000100200300400LiquidityRisingYieldCurveSteepening747678808284868890929496980002040608101214020406080100-40-200204060LooseTight Figure4Trade-weightedUSandRelativeLiquidityOursisessentiallyacyclicalagethereexistdistinctindustrialandfinancialcycles.Theseareoftenbutnotalwayslinkedandtheyaredrivenatdifferenttimesbyanequivalentcycleofliquidity.Liquidityisaquantitymeasure.Lookedatinmoreconventionaltermsweanalysethemovementsinboththestockofmoneyanditsvelocity.Velocityvariesgreatlyspurredinparticularbyfinancialinnovationandde-regulationbutalsobytheebbandflowoffundsbetweentheindustrialeconomyandtheassetorfinancialeconomywhichisourmainfocus.Figure5showsthelatestbreakdownofUSandChinesecreditwhichhighlightstheimportanceofShadowbanking.Figure5BreakdownofUSandChineseCreditEnd-2013USSavingsvs.FedLiquidityAdv6mLHSTrade-weightedUSIndexYoY.ChgRHSChinesePrivateSectorLendingUSPrivateSectorLending4296521215LendingSecuritizationFinanceHousesConsumerCreditMortgageBanksCommercialPaperCentralBank61067953TrustLoansEntrustLoansBankLoansAcceptancesForCurrLoansOtherGoodMoneyBadMoneyStrongUSDollarWeakUSDollar8081828384858687888990919293949596979899000102030405060708091011121314-80-60-40-20020406080-25-20-15-10-50510152025 CentralBankshaveonlyrecentlyputcreditbackintotheirmodels.FortoolongtheyhavebeenpersuadedCanute-likeofthehorizontalistviewthatonlyinterestratesmatterandthattheysetthem.Noonehaseverexplainedwhichratestheyspecificallysetbutstill.InthisWorldthesupplyofliquidityisperfectlyelasticandnooneiseverconstrainedbyalackoffundingAnyonethathaseverworkedinfinancemustacknowledgethatmoneyisnotfungibleincrisesitishoardedandneverflowstowhereitismostneeded.Putdifferentlyvelocitycollapses.OurthinkingcentresonwhatwecalltheQualityTheoryofMoney.Thisessentiallysaysfourthings1.moneycirculatesbecauseithasvalueitdoesnothavevaluebecauseitcirculates.Inotherwordsthespeedofcirculationvelocitydependsonitsprice2.thepriceofmoneyistheexchangeratenottheinterestratelikethepriceofanythingitrepresentspurchasingpower3.moneyconceptuallyexistsintwoformsmeansofpurchasewhichstartsthecircuitandmeansofsettlementthatendsit.CentralBanksarenear-monopolysuppliersofmeansofsettlementmoneylegaltenderincrises.Monetarydisequilibriumhighlightedintheexchangerateoccurswhenthesemoniesgetoutofline4.moneyitselfflowsthroughtwocircuitstheindustrialeconomyandtheasseteconomy.SincethesupplyofassetsislesselasticchangesinthetempoofmoneyintheassetcircuitdriveassetpricesupanddownInthoserareperiodsofmonetaryequilibriumthevelocityofmoneyisstableandtheconclusionsofourQualityTheoryalignwiththoseofthetraditionalQuantityTheory.IfmonetaryvelocityinMiltonFriedmanssenseisstablethenmoneymattersnotcreditandtheasseteconomyisunimportant.Inpracticevelocityishighlyunstableandcreditisimportant.Creditcancausepricerisesbutwhichpricesriseorfalldependsonwhereitenterstheeconomiccircuit.Butifcreditdefaultsthenthepricelevelwilldropalthoughnotnecessarilythesamepricesthatoriginallyroseintheupswing.Forgoodspricestorisemoneyneedstogetintotheindustrialcircuit.Thisisusuallythroughfasterinvestmentspendingwhichthenfiltersintohigherwagesandmoreconsumption.Itisunlikelythatbankswilllenddirectlytoconsumerswithoutcollateral.Thismeansthatbroker-dealersinTreasurymarketsandmortgageborrowersaremorelikelytogetloans.Thereforetherealeconomyresponselargelydependsfirst-of-allonavibranthousingmarket.AcorollaryisthatCentralBankQEquantitativeeasingisnotnecessarilyhighstreetinflationary.QEhasbeenusedpreviouslytoresolvefourwell-knowndebtcrises1Germany19232US19333Britain1974and4Japan1995.Thefirstandthirdwereinflationaryresolutionsandthesecondandfourthdeflationaryordisinflationaryresolutions.WhyTheissuedoesnotconcerntheQEbutwhoholdsthedebtInthecasesof1920sGermanyand1970sBritainthepublicsectorwasheavilyindebtedandthedecisionbythemonetaryauthoritytomonetizethisdebtdirectlyincreasedprivatesectorliquidity.Thisunwantedcashwasquicklyspentinnearfullemployment economiestherebycreatinginflation.Incontrastinthecasesof1930sAmericaand1990sJapantheprivatesectorsweremostindebtedandextraliquidityfollowingQEpoliciessimplyledtothedebtbeingliquidatedratherthanmoneybeingspentintheanywaydepressedrealeconomy.AgainthelessonofthisCrisismuchlikethe1930sisthatmonetaryinflation--thekeyleverindevaluingprivatesectordebt--causesassetpriceandnothighstreetinflation.Figure6broadlycomparestheresponseofvariouspricestoFederalReserveQEinbothperiods.Figure6MonetaryInflationThe1930sExperienceUpdated-20020406080100120140160ConsumerRealEstateWholesaleCottonSilverPerpetualBondOilStockPricesSP500GoldZincPalmOilCopperTinSteelUSFedMonetaryBase1930-39AverageCumulativeIncreaseAverageCumulativePerformanceofSelectedAssetClassesThroughQE1QE2andQE3SinceLehmanCrisis-20020406080100120140USBondsConsumerPricesGoldGlobalEquitiesUSHighYieldOilCopperUSMonetaryBaseEmergingMarkets Inpracticetheunderlyinglevelofinterestratesisnotsetinfinancialmarkets.Ratheritisformedintheindustrialeconomybythemarginalproductivityofcapital.WegoontoarguelaterthatChinatheWorldsmarginalproducerlargelycontrolsthelevelofglobalinterestrates.ThisChineseoverproductionandnotthegeniusofCentralBankersmightexplaincurrentlowrealinterestrates.HoweverinterestratespreadsaredeterminedinfinancialmarketsandnotablythemostimportanttheslopeoftheTreasuryyieldcurve.ThisasweshowmovescloselyandalittlebehindtheLiquidityCycle.OuroverallimpressionisthatastheWorldhasgottenbiggerithasbecomemorevolatile.Regularbankingcreditcrisesseemtohitevery8-10yearssuchasin1996197419821990199798200708.MoreovereachcyclehastracedoutastylisedM-patternstartingwithamonetaryinflationbyCentralBankersandendingwithacostinflationitselffrequentlytheresultofhigheroilprices.ThefirstpeakoftheMisassociatedwithstrongbondsreboundingfinancialsharesandweakpapercurrenciesthesecondpeakislinkedtoweakbondsstrengthfromcyclicalsharesbuoyantpapercurrenciesandevidenceofeconomicpick-up.Lookingaheadifwearecorrecta2016BankingCrisismaybeonthecardsThreetrendsdescribethemoderneconomytheproductivityofindustrialcapitaltheelasticityoffinancialcapitaltheinertiaofconsumerspendingCapitalismislargelyaboutthedistributionofthesurplusnotaboutconsumptionorproduction.Consumptionandfinancefacilitatetheaccumulationofcapitaltheaccumulationofcapitaldoesnotfacilitateconsumption.Aclearlessonofeconomichistoryisthatconsumerspendingisusuallydifficulttoencourage.Itplods.Henceprofitabilityandinparticularthereturnoncapitalarethekeyvariables.Thesehaveatendencytoriseandfallinlongwaves.Thesetrendsspeedupslowdownandre-directtheaccumulationofcapitalbetweenindustrialsectorsandbetweennations.Theseshiftsshowupintheflowoffundsdatathatweregularlymonitor.Afallingmarginalproductivityofcapitalisreflectedthroughweakerprivatesectorcashinflowsi.e.PrivateSectorLiquidityandthisforcesadjustmentthroughafallingrealexchangerate.Herethemainconduitsofchangearethenominalexchangerateandassetprices.Highstreetpricesandwagescanplayarolebuttheytypicallytendtobeslowermovingparticularlyinmatureindustrialeconomies.Fallingprofitabilitydoesnotnecessarilyimplyasavingsinvestmentimbalance.Inacapitalisteconomytheflowoffundsidentitymeansthatliquidityratherthansavingsdeterminescapitalspending.Howeveritseemstobeclearthatovertimethepoolofsavingsrisesfasterthanconsumption.Thishasledmanytoprojectsecularstagnation.Itdoesshowtheimportanceofre- cyclingfundsintocapitalspendingifthepaceofeconomicactivityistobemaintained.Thisre-cyclingisdonebyfinancialmarkets.Creditmarketsandothermechanismsdeveloptospeedupcirculationtimesandsoencouragemoreconsumerandcapitalspending.Thissimultaneouslyheightensthesupplyofcreditandliquidityandbroadenstherangeofinstrumentsthatcanbepurchased.Themodernmonetarysystemiscreditdebt-basedandhighlyleveraged.Collateralbecomesvulnerablewhendebt-repaymentiscompromisedandsoliquidityoftenbecomeshugelypro-cyclical.WhatsmoresinceinacrisistheonlytruecollateralislegaltenderakaCentralBankmoneyleveragecanbeextreme.AsaresultCentralBanksarerequiredtoplayabigger-and-biggerfinancialstabilityrole.Afterhavingmoveddownthrough2007and2008collateralandliquidityhavebeenmovinguptogethersince2009helpedbyCentralBankQE.InessenceastheWorldgetsbiggeritbecomesmorefinancialandmorevolatile.Thisexplainswhyeconomiesbothtrendi.e.throughprofitabilityandcyclei.e.throughliquidityandwhythetwoareoftenconnectede.g.throughCentralBanks.Considerthelattersresponsetoafallingrealexchangerate.Fortrade-focussedeconomiessuchassayAsiaorGermanyastableexchangerateisparamountthereforetheirCentralBankswilltendtooperatepolicytomanagethenominalexchangeratee.g.pro-cyclicalCentralBankLiquidity.Incontrastamorefinancially-developedeconomysuchasBritainortheUSwillfirsttrytoensurethestabilityoftheircreditsystemse.g.counter-cyclicalCentralBankpolicybecausesharpplungesinassetpricesunderminecollateral.PerhapsthistellsuswhyGermanBundsBritishhousepricesandAmericansharesareoftenthethreebestinvestmentsCentralBanksoftenmakepolicyerrors.Theseerrorscanbesizeableandtypicallycoincidewiththeirattemptstofixinterestrates.ApartfromobviouslysettingtheirpolicydiscountratetheMarketnotCentralBanksdeterminesallotherratesacrossthetermstructure.Thepriceofmoneyistheexchangerateandnottheinterestrateandsoattemptstocontrolinterestratesthroughaddingandsubtractingliquiditycancausecurrencyinstability.OntheotherhandmoreCentralBankmoneydoesnotautomaticallycreatehighstreetinflationandleadtoeconomicimbalances.Thismuchisclearfromthepastfiveyears.Howeveritcanandfrequentlydoesleadtofinancialimbalancedistortscreditmarketsandencouragesanexcessivereachforyield.Thisthreatismoreimmediatethanhighstreetinflationandattimesviz.2008moredevastating.HowshouldweusethisframeworktounderstandthecurrentcrisisLong-termsupplyshocksareimportantandarguablythebiggestsupplyshockinrecenthistoryhasbeentheFalloftheBerlinWall.Thiseconomicallyenfranchised2-3billionnewproducersnotconsumersandhard-hitWesternprofitability.AsaresultofthissupplyshockcapitalmustflowEastwardsandDevelopedMarketsrealexchangeratesneedtofallwhileEMrealexchangeratesneedtorise.Howevertheadjustmentchannelsareasymmetric.EMeconomiesbeingtrade-relatedpushadjustmentthroughhigherassetpricesratherthanahighernominalexchangerate.ExchangeratestendtobeanchoredtotheUSdollar.Incontrastthefinancially-developedDMwhichneedtoseelowerrealexchangeratescannotallowtheirassetpricestofallheavilybecausetheblowtocollateralwouldupsettheircreditmarketsandunderminethebalancesheetsofcredit-providers.Hencetheytendtoprefertoseenominalexchangerateweakness.ThisframeworkexplainswhyEMassetpricesexploded upwardsthroughthe1990shaltedonlybytheupwardmovementintheUSdollarwhenatightFederalReserveandthelifttoproductivityfromtheUStechnologyboomboosteditsrealexchangerate.ApartfrommonitoringLiquiditydataovertheperiodwehavewrittenonfouroftenconnectedresearchthemes.Weattachtherawandunrevisedreportsintheirentiretytoevidencethesethemesassubsequentchapters.Theyrepresentourhitsandmisses.ThethemesareQualityTheoryofMoneyandtheRiseofGoldLiquidityandtheShadowBankingSurgeHowChinaControlsWorldInterestRatesStyleSelectionVs.AssetAllocation 1.QualityTheoryofMoneyTheBernankeDoctrineandtheRiseofGoldInaseriesofreportsstartingwithHarryPotterandtheFederalReserveNovember2002weexploretheUSFedsincreasinguseofitsbalancesheettoinjectfundsintotheUSfinancialsystem.TheMoneyManBernankesDoctrine10YearsOnNovember2012examinesthelegacyofDeflationMakingSureItDoesntHappenHereBernankesNovember21st2002speechthatsignalledthispolicychange.ByincreasingFedliquidityfasterthanUSprivatesectorliquiditytheUSdollarwaslikelytoweakenandthegoldpricecertaintorise.WesettargetsenroutebutultimatelywewerenotsurprisedtoseetheUSdollargoldpricetestUS2000oz.SeeWhyGoldWillKeepRising...AndOilFebruary2009.AllThatGlistersIsNotBlackGoldOctober2006outlinesourviewthatthegoldoilratioiscriticaltounderstandingoilpricesandforthatmatterothercommodityprices.ThecommoditypriceconstellationispricedfromthenominalgoldpricethepolestarwhosepositioninmanywaysisinthegiftoftheFed.InotherwordstodaytheUS1300oz.goldpriceisasconsistentwithaUS100bbloilprice13xasUS35oz.goldpricewaswithaUS2.70bbloilpriceintheearly1970sbeforethedemiseofBrettonWoods.TheQualityTheoryofMoneySeptember2006arguedthatmoneycirculatesbecauseithasvalueanddoesnothavevaluebecauseitcirculates.InotherwordsstablemoneyisimportantandthemoretraditionalQuantityTheoryofMoneyonlyseemstoworkwellwhenthevalueofmoneydoesnotchange.TounderstandstablemoneywesplitCentralBankliquidityfromPrivateSectorliquidity.RelativelymoreCentralBankliquidityweakenscurrenciesrelativelylessCentralBankliquiditystrengthensthem.Theformeroftendescribesamonetaryinflationandthelatteramonetarydeflation.Financialcrisesinturncanbeultimatelycategorizedascrisesofmonetaryinflationandcrisesofmonetarydeflation.InJapansGreatExperimentTheLandofRisingAssetPricesApril2013weturnouranalysistoAbenomicsinJapanarguingthatthesameeventswouldoccurstartingwithamuchweakerYenandendingwithrisingassetprices. 2.LiquidityandtheShadowBankingSurgeWhatisLiquidityThisisaquestionthatisnoteasytoanswerandthisisthereasonwespendsomuchtimetryingtobeprecise.MoneyCreditandGlobalLiquidityFebruary2014updatesanearlierreportandprovidesbackground.Liquidityisessentiallydefinedasallformsofcashandcredit.Itisasourceratherthanauseoffundsmeasure.Inpracticeitcomprisesalltypesoffundingforcreditprovidersbeyondthetraditionalbankdepositsorwhateconomistsbyconventiontermmoneysupply.Itcoversnon-depositsourcessuchaswholesalefundinge.g.reposandcommercialpaperwhichballoonedtostandbiggerthanthebankingsectorandthencollapsedpost-Lehman.Yettodayshadowbanksremainimportant.Thesupplyofmoneyisnotnecessarilyaffectedbythisincreaseinfundingbutthevolumeofcreditshouldbe.AsanexampleUSliquiditytotalsaroundUS24trillionwhereasUSM2MoneySupplyisonlyUS8-9trillionorroughlyone-thirdthesize.MoreoverLiquidityhasaGlobaldimensionsince2006ChineseLiquidityhasexplodedupwardsbyawhopping430.Aseriesofreports21stCenturySchizoidBanksDecember2007andNewYorkSlidesWashingtonWakesChicagoDreamsMarch2008exploretheriseofshadowbankingandtheleverageimplicitintherepoandwholesalemarkets.InTheNikkeiNASDAQ...NottingHillJuly2007wewarnabouttheimpendingbubblethatthiscreditboomwastheninflating.DissentInsideTheFedApril2008arguesthatUSpolicymakersmaybeunderestimatingtheinherentleverageinthesystem.MoreoveritpointstotheuseoftheTaylorRuleandtheover-emphasisoninterest-ratesettingratherthanliquiditymanagementasamajorsystemrisk.TobeearlyistobewrongandwewereearlyincallingtheultimateCrisis.Ourdatapointedto2007ratherthan2008asthelowwatermarkofliquiditybutthatsaidnootherrivalindicatorsgotclose.IntheaftermathweproducedTheMessageFromAPreviousLowFebruary2009andMay2011.Thisgavearoad-mapforthefuturewithacommentaryillustratedbyaseriesofcontemporary1930s40scartoonsdrawnbyDavidLowduringthelastdebtcrisis.OddsofaQE3...100August2011publishedafterQE2suggestedthatitwasonlyamatteroftimebeforepolicy-makerswouldbecompelledtoaddmoreliquidity.HoweverwenoteinAsianLiquidityNoTigerIntheTankFebruary2012thatinsharpcontrasttotheUSAsianemergingeconomieswerestartingtosufferthedangerousreversalintheirliquiditythatisnowadverselyaffectingassetpricesacrosstheEmergingMarkets.JapanIsTheNewFranceFebruary2009arguesthatexchangeratevolatilitynothigherinflationisthelikelyoutcomeofthepost-LehmandebtcrisisandQE.Thelessonofthe1930swasthattheeconomiesoftheearlydevaluersagainBritainandtheUSAperformedbest.WesuggestherewronglygiventheriseofAbenomicsthatJapanmaybethelasteconomytodevalueandhencewouldsufferlikeFranceinthelate-1930s.MaybeJapanhasnowescapedthisdeflationtrapbutChinaandtheEurozonecouldstillgetcaughtChineseLiquidityandChinasShadowBankingSectorMarch2014focusesonhowwemeasuretheliquidityimpulsefromShadowBanking. 3.HowChinaControlsWorldInterestRatesThisthemewastriggeredbythepopularbutfalsenotionofaglobalsavingsglut.Wearguethisideaiswrongfortworeasons1asavingsinvestmentimbalancecanoccuratmanydifferentratesofcapitalinvestmentand2lowrealinterestratessuggestanequallylowmarginalreturnoncapital.The1989FalloftheBerlinWalleffectivelyeconomicallyenfranchised2-3billionnewproducersnotconsumers.OntopChinawasinthemidstofamajorcapitalspendingboomfinancedbythePBoCPeoplesBank.BotheventsgluttedtheWorldwithexcessproductandmadeithardforWesterncapitaltocompete.ConsequentlytheystoppedinvestingandinsteadspenttimecuttingcostsandinvestingtherisingfreecashflowintowholesalemoneymarketsseeTheme2.Theresultwasanelevatedaveragereturnoncapitalfromcost-cuttingreportedtoshareholdersandadepressedbuthiddenmarginalreturnoncapital.ThelattermeantlownewinvestmentandthisforceddownrealinterestratesinfinancialmarketsnotablyTIPSyields.Thusitwasnotthegeniusofpolicy-makersbuttherealityofChinasinvestmentboomthatledtofallingWorldrealinterestrates.SeeHowChinaSetsWorldInterestRatesMarch2007andHowChinaControlsWorldInterestRatesJune2013.ThisideaistakenacoupleofstepsfurtherinGoodMoneyBadMoneyandtheChineseElephantSeptember2013andChinaAmericaandCollapsingCapitalFlowstoEMJanuary2014.InthefirstreportwesuggestthatthelatestslowdowninChineseliquidityandthedropincapexisbehindthejumpinUSrealinterestratesasthepreviousforcesunwind.ThesecondreportcontinuesthethemethatasChinaslowsittakesdownEMwithitbecausetheseeconomiesaretiedtotheskiddingChinesecapexcycle.ThethreatofUStaperingisthussecondarytothefactofChinesetighteningbythePBoC.ThelinkbetweenChineseliquidityandtheUSbondmarketisexploredinGrossInterestRatesandtheEndofQE2April2011andinTheNewOldYieldCurveDecember2013.Bothreportsarguethatthelong-endofthebondmarketdrivestheshort-endandnotviceversa.Thelevelofthelong-endissetbyinflationexpectationsandbyrealinterestratesseeabove.Thetransmissiontotheshort-endisthroughtheyieldcurvewithasteepcurveimplyinglowshort-termrates.TheFederalReserveandotherCentralBanksdonotsetinterestratesthemarketdoesbutbyitsliquidityinjectionstheFedhasabigsayoverthetermstructure.Thesereportsshowthatrisingliquiditycausesasteepeningyieldcurvewithinsixmonthswhiledecliningliquidityproducesaflatteningcurve.Inflectionsintheliquiditycycleareimportantforbondsandwehaveoneagainnowinearly2014. 4.StyleSelectionVs.AssetAllocationTSSvsTAAThecentrepieceofourliquidityanalysisisthatinvestorpowerratherthanearningspowerdeterminesassetpricing.InthereportMoneyMoneyMoneyADifferentAssetAllocationAugust2006wenotethatatthemacro-levelPEsmaybeunboundedandnotmean-revertingandsocannotbeusedtoguideassetallocation.InsteadwesuggestPMorprice-to-moneyratios.AcorollaryisthatinvestorstendtobemorevolatilethantheirinvestmentsThereforeweanalysetheinvestmentclimatei.e.theliquiditybackdropandinvestorsmoode.g.riskappetitetounderstandthis.Monetaryinflationanddeflationdescribetheinvestmentclimateandcostinflationandcostdeflationaremajorinfluencesonriskappetite.Macro-FinanceOrWhatTheyDontTeachYouAtTheChicagoBusinessSchoolSeptember2010summarisesmanyoftheseideas.Stylesvs.AssetsJune2004wasanearlyreportthatarguesthatinvestmentstylereturnsarelesscorrelatedandhaveamorestablevariancecovariancematrixthanassetreturns.WhatCanYaleTeachUsJuly2011updatesanearlierreportthatsuggestsmanyassetallocatorswouldbebetteroffdiversifyingacrossstyles.ThusTacticalStyleSelectionTSSmaybepreferabletoTacticalAssetAllocationTAA.TheideathattheinvestmentclimatecanchangeisexploredinTheVolatilityofVolatilityMay2010.ThisintroducestheideaoffourregimesCalmSpeculationTurbulenceandRebound.Eachregimedescribesadifferentvariancecovariancematrixandvolatilityineachregimeisverydifferent.TheReturnofTAADecember2012notesthatthethenfashionforriskonriskoffisafacetoftheseinvestmentregimes.Thereportshowsthatassetallocationshouldbedoneinabsolutetermsbycomparingassetsagainstmoneyandnotinrelativetermsagainsteachother.Thusthebondequityyieldgapishighlyunstableanddependentontheinflationbackdrop.AssetvaluationistackledfurtherinLiquidityandModernFinanceLookingInsidethePEAugust2004.ThisbreaksdownPEvaluationintoaprice-to-moneyratiothatrepresentsportfolioexposureandaliquidityfactor.TheeffectsofinflationonassetreturnsandriskappetiteisarecurringthemeexploredforbondsinLostintheBrettonWoodsMay2010andforequitiesinTheBearMarketinValuationsandtheBullMarketinHistoryJune2011andTheBearMarketinValuations...Part2September2011.Equityvaluationandownershipisdependentontheinflationregimewithvaluationshighestatlowinflationcirca2-3andlowereitherside.Bondyieldsrespondtobothmonetaryandcostinflationbutasymmetrically.Bothinflationsarerequiredtopushyieldshigherbuteithercostormonetarydeflationissufficienttopushyieldsdown. 5.ConclusionLiquidityMakesTheModernWorldGoRoundThebottom-lineisthatshiftsinmonetaryconditionscausechangesinassetpricesandexchangerates.Monetaryconditionsaredefinedbythesourcesoffunds.Thesesourcesoffundsprecedeintimingtheusesoffundsorthingslikecapitalandconsumerspendingexportsandfiscaldeficitswhichmakeupthedomainofeconomicanalysis.MoreoverthesourcesareconceptuallybiggerthanCentralBanksandevenbiggerthantraditionalCommercialBanks.CentralBankQEbyitselfisaninaccuratemeasurebecauseoftheendogenousliquiditycreatedbytheprivatesector.Thusthetotalsourcesoffundsincludeboththesecreditflowsaswellasfundsprovidedbyshadowbankswhichtypicallyborrowdirectlyfromthecapitalmarketsandwholesalemoneymarkets.Somecallthismoneyinallitsforms.Ontopwearguethatinterestratesarenotthepriceofmoneybutacategoryofprofits.Interestratesaloneignoreriskpremiaandtheoftenrestrictivetermsbehindloans.Thereforetheycannotbeusedtomeasureliquidity.ThusinourviewtryingtopredictCentralBanksinterestratepolicyisentirelypointless.Theexchangerateisthetruepriceofmoneyandswingsinthesourcesoffundscausechangesinrealexchangeratesinmatureeconomieswheregoodspricesandlabourcostsarestickyassetpricesmovebymore.Theliquidityframeworkcanberepresentedsymbolicallytoshowhowthetwomaindrivers-monetaryconditionsandriskappetite-affectassetprices.Liquidityisthebestgaugeofmonetaryconditions.LetPfdenoteaverageassetpricesMrepresentsliquidityandkisamultiplier.wherekdefinestheprice-to-moneyratioameasureofportfoliostructureandndenotestheroughlyconstantnumberofassetsoutstanding.Henceifliquidassetsrepresent20ofportfoliosthentheprice-to-moneyratiois4times8020.Henceassetpriceshavetwomovingpartsliquidityandwhatwehavetermedriskappetite.Assuminganunchangingprice-to-moneyratioPMorportfoliomixthenexpansionsofliquiditywilldriveassetpriceshigher.LetdeviationsofthisportfoliomixorPMratiofromitsunderlyinglevelortrendmeasureinvestorsriskappetite.Itfollowsthatarelativelyhighexposuretoriskassetssuchasequitiesimpliesahighriskappetiteandsimilarlyviceversa.Ideallyweshouldincreaseexposuretoriskassetswhenliquidityishighandrisingandwhenriskappetiteisunusuallydepressed.Ultimatelyflowoffundsandcapitalflowsarethekeydriversofeconomicsandmarkets.Themoderneconomyisavastre-financingmechanismthatrequiresliquidity.Unlikemoderneconomicanalysiswelargelyfocusonsourcesandnotusesoffunds.InourWorldliquidityratherthan savingsdeterminestheeconomiccyclethroughvariationsininvestmentspending.Manyoftheabovethemesareconnected.InvestmentregimesTheme4areclearlylinkedtoliquidityandchangesinCentralBankpolicyTheme1.ControversiallytheBernankeDoctrineTheme1andtheChinaboomTheme3provedtobemajorfactorsbehindtheexplosionofGlobalLiquidityandtheshadowbankingsystemTheme2aheadofthe200708LehmanCrisis.ThefollowingreportscontainedinfoursectionsoneforeachthememayhelptoclarifyourthinkingWehavedeliberatelyexcludedquantresearchfromthissurvey.AseriesofresearchpapersdetailingdataconstructionGrangerCausalityTestsandmodelapplicationsusingtheGLIdatasetisalsoavailableonrequest. Section1QualityTheoryofMoneyandtheRiseofGoldHarryPotterandTheFederalReserveOrisGreenspanputtingtheUSbackontheGoldStandardNovember2002TheMoneyManBernankesDoctrine10yearsonNovember2012WhyGoldwillKeepRising..AndOilFebruary2009TheQualityTheoryofMoneySeptember2006JapansGreatExperimentTheLandofRisingAssetPricesApril2013 1CROSSBORDERCAPITALGlobalViewNovember2002MarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comCROSSBORDERCAPITALSourceCrossBorderCapitalHarryPotterAndTheFederalReserveOrIsGreenspanPuttingTheUSBackOnTheGoldStandardTenyearsagomanyinvestorsbelievedthattheUSFederalReservewastargetingthepriceofgold.IndeedChairmanAlanGreenspanvirtuallysaidso.Butthegoldpriceslumpedfromlate-1996precedingafive-yearperiodofassetmarketturbulenceandcoincidingwithGreenspansgrowingbeliefintheneweconomy.RecentlyUSdollargoldpriceshaverisennoticeablyfromtheirmid-2001lows.CouldtheFedberevertingtoagoldpricetargetThiswoulddovetailwithGreenspanslong-heldbeliefs.WhatsmoreitwouldhavenegativeimplicationsfortheUSdollarandbondmarketsbutitwouldaddmuchneededsupporttoWallStreetandtoglobalstockmarkets.Figure1.GlobalLiquidityCycleIndexAdvancedBySixMonthsAndGoldPriceSDRoz.1980-2002808182838485868788899091929394959697989900010203020406080100-40-30-20-1001020304050LiquidityAdvancedby6MonthsLHSLooseTightIndexSDRGoldPriceRHSYoYChg.CentralBankssellinggoldInsideTheChamberOfSecretsAlthoughitisunfashionableweoftenwatchgold.GoldisnotjustthemysticalmetalprizedbywizardsandfetedatHogwarts.Ratheritisthenaturalcorollarytomonitoringtheliquiditycyclebecausethegoldpriceisthepriceofliquidity.Imbalancesingloballiquidityarehighlightedwithinaroundsixmonthsbyswingsinthenominalpriceofgold.Thusgoldisanimportantbarometerofglobalfinancialstability.Thegoldpriceleadsotherassetrawmaterialproducerandretailpricesbybetweenthreemonthsandaroundthreeyears.SeeFigures12and3.Theserelationshipsarerobust.RoyJastramanauthorityonthehistoryofgoldnotesGoldmaintainsitspurchasingpoweroverlongperiodsoftimeforexamplehalf-centuryintervalsAndTheamazingaspectofthisconclusionisthatitisnotbecausegoldeventuallymovestowardscommoditypricesbutbecausecommoditypricesreturntogold.1RoyW.JastramTheGoldenConstantNewYorkJohnWileySons19771 2CROSSBORDERCAPITALSourceCrossBorderCapitalFigure2.GoldPricesAdvancedByNineMonthsAndEconomistCommodityPriceIndex1980-2002Year-on-YearPercentageChanges808182838485868788899091929394959697989900010203-50050100150200-50050100150200GoldPrice-Advancedby9MonthsIndexofCommodityPricesYoYChg.YoYChg.Butitsnotjustitstrackrecordthatmakesgoldworthwatching.Theworldsmostimportantpolicy-makerFedChairmanAlanGreenspanisakeenobserverofthegoldprice.Greenspanhashadalong-termloveaffairwithgoldAnalmosthystericalantagonismtowardthegoldstandardisoneissuewhichunitesstatistsofallpersuasions.Theyseemtosensethatgoldandeconomicfreedomareinseparablethatthegoldstandardisaninstrumentoflaissez-faireandthateachimpliesandrequirestheother.AlanGreenspanGoldandEconomicFreedomJuly1966Inanop-edarticlewrittenfortheWallStreetJournalsome15yearslaterGreenspanunderscoredtheimportanceoftargetingthenominalgoldpriceThosewhoadvocateareturntoaGoldStandardshouldbeawarethatreturningourmonetarysystemtogoldconvertibilityisnomeretechnicalfinancialrestructuring.Itisabasicchangeinoureconomicprocesses.Howeverconsideringwherethepoliciesofthelast50yearshaveeventuallyledusperhapstherearelessonstobelearnedfromourmoredistantGoldStandardpast.TheonlyseemingsolutionisfortheU.S.tocreateafiscalandmonetaryenvironmentwhichineffectmakesthedollarasgoodasgoldi.e.stabilizesthegeneralpricelevelandbyinferencethedollarpriceofgoldbullionitself.AlanGreenspanWSJ1981Ina1994testimonyastheFedChairmanGreenspansaidThepriceofgold...hasbeenespeciallysensitivetoinflationconcernsandGoldisadifferenttypeofcommoditybecausevirtuallyallofthegoldthathaseverbeenproducedstillexists.Andthereforechangesinthelevelofproductionhaveverylittleeffectontheongoingpricewhichmeansthatitsvirtuallywhollyamonetarydemandphenom-enon.Soitsastoreofvaluemeasurewhichhasshownafairlyconsistentleadoninflationexpectationsandhasbeenovertheyearsareasonablygoodindicator.Itdoesthisbetterthancommoditypricesoralotofotherthings.AlanGreenspanSemi-annualTestimonytoCongressFall1994 3CROSSBORDERCAPITALSourceCrossBorderCapitalFigure3.GoldPricesSDRoz.AdvancedBy12MonthsAndUSLongBondYield1981-20028182838485868788899091929394959697989900010203150200250300350400450500550345678910111213141516SDRoz.BondYieldRHSSDRGoldPriceAdvancedby12MonthsLHSABChighinflationlowinflationdeflationQuestionedbytheUSSenateBankingCommitteeGreenspanre-iteratedtheimportanceofgoldAnythingwhichwouldchangetheviewoflong-terminflationprospectsintheUnitedStateswhetheritbeagoldstandardwhetheritbecrediblemonetaryandfiscalpolicyorsomecombinationwilleffectivelyreducebothnominalandrealinterestrates.AlanGreenspanCommentstoSenateBankingCommitteeFebruary1995Andmorerecentlytothesamecommitteeheagainstressedthevalueofthegoldsignallikealotofcommoditypricesandperhapsbetterthanmostthegoldpricehasbeenusefulinmyjudgementintryingtogetsomesenseofwhatinflationarypressureshaveevolvedinthiscountry.AlanGreenspanCommentstoSenateBankingCommitteeFebruary1999USMonetaryPolicy1987-1996Theproofofthepuddingliesintheeating.SoitshouldbeclearfromFigure4thattheheightenedstabilityoftheUSdollargoldpriceroughlycoincidedwiththetenureofGreenspanasFedChairmanfrommid-1987.Stabilitywasspectacularlyachievedbetweenlate-1993andearly-1996.ItwouldappearthatatargetlevelofUS380oz.wassetandbroadlyadheredtobyfine-tuningUSmonetarypolicy.TohititspricetargettheFedalteredthevolumeofdollarliquidityratherthanbuyingorsellingphysicalgold.MoreremarkablygoldroughlymaintainedUS380oz.throughtheturmoiloftheKuwaitInvasionin1990-91andtheupheavalsoftheUSSavingsLoanCrisisatimewhentheexistenceofmanyUSfinancialcompanieswasseverelythreatened.WhatWentWrongButgivenGreenspansclearenthusiasmforgoldwhydidheallowtheUSdollarpriceofgoldtoplungefromjustoverUS400oz.inlate-1996tobarelyUS250oz.bymid-2001a39dropSurelyaccordingtohisstatedcriteriaabovethisforeshadowedsignificantdeflation 4CROSSBORDERCAPITALSourceCrossBorderCapitalGFMSFigure4.USDollarGoldPriceAndRecentDollarAreaCrises1980-2002USoz.DeflationandFinancialMarketCrisesAsianCrisisRussianCrisisArgentinaCrisisBrazilCrisis200300400500600700200300400500600700USoz.8081828384858687888990919293949596979899000102-400-2000200400600800-400-2000200400600800OuncesNetOfficialGoldSalesItdid.Butdeflationneedstobecarefullydefined.Pricedeflationcanarisefortworeasons1costdeflationwhichusuallyarisesbecauseofanimprovementinproductivityperformanceand2monetaryprofitsdeflationwhichistheresultofinsufficientcirculatingmediumi.e.toolittlemoney.Monetarydeflationsdonotnecessarilymeanfallingpricesbuttheyoftenprecedethem.Did1996-2001signalacostdeflationoramonetarydeflationJudgingfromcontemporaryspeechesGreenspanprobablybelievedatthetimethattheweaknessinthegoldpricereflectedfallingindustrialcostsasUSproductivitysoared.Indeedhefrequentlyspokefavourablyabouttheso-calledneweconomy.Howeverinourviewthegoldpriceisamorespecificmeasureofmonetaryimbalance.Consequentlyweviewedtheweakgoldpriceasconfirmationofmonetarydeflation.Monetarydeflationiseconomicallythemostperniciousformofdeflationbecauseitdestroysprofitsandultimatelycapital.Costdeflationmaypunishcertainindustriesoftentheleastefficientbutfortheentireeconomyitisusuallyaplus.Takethefallingpriceofcomputers.Typewritermanufacturersscreamedasone-after-anothertheywentoutofbusiness.Buttherestoftheworldbenefitedhugelyfromcheaperfasterprocessingpower.MuchthesameargumentappliestodaytoChinese-madeTVsandKorean-madecars.Inshortin1996Greenspanwascontenttooverseeafallinggoldpricebecausehewronglybelievedthatitreflectedeconomicsuccessinboostingproductivityandnotmonetaryfailure 5CROSSBORDERCAPITALFigure5.USMonetaryConditionsCentralBankLiquidityIndicatorIndexAndFedFundsRateInverted1999-20020204060801009900010203012345678InterestRatesRHSInvertedCentralBankLiquidityLHSIndexSourceCrossBorderCapitalinnotsufficientlyeasingliquidity.The1997AsianCrisisthe1998RussianCrisisthe2002ArgentineandefaultthefirmUSdollarandthelackofpricingpoweracrossglobalindustryallshowthatdollarliquiditywastootight.ButtherecentdownwardrevisionstoUSproductivitytrendsalmostcertainlyconvincedGreenspanthathispriorassessmentwaswrongtheweakgoldpricereflectedmonetarydeflation.Somethinghadtobedonetoreverseit.BackToUS380oz.Early-2001sawaseachangeinUSmonetarypolicy.Fedliquiditywasboostedandinterestrateswerecut.SeeFigures5and6.WithinmonthstheUSdollargoldpricehadjumped.IthascontinuedtotrendhigherbolsteredbyincreasingdollopsofFedliquidityandeverlowerinterestrates.IfheistruetoformAlanGreenspanwillcorrecthispreviouserrorandreturntheUSdollargoldpricetohisprevioustargetlevelofUS380oz.WhatissignificantaboutUS380oz.Onlythatitisroughlythemedianaveragegoldpricesincethemid-1980s.Areturntothislevelwouldjudiciouslybalancethecompetingclaimsofdollardebtorsanddollarcreditors.Debtorsloseindeflationscreditorswin.ThustoredresstherecentadvantagetocreditorstheFedmustcreateanoffsettingmonetaryinflationthattemporarilyfavoursdebtors.WhatdoesallthismeanformarketsFirstahighgoldpricetargetofcircaUS380oz.impliesthattheUSFederalReservemusteasemuchfurther.Butsurelyatonly1Americasrock-bottomlevelofinterestratesdramaticallyreducespolicy-makersfirepowerWrong.Quantityliquiditycanstillbeeasedsignificantly.Moreliquiditywillbebullishforstockmarketsandtherealeconomy.Agreatmistakeistoconfusethecostofcreditwiththepriceofmoney.Interestratesmeasurethecostofcreditandprevailinglowcreditcostslargelyreflectanabsenceofcreditdemand.AswearguedearliertheUSFedshouldcontrolthepriceofmoneyi.e.thegoldpricebyaddingandsubtractingliquidityfrommarketsthroughopenmarketoperations.InotherwordslooseningwhenthegoldpriceisbelowsayUS375oz.andtighteningwhenitgetsaboveUS385oz.2Notealsothatsignificantnon-USCentralBankssellingcontributedtogoldpriceweakness.SeeFigure4.233Intwopreviousreportswetrytoironouttwoanomalies1ifUSliquiditywastightwhydidthetechbubbleoccurSeeEuropeYouAreTheWeakestLinkCrossBorderCapitalAugust2002and2althoughGreenspanshouldhaveeasedliquidityfromlate-1996inresponsewhatoriginallycausedthedeflationSeeMonetaryDeflationTheEconomicConsequenceofJapanCrossBorderCapitalOcto-ber2002. 6CROSSBORDERCAPITALSourceCrossBorderCapitalFigure6.USDollarGoldPriceUSoz.2000-2002WeeklyJFMAMJJASONDJFMAMJJASONDJFMAMJJASON240260280300320340240260280300320340USoz.000102SecondarisingUSdollargoldpriceimpliesaweakeningpaperdollar.WillthismeanthatthedollarisweakrelativetootherpapercurrenciessuchastheJapaneseYenandEuroOnthefaceofthingsthisassertionisprobablycorrect.ItisveryunlikelythateithertheBankofJapanortheECBwilltargetgold.HoweverbothCentralBankswillpayattentiontothecross-ratesoftheircurrenciesagainsttheUSdollar.Consequentlyultimatelyexpectmonetaryeasinginbotheconomiesasthepaperdollarweakens.Thesemoveswillbereactiveandthereforeitislikelythatthedollarwillremaintheweakestofthemajorcurrencies.ThirdrisingUSdollarYenandEurogoldpricessuggestgeneralstrengthingoldi.e.thecurrency-weightedorSDRpricewillincrease.Thiswillhavesignificantimplicationsforassetmarketvaluations.Figure3highlightstheclosehistoricalrelationshipbetweenSDRgoldandUSbondyieldssome12monthslater.Inshorthighergoldpricesspelldangerforbondinvestors.Butequitiescouldprovethewinner.SeeFigure7.Ourphilosophyistovalueassetsagainstinflationandnotagainsteachother.Afallingbondmarketwillnotdisturbequitieswhenexistinginflationratesarelowandrisinggently.Equityvaluationssuffergreatlyduringperiodsofdisinflationanddeflation.Indeedwehaveshownthatsub-3inflationisnegativeforUSequityvaluations.Thereforehighergoldpriceswillcauseequitiestosignificantlyoutperformbonds.Fourthrisinggoldpricessignalmonetaryinflation.Monetaryinflationdoesnotmeanpriceinflationbutittypicallyprecedesit.Inflationmustbeviewedasaprocessandnotanevent.Commodityandgoodspricesriseinasequencetypicallystartingwithgoldandpreciousmetalsmovingthroughbasemetalsoilandmanufacturedproductsandendingupperhapssomethreeyearslaterwithservicesectorprices.Duringthistransitionphasepricingpowershiftsandprofitmarginstrengthfollowsthesequenceofpriceincreases.Consequentlyduringtheearlystagesofamonetaryinflationtheprofitsofearly-cyclecommodityandbasicindustrieswillgrowrelativelytotheprofitsofservicebusinesses.Butbythelaterstagesofthemonetaryinflationprofitsinservicebusinesseswillhavecaughtup.InshortUScyclicalvalueequitiese.g.chemicalssteelspulpindustrialmaterialshedgedintoEurosmaybetodaysbestinvestmentbet.4SeeWallStreetAnExpensiveIslandInAnOceanOfLiquidityCrossBorderCapitalJune2002.4 7CROSSBORDERCAPITALCROSSBORDERCAPITALLIMITEDMARCOLHOUSE289-293REGENTSTREETLONDONW1B2HJTELEPHONE02075350400FACSIMILE02075350435REGULATEDBYTHESECURITIESANDFUTURESAUTHORITYCROSSBORDERCAPITALLIMITED2002.ALLRIGHTSRESERVEDThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.SourceCrossBorderCapitalFigure7.GoldPricesAndEquityMarketPerformance1988-2002YoYChange6-MonthMovingAverage888990919293949596979899000102-40-200204060-40-200204060YoYChg.EquityMarketsRelativeToBondsSDRGoldPrice 1GlobalViewGlobalViewNovember201296BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalDatastreamFigure1TheUSDollarGoldPriceUnderDifferentFedRegimesUSoz.Monthly1979-2012TheMoneyManBernankesDoctrine10YearsOnQE3isthelatestchapterintheBernankeFedsmonetaryeasing.UnlikeQE1andQE2thisliquidityinjectionisfocusedonboostingeconomicgrowthnotonsavingthebanks.Yetwebelieveitwillhavethesameresultsasitsimmediatepredecessors.ThereisalongertrackrecordofQEagainstwhichtojudgethisthanmanyrealise.BernankesQEpoliciesdidnotstartin2008theykicked-offsixyearsearlierin2002orroughlycoincidentwithanimportantspeechhemadenowalmostexactlyadecadeago.QErarelydoesmuchforunderlyingeconomicgrowthbutitdoesboostgoldandcommoditypricesspill-overintosurgingEMequitiesandbearishlysteepenbondyieldcurves.All-in-allwemaybereturningtoRiskOninvestmentmarketsbutknowingexactlywheretoholdthisriskwillbecritical.TheBernankePutTwodatesstandoutinrecentWesternfinancialhistory9thNovember1989and21stNovember2002.ThefirstmarkedtheFalloftheBerlinWallthatdeepenedandacceleratedtheEmergingMarketRevolution.ThesecondwasthedateofnewFedappointeeBenBernankesDeflationMakingSureItDoesntHappenHerespeech.WebelievethatthislatterdatemarkedthetruestartoftheFedsQEpolicies.Thesehelpedtofuelthe2004-2007assetbubbleviaafeeding-frenzyinUSwholesalemoneymarketsascreditproviderswolfed-downcheapandabundantfunding.Weareclosetotheten-yearanniversaryofBernankesspeechandithasunquestionablyleftitsmarkonglobalmarkets.SeeFigure1.Figure1showstheUSdollargoldpricethroughdifferentpolicyregimesbroadlydescribedbytheincumbentFedChairman.InthefirstperiodshownChairmanVolckeroversawavolatilegoldpricebytargetingUSmoneysupply.7980818283848586878889909192939495969798990001020304050607080910111220030050010002003005001000VolckerEraGreenspanEraGreenspanEraBernankeEraIIIDeflationandFinancialMarketCrisesAsianCrisisRussianCrisisArgentinaCrisisBrazilCrisisDec5th96IrrationalExuberanceLTCMENRONFedEasingLiquidityNeutralMoneyGoldspanMonetaryDeflationIrrationalExuberanceStructurallyLowRealInterestRatesWorldcomBriefPeriodsofMonetaryInflationFedTighteningLiquidityBernankeBoomMonetaryInflationMonetaryDeflationTargetMoneySupplyTargetPriceofGoldTargetInflationSustainedMonetaryInflationTargetAvoidanceofDeflationVolatilegoldStablegoldFallinggoldRisinggoldFederalReserveChairmen GlobalView2ThesecondperiodorGreenspanIfeaturedanimplicitgoldpricetargetwhichbroadlyalignedwiththethenFedChairmansstatedbeliefs.ByGreenspanIIChairmanGreenspanhasbeenpersuadedbyirrationalexuberancetomoveawayfromagoldpricetargettoanimplicitinflationtarget.TheresultingtightermonetarystanceledtheUSdollargoldpricetoskidlowerandtheshortageofUSdollarstousherinasequenceofdefaultsbymajordollardebtorsstartingwithThailandandembracingRussiaandBrazilbeforehittingENRONandWorldCombackhome.BernankessecondmenttotheFedmustbeseeninthecontextofthisworseningdebtbackground.BernankesDeflationspeechwasthefirstimportantonehemadeafterjoiningtheFed.Hecameinasanacademicexpertoncredittransmissionthe1930sDepressionandJapanspost-Bubbleeconomy.Withhindsighthelookedwell-suitedtothethencomingdecade.TheDeflationspeechstartedbydismissingthethenprevailinginflationparanoiaintheUS.BernankearguedthatJapansexperienceofdeflationslowgrowthandbankingproblemswasthemoresinisterthreat.Realinterestratescouldrisesharplyoncenominalinterestrateshitthezerolowerboundleadingtosizeablejumpsinrealrepaymentburdensandworseningbankbalancesheets.YethedismissedtheideathatatzerointerestratestheFedhadrunoutofammo.PreventionbeingbetterthancureBernankearguedforaabufferzoneoninflationtargetingi.e.1-3beingpreferredto0btheFedasactivelenderofthelastresortcaggressiveandpre-emptiveinterestratecutsanddthatdeflationcouldalwaysbereversedunderafiatmoneysystem.Hereoneparticularquotefromthespeechisworthre-consideringLikegoldUSdollarshavevalueonlytotheextentthattheyarestrictlylimitedinsupply.ButtheUSgovernmenthasatechnologycalledaprintingpress...GettingdowntospecificstheBernankeDoctrineconsistsofsixpolicyactions1RapidFedbalancesheetgrowththroughassetpurchases2EnsurethisgetsthroughtofinancialmarketsbyexpandingtherangeofassetsboughtPeriodAverageAnnualRealGrowthJune1997toMarch20006.1over38monthsor20.6April2000toFebruary20011.611monthsor1.5March2001toSeptember20025.819monthsor9.3October2002toMarch20053.630monthsor9.2April2005toSeptember2008-0.342monthsor-1.0SourceCrossBorderCapitalUSFederalReserveFigure2Pre-CrisisUSFederalReserveBalanceSheetExpansionPercent1997-2008 3GlobalView3Cutshort-termratesaggressivelyandearlyuseforwardguidancee.g.Japanszero-ratetargetandtrytosetabondyieldceiling4BuyGSEdebtandorforeigndebtandusepurchasesofbanksCPcorporatebondsandotherprivateassetsascollateralagainstFedloans5DepreciatetheUSdollarandtheexampleofsuccesshecitesisdevaluationagainstgoldin1933-346Enactamoney-financedtaxcut.QuantitativeEasingPlusQualitativeEasingTheFedsnetliquiditystimulusdependsuponboththesizeandthecompositionofitsbalancesheeti.e.quantitativeandqualitativeeffects.IndeedBernankewasveryspecificinthewakeoftheLehmanCrisisthatFedpolicywasstrictlyfocussedonsupplyingcreditwhereneededratherthanawilly-nillysplurgeofmoney.InshortitwasmorethanasimpleQE.RecentattentionhasstillfocussedmoreonthesizeofQEprogrammesbutindividualactionsinspecificsecuritiesaresometimesmoreimportantthanothers.Figure2showsthatitishardtofingerprinttheFedsbalancesheetaloneasaculpritbehindthe2004-07bubblealthoughinthewakeofthe200001recessiontheFedeasedconsistentlyforfouryears.Toputthisincontextintherun-uptotheLehmanCrisistheFeds2001-05easingmatchedinsizethehugeinjectionsmadeduringtheperiodoftheAsianCrisisandY2K.AmajoreasingeffectalsocomesthroughthechangingcompositionoftheFedbalancesheet.RecentanalysisbytheIMFconfirmsthatthetypeofassettransactionheremattersbecauseeachcanhavedifferentcollateralmultipliereffects.Whatsmoregoodcollateralcanbere-hypothecatedanumberoftimes.AstarkexamplecomesfromthecollateralisedUSwholesalemoneymarkets.SeeFigure3.Theseexplodedinsizeintheearly2000sprovidingmuchofthefuelfortheassetbubble.05000001000000150000020000002500000Jul-01Jan-02Jul-02Jan-03Jul-03Jan-04Jul-04Jan-05Jul-05Jan-06Jul-06Jan-07Jul-07Jan-08Jul-08Jan-09Jul-09Jan-10Jul-10Jan-11Jul-11Jan-12Jul-12SourceCrossBorderCapitalUSFederalReserveFigure3USRepoandCommercialPaperMarketsUSdollarmillionsMonthly2001-2012CommercialPaperRepos GlobalView4MorethanaUS1trillionwerefundedthroughreposandnearlythesameagainthroughcommercialpaperissuancemuchofitbyfinancialcompaniesandwiththeFedoftenacounterparty.SincetheLehmanCrisisfundingfromthesemarketshasdroppeddirectlybyacombinedUS2trillionandinpracticebymoresincetheseresourcesareusedforleveragedfinance.Thusthemid-to-late2000ssawtheUSFedpumpinginliquidityandbolsteringcollateraltosuchanextentthatfinancialmarketsracedhigher.TobefairtheFedhadlittleideahowleveragedthesystemhadbecomeandjusthowvulnerableitwastoaliquidityshock.Thereforewhenpolicy-makersbegantocontractliquidityastheirfearsgrewovertheinflationaryeffectsofthenrisingoilpricesfinancialmarketssputteredgroanedandcollectivelycollapsedasbank-after-bankracedtograbwhatlittlemarginalliquiditywasleft.Thedominoesfellandtherewereanawfullottofall.InflatingSerialBubblesItisalwayshardtoexplainwhypolicy-makersresponsetothisrecentdebtcrisishasbeentoissuestillmoredebt.Yetthisiswhattheyaredoing.BernankeandincreasinglyDraghiinEuropearetheclearestexponents.Theplainfactisthatweliveincredit-marketeconomiesservedbyfinancialinstitutionsthatuseCentralGovernmentliabilitiesastheirmaincollateralagainstwhichtolevertheirbalancesheets.Holesintheirbalancesheetsmadebybaddebtshavetobemadegoodbypolicy-makers.Thisiswhatishappeningnowandforthatmatterhasalwayshappened.Debtsneedtobesettledandtherequiredmeansofsettlementcancomefromnewproductiongreatersavingsi.e.lessspendingandormorelikelyprintedaslegaltenderbyCentralBanks.ThuspreviousincumbentChairmanGreenspanmaybelessdirectlytoblameforthe200708debaclethanmanystillthink.CertainlyhewasattheFedshelmbutthescaleofthepolicyerrorsthattheFedmadehavetheiroriginsintheBernankeDoctrine.SourceCrossBorderCapitalFigure4RoadMapandStylisedInvestmentCycleSchematicAssetBoomAssetBoomAssetBoomAssetBoomBankingCrisisBankingCrisisBankingCrisisRangingMarketRangingMarketMid-1980sMid-1990s2011-1319912007081986-901998-992004-062009-10197419821983-842013-142016-17RecessionRecessionRecessionInflationInflationWeakEconomiesWeakEconomies 5GlobalViewOneconclusionreinforcedbytheBernankeDoctrineisthatthebusinesscyclehaschangeditsnature.Nolongerdoweseethetextbookmodelof1recession2policy-easing3recovery4growth5inflation6policy-tightening7recession.Ratherthecycleisnow1bankingcrisis2firstQE3bankingsystemstabilization4economicstagnation5secondQE6commodityboom7recession.Inotherwordsthemoderncyclestartswithabankingcrisisandendswithacommodityboom.SeetheschematicchartinFigure4.ThechartdescribesanM-shapedcycleofliquiditywiththefirstpolicy-easingfocussedonsecuringtheintegrityofthebankingsystemandthesecondtypically18-24monthslaterfocussedonre-ignitingeconomicgrowth.PutanotherwaythismeansthatinvestorsseetwoassetboomsperbankingcrisisAndthesebankingcrisesseemtoregularlyrecurevery8-10years.InotherwordstheRiskOnRiskOffsequencesinfinancialmarketsowemuchtothechangingtempooftheliquiditycycle.Figure5highlightstheactualswingsinourGlobalLiquidityIndexGLI.QEpolicieswhichfuelthiscyclehavesomeimpactonthebusinesscyclebutdonotchangetheunderlyinggrowthtrend.InsummaryQEsleadtothreethingsRisinggoldcommoditypricesSteepeningYieldCurvesRisingEMThusonaveragegoldrosebyaround55throughQE1andQE2androse35outsideofi.e.in-betweentheQEperiods.Oilroseby99duringtheQEsandbylessthan10outside.Similarlythetrade-weightedUSdollarwasflatoutsideoftheQEsbutdepreciatedbyover14throughQE1andQE2.Bernankeina2012speechclaimedthatFedQEpoliciestakenoverallreduced10-yearTreasuryyieldsbybetween80-120bp.TheevidenceinFigure6suggeststheveryoppositeQE1raisedyieldsbyaround200bpatthelong-endwhileQE2raisedthembysome50-100bp.Figure7summarisesthenetimpactonassetpricesperUS100billionofUSFedQE.Pricesareexpressedinpercentagechangesandbondyieldsinbasispoints.Figure5GlobalLiquidityCycleIndexNormalRange0-1001965-2012SourceCrossBorderCapitalUSFederalReserveECBBankofEnglandBankofJapanIMFScandinavianBankingCrisisJapaneseTighteningUSSLCrisisSoaringCommoditiesUSCreditSqueezeSterlingCrisisPennCentralBankruptUSCommercialPaperCrisisUSFiscalSpendingBoomInflationaryBoomEndOfBrettonWoodsVolckerFedReaganElectionLDCDebtCrisisFailureofContinentalIllinoisPlazaAccordWeakUS1987CrashMexicoPesoCrisisEmergingMarketBoomBondCrashAsianCrisisRussianCrisisTechY2KEnronWorldcomUSSub-primeCrisisGSEsAIGBailoutNorthernRockBearStearnsLehmanFailureUKBanksNationalisationOPECIOPECIISurgingDollarJohnsonMattheyJapaneseBubbleBaringsCollapseArgentinaCrisis911RealEstateCommoditiesBoomLooseTightUSBankCrisisUKBankingCrisisStockMarketBoomGoldAssetMarketBoomBankingCrisisLouvreAccordRiskOnRiskOff656769717375777981838587899193959799010305070911020406080100020406080100 GlobalView6Figure6QEUSFedFunds2-Yearand10-YearTreasuryYieldsPercentWeekly2005-2012SourceCrossBorderCapitalUSFederalReserve012345605012007050120080501200905012010050120110501201210-2YieldCurveQE1QE2QE3FedFunds2-YrTreasury10-YrTreasuryFedFunds2-YrTreasury10-YrTreasuryFigure7ImpactonVariousAssetPricesofUS100billionofUSFedQEAveragesPercentandBasisPoints2008-2011SourceCrossBorderCapitalUSFederalReserveDatastream024681012GoldOilBondYieldsbpMSCISPEM 7GlobalViewWetakeQE1asNovember25th2008toMarch31st2010andQE2asNovember3rd2010to30thJune2011.QE3wasannouncedonSeptember13th2012.OverallboththeMSCIWorldandSP500indexesrosebyaround45whiletheMSCIEmergingMarketindexdoubled.ThebiggestperdollarimpactsareonoilandEMequitiesat4perUS100billion.Goldbullionprovesatadbetterthanstocks.Thebiggestloserisbondsand10-yearyieldsrisebyaround11bpperUS100billionofQE.TakingtheFedsprojectionsofUS85billionpermonthofQE3andusingthemultipliersimpliedbyFigure7suggeststhatoilpricesandEMequitiescouldrisebysome40andothersharepricesbyaround20.Clearlysomeofthismayhavealreadybeendiscounted.Yetbondyieldsarevulnerable.AgainaccordingtothedatainFigure7QE3couldaddaround115bpatthe10-yearduration.MoreoverfurtherevidenceinFigure8showsthattheonoffQEphaseshadsignificantimpactoncapitalinflowsintoEM.Inshortthereisasignificantspill-overofthisliquidity.Thedatarecordarolling9-monthmovingaverageofallnetinwardfinancialflowsexFDIintotheEMeconomies.ThescaleofthesubsequentEMcapitaloutflowsincetheendofQE2inmid-2011iswidelymisunderstoodbutitneatlyexplainstheoftendramaticunderperformanceoftheEMequitymarketsovertheperiod.NowmoneylookssettocomebackintoEM.AreBondsDueASkyFallInthefinalweeksofQE2wewarnedthatanyresultingdropinUSliquiditywouldtriggerahugeRiskOffrallyunderpinnedbysoaringbondpricesandtumblingyields.WewereinaminorityandlinedupagainsttheFedforonewhobelievedthebiggerriskwasasmallriseinyields.IntheeventevenweweresurprisedbyhowlowTreasuryyieldssubsequentlyfell.WiththeFednowfocussedonanothereasingdubbedQE3andonethatcouldeasilyexpandtheirbalancesheetbyupto100bymid-2015therecouldbehugeriskstobondprices.InotherwordsweshouldexpectaRiskOnrallyfeaturingsteepeningyieldcurvesandamajorjumpinlong-datedTreasuryyields.QE1QE2QE3-1000000-800000-600000-400000-20000002000004000006000008000001000000Jan-07May-07Sep-07Jan-08May-08Sep-08Jan-09May-09Sep-09Jan-10May-10Sep-10Jan-11May-11Sep-11Jan-12May-12Sep-12Figure8QEandCross-borderCapitalFlowstoEmergingMarketsUSdollarmillionsMonthlyAnnualised2007-2012SourceCrossBorderCapitalIMFOECD GlobalView8Figure9showsthelong-termrelationshipbetweenUSDollarArealiquidityi.e.USApluspartsofAsiaincludingChinaandthe10y-2yyieldcurvestatisticallythereisstrongevidencethatliquiditycausesGrangerCausalityTestsyieldcurveswings.Typicallyrisingliquidityleadstoasteepeningcurveasbondriskpremiarisewhiletighterliquidityleadstoacurveflatteningandfallingriskpremia.HoweveritcouldbearguedthatthelatestreadingssuggestthatpredictionsofacomingcurvesteepeningareprematurebecausetheyieldcurveisstillinaflatteningphaseinresponsetopreviouslytightUSDollarArealiquidity.Setagainstthispossibilityiscounter-evidencefromcurveconvexity.Asyieldcurvessteepenandflattentheyalsochangetheirconvexityasrateexpectationsgetbuiltintoprices.Asteepeningcurvetendstoseerisingconvexityi.e.itbulgesinanticipationofafutureflatteningwhereasaflatteningcurvetendstoseeconvexitydisappear.Figure10showsthataccordingtothesmallnegativeconvexityreadinginthecurrentUS10y-2yyieldcurvethecurvedeservestobemuchflatterthanitisbecausethemarkethasalreadybuiltintheequivalentflatteningassumptions.Inshortconvexityalignswiththeliquiditydatawhereastheyieldcurveslopelooksanomalous.ThereasonforthismayliewithfundinginterestrateexpectationsandtheFedsforwardguidanceonpolicyrateseventhoughwedoubtthatBernankeisinanypositiontodeliverthelatter.InshortanunusuallylowFedFundspolicyrateasnowwillartificiallysteepenthecurve.OurconclusionsarethatcurrentQEpoliciesplusanear-zeroFedFundsslateduntilmid-2015mayaddasmuchas125bptothe10y-2yyieldcurveslope.Inshortthe10y-2yTreasuryCurveisnot150bpofpositivecarrybutimplicitlyonly25bpandeffectivelyitisalreadymuchflatterthaninvestorsthink.Startingfromtheseimpliedlevelstheoddsofthecurvesteepeningsubstantiallyoutweightheoddsoffurtherflattening.LiquidityRisingYieldCurveSteepening8082848688909294969800020406081012020406080100-150-100-50050100150200250300350Figure9US10y-2yYieldCurveandUSDollarAreaLiquidityBasisPointsandIndexMonthly1980-2012SourceCrossBorderCapitalUSFederalReserveIMFUSDollarAreaLiquidityIndexLHSUS10Y-2YYieldCurveBasisPointsRHS 9GlobalViewThenetconclusionisthatbondslookrisky.TheUSTreasurycurvecouldsufferabearishsteepeningovercomingmonthsasQE3engages.ThisispreciselywhathappenedfollowingthecommencementsofQE1andQE2earlier.Moreoveritisentirelyconsistentwithadetailedexaminationofcurveconvexity.Theriskisthatbondsmayseeanexaggeratedsell-off.WehavearguedelsewherethattheEurozonebondmarketisseeinganequivalentcurvesteepeningasDraghiexpandstheECBbalancesheetfurther.ButontopcreditspreadsacrosstheEurozonebondmarketsaretighteningagainstthemedianbenchmarkastheECBactsaslenderoflastresortbothforbanksandincreasinglyforcertainnationalgovernmentstoo.Thenegativeimpactonsafe-havenGermanBundslooksveryworrying.Inadditionmanyassetallocatorshavelatelydeployedso-calledriskneutralstrategiesthatallocatemoretolowvolatilityassets.Asbondvolatilityhasprogressivelycollapsedsofixedincomehasenjoyedbumperallocations.Butbondvolatilitytendstomovecloselywithanexpandingliquiditycycleasteepeningyieldcurveandgrowingcurveconvexity.Thereforethiscouldallendbadlyforbonds.ButwhatisbadnewshereforbondinvestorsmaysimplyconfirmabullishRiskOnenvironmentforotherassets.Itlookstimetore-allocatetoequitiesEMandgold.AsFigure11showsmostinvestorsarepositionedtheotherwaybondexposurelookscyclicallyveryhighandEMexposureespeciallylow.Figure10US10y-2yYieldCurveandFive-YearConvexityBasisPointsandPercentMonthly1962-2012SourceCrossBorderCapitalUSFederalReserve-3-2-101234Jan-1962Jan-1964Jan-1966Jan-1968Jan-1970Jan-1972Jan-1974Jan-1976Jan-1978Jan-1980Jan-1982Jan-1984Jan-1986Jan-1988Jan-1990Jan-1992Jan-1994Jan-1996Jan-1998Jan-2000Jan-2002Jan-2004Jan-2006Jan-2008Jan-2010Jan-2012-0.80-0.60-0.40-0.200.000.200.400.600.8010y-2yYieldCurveBasisPointsLHS5yConvexityCurvatureRHS GlobalView10CROSSBORDERCAPITALLIMITED96BAKERSTREETLONDONW1U6TJTELEPHONE02079082800FACSIMILE02079082835AUTHORISEDANDREGULATEDBYTHEFINANCIALSERVICESAUTHORITYCROSSBORDERCAPITALLIMITED2012.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.SourceCrossBorderCapitalUSFederalReserveECBBankofJapanBankofEnglandPeoplesBankofChinaIMFDatastreamFigure11InvestorExposureSentimentEmergingEquityandBondMarketsIndexNormalRange0-100Monthly1980-2012EquitiesIndexLHSStandardDeviationsRHSBondsIndexLHSStandardDeviationsRHS-1sd2sd1sd-2sdMean808182838485868788899091929394959697989900010203040506070809101112020406080100SpeculativeOptimisticRiskAversePessimistic 1GlobalViewFebruary200996BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalDatastreamFigure1TheFedsandGoldPriceRegimes1980-2008GlobalViewWhyGoldWillKeepRisingAndOilWeexpecttheUSdollargoldpricetoheadtowardsUS2000oz.spurredbytwostructuralforcesquantitativemonetaryeasingintheWestandoverproductionintheEast.Othercommoditypriceswillfollowgoldupwards.ConsequentlythedaysofUS100bbloilwillreturn.TheReturnofMonetaryInflationTheUSdollargoldpricehasmovedthroughfourdistinctregimessinceitslastmajorpeakofUS850oz.in1980.SeeFigure1.ThefirstphasewasoverseenbythetoughFedChairmanPaulVolckerandwasbroadlycharacterisedbylargecyclicalswings.Phasetwo1988-96correspondedtotheinitialtenureofnewFedChairmanAlanGreenspan.Greenspanalong-timegoldwatcherwasthoughttofavourtargetingthegoldpriceasameansofmonetarycontrol.FormuchofthisperiodthegoldpricehoveredclosetoUS400oz.Frustratedbyso-calledirrationalexuberanceinUSfinancialmarketsduringthemid-decadeGreenspantightenedmonetarypolicyandforcedthegoldpricelower.TheresultingUSdollardeflationtriggeredthe199798AsianandRussiandebtcrisesandultimatelyledontothedefaultsofENRONandWorldComin2001.80818283848586878889909192939495969798990001020304050607080920030050070010002003005007001000DeflationandFinancialMarketCrisesAsianCrisisRussianCrisisArgentinaCrisisBrazilCrisisDec5th96IrrationalExuberanceLTCMENRONFedEasingLiquidityGoldspanIrrationalExuberanceStructurallyLowRealInterestRatesWorldcomMonetaryInflationFedTighteningLiquidityBernankeBoomMonetaryInflationMonetaryDeflationUSoz.LogScale GlobalView2Followingthelate-1990sgreatgolddeflationweturnedbullishofgold.ThegoldpricebottomedatUS256oz.inApril2001andthenstartedtoclimbroughlycoincidentwithcurrentFedChairmanBenBernankesfirsttenureattheFed2002-05.BernankespromisethatthattheFedwouldprintmoneyifJapan-likedeflationthreatenedspookedthegoldmarket.Wefiguredthatbecausecostdeflationwasanever-presentriskgiventhestructuraloverproductioncomingfromChinaandemergingAsiapolicy-makerswouldhavetocreateanoff-settingmonetaryinflation.Arisinggoldpriceistheclearestsignalofthismonetaryinflationorwhatisincreasinglynowcalledquantitativeeasing.Risinggoldpricesdonotfollowinflationinflationfollowsrisinggoldprices.Itisbesttothinkofinflationasaprocessandnotanevent.Itstartswithmonetaryexpansionandnextpassesthroughseveralstages.Theseincludepreciousmetalsoilbasemetalsintermediategoodsconsumergoodsandfinallyconsumerservices.Ontopgoldperformsparticularlystronglyifrealinterestratesarealsolowbecauseitmeansacheapcost-of-carry.Accordingtoourregressionanalysisthe50pointjumpinourUSFedliquidityindexthroughthesecondhalfof2008shouldaddasmuchas5pointstotheannualchangeintherealgoldprice.Ifrealinterestratesfalltozeroourestimatessuggestthattherealgoldpricecouldriseatanannualclipof17.Amoveupto1realinterestrateswouldtrimthisgainbyaround5pointsperannum.SeeFiure2.TwinStructuralForcesunderpinGoldWebelievethatthefinancialoutlookoverthenextfewyearswillbecolouredbytwokeyseculardevelopmentsChineseoverproductionbyskimmingthereturnoncapitalhasreducedrealinterestratesStructurallyfragileWesternfinancialsystemsareexposedtoafundinggapthatneedstobemadegoodbyCentralBankquantitativeeasingChineseoverproductionwillnotdisappearquicklybecauseitstemsfromnationalemploymentpolicywhichaimstocreatejobs.Wehavepreviouslydiscussedtheparallelwith1920sAmericawhereoverproductionduringthe1920sledfirsttotheInterwarSlumpbeforefactorssuchasadvertisinginstalmentcreditandmail-orderboosteddomesticUSconsumerspendingthroughthe1940s1950sand1960s.Equallythecurrentcreditmalaisewillnotgoawayforsomelongtime.Westernbankshavelong-termfundingproblemsfollowingthedemiseofwholesalemarkets.Theirproblemsconcernbadliabilitiesmorethanbadassets.CentralBanksaretheonlyinstitutioncapableoffillingthisfundinggapbyprintingmoneybutwefigurethattheywillhavetoplaythisroleforyearsratherthanjustmonths.Moreoverratherlikethesimilarbackdropinthe1930sthisneednotnecessarilybeinflationaryinthesenseofrapidlyrisingconsumerprices.From1933-39USconsumerpricesrosebyacumulative8.5oranaverageof1.2perannum.Wholesalepricesroseinaggregateby16.7acommoditybasketby34.4cottonby22.2oilby50.4copperby93andscrapsteelby131.6.Goldwhichwas26.33oz.in1933hadalreadyrisenfromits1931lowof17.06oz.butwentontoalmostdoubleto34.42oz.by1930.Therealmessageisthatperiodsofinflationanddeflationhidesometimeshugerelativepriceswins.RegressionResultsMonthlydata1976-2008AnnualPercentageChangeinRealUSGoldPriceConstanttrend16.9Effectof10pointriseinUSFedLiquidityIndex0.6Effectof1pointfallintherealinterestrate5.2R-Squared40.5 3GlobalViewWithoutquestionAmericasFederalReserveiscurrentlycreatingcreditatthefasterrateandintheshortesttimethatiteverhas.FacedwiththechoicebetweeninflationanddeflationUSpolicymakershaveoptedforinflation.WritinginthejournalForeignAffairs1FedChairmanBernankethenalesswell-knownacademiclucidlyoutlinedhisviewstheeconomicrepercussionsofastockmarketcrashdependlessontheseverityofthecrashitselfthanontheresponseofeconomicpolicymakersparticularlycentralbankers.Afterthe1929crashtheFederalReservemistakenlyfocuseditspoliciesonpreservingthegoldvalueofthedollarratherthanonstabilizingthedomesticeconomy.Byraisinginterestratestoprotectthedollarpolicymakerscontributedtosoaringunemploymentandseverepricedeflation.TheU.S.centralbankonlycompoundeditsmistakebyfailingtocounterthecollapseofthecountrysbankingsystemintheearly1930sbankfailuresbothintensifiedthemonetarysqueezesincebankdepositswereliquidatedandsparkedacreditcrunchthathurtconsumersandsmallfirmsinparticular.WithoutthesepolicyblundersbytheFederalReservethereislittlereasontobelievethatthe1929crashwouldhavebeenfollowedbymorethanamoderatedipinU.S.economicactivity.ThedownturnfollowingthecollapseofJapansso-calledbubbleeconomyofthe1980swasnotassevereastheGreatDepression.Howeverinsome1SeptemberOctober2000crucialaspectsJapaninthe1990swasaslow-motionreplayoftheU.S.experience60yearsearlier.AftereffectivelyprecipitatingthecrashinstockandrealestatepricesthroughsharpincreasesininterestratesinmuchthesamewaythattheFedtriggeredthecrashof1929theBankofJapanseemedinnohurrytoeasemonetarypolicyanddidnotcutratessignificantlyuntil1994.AsaresultpricesinJapanhavefallenabout1percentannuallysince1992.AndmuchlikeU.S.officialsduringthe1930sJapanesepolicymakerswereunconscionablyslowintacklingtheseverebankingcrisisthatimpairedtheeconomysabilitytofunctionnormally.Bernankesinitialresponsewasthenowoft-quoted2002speechDeflationMakingSureItDoesntHappenHere.Hisreactiontothe2007creditcrisiswhileatfirstslowacceleratedsharplyaftertheLehmandebacleinSeptember2008.Inthesubsequentperiodtoend-2008theFederalReservesbalancesheetmorethandoubled.Duringthe1930stheFedsbalancesheetgrewbyasimilar75butthenoverfiveyearsandnotjustfivemonthsWebelievethattheFedmustcontinuethisaggressivequantitativepolicystancebecauseofbanksstructuralfundingproblems.ExtrapolatingcontinuedlowrealinterestratesaswellwereckonbasedonpastdatathattherealUSdollargoldpricewillgrowatanannualclipofatleast15.Addinginatrendinflationfigureof2-3thisclearlycouldbetoolowsuggeststhatinlessthanfouryearstimebyend-2012thepriceofgoldcouldbreakUS1600oz.Lessthan18monthsfurtheronthegoldmarketshouldtesttheUS2000oz.level.InflationisaProcessWhatdoesthistellusaboutoilandothercommoditypricesWefigurethatcommoditypriceshavetwomovingparts1acurrencyofdenominationeffecte.g.thenominalgoldpriceand2arealexchangeratioe.g.thegoldoilratio.Thuscommoditypricesmaychangebecauseofeitherfactor.WhatistrueoftheFedprintingmoneyisalsotrueforotherCentralBanksaswell.Althoughthedistributionofbadassetsamongbanksmaywellbeskewedtoafewthespreadofbadliabilitiesrunsbothwideanddeep.ThereforeexpectallofthekeyCentralBankstoundertakeextensivequantitativeeasing.Itfollowsthatthenominalgoldpricewillrisesubstantiallyinallcurrencies.Yetcomparedtomanyindustrialcommoditiesgoldbullionlooksexpensive.Thisisnowalsotrueagainstoilfollowingthelatterspricecollapseoverrecentmonths.Figure3showsthelong-termgoldoilratio.Thishastendedtoconvergeonaratioofaround12-15barrelsofoilperoz.ofgold.Howeverduringeconomicboomstheratiousuallybreaksbelow10timesandduringfinancialcrisesitoftenbreaksabove20times.Thecurrent22.5times90040looksperfectlyconsistentwithpasthistory. GlobalView4AssumingaUS1600oz.goldpricetargetforend-2012andexpectingsomemoveofthegoldoilratiobacktowardsitsmedianvalueof15timesgivesanoilpriceofoverUS100bbl.AsimilarrationaleappliestotheothercommodityexchangeratiosshowninFigure4.WeconcludethattheUSdollargoldpricewillbreakitsrecentMarch2008highofUS1011oz.andheadontowardsUS2000oz.spurredbytwostructuralforcesquantitativemonetaryeasingintheWestandoverproductionintheEast.Inflationiscomingbackbutslowlyandprogressivelyandstage-by-stage.Thehugeexcesscapacityexistingacrosstheconsumerindustrieslikelymeansthatconsumerpriceswillstaydepressedforsometime.Howevergoldandpreciousmetalswilllead.Oilbasemetalsothercommoditypricesandultimatelyassetpriceswillfollowgoldupwards.Inflationisaprocessnotanevent.ConsequentlythedaysofUS100bbloilwillreturn. 5GlobalViewFigure3GoldOilRatiobarrelsoz.1850-2008Figure2RealUSdollarGoldPriceandRealUSInterestRatesMonthly1976-2008SourceCrossBorderCapitalUSFederalReserve-100-50050100150200-6-4-2024681012RealUSGoldPriceYoYChg.YaxisRealUSInterestRatesPercentXaxisExcessDemandForOilExcessDemandForGoldNormal12-15x051015202530354018651870187518801885189018951900190519101915192019251930193519401945195019551960196519701975198019851990199520002005SourceCrossBorderCapitalDatastream GlobalView6Figure4Long-termCommodityGoldRatioVariousRanges0.00.20.40.60.81.01.21.41.6187318781883188818931898190319081913191819231928193319381943194819531958196319681973197819831988199319982003200805101520253035401860186618721878188418901896190219081914192019261932193819441950195619621968197419801986199219982004201001020304050607080901900190419081912191619201924192819321936194019441948195219561960196419681972197619801984198819921996200020042008CopperGoldNickelGoldSteelGoldWheatGold0.00.51.01.52.02.53.03.54.04.55.018411847185318591865187118771883188918951901190719131919192519311937194319491955196119671973197919851991199720032009SourceCrossBorderCapitalDatastreamMetrictonneounceMetrictonneounceMetrictonneounceBushelounce 1CROSSBORDERCAPITALCROSSBORDERCAPITALGlobalViewSeptember2006MarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comTheQualityTheoryOfMoneyThisreporthasbeendugoutfromourarchives.Itmayhelptoexplaintonewclientshowandwhyweuseliquiditytounderstandassetmarkets.Bewarnedtherearenopictures.FaroutintheunchartedbackwatersoftheunfashionableendoftheWesternSpiralarmoftheGalaxyliesasmallunregardedyellowsunOrbitingthisatadistanceofroughlyninety-twomillionmilesisanutterlyinsignificantlittlebluegreenplanetwhoseape-descendedlifeformsaresoamazinglyprimitivethattheystillthinkdigitalwatchesareaprettyneatidea.Thisplanethasorratherhadaproblemwhichwasthismostpeoplelivingonitwereunhappyforprettymuchofthetime.Manysolutionsweresug-gestedforthisproblembutmostofthesewerelargelyconcernedwiththemovementsofsmallgreenpiecesofpaperwhichisoddbecauseonthewholeitwasntthesmallgreenpiecesofpaperthatwereunhappy.TheHitchHikersGuidetotheGalaxyDouglasAdams1979.Unlikeothercommoditiesmoneyingeneralhastheuniquefeaturethatitisnotusedupitcandisappearandreappearfromcirculationanditsspeedaroundthecircuitchangeswithitsvalue.AccordingtotheQualityTheoryofMoneymoneyhasbothanoptimalpriceandanoptimaljurisdiction.Moneycirculatesbecauseithasvalueitdoesnothavevaluebecauseitcirculates.Moneysfunctionasameansofcirculationderivesfirst-and-foremostfromitsroleasthestandardofvalueorfinancialmeasuringrod.Itsvari-ablespeedtellsusthatmoneycanactasbothameansofcirculationandameansofnon-circulationorstoreorvalueforhoarding.Thekeytounderstandingthisvariablevelocityliesinrecognisingthatmoneytakestwoformsduringcirculationameansofpurchasetostartthecircuitandameansofsettlement1toendit.Thestandardofvaluepropertydetermineshowmoneyisdistributedbetweentheseforms.Asastablestandardofvaluemoneywillbeusedwidelyasameansofsettlement.Inturnameansofsettlementwillbeadvancedandborrowedasameansofpurchase.Howeverifthestandardofvalueisdepreciatingmoneybecomesmoreattractiveasmeansofpurchasethanasmeansofsettlement.Equallyanappreciat-ingstandardofvaluefavoursmeansofsettlementmoneyovermeansofpurchasemoney.Thisexplainswhycreditmoney2dominatesduringinflationsandwhycashiskingduringdeflations.1Alsoknownasmeansofpayment2Creditgivestime-limitedaccesstomeansofsettlementmoneyanditisissuedatadiscountknownastheinterestrate.Thepurchasingpowertotheborroweristhus1-rpwhererdenotestheinterestrateandptheoverallpricelevel. 2CROSSBORDERCAPITALFormorethanfivecenturiesGreshamsLawhaswarnedthatbadmoneydrivesoutgood.Butthisruleonlyappliestomoneyasameansofpurchase.Itsequivalentinversiongoodmoneydrivesoutbadasastandardofvalueandmeansofsettlementhasappliedonalargerscaletomonetarysystemsthroughouthistory.Thusworthlessmoneyisnotacceptedaspaymentstablemoneyiswidelyaccepted.ThisderivativeofGreshamsLawappliesinternationallyaswellasdomestically.ItexplainswhytodaytheAmericandollarservesasworldmoneyandtheoldHungarianPengodoesnot.Abundantmoneywhosevalueisdecliningwillinitiallycirculatefasterwithgreatermomentum.Scarcemoneywhosevalueisrisingwillbetreasuredandhoardedasafuturemeansofsettlement.Changingmonetaryvelocity3therebyoftenexaggeratesandsometimesprolongsthebusinesscycle.ThisistheessenceoftheQualityTheoryofMoney.IncontrasttoitsmorepopularQuantityTheorycousintheQualityTheoryincor-poratesavariablevelocityofmoney.Moreovertheforcesembodiedinchangingvelocityarecreatedwithintheeconomicsystemineconomics-speaktheyareendogenousnotexogenous.ClassicalEconomicsusedameansofpurchasedefinitionofmoneyascashandborrowingsi.e.credit.Thedevelopmentofthefinancialsystemmeantthatcreditplayedanincreasingrole.HencetheCurrencyversusBankingSchooldebatesintheNineteenthCentury.ForgedindepressionandhammeredbyrepeatedcrisesModernEconomicsevolvedameansofsettlementdefinitionofmoneybasedoncashsavings4.Ascashsavingsdifferfromcreditsomeansofsettlementmoneydiffersfromitsantithesismeansofpurchasemoney.Creditincreasesandprolongsadebtsavingsextinguishdebts.Savingshaveintrinsicvaluecreditdoesnot.KeynesunfairlycriticisedLockeforbeingthefatheroftwoquantitytheories5.YetLockewassimplyrecognisingthesetwoformsofdomesticmoney.Todaythedistinctionbetweenmeansofpurchaseandmeansofsettlementmoneyremainsrareperhapsbecausepur-chasesarenotdistinguishedfrompaymentswithinthecirculationprocess.Insteadmoneyislargelyunderstoodfromitsmostvisibleformasameansofsettlement.Consequentlythepriceofmoneyistakentobetheinterestratetherentalcostofmeansofsettlementmoney.Thepriceofmeansofpurchasemoneyistheexchangerateandnottheinterestrate.Thepriceofmoneylikethepriceofanycommodityenteringcirculationisitspurchasingpowerorwhatyoucanbuywithit6.SoitwasthattheBankofEnglandoperatedthroughoutmuchofthenineteenthcenturywithtwodistinctunitstheIssueDepartmentwhichcontrolledthefiduciaryissueandhencetheexchangerateandtheBankingDepartmentwhichoperatedinthecreditmar-ketsandsettheBankRate.3MonetaryvelocityissometimesknownastheinverseofMarshalliank4Weusethetermcashsavingstodistinguishthemfromfinancialinvestmentsandunplannedinventorybuilding.5ThegreatLockewasperhapsthefirsttoexpressinabstracttermstherelationshipbetweentherateofinterestandthequantityofmoneyinhiscontroversywithPetty.HewasopposingPettysproposalofamaxi-mumrateofinterestonthegroundthatitwasasimpracticalastofixamaximumrentforlandsincethenaturalValueofMoneyasisapttoyieldsuchayearlyIncomebyInterestdependsonthewholequantityofthethenpassingMoneyoftheKingdominproportiontothewholeTradeoftheKingdom...Lockeexplainsthatmoneyhastwovalues1itsvalueinusewhichisgivenbytherateofinterest...and2itsvalueinexchangeandinthisithastheNatureofaCommodityitsvalueinexchangedependingonlyonthePlentyorScarcityofMoneyinproportiontothePlentyorScarcityofthosethingsandnotonwhatInterestshallbe.ThusLockewastheparentoftwinquantitytheories.Inthefirstplaceheheldthattherateofinterestdependedonthepropor-tionofthequantityofmoney...tothetotalvalueoftrade.Inthesecondplaceheheldthatthevalueofmoneyinexchangedependedontheproportionofmoneytothetotalvolumeofgoodsinthemarket...ButheneverIthinkproceedstoagenuinesynthesis.J.M.KeynesTheGeneralTheory1936.6Theinverseofthegeneralpricelevel. 3CROSSBORDERCAPITALTheexchangerateisessentiallytherateatwhichmeansofpurchasemoneycanbeex-changedformeansofsettlementmoney.Afallingi.e.depreciatingexchangerateshowsthatmoremeansofpurchasecanbeexchangedperunitofmeansofsettlementarisingi.e.appreciatingexchangeratetellsusthatfewermeansofpurchaseareobtained.Thusafallingexchangerateencouragesmeansofsettlementtobecomemeansofpurchaseandsospeedsupthevelocityofmoney.Equallyarisingexchangeratereducesvelocity.Inshortvelocityispositivelylinkedtomonetaryinflationandnegativelyrelatedtomonetarydeflation.ModernEconomicsfocusesonmoneyleavingtheeconomiccircuittheusesoffundswhereasClassicalEconomicsanalysesmoneyenteringthecircuitthesourcesoffunds.ThusKeynesiansconcentrateondiscretionaryspendingandMonetar-istsoncashsavings.Monetarismepitomisesthemeansofsettlementview.KeynesianismisoftenexpressedasaspecialcaseofMonetarismwherepublicsectordepositsdisplayconstantvelocitybutprivatesectordepositsoftensufferaveryloworzerovelocity.Bothschoolsfailnotbecausemoneyisunimportantbutbecausetheyignorethedifferentformsofmoneyandspecificallytheimportanceandelasticityofcreditanditsmetamorphosisintoandoutofsavings.ModernEconomicsdefinestheso-calledsupplyofmoneytoconsistlargelyofbankdepos-its.Bankdepositscannotbespentdirectly.TheymustbefirstconvertedintoStateorprivatesectorcreditviapapermoneyorcheques.Chequesaresimplyveryshort-termcreditse.g.lastingafewdaysandwhollydependentontheiracceptabilitytothedrawer.Inacrudeandbasicbankingsystemofsayacenturyortwoagodepositreceiptsdidphysicallycirculateandcouldactlikecash.Everydepositwasvirtuallyassuredofservingasacredit.Buttodaybankdepositsareauseandnotasourceofpurchasingpowerandtheyareoftenheldasanalternativetootherassets.Creditisthekeysourceofpurchasingpowerandcreditsarenotautomaticallygeneratedfromcashdepositseventhoughthereversenearlyalwaysapplies7.NotsurprisinglyMonetarismspredictionscommandagreaterprecisionwhenthebankingsystemsloandepositratioisconstant.Ironicallythiscoincideswithperiodsofstablepriceswhenthequalityofmoneyisuntarnished.ThustheheydaysofaccurateMonetarismweretheGoldStandard1870-1914andBrettonWoodsfixedex-changeratesystem1945-72yearswheninflationwaslargelyunknown.TheQuantityTheoryofMoneyisthereforeaspecialcaseoftheQualityTheoryofMoney.Letustermtheflowofmeansofpurchasemoneyliquidityanddubtheflowofmeansofsettlementmoneysavings.Bothcreditandcashserveasmeansofpurchasemoneyorliquiditybutonlycashismeansofsettlementmoney.Therateatwhichliquidityisturnedintoasavingssurplusexpressesthetempoofeconomicactivityandinturnismeasuredbyafluctuatingaggregatepricelevel.Monetarydisequilibriumdescribesimbalancesbetweenthesourcesandusesoffundsthatisbetweenliquidityandsavingsratherthanbetweenspecificusesi.e.investmentandsavings.Theseimbalancesarere-solvedbychangesintheoverallpricelevelandnotbychangesininterestrates.Forexam-pleoverproductionandtheresultingexcesssupplyofgoodsimplythatasimultaneousexcessdemandformeansofpurchasemoneyexists.YetModernEconomicsrecommendsaremedyoflowerinterestratesbecauseitwronglyseestheproblemasexcessivesavingsratherthanasalackofcreditsupply.Cuttinginterestratessimplyworsenstheimbalancebyencouragingastillgreaterdemandformeansofpurchasemoneyi.e.liquiditywithoutnecessarilyprovidingnewsources.Theresultisfurtherandpossiblycumulativepricedeflation.7Thuseverycreditcreatesadepositbutnoteverydepositcreatesacredit. 4CROSSBORDERCAPITALParadoxicallyonesolutiontooverproductionistoraisenotlowerinterestratesandsodiscourageusesofliquidity.Howeverthispotentiallyweakenseconomicactivityandde-stroysjobs.Anotherandmoreamenablesolutionistoinjectgreaterliquidityintomarkets.Incaseswherethetake-upofprivatesectorloansishamperedbythefearoffallingpricestheremaybenoalternativetoextraCentralBankcreditthroughopenmarketassetpur-chases.Anincreaseinthesupplyofcreditmayultimatelyraiseinterestratesbecausethecon-comitantincreaseinpriceswillinturnboostcreditdemand.Interestratesandpricestendtomovetogetherbecausecreditinfluencesbothandbothinfluencecredit.Keynesdubbedthiswell-establishedrelationshiptheGibsonParadox.Unfortunatelyitservestoperpetuatethecommonerrorofconfusingthepriceofmoneywiththeinterestrate.Thusmonetarydisequilibriumandthesubsequentadjustmentifanyistoooftenanalysedintermsofthemovementorlackofthemarketrateofinterestawayfromsomelong-termnorm8.ModernEconomicshasbecomeatheoryofthefailureoftherateofinteresttoadjust.Tobetterunderstandmoneyourfocusshouldbeonassetdurationandtheecono-myschangingcapitalstructure.Durationmeasuresthetimingofaveragecashpay-mentsandreceipts9.Bycombiningbothliquiditypreferenceandtimepreferencetogetheritdescribestheflowofliquidityovertime.Liquiditythusembraceslowdurationthetimeuntilmeansofpurchasearrivesormeansofsettlementareneededandwidemar-ketabilityhowgenerallyacceptedarethemeansofpurchase.Theconceptofdurationneatlytiesinwithmoneysqualitativedimensionbecausedura-tionwillchangeparipassuwiththepriceofmoney.Moremeansofpurchasemoneywilllengthenportfoliodurationandmoremeansofsettlementwillshortenit.CriticsoftheQuantityTheoryofMoneyarguethatanexpandingcreditordepositbasecannothaveanyrealeffectbecauseinbothcasestheireconomicinfluencewillbeoffsetbyanequivalentchangeontheothersideofthebalancesheet.Thuseveryincreaseinsaybankcreditsmustbebalancedbyanequalriseinbankdebits.Howeverviewedintermsofdura-tionallincreasesinmeansofpurchasemustlengthenduration.Eventhoughassetsmustequalliabilitiesimbalancesinthesourcesandusesoffundsandhencebetweenmeansofpurchasemoneyandmeansofsettlementmoneytriggerchangesinthepriceofmoneyi.e.theexchangerateandtherebyinducechangesindesiredportfolioduration.Realandfinancialassetsarereshuffledcausingtheirpricestochangeasthenewdesireddurationisestablished.Oncethesourcesandusesoffundsequatesothevalueofmoneystabilises.Astablevaluewillencouragethegreateruseofmoneyandbe-causemoneyactsasabridgebetweenthepresentandthefutureastablevaluewillpro-motelonginvestmenthorizons.Inturnthiswillfosterfurtherinvestmentgreaterpro-ductivityandfastereconomicgrowth.Bycontrastunstablemoneywillforceshorterhori-zonsandlessproductiveactivitiessuchashoardingandspending.Averageassetdurationrisesifcapitalassetsarepurchasedanditfallsiftheyarescrappeddevaluedorreplacedbycashandconsumeritems.Thusthecapitalistcycleisfundamentallyacycleofchangingassetdurationthatisoftencausedbyunstablemoneyandnotacycleofchanginggrowth.Uncertaintyaboutthevalueofmoneyandtheappropriateassetdura-tionwillexplicitlyappearasaswollenriskpremiumandhigherlong-terminterestrates.DestabilisingthevalueofmoneydestabilisesthecapitalisteconomyasLeninwasfondoftellingus.Byraisingriskpremiaunstablemoneyforciblyshortensthedurationoftheassetstructureslashestangibleandfinancialinvestmenthastensassetsalesandencour-8Sometimesthereturnoncapitalinindustryandatothertimesthelong-termaveragerate.9FrederickMacaulayin1938firstcalculateddurationasthetime-weightedsumofallfuturecashreceiptsdiscountedbyprevailinginterestrates. 5CROSSBORDERCAPITALagesgreatercashholdings.Acquiringmoneyforitsownsakeduringuncertaintimesinevi-tablymeansanexcesssupplyofgoodslabourandassets.Assetpricescollapseandunem-ploymentsoars.Liquiditytheflowofcashplusnewcredithelpstodeterminethedura-tionoftheassetstructureandinturnthereturnoncapitalthepaceofeconomicgrowthandthedistributionofincomesbetweenwagesandprofits.Financialcrisesresultfrompronouncedimbalancesbetweenmeansofsettlementmoneyi.e.savingsandmeansofpurchasemoneyi.e.liquidity.Liquidityisplainlycentraltothecapitalistcycle.Bothshortagesofsavingsandshortagesofliquiditycanhaltproductionbyinterruptingthecirculationprocess.Thelatteraremostcommonandironicallytheyoftenfollowacreditboom.Soitwasthatthetypicalnineteenthcenturybusinesscycleendedinpricedeflationandnotpriceinflation.EvenwithoutCentralBanktighteningfinancialliquiditymaydryupifvelocityslowsasaresultoffallingprices.Slowervelocitycanfollowaninvestment-inducedproductivitysurgeorarunawayconsumerboomthatabsorbscash.Thecorollaryisthatfinancialcrisestaketwoformscrisesofmonetarydeflationandcrisesofmonetaryinflation.Bothdrainfinancialmarketsofliquidityi.e.cashorcreditandbothforcedurationdown.The1987stockmarketcrashwasamonetaryinfla-tioncrisisduringthelate1990stheworldsufferedamonetarydeflationcrisiscentredontheUSdollarzone.Japanslongperiodofdeclineinthe1990sstartedwithamonetaryinflationcrisisin1990laterpunctuatedbyamonetarydeflationcrisisaround1995.The1929WallStreetcrashwasalsoacrisisofmonetaryinflationbutthefargreaterstockmarketslidethrough1931wasacrisisofmonetarydeflation.TheseconclusionsareimportantbecausetheyshowwhyinterestratetargetsandtheblindpursuitoftheTaylorRule10aredangerouslywrong.Settinganinterestratetargetwhetherthroughhistoricnormorbycomplexformulaisunlikelytobeeffec-tive.Interestratesthecostofcreditarebeingaskedtodotoomuchtheymayinfluencethepriceofmoneybuttheyarenotthepriceofmoneyandtheylikelydistractattentionawayfromthetrueprice.Inamonetarydeflationhighriskpremiadriveawedgebe-tweenlenderandborrower.IfinterestratesaretargetedabovemarketclearingratesCentralBankshavetowithdrawfurtherliquidityfrommarketsandsostiffenriskpremia.Thisresultsinevenmoredeflationgreatercreditrisklesscreditdemandandtheneedforstilllowerlevelsofmarketclearinginterestrates.IrvingFisheroncenotedthatlownominalinterestratesoftengohand-in-handwithhighrealinterestratesbecausedeflationdevastatescreditdemand.Eightymoreyearsofexpe-rienceconfirmthatthoseeconomiesthattargetinterestratestypicallysufferfivetraitslowliquiditylownominalbondyieldsweakeconomicactivitynegligiblecreditdemandexcessivedemandformeansofsettlementconsequentstrongcurrenciesandhighcreditriskbecauseoftheinabilitytoreliablysettlecontracts.Thisdescribestheeconomictur-moilintheinter-waryearsitalsorelatestoJapaninthe1990sandsurelyexplainsmuchofthe2001-2003Eurozoneexperience.Astheworldeconomyhasgrownbiggerinthelasttwentyyearsithasbecomemorefinan-cialandfinancialmarketscanbevolatile.Unstablepricesleadtobadinvestmentdeci-sionsandpoorresourceallocation.Tostabilisethisinstabilityexchangeratesnotinterestratesshouldbetargeted.WeneedmoreenlightenedCentralBanksthatarenotstraight-jacketedbyinterestraterulesandthatinsteadmanagethevolumeofcashandborrowingstocontrolthevalueoftheirmonies.Goodqualitymoneyhasstablevalueandgoodqualitymoneyismorewidelyused.Thehistoryofwealthcreationisthehistoryofstablemoney.Risingcurrencymarketvolatilitywillwarnusaboutupcomingmonetaryinstability.Untilthepricesoftheworldsmoniesarestabilisedthespectreoffinancialcriseswillstillcastitsunnecessaryshadowoverourfutureeconomicwell-being.10Interestratesbecomealinearaverageoftheoutputgapandthetargetinflationrate. 1GlobalViewGlobalViewApril2013SourceBankofJapanCrossBorderCapitalFigure1JapaneseMonetaryBaseandCallMoneyBalancesOutstandingYenTrillions1990-2014EDomesticJapanesestocksandrealestatewillbenefitbutglobalbondpricesfacebigdownsiderisks.Thehigher2inflationtargetmattersforJapanbutrisingrealinterestratesandbondriskpremiaareamoreseriousthreattoglobalbondsthanWorldinflationwhichislikelytoremainsubdued.HigherJapaneseinflationwillfeedthroughgloballyviaahigherbondriskpremium.Long-termdatashowthatJGBsleadglobalbonds.BoJOpenstheTaps...FullyFirstthefacts.Figure1showsthattheJapanesemonetarybasehasbeenlatelyexpandingrapidlyevenunderpriorBoJGovenorShirakowa.Theearlier200003monetaryeasingwasoffsetbyasimultaneousrun-downincallmoneybalancesbythecommercialbanksbutthisisnotcurrentlyhappening.TheBoJbalancesheetcurrentlystandsataroundY164trillionofwhichtheMonetaryBasecomprisesY142trillion.Byend-2013theseareslatedtogrowfarmorerespectivelytoY220trillionandY200trillionandbyend-2014toY290trillionandY270trillion.Inotherwordsthemonetarybasewillexpandbyroughly40annuallyineachofthenexttwoyears.ThispacewillleaveevenBernankebreathless.ThreequartersorthebulkofthisriseY100trillion.comesfromanincreaseinJGBholdingsalthoughloansupportprogrammesalsorisebyaroundY15trillion.TheBoJalsoforeseesbanksreservesjumpingfromaroundY50trilliontoawhopping96BakerStreetLondonW1U6TJTel442079082800crossbordercapital.com050000100000150000200000250000300000199001199101199201199301199401199501199601199701199801199901200001200101200201200301200401200501200601200701200801200901201001201101201201201301201401CallMoneyOutstandingMonetaryBaseJapansGreatExperimentTheLandofRisingAssetPricesAnotherCentralBankerconvertstoBernankeism.FaithinlargeandunlimitedQEisgrowingbutwhatdoesitallmeanNewBankofJapanGovernorKurodasdecisiontodoublethesizeoftheBoJbalancesheetwithintwoyearsmayproveassignificantfortheWorldasforJapanherself.ThebiganomalyinWorldmarketsisnotlowinflationbutlowrealinterestratesJapanmaychangethis.ForthoseofuswhohavebothlongbelievedinthepowerofliquidityandwhohavearguedformorethantwentyyearsthatJapansproblemslargelyresultfromtheBoJstightliquiditystancethenextfewyearswillbeseminal.TheYenisinseculardeclineJapanlookssettoreturntoherMercantilistrootsandtothepre-Mienomonetarypolicydays. GlobalView2Y175trillion.InotherwordsJapansQEpolicymuchliketheFedsexperienceexpectsbankliquiditytosoar.YetitisludicroustoargueasisnowthevoguethatthescaleofJapansmonetarystimulusisinanywayrelatedtothesizeoftheBoJbalancesheetasapercentageofGDP.Thisstatisticreflectsnationalinstitutionalcharacteristicsforexampletheimportanceofbankfundingofcreditthesizeofreserverequirementsandtheuseofcashovermoneysubstitutessuchascreditcards.IfanythingitrepresentsaninversemeasureoffinancialdevelopmentwithafinanciallysophisticatedeconomylikeAmericaenjoyingalowratioandapoorunderdevelopedonelikeasmallAfricaneconomyexperiencingaveryhighratio.WhatreallymattersformarketsisthepaceofgrowthinCentralBankmoney.Thisdegreeofmoney-printingislikelytosubstantiallyboostourBoJliquidityindicator.AccordingtoourinternalestimatesJapansliquiditycouldultimatelyjumptoanindexvalueofaround85-90comparedtothecurrent65.SeeFigure2.ThisshouldproveimportantbecausethisindexveryobviouslyleadsJapanesebusinessactivitybyseveralmonths.TheTransmissionProcessSecondwhatdopolicy-makersexpectThemechanismthroughwhichQEworksisfarfromagreedamongexperts.AschematicdiagramshowsourthinkinginFigure3.AcentralissueiswhetheritmattersexactlyhowQEtakesplaceEssentiallytheCentralBankhasthreepolicychoicestoaddressdysfunctionalcreditmarkets1buydistressedassetsdirectlyfromthebanks2lendadditionalfundingtothebanksviamoneymarketoperationsand3buygeneralassetsintheopenmarketthroughsaybondmarketoperations.Allthreechannelsraiseeconomy-wideliquiditybuttheimpactonthebankingsystemandanyresultingcreditmultiplierwilldiffercase-by-case.ThussomeQEismoreeffectivethanothers.Forexampleitisnotnecessarilytruethatthethirdchannelwillautomaticallyboostthevolumeofbasemoney.Worriedbymoralhazardissuesin0204060801001201980-011980-111981-091982-071983-051984-031985-011985-111986-091987-071988-051989-031990-011990-111991-091992-071993-051994-031995-011995-111996-091997-071998-051999-032000-012000-112001-092002-072003-052004-032005-012005-112006-092007-072008-052009-032010-012010-112011-092012-07BoJLiquidityConcidenceDiffusionIndexFigure2JapaneseCentralBankLiquidityIndexandJapaneseCoincidentDiffusionIndexLagged12MonthsMonthly1980-2013SourceJapaneseMinistryofFinanceCrossBorderCapital 3GlobalView200809theBankofEnglandchosethisthirdchannelpreferringtobuyassetsintheopenmarketthanlendtobanks.Inotherwordswhenbuyinggiltsitsimplyswappedgoodcollateralforgoodcollateral.ManyexpertsincludingtheIMFnowbelievethatcollateralchainsareanimportantpartofthecreditmultipliersothisneutralBoEliquidityimpactonsystem-widecollateralhasunderstandablyproveddisappointing.ButatthesametimetheaveragedurationofassetsheldintheUKfinancialsystemfellbecauseofthereplacementoflongdurationgiltswithzerodurationcash.ECBpolicylargelyshunneddirectpurchasesofdistressedassetsandbondpurchasespreferringinsteadtogiveshort-termfundinghelpviacollateralisedloansadmittedlycollateralwasbroadlydefined.TheFederalReservehasfollowedallthreeroutes.IthassucceededinreducingtheaveragedurationofUSassetsbutithasalsoswappedgoodassetsforbadassets.Inshortitembracedbothliquidityanddurationeffectswhichtogetherseemedtohaveworked.USbanksarenowlessencumberedbyunderperformingassetscomparedtotheirEuropeancounterparts.AdmittedlythenewBoJpolicyhasvisiblesimilaritieswiththeUKapproachbutthelargejumpexpectedinJapanesecommercialbanksreservesandthekeyroleplayedbythesebanksinmonetarytransmissionprobablymakesitmorelikeUSpolicyinpractice.InshortmoreliquiditywillencourageJapanesebankstomakenewloansandpushJapaneseinvestorstobuymoreriskassets.Thisshouldoperatethroughwhatweknowasthebroaddurationchannelpartoftheportfoliobalanceeffectwhichsimplysaysthatallinvestorsnotjustbankstargetaspecificassetdurationi.e.timehorizondictatedbyliabilitiesandwhenportfoliodurationispushedbelowthistargettheywillseektorebalanceportfoliosbyeitherspendingthesurpluscashandorbuyingmorelonger-datedassets.ThusweentirelydisagreewiththenowwidespreadviewthatBoJactionswillflattentheJapaneseyieldcurverathertheoppositeistruesincepolicymoveswillmorelikelysteepenit.AsteepercurveisalsoalsonecessaryfirstbecausetheFigure3HowCentralBankPolicyWorksSourceCrossBorderCapitalCentralBankBSConsumerPricesExchangeRateRiskAssetsYieldCurveFundingBanksBSLendingMarginsCollateralWagesProfitsTradeCapitalSpendingConsumerSpendingWSMarketsTheMonetaryTransmissionMechanism GlobalView4riskpremiumonriskassetstypicallymovesoppositelytotheriskpremiumonrisk-freebondsandsecondbecausebanksnetinterestmarginsonnewloanscorrelatescloselyandpositivelywiththeslopeoftheyieldcurve.Putanotherwayaflatteningyieldcurvewouldtellusthattheperceivedrisksonotherassetsarerisingandthatlendingisbecominglessattractive.Exactlywhatpolicy-makersdonotwanttosee.Yieldcurvestendtomovepro-cyclicallyandtoslightlyleadthebusinesscycleseeingtheirlowpointsaroundayearbeforeabusinessrecessionandpeaksshortlyafterrecoverycommences.Thewideningspreadconfirmsareturntogoodtimes.Ineconomics-speakthistellsusthatinbusinessrecoveriesthemarginalvalueofconsumptionfallspeoplebecomelesshungrysoitmakeslesssensetopayhighpricesforbondswhichtraditionallyprovideuswithdependableincomes.IftheBoJisactingliketheFedwhatcanUSexperiencetellusOverallthatQEworksanditdoessobyraisingtheriskpremiumonriskfreeassetslike10-yearTreasurybondsandloweringtheriskpremiumonriskyassetslikeequitiesandrealestate.Moreoveritmaytakesomeyearstofullyfeedthrough.Admittedlyanumberofso-calledeventstudiesclaimtoprovetheoppositethatFedbuyingofspecificbondissuespushesdowntheirprices.Thisisindisputablebutthewrongargument.Itislikesayingthatthrowingaballintheairdefeatsthelawofgravity.ByreducingtheavailabilityofcertainissuestheFedwillpushuptheirpricesbutbydoingsoitincreasestheamountofcashinthesystemandthisistheleverthatraisesoverallbondriskpremiaandlowersriskpremiaonotherassets.InshorttheBoJbuysbondsbutsimultaneouslyotherinvestorsswitchfromJGBstoriskassetsconfidentthatthereisanewliquiditycushion.TheUSexperienceplainlyshowsthatrising10-yearTreasuryyieldsandsteepeningyieldcurveshavecoincidedwithQEandthereversetookplacewiththeperiodicendingofQE.Figure4showsthis.Lookedatanotherwayasteepeningyieldcurveisnormallybullishforstocks.SourceCrossBorderCapitalUSFederalReserveFigure4USTreasuryYieldsandYieldCurveSlopeThroughQEPeriods2007-2013FedFunds2-YrTreasury10-YrTreasuryQE1QE2QE310-2YieldCurve01234562007-012008-012009-012010-012011-012012-012013-01 5GlobalViewFasterinflationisbecomingeveryonesfear.ButdoesthepersistentlowrateofconsumerinflationineveryeconomythathassofarengagedQEconfirmthatCentralBankliquiditydoesnotaffecthighstreetpricesRecentexperiencecertainlytellsusthattheinflationprocessiscomplex.ItremainsourviewthatinflationlargelydependsonwhoownstheoutstandingdebtratherthanthepursuitofQEormonetisationperse.Therehavebeenfourmajordebtcrisesinthelastcentury1920sWeimarGermany1930sUSDepressionBritaininthe1970sandJapaninthe1990s.AllfourultimatelysawthesamepolicyresponseCentralBankQEbuttwoturnedoutinflationaryandtwodeflationary.ThekeydifferenceliesinwhichsectorpublicorprivateholdsthedebtAhighprivatesectordebtburdenmeansextraliquidityisfirstusedtopayoffprivatedebtratherthanbeingspent.Withalargepublicsectordebtburdenliquidityincreasinglyfinancesthepublicdeficitandistypicallyspentbyanon-indebtedprivatesector.Highstreetinflationdoesnotrequireabigpublicsectordeficitalthoughitisnotsurprisingthatthetwooftencoincidebecauseinsuchcasespublicdebtbeginstolookunsustainable.Thebottomlineisthatexcessprivatedebtleadstodeflationarydefaultandexcesspublicsectordebtleadstoinflationarydefault.Inotherwordsthegovernmentsectorservesastheproverbialmonetaryhelicopter.Worryinglysomegovernmentsareincreasingthesizeofthishelicopter.HigherInflationOrHigherRealInterestRatesWeacknowledgefearsthatinflationcouldbeignitedbutitseemsmoreplausiblethatextraBoJliquidityatleastinitiallybooststherealeconomyseeFigure2andsteepensyieldcurvesseeFigure4.Inshortrealratesandriskpremiamayrisemoresignificantlythaninflationexpectations.BoJmoney-printingisprobablycertaintoenddeflationinthehighstreetandAbesElectoralpromiseofmoderate2inflationseemsFigure5BoJLiquidityInjectionsandMovementsinTrade-weightedYenSourceBankofEnglandCrossBorderCapital-30-20-1001020304080828486889092949698000204060810120102030405060708090100-30-20-1001020304080828486889092949698000204060810120102030405060708090100YenTrade-weightedExchangeRateYoYChg.LHSBoJLiquidityRHS GlobalView6attainablealthougheventhismaytakesometimebecauseconsumerpricestendtobestickyanddeterminedbycosts.TheriskofmuchhigherdomesticinflationthereafterwilldependontheintegrityofthecreditmultiplierandonthescaleofJapanesepublicsectordebt.Atover150netofGDPJapansprevailinglargepublicsectordebtburdenplainlyposesathreatparticularlyoncetherelativesizeofprivatesectordebtsdiminish.Evenacceptingapotentialriseininterestpaymentsongovernmentdebtthismaystillbesomewayoff.Equallyiftheold-fashionedmoneymultiplierlinkingbasemoneytothequantityofbroadmoneyisundiminishedthenQEmightbeexpectedtoexpandthemoneysupplydramaticallyandsodriveinflationhigher.Howeverthemultiplierinmosteconomiesisbroken.FirstmoneysupplyistodayaconceptwiderthanthecommercialbanksandcompriseslendingundertakenbyanarrayofOFIs.Secondthesourceoffundingisnolongerexclusivelybankdepositsbutlatelycomesfromwholesalefundsandmanyofthesepoolshavebeenprovidedbycash-richcorporationswhonowprefertositoncashratherthaninvestit.Thirdindebtedcapital-shortWesternbankslikelyplantode-levertheirbalancesheetsfurther.ThefragilityinthesupplyofwholesalefundshaspunchedaholethroughcreditprovisioncausingwholesalemarketstocollapseinmanyeconomiesandCentralBankstoexpandtheirbalancesheetsinordertoplugthegaps.AdmittedlythisdescriptionappliesmoreaccuratelytotheUSandEuropethanJapanbutinessenceallCentralBanksaretakingdysfunctionaldomesticwholesalemoneymarketsontotheirbalancesheets.MoreoverunlikeWesternbankstheirJapanesecounterpartsalreadyhaveatwenty-yearhead-startinde-leveringbalancesheetsandmostlargeJapanesebanksareabletofulfillatestBaselIIIcapitalrequirements.ThereforeJapanhasafinancialsectorthatislessvulnerabletofurthercreditdeclines.TotheextentthatthetraditionalmoneymultiplierstillworksthemoreJapancouldfaceastrongnear-termjumpinbusinessactivityandafutureSourceBankofEnglandCrossBorderCapital406080100120140160180200757677787980818283848586878889909192939495969798990001020304050607080910111213BubbleEconomyLouvreAccord1987MienoatBoJDeflationarySpikeAsianCrisisY2KQE2001-05OPECIIProductivityGrowthPlazaAccord1985QEAbenomicsNewJapanAgeingEconomyStrongYenPolicy406080100120140160180200757677787980818283848586878889909192939495969798990001020304050607080910111213BubbleEconomyLouvreAccord1987MienoatBoJDeflationarySpikeAsianCrisisY2KQE2001-05OPECIIProductivityGrowthPlazaAccord1985QEAbenomicsNewJapanAgeingEconomyStrongYenPolicyFigure6Trade-WeightedYen1975-2013 7GlobalViewFigure7JapaneseEquityPEMultiplesandCPIInflation1921-2012AnnualSourceCrossBorderCapitalPEorInvertedYieldInflationDeflationEquities2.5InflationBondEquityThresholdBondsBACommoditiesDEFLATIONARYPRESSUREHighBondEquityCorrelationNegativeEquityBondCorrelationHighVolatility0.0010.0020.0030.0040.0050.0060.0070.0080.00-20.00-10.000.0010.0020.0030.0040.00InflationPE GlobalView8Figure8USRealInterestRatesandEquityValuationsPEsAnnualData1882-2012SourceCrossBorderCapitaldomestichighstreetinflationproblem.Weknowthatrisingassetmarketsandstrongerrealeconomiesusuallyleadinflation.WhatdoesBoJactivitymeanforfutureassetpricesInourviewCentralBanksmorelikelycancreateassetpriceinflationthanhighstreetinflation.Themainmonetarytransmissionisnotthroughhighstreetinflationbutviachangingriskpremiaanddurationeffects.Highstreetinflationislargelyacostphenomenonwhereasassetinflationcomesfrommonetaryinflationwhichisunquestionablyinthegiftofpolicy-makers.LowerriskpremiaandthedemandformoredurationwillsupportriskassetsJGBBondMarketJapanesebondyieldsforexamplecomprisethreecomponents1inflationexpectations2realyieldsand3ariskpremium.TheBoJliketheFedwantstopermanentlyraiseinflationexpectationsmoderately.TheBoJhasa2inflationtargetanditseemslikelythattheyconsiderthisasanaverageratherthanaceiling.Realyieldsaredeterminedbythemarginalreturnoncapital.Theselatterreturnsremaindepressedbuttheyarepro-cyclicalandwillmoveupwithastrongereconomy.Thebondriskpremiumisclosely-linkedtotheslopeoftheyieldcurveandthesteeperthecurvethegreaterthepremium.Moreliquidityunambiguouslycausesyieldcurvestosteepen.AddingthesefactorstogetherJGByieldsmustriseoverthemediumterm.Thustheirrecentfalllooksbizarreandshouldbeshort-lived.Assumingatleast2medium-terminflationandarealrateplusbondriskpremiumofonly0-JGByieldscouldstilltest2orawhoppingjumpcomparedtocurrent10-yearyieldsof50bp.TheYenTheoutlookfortheYenremainsnegative.WehavearguedbeforethatJapaneseexchangeratepolicyfordecadesfocussedonmaintainingafirm-to-strongYeneasingwhentheYenbecametoostrongandtighteningwhenitwasnotstrongenough.Thismouldy0.2205x13.928R20.074705101520253035-20.00-15.00-10.00-5.000.005.0010.0015.0020.0025.00 9GlobalViewhaslatelybeenbrokenbecausepolicy-makersarenoweasinginthefaceofaweakYen.Figure5demonstratesthis.Asaguidewereproducethelong-termtrade-weightedYenchartinFigure6torestateourpredictionthatwearestilllookingforafurther15-20slideintheYenoverthemediumterm.JapanlookstobereturningtoitsearlierandhighlysuccessfulMercantilistmodel.JapaneseEquitiesStocksshouldbenefitsignificantly.Equitymarketsingeneralbeingaquasi-realassetarelargelypricedoffinflation.Peakequityvaluationsoccurwhentheinflationrateislowcirca2-3buteithersideofthisthresholdPEmultiplestraceoutabell-curvewherebothhighandlowinflationratesareassociatedwithlowervaluations.InshorttheslatedmovefrompricedeflationinJapantomildinflationisverybullishforstocks.Figure7showsthelong-termrelationshipbetweenJapanesePEsandinflation.Thetheoreticalrelationshipisdrawnbelow.Afasterinflationratelooksunambiguouslybadforbondsbutgoodforstocks.ThemoveawayfromdeflationontheextremeleftofthelowerchartcausesbondvaluationstodropbutshouldallowstockPEstoexpandbacktowardstheirpeak.InadditionifBoJmonetaryactionssuccessfullycreateGDPgrowthandsoforceJapaneserealbondyieldstorisethiswouldbefurtherbadnewsforbondsbutpotentiallybetternewsforstocks.RisingrealinterestratescoincidewithfasterrealeconomicgrowthandhencehigherPEmultiples.Thelong-termdatafortheUSmarketshowninFigure8tellsusthatpositiverealinterestratesarenormallyassociatedwithhigherequityvaluations.TheBiggerIssuesGlobalAssetPricesLetusputJapaninaglobalcontext.Theimpactoftheseshiftsonnon-Japanassetpriceswillbelargelynegativebutoverallstockscomeoutbetterthanbonds.TheweakerYenmustposecompetitiveness0246810121416188081828384858687888990919293949596979899000102030405060708091011121302468101214161880818283848586878889909192939495969798990001020304050607080910111213SourceBankofJapanUSFederalReserveCrossBorderCapitalFigure910YearJGBandUSTreasuryYields1980-2013USJapan GlobalView10problemsforothereconomiesparticularlyinEM.HigherJapaneseinflationmayhaveaminimaldirecteffectelsewherebutindirectlyviaarbitrageacrosstheglobalbondmarketstheimpactofrisingJGByieldscouldprovehuge.Globalbondmarketsarehighlycorrelated.USandJapaneseyieldsshowa0.866monthlycorrelationsincethemid-1980sandGrangerCausalitystatisticaltestsrevealthatJGByieldscausemovementsinUS10-yearyieldssomefivemonthsaheadwiththedirectionofcausationseeminglyone-way.Figure9postsawarningsinceJGByieldshaveprovidedaconsistentfloorbeneathequivalentUSTreasuryyieldsformorethantwodecadesnow.ThereforetheprospectiveorplannedriseinJapaneseinflationandthepotentialriseinJGByieldscouldbekeyfactorsthatdriveglobalbondyieldshigher.ManyinvestorsseemtoworrythatJapanmaybecreatingtoomuchinflationwhichcouldbeexportedtoothers.Ourmainfearisdifferent.ExtrememonetaryactionsbytheBoJseemcertaintoend-deflationdomesticallyandbecauseofthistheywilltriggeranassetallocationswitchfromJGBstoJapanesestocks.OneresultwillbeariseintheriskpremiumonJGBsexpressedthroughasteepeningoftheyieldcurveandexportedtoGlobalbondmarkets.ButsecondbystimulatingbusinessactivityandmoreimportantlythelendingmechanismtheBoJmayhelptopushuprealinterestratesinJapanandmaybegloballytoo.Figure10andFigure11respectivelyshowWorldrealinterestratesandinflationusinglong-termdatafromtheUKandUSmarkets.Thepost-1990declineinWorldinterestrateshaslargelymirroredJapansslumpwithrealinterestratesslidingandinflationexpectationsdroppingbackfromaroundthesamedate.Inthelate-1980smedium-termrealinterestratesstoodatcirca4andannualinflationexpectationssatataround4-5.Bothcomponentsslidoverthefollowingtwodecadeswithrealratestouchingnegativeterritoryandexpectedinflationsettlingaround2-3.LatestWorldinflationusingthisSourceCrossBorderCapitalFigure10WorldRealInterestRatesPercent1872-2012-15.0-10.0-5.00.05.010.015.020.0187218761880188418881892189619001904190819121916192019241928193219361940194419481952195619601964196819721976198019841988199219962000200420082012 11GlobalViewSourceCrossBorderCapitalFigure11WorldInflationPercent1872-2012simplemeasureis2.8againstalong-term1972-2012averageof2.5.Inotherwordsitlooksin-linewithhistory.OntheotherhandWorldrealinterestratesat0.1aresignificantlybelowtheirlong-termaverageof2.1.Ifmean-reversiondoesoccurthenbypushinguprealinterestratesitislikelytoadverselyaffectglobalbondsbutwillmoreprobablyhelpstocks.AlthoughhigherinflationalsomattersforJapanrisingrealinterestratesandbondriskpremiaposeamoreseriousthreattoglobalbondsthanrisingWorldinflation.Itverymuchremainsourviewthatequitymarketsarebifurcatedbetweenunderstandingthemarginalandaveragereturnsoncapital.AlowmarginalreturnisbehindcurrentlydepressednewcapitalexpenditurelevelsacrosstheG20andreflectedinlowrealinterestrates.AhighprofitshareinGDPisnotananomalyratheritreflectssizeableaverageratesofprofitabilityonexistingcapital.Thisdifferenceisultimatelyunsustainablebutwhileitpersistsitfavourslargeoversmallcompanies.Thelatterdependmoreforgrowthonnewinvestmentswhereastheformercansit-backandcuttheircosts.WeagreethatJapanisnolongertheWorldsmarginalproducerandsoaloneshemaynotmuchaffectWorldrealinterestratesbutJapanspossiblerenaissanceiscoincidingwithwidespreadQEanditmayjustbealsocoincidingwithdeclineelsewhereThegapbetweenthemarginalandaveragereturnsoncapitalreflectswesummisetheimpactofChina.Chinaisatbestaquasi-capitalisteconomythatproducesforemploymentmorethanforprofit.ConsequentlyitiseatingitsownlunchbecauseresourcesarebeinginefficientlydeployedandultimatelywillconstrainGDPgrowth.InshortChinaisalowproductivitygrowthbutformerlyhighinputgrowtheconomy.Whenthelatterslowswhichitmustoveralloutputgrowthwillfalter.IndeedrisingwageratesinChinacouldsuggesttheeconomyisnowatthispoint.ThisturningpointisimportantbecauseitmayallowothermoreefficientproducersliketheUS-15.0-10.0-5.00.05.010.015.020.025.0187218761880188418881892189619001904190819121916192019241928193219361940194419481952195619601964196819721976198019841988199219962000200420082012 GlobalView12JapanandGermanytotakebackmarketsharefromChina.LookedatanotherwaytherearerarelyanyunrelatedeventsinWorldmarkets.Japanslongdeclinefromthepeakof1989coincidedwiththeriseofChina.JapaneseindustrywasfurtherhamperedbythestrongappreciationoftheYenagainsttheUSdollarandChineseRMB.Nowthependulumthreatenstoswingbackalittle.TheYenhascollapsedChinesegrowthisfalteringChinesecostsarerisingandJapanesemonetarypolicyissettoignite.WearguedperhapswronglylastSeptemberthatBernankesQE3andtheexplicittargetingofindustrialgrowthbypolicy-makerswastheequivalentofpreviousChairmanVolckerscelebratedtightmonetarypoliciesintheearly1980sthatkilledinflationandboostedbonds.OurerrorlayinnotwaitingandgivingthisaccoladetoKurodainstead.HeiscopyingBernankebutunlikehisAmericancounterpartheisdoingsowithinabankingsystemthatiswell-capitalisedandreadyandabletore-leveritself.JapannotAmericaistherealmonetaryexperiment.CCCCCROSSBORDERROSSBORDERROSSBORDERROSSBORDERROSSBORDERCCCCCAPITAPITAPITAPITAPITALALALALALLLLLLIMITEDIMITEDIMITEDIMITEDIMITED96B96B96B96B96BAKERAKERAKERAKERAKERSSSSSTREETTREETTREETTREETTREETLLLLLONDONONDONONDONONDONONDONW1UW1UW1UW1UW1U6TJ6TJ6TJ6TJ6TJTTTTTELEPHONEELEPHONEELEPHONEELEPHONEELEPHONE0207908280002079082800020790828000207908280002079082800FFFFFACSIMILEACSIMILEACSIMILEACSIMILEACSIMILE0207908283502079082835020790828350207908283502079082835AUTHORISEDANDREGULATEDBYTHEFINANCIALCONDUCTAUTHORITYCROSSBORDERCAPITALLIMITED2013.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose. Section2LiquidityandtheShadowBankingSurgeMoneyCreditandGlobalLiquidity-February201421stCenturySchizoidBanksDecember2007NewYorkSlidesWashingtonWakesChicagoDreamsMarch2008TheNikkeiNASDAQ.NotingHillJuly2007DissentInsidetheFedApril2008TheMessagefromaPreviousLow-February2009andMay2011OddsofQE3.100-August2011AsianLiquidityNoTigerintheTankFebruary2012JapanistheNewFranceFebruary2009ChineseLiquidityandChinasShadowBankingSectorMarch2014 MoneyCreditandGlobalLiquidityFinancialde-regulationandtherapidgrowthinfinancialassetshasmadecreditafarmoreimportantstatistictowatchthantraditionalmoneysupplyandhaselevatednon-bankstoaparandevenabovebanksascreditproviders.YetgreaterfinancialsophisticationandtheappearanceofderivativesandsecuritisationsMBSmortgage-backedsecuritiesandCDOscollateraliseddebtobligationsalsomakethetaskofmonitoringcreditmuchharder.Thisnoteexamineshowourliquidityindexesdothejob.Liquiditycanbedefinedastheflowofmoneyintomarkets.DeregulationandfinancialinnovationmeansthatmoneyexistsinanincreasingnumberofdifferentformswhicharebestmeasuredfromFlowofFundsstatistics.Itiseasytodemonstratefrompublisheddatathatthecreditpoolisfarbiggerandhasgrownmuchmorerapidlythantraditionalmoneysupplymeasures.WeconcentrateinthisreortontheUSbecauseitsfinancialsstemhasthelarestmostdeveloedandmostsophisticatedmarketsandinstitutions.Some70ofUSnon-bankfundingofthenon-financialcorporatesectorcomesfromcapitalandmoneymarketscomparedto30intheEurozone.-wherepossibletraditionalloansaswellassecuritisedcredits.Moneysupplyisshownalongside.WehaveusedM2thebroadestavailableaggregatealthoughevenifwehadestimatedthenowdefunctM3statisticittoowouldhavebeenoutpacedbycreditgrowth.Inotherwordscredithereisnearlytwo-and-a-halftimesgreaterthanmoney.Liquidityisbiggerstillbecauseitincludes.measuredasthemonetarybaseCentralBankcreditplusthecreditextendedbyprivatesectorfinancialinstitutions.Inasimpletextbookfinancialworldconsistingentirelyofconventionalbankscreditisstraightforwardtodefineastotalbankloans.Butstructuralchangehasrenderedonceusefulmoneysupplymeasurementout-dated1financialde-regulationfromtheearlyCrossBorderCapitalLtdTel442078684104MarbleArchTower55BryanstonStreetwww.liquidity.comLondonW1H7AAsanterecentrapiinnovationonewinanciaprouctsurtesetraitionadefinitions. Inthisreportweexplainindetailhowliquidityisdefinedandwhyitisessentialtotakeaheterodoxflow-of-fundsapproachtomacro-investingratherthanfocussingonconventionalmoneysupplyand...howmoneyisspentbutthesestandardtoolsdonotexplainhowspendingisfinancedandthereforetheycannotshowwhetherornotitissustainable.Moneysupplymaytellusabitmoreaboutfinancingbutitonlyfocusesonhighstreetbanksandthenonlyonepartoftheirbalancesheetsi.e.deposits.Aquickcounter-examplemayhelpIn2013USstockpricesrosebynearly30AmericancorporationsmeasuresofUSmoneysupplyincreasedbybarely6whilebankcreditwasessentiallyflatandtheeconomyonlypickedupabitofspeedthroughtheyeartoaverage2GDPgrowthTheevidencefromthemarketssuggeststhatliquiditywasabundantbutthisstrengthwasnotobviousfromthesestandardmacromeasures.Inthiscasethemissingelementwassurgingcorporatesavings.ThisperceptiongapTroublinglyifthesetraditionaleconomicindicatorscannotguideinvestmentperformancetheycouldprovedisastrouswhenusedtoaccessrisk.MoneysupplyandNationalIncomeAccountsarenotentirelyuseless.Rathertheysimplygiveanincompletepictureofthemoderneconomicsystemlargelybecauseastimehasmovedonmassiveamountsofcapitalhavebeenaccumulatedbyindustryandthefinancialsectorhasbecomelargerand30000.0Figure1Figure1--USMoneyPrivateSectorCreditandLiquidityUSinBillionsUSMoneyPrivateSectorCreditandLiquidityUSinBillionsMonthly1972-201315000.020000.025000.05000.010000.02.Jan-72Jan-76Jan-80Jan-84Jan-88Jan-92Jan-96Jan-00Jan-04Jan-08Jan-12SourceCrossBorderCapitalUSFederalReserveTotalPrivateCreditTotalLiquidityM2Money vastlymorecomplex.Inshortthemoderneconomynowoperatesasahugere-financingmechanism.Liquidityincreasinglyreflectsfinancialintermediationbeyondthetraditionalbankingsystem.TorootsofthesenewsourcesofliquidityamongtheshadowbankswholesalemoneymarketsandCentralBankbalancesheets.FlowofFundsstatisticsshowafarmorecomprehensivepictureoffinancingactivitybymeasuringthenetacquisitionoffinancialassetsbyeacheconomicsector.Unlikespendingflowswhichoncespentdisappearfinancialflowsaccumulateandtheyareultimatelyreflectedinswellingconsequentlycurtailfurthernewflows.SeeFigure2.Traditionalmoneysupplymeasuresmissedthe2013USliquiditysurgepartlybecausetheleapincorporatecashflowswasusedtopay-offexistingloansandorlefttoaccumulateinwholesalemarkets.Inshortitby-passedthehighstreetbanks.ThishasbecomeanincreasingissueoverthepastdecadeandeversinceindustrialFigure2Figure2--FlowofFundsAccountingSchematicFlowofFundsAccountingSchematiccorporationsslashedcapitalspendingandbecamenetfreecashflowgenerative.Ratherthanborrowingfrombanksthesefirmspaidbackbankloansandinsteaddepositedsurplusfundsinthewholesalemoneymarkets.CurrentACCapitalACConsumption-CCInvestmentI-IIncomesW-GDPP-MoneyMks-MMMMLending-BDBDBorrowingBL-BLTOTALHHSIfBDGDPCICSBLBLIf..isdefinedasbankdepositsSourceLiquidityHHSCSBLMMIIfMMBDFlowofFundsidentitydefinesLiquidityKEYGDPdenotesBDisbankPrepresentsHHSishousehold3NationalIncomedepositsprofitssavingsWiswagebillBLisbanklendingIfisfinancialassetpurchasesCSdenotescorporatesavings Inthelastdecadetheselaterfundingmarketshavetakenonhugeimportance.AccordingtotheNewYorkFed....wesawduringtherecentfinancialcrisisthatthetri-partyrepomarketwasoverlyreliantonmassive.Estimatessuggestthatby2007therepomarkethadgrownto10trillionthesameorderofmagnitudeasthetotalassetsintheU.S.commercialbankingsectorandintradaycredittoanyparticularbrokerdealermightapproach100billion.And...riskwasunderpricedwithlowrepohaircutsahaircutbeingademandbyadepositorforcollateralvaluedhigherthanthevalueofthedeposit.NYFederalReserveFeb2014MoneyisCreditOnereasonwhymoneyisanambiguousmeasureofactivityincredit-basedeconomiesisbecauseitexistsintwoqualitativelydifferentforms1moneyasmeansofpurchasewhichstartsthefinancialcircuitand2moneyasmeansofsettlementwhichclosesit.InbetweenalotgoesonWheneconomiststalkofmoneysupplytheyusuallymeanthelatter.Howeveritisonlyhalfthestory.MeansofpurchasemoneythatstartstheeconomiccircuitisequallyandperhapsmoreimportantbuthowisitmeasuredTheflowofmeansofpurchasemoneytheoreticallydefinesliquidity.Liquidityenablesnewtransactionsandtendstoextenddebtsratherthanextinguishthem.Itisafarbroadermeasurethanmoneyandafarbettermeasurethaninterestrates.Weoftenthinkofitasmoneyinallitsforms.Figure3Figure3--GlobalLiquidityIndexGLIDevelopedWorldexEmergingMarketsGlobalLiquidityIndexGLIDevelopedWorldexEmergingMarketsMonthly0Monthly0--10019651001965--20132013EmergingMarketTechY2KSurgingRealEstateCommoditiesLooseStockMarketGoldAssetMarketBoomRiskOn100100SoaringCommoditiesUSFiscalSpendingBoomInflationaryBoomReaganElectionWeakUS1987CrashBoomBondCrashAsianCrisisOPECIOPECIIDollarJapaneseBubbleBoomBoomLouvreAccord60806080ScandinavianBankingCrisisJapaneseTighteningUSSLCrisisUSCreditSqueezeSterlingCrisisPennCentralBankruptUSCommercialPaperCrisisEndOfBrettonWoodsVolckerFedLDCDebtCrisisFailureofContinentalIllinoisPlazaAccordMexicoPesoCrisisRussianCrisisEnronWorldcomUSSub-primeCrisisGSEsAIGBailoutNorthernRockBearStearnsLehmanFailureUKBanksNationalisationJohnsonMattheyBaringsCollapseArgentinaCrisis911TightUSBankCrisisUKBankingCrisisRiskOff02040020404SourceCrossBorderCapitalUSFederalReserveECBBankofEnglandBankofJapanIMFBankingCrisis577775777575757 Definition1Theoreticalliquidityisaquantitativemeasureoffundingsourcesmadeupofpuremeansofpurchasesuchascreditandmeansofsettlementthatcanbeusedasmeansofpurchasesuchascash.Definition2Practicalliquidityismeasuredbyaddingtogetherthesizesofcreditprovidersbalancesheetsi.e.allformsofbankandshadowbankcreditavailabletofinancialmarketsincludingthecredittransactionsoftheCentralBankwhichlargelyrepresentthesupplyofcash.resoneyButwhatdefinescreditBalancesheetsmustbalanceandcreditanassethastoequalfundingaliability.Creditgivesaccesstomeansofsettlement.Creditcanbecross-checkedfromthesumoffundingsourcesontheliabilitiessideofcreditprovidersbalancesheets1cash2commercialbanksdepositsassumingthattheseareinsuredbytheCentralBanks3loansandoutrightsecuritiespurchasesbytheCentralBank4depositsinwholesalemoneymarketsthatcanbeturnedintoshort-termcashsuchascommercialpaper5assetsthatcanberepoedforcashdirectlybytheCentralBankorindirectlybycommercialbanksandbysecuritylenderswhocanreceivelargeamountsoftemporarycashfromshortsellersandderivative-playersand6capitalthatcanberaisedfromeitherthepublicandorprivatesectors.MoneysupplyorM2measuresthestockofmeansofsettlementmoneybasedonlyondepositsathighstreetbanks.Seeitem2above.Itisonlypartoftheanswer.Inadditiontheassociateddepositmultiplierisafamiliartextbookratiothatshowsbyhowmuchcommercialbankscanexpandmeansofsettlementfromanarrowcashbase.TheCentralBankunderwritesthismultiplierprocesswhenitactsaslenderofthelastresort.Theequivalentactionandratioforshadowbanksisrespectivelythebuyerofthelastresortandthecollateralmultiplier.Thelatterhasbecomemuchmoreimportantanditgaugeshowmuchcashcanberaisedfromagivencollateral.Theso-calledassethaircutistheequivalentofthereserverequirementthatgovernsthestandarddepositmultiplier.Anotherreasonwefocusonliquidityisthatcreditproviderstypicallylendfirstandthenattempttogatherfunding.Thusdepositsaresometimesdwarfedbyothersourcesoffundingandliquidityfrequentlyexceedstheflowofdepositmoney.Thereareanumberofotherfundamentalproblemswiththistraditionalmoneysupplydefinition1strictlyonecannotspendabankdeposit.Itisilliquidandonlymadeliquidbyincludingthecreditofthebank.HenceifIhaveadepositintheBankofTimbuktuIcannotsimplywriteachequeandpresentittoaNewYorkstoreinordertopurchasegoods.IncontrastanequivalentdepositheldinCitibankisliquidbecause5.aremostimportant.2AlthoughmyCitibankandBarclaysbankdepositsareconsideredlegaltenderdomesticallyWesterncommercialbanksnolongermonopoliseglobalmoneyandcredit.3Financial deregulationhasallowedmanyinvestorstobecomebanksandmanybankstobecomeinvestorstherebyblurringwhatwetraditionallythinkofasbankdepositsandbankloans.Thusyoucanholdsparecashin.onlyprovidersofcreditnordotheyobtainalltheirfundingfromretaildeposits.Domesticshadowbanksforexamplehavebecomeveryimportantalternativeproviders.Moreoveraloancanjustaseasilytaketheformofapurchaseofatradablesecurityi.e.securitization.And5internationalmoneymustbemonitoredsinceswingsintheChinesecreditcycleforexamplearebecomingasorevenmoreimportantgloballythanthemoreprosaicmovementsinUSmoneyandcredit.IndeedFigure4showstherecentrelativemovementinChineseandGlobalLiquidityinUSdollarterms.Since2006Chineseliquidityhasjumpedby430comparedtoan80riseinnominalGlobalLiquidity.Figure5illustratesthegrowthofChineseshadowbankingandhighlightsthatitnowcontributesaroundonethirdofChineseliquidityoutsideofthePBoC.Figure6summarisesthetheoreticaldifferencesbetweenmoneybankcreditandliquidity.Wenotedearlierthataworkabledefinitionofliquidityisthesumtotalofallavailablecashandcredit.TomeasurethiswecombinethebalancesheetsoftheCentralBankandtheentireFinancialSystem.MoneylargelyrepresentstheupperrighthandpanelsoftheCentralBankandcommercialbanksbalancesheet.BankcreditisthebulkFigure4Figure4--TheChineseLiquidityBoomTheChineseLiquidityBoomTotalLiquidityUSmillionsMonthly2006TotalLiquidityUSmillionsMonthly2006--20132013ofthelefthandpanelofbanksbalancesheets.Butliquidityisessentiallytheentirelefthandpanelsofthe1000000002000000060000000700000008000000090000000120000001400000016000000180000001000000020000000300000004000000020000004000000600000080000006SourceCrossBorderCapitalPeoplesBankofChinaIMFWorldLHSChinaRHS02006-012007-012008-012009-012010-012011-012012-012013-010 combinedbalancesheetsoftheCentralBankthehighstreetbanksandtheshadowbanks.Wefocusontheleft-handorassetssideofthisaggregatebalancesheetmakingafewadjustmentssuchasexcludingreserves.privatesectoraswellassecuritiespurchasedfromtheprivatesectorwhetherbyCentralBankacommercialbankaninsurancecompanyoramoneymarketfund.Howeversinceweareinterestedinthesupplyofliquidassetstheissuanceofdebtoverthreemonthsmaturityandequitybyindustrialcorporationsorbygovernmentsisexcludedbecauseitconstitutesauseorabsorptionoffunds.IncontrastabondorequityissueFigure7showsthesizebreakdownofUSliquiditybysourceatend-2013.AggregateUScashandcreditorliquiditycurrentlytotalsaroundUS24trillionornearlytwo-thirdsbiggerthanM2moneysupply.WecanseefromFigures6and7thatM2moneysupplyislikelytobeonlyasmallpartofthefinancialsectorbalancesheetandmayormaynotmovewithit.InotherwordscreditcanexpandbutM2couldfallandviceversa.TheFigure5Figure5picturemaybemuddiedbyanon-depositfundingbybankse.g.issuanceoflong-termdebtandcommercialpaperandbcreditextendedbynon-bankse.g.creditcardcompaniesmortgagelendersrepomarketsorwhatwecollectivelycallshadowbanks.FocussingoncashandcreditflowsandparticularlyonthenetaccesstorowtnneseaowannganrowtnneseaowannganooaanceeetaanceeetAnnualChangeMonthly2003AnnualChangeMonthly2003--2014201450.0060.005.43.120.0030.0040.00.9.98.4TrustLoansEntrustLoansBankLoansAcceptancesForCurrLoans-10.000.0010.0020032003200320042004200520052005200620062007200720082008200820092009201020102010201120112012201220132013201367.3Other7SourceCrossBorderCapitalBloombergPeoplesBankofChina310300301300300280310311310311310310310300301300300280310311310311310310310300301 liquiditybytheprivatesectorgivesabetterinsightintofutureeconomicactivity.ForexampleFigure8showstheclosecorrelationbetweenourindexmeasureofUSPrivateSectorLiquidityandthegrowthrateofUSorporateectorretaretetromteowounsstatstcs.retaretetsawedefinitionofcreditmonitoredbytheFederalReservebutunlikeourdataonlyavailablequarterlyinarrears.Admittedlyliquiditycansometimesbehardtomeasureaccuratelybecausetimelyandreliableinternationalstatisticsarenotalwaysavailable.Thereforewealsocalculateinparallelnormalisedmonthlyindexes-savingsbroadcreditflowsandmeasuresofavailablefunding.Theseindexesarebasedonrolling41-monthaveragesandstandarddeviationsandtheyarecalibratedtorangebetween0-100witha50pointmeanseeGlobalLiquidityIndexes2014edition.guregure--enngqutycematcenngqutycematcAssetsLiabilitiesSecuritiesNotesCoinLendinge.g.DiscountBanksReservesCentralBankAssetsLiabilitiesForexReservesGovernmentDepositsCommercialBanksMoneySupplySecuritiesTimeDepositsCashOtherSTFundingReservesatCentralBankDebtIssuesLiquidityAssetsLiabilitiesLoansSTFundingShadowBanks8SourceCrossBorderCapitaluuCashShareholdersFunds AnotherdifferencethatwecanincorporateintheseindexesistogiveafullerweighttoCentralBankLiquiditymuchliketheDivisiaapproach.SeeFigure3whichchartsasanexampleourindexofGlobalLiquidityexcludinEmerinMarkets.EvenacknowledinrecentuantitativeeasinoliciesthenominalvalueofCentralBankmoneyisstillonly10-15oftotalliquidity.HoweverCentralBankcashprovidesabsolutecollateral.Mostassetscanbecollateralizedandre-hypothecatedbutsomemorethanothers.ThisaddsasubtlecollateralmultipletoliquiditycreationthatplainlywasnotandisnotwellunderstoodevenbytheUSFedin2008.Herethesizeofhaircutsinrepomarketscanbesignificant.ConsequentlyCentralBankscanexercisehugeleverageonprivatesectorliquidity.Figure7Figure7BreakdownofUSLiquidityUSBillionsBreakdownofUSLiquidityUSBillionsEnd2013End201310083.4483.43717.5LendingSecuritization2189.61420.71168.95072.5FinanceHousesConsumerCreditMortgageBanksCommercialPaperCentralBankSourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandFigure8Figure8USPrivateSectorLiquidityIndexandAnnualGrowthUSCorporateSectorCreditMarketDebtUSPrivateSectorLiquidityIndexandAnnualGrowthUSCorporateSectorCreditMarketDebtQuarterly1980Quarterly1980--201320136070809010010.0015.0020.00010203040-5.000.005.009SourceCrossBorderCapitalUSFederalReserveUSPSLCMDNonFidCorpBusiness1980Q11981Q11982Q11983Q11984Q11985Q11986Q11987Q11988Q11989Q11990Q11991Q11992Q11993Q11994Q11995Q11996Q11997Q11998Q11999Q12000Q12001Q12002Q12003Q12004Q12005Q12006Q12007Q12008Q12009Q12010Q12011Q12012Q12013Q12014Q1 InsummarLiuiditnotmonesuldrivestheWorldeconombutliuiditiseasiertoConclusionLiquidityMakesTheModernWorldGoRoundConclusionLiquidityMakesTheModernWorldGoRounddefinethanitistomeasure.Oneofthelessonsofthe2008FinancialCrisisandoursubsequentexperiencesassociatedwiththedeclineinimportanceoftraditionalWesternbankingisthatitiscriticaltowatchFlowofFundsdata.Tobetterexplaintheliquidityframeworkwecantorecastitintermsofthestandardquantitytheoryofmoney.Weoftenrefertoliquidityanalysisasthequalitytheorysimplybecausethevelocityofmoneyisalwayschangingeitherbecauseofregulationinnovationorbecauseofchangesinthevalueofmoney.MoneyMtimesitsvelocityvmustequalthevalueoftransactionsi.e.priceTtimesvolumeTIntermsofchangesExpandingtheright-handsidewhereGDPiseconomicactivityAisthestockofassetsPfassetpricesandBDbankdeposits.SinceGDPI-SwhereIdenotescapitalspendingandSissavingsthiscanberewrittenas-Re-arrangingtheexpressiongivesourdefinitionofLiquidityLWecanalsomeasureFinancialLiquidityastheleft-handsideLminusrealinvestmentI.Thisquantifiesmoneygoingintothefinancialasseteconomy.Itcomprisessavingse.g.householdsavingsandcorporateprofitschangesinthesupplyofmoneyandchangesinthevelocityofthismoney.Changesinvelocityeffectivelymeasuretheimpactofcredit.Velocityisnotconstant.Ratheritfluctuatessignificantly10.swingsinliquidity. sassetmaretqutytransmssoncannesnowaccepteyentraanssucaste...obtainingahighervaluationofassetscanbeseentobetheimplicitifnotexplicitrationaleforlarge-scaleassetpurchasesquantitativeeasingbysomemajorcentralbanksandcancontributetoaddressingtheparadoxofleverage...ThesemeasuresprovidingliquiditytothefinancialsystemviacollateralisedlendingasinthecaseoftheECBmightalsoindirectlysupportassetvaluationbyhelpingtoavoiddisorderlydeleveragingandfiresalesbybanks.Thefocusonthesizeandcompositionofcentralbankbalancesheetsobviouslycontrastswiththeirrelevancepropositiononnon-standardpolicymeasuresputforwardintheneo-Wickselliantradition.SuchmeasureswouldbeseenasirrelevantevenwhenthezerolowerboundhasbeenreachedtotheextentthattheydonotchangethefutureexpectedpathofinterestratesEggertsonandWoodford2003.Howeverinterestratesandassociatedriskpremiawhiledisregardingquantityvariableswouldnotappearsufficienttocapturethewaymonetarypolicyoperateswhentheefficiencyoffinancialmarketsandfinancialintermediationareimairedamidstdeleverainressuresandheihteneduncertaintandriskaversion.Insuchcircumstancestheroleofthecentralbankastheissueroftheultimatesafeandliquidassetmoneyanditscapacityasintermediaryandriskabsorberoflastresortcometothefore.ThishasbeenthecasefortheEurosystemandtheUSFederalReservealike.111ECBWorkingPaperno.1528April2013TheECBSnon-standardmonetarypolicymeasuresTheroleofinstitutionalfactorsandfinancialstructurebyPhilippineCour-ThimannandBernhardWinkler 1CROSSBORDERCAPITALGlobalViewDecember2007MarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comCROSSBORDERCAPITAL21stCenturySchizoidBanksISeeNoCreditBlamethegrey-suitsFixatedbyinterestratemanagementCentralBankshavebadlymisreadthecycle.Theytightenedsharplyandprobablybytoomuchthrough2005and2006andnowtheyarebeingencouragedtoeaseaggressivelyprobablyatthewrongtimeInvestorsarenothelpingbyexaggeratingthescaleofthecurrentproblems.Consequentlywefearthatpolicy-makerswillploughbackfundsatthetimethattheyareleastneeded.Inshortfutureinflationproblemsarebeingprimed.TheCycleisback.Togainperspectivethreethingsshouldberemembered1thescaleoftherecentturnaroundintheUStradeaccountsisremarkablewithnetexportsrisingsofastinvolumetermsthatAmericasentiretradedeficitcouldvanishintwoyears.Theflow-of-fundscounterparttothisisstrongprivatesectorliquidity2signallingbetterliquiditytheUSyieldcurveisbeginningtosteepensharplymuchasitdidintheearly1990sthelasttimethatUSbanksneededre-capitalisingand3investorsseemtobeunwiselybettingontheendofAmericaoratleasttheendoftheUSdollar.ButexportsarefourtimesmoreimportanttotheUSeconomythanhousing.Thecausesofthecurrentliquiditycrisisshouldbedistinguishedfromthetrigger.Thecauseslieinthesecularlossofcontrola.k.a.therelinquishingofcontrolovercreditbyCentralBankerscombinedwiththeirvirtuallynowuniversalfocusoninterestrateinflationtargeting.ThetriggerisCentralBankersmisreadingofthecreditcycle.Byremovingtheconstraintsonprivatesectorcreditexpansionfromtheearly1980sonwardspolicy-makersallowedaproblemtobuild.Bynarrowlyfocussingontheconsequenceoftoomuchcreditsolelyfortheconsumerpriceleveltheyeffectivelyturnedawayfromtherealproblemandconsequentlyforcedfinancialmarketstosufferwilderswings.WeareremindedofBritishAdmiralNelsonsfamousretort.RaisinghistelescopetohisblindeyehecounselledIseenoshipsThisdecadesassetpriceinflationrestsontwoproductivitymiraclesChineselabourandWallStreetfinanciers.Thegreaterthesetwoproductiveforcesthemorethatmonetaryinflationisexpressedthrough1risingassetprices2CentralBankshavesetcoursetoover-stimulatetheGlobalLiquidityCyclespurredbyfinancialmarketconcerns.TheWorldsBankingandFinancialsystemisallegedlyenervatedbyadeepandwidespreadcreditcrunchandsounabletofight-offprospectiverecessionintherealeconomy.Short-terminterestratespreadscertainlysupportthispopularstorylonger-termcreditspreadsaremoreequivocalbutcreditflowdatagiveabigthumbsdown.DisregardingpastunreliablesurveysofloanofficersintentionsdatameasuringnewcreditextendedunambiguouslyshowcontinuinggrowthinbothAmericaandoutside.WhatsmorecreditflowsarestrongoutsideoftheUSAandwhencomparedtothispoolofglobalcreditthesub-primelosseslooksmall. 2CROSSBORDERCAPITALSourceCrossBorderCapitalBankofJapanECBUSFederalReserveIMFdeterioratingcreditqualityand3swellingtradedeficits.Fuelledbyincreasingdollopsofnewcreditrisingassetpricesdeterioratingcreditqualityandwideningtradedeficitscancontinueforyears.Theyneedatriggertoreverse.Thetriggerisoftenareversalintheshort-termcreditcyclethattemporarilycurtailsinflowsofthehallucinatorycreditdrugthisisusuallyspurredbyconsumerinflationfears.ButinaWorldwherepricesarestructurallyhelddownby1lowcostChineselabourand2astableexchangerateregimewhichallowsthemassimportofcheapgoodsintotheWestandparticularlyintoAmericamonetaryexcessintherealeconomyisinsteadchannelledthroughtradeimbalancesNOTfasterconsumerpriceinflation.Sowiththeirmaineconomiccompassimpairedpolicy-makersfounditdifficulttosteer.Theyoftenmisreadthemonetarycurrentstighteningwhentheyshouldhavebeeneasingandeasingwhentheyshouldhavebeentightening.The5-YearCreditLiquidityCycleSoitwasthatbylate2006early2007theoncesurgingnetflowofWorldcredithadslowedtoatricklecreditqualityproblemstypicallyfollowaround6-12monthslater.WorriedthatinflationwasrisingCentralBankersandnotablytheUSFederalReservesignificantlytightenedliquiditythrough2005and2006.Yieldcurvesflattenedandultimatelyinverted.Afterinflationpressuresprovedbenignpolicy-makerswereslowtoease.Sadlytheyignoredthewisercounselofbondmarketsthewarningsfromalreadyskiddinghousepricesandthestarkfactsfromliquiditydata.Figure1showsthattheGlobalLiquidityCycleleadstheyieldcurvebyaroundsixmonthswithasteepcurvelargetermpremiumcorrelatedwithabundantliquidityandaninvertedcurveindicatingtightliquidity.InsteadtheysetcoursefortheeconomicrockssteeredbytheirnewTaylorRulecompasses.MarketslistedbadlyinJulyandAugustandcameclosetodisasterthisNovember.Figure1.GlobalLiquidityCycleAndG7YieldCurve10-YearLessThree-Month1980-200780818283848586878889909192939495969798990001020304050607020406080100-200-1000100200300IndexBasisPointsOverallLiquidityLHSLiquidityRisingYieldCurveSteepeningYieldCurveRHSTheUSFedisalwaysquicktoremindusthatahealthyeconomyrequiresahealthyfinancialsystem.Moreoverinrecentyearsandparticularlythecurrentperiodwhencapitalratiosratherthanreserverequirementshavebeenusedtocontrolthegrowthofthefinancialsectorpolicy-makershavefollowedtheprincipalthatalotofgoodCentralBankmoneyisoftenrequiredtooff-setalittlebaddebtintheprivatesector.ConsequentlyCentralBankshavebecomereactiveparticularlypost-1994actingbothwithalacrityandinsize.Theyhavetypicallyshelvedotherpolicyobjectiveswhiletheyrestorethejanglednervesofthecreditmarkets. CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamFigure2.LosingTractionG7InterestRatesVersusTaylorRuleTarget1978-20077879808182838485868788899091929394959697989900010203040506070246810121402468101214PercentTaylorRuleActualInterestRateElsewherewehaveexaminedinmoredetailthedynamicsofthemodernfinancialsystemandwarnedbothof1itsincreasingpro-cyclicalleverageand2thestructuraldeclineinitsliquidity.USbanksforexamplehavelessthan2oftheirassetsinvestedincashandTreasurybondsitwasover55inthe1950sanddepositsmakeupbarely50oftheirfundingalmost90inthe1950s.Wealsoargue3againstthesuggestionthatCentralBankshavelostcontrolofmarkets.Yetitmaybetruethattheyhavelosttraction.AsFigure2highlightsthepathofshort-terminterestratesaroundtheso-calledTaylorRuletargetpathisbecomingmorewobblypolicyrateshavetobejackedhigherandslashedmoreaggressivelytoturnmarkets.Howeverwedrawtheimportantdistinctionbetweenpolicy-makerscontroloverliquidityandtheircontrolovercredit.Theystillinfluencecreditbutgiventheircomparativelysmallsizee.g.theUSFedisroughlyonetwenty-fifththesizeofAmericasliquidcreditmarketsandonesixtieththesizewhenbondsareincludedtheycanneitherdeterminetheoverallgrowthofcreditwitheasenorsetthelevelofinterestratesi.e.thecostofcredit.Thesearelargelyunderprivatesectorcontrolwhichisafterallwhatthecurrenthiatusinshort-termcreditmarketshighlightse.g.thespreadbetweenUS3-monthLIBORand91-dayTreasuryBillsstandsat200bpsagainstthenormal40-50bps.InstantLiquidityGonnaSaveYouButCentralBanksstillretaincontroloverliquidity.ThissoundslikeafussydistinctionbecausesurelyliquidityincludescreditLiquiditymeasurestheabilitytoalterthedurationofourassets.Inotherwordstoseamlesslyshiftoutofinvestmentswithlongpay-backsintocashinstrumentswithoutdisturbingprices.Liquidityconsistsofmeansofpurchasemoneye.g.creditbutalsoincludesmeansofsettlementthatcanalsobeusedasmeansofpurchasee.g.cash.Intimesofuncertaincreditmeansofsettlementmakeupalargerpartofliquiditybecausetheyareofhigherqualityi.e.theirvalueismorecertain.TheimportanceofCentralBanksisthatthecrediti.e.meansofpurchasetheyissueisby 4CROSSBORDERCAPITALdefinitionlegaltenderthatisofficialmeansofsettlementatleastwithintheirmonetaryjurisdictions.Thuswhencreditmarketsaregummedupsaybecauseoffearsthatinsufficientfuturemeansofsettlementi.e.profitsandsavingswillbeproducedbytheprivatesectortocovertheperhapsexcessivevolumesofmeansofpurchasei.e.creditalreadyissuedthenCentralBankscancometotherescuebyprintingmoremeansofsettlementtorestorebalanceandsocompletethemonetarycircuit.Theyaretheonlyinstitutionthatcaninstantlycreatenewmeansofsettlement.Intimesofcrisisthecashi.eCentralBankcreditcomponentofliquidityconsequentlyjumps.CentralBanksaremonopolysuppliersofcurrencybutonlyoneamongseveralprovidersofcredit.GiventhesemonopolypowersitfollowsthatundernormalcircumstancesCentralBankscancontrolthevalueoftheircurrenciesi.e.exchangerates.Howevertheybecomecompromisedduringfinancialcrisesbecausetheneedtoprintmeansofsettlementforcesthemtoyieldcontroloftheirexchangerates.Notsurprisinglyfinancialcrisesnearlyalwaysfeatureconcurrentmini-currencycrises.TodayisnoexceptionastherecentplightoftheUSdollarattests.ButjusthowreactiveshouldCentralBankersbeLookingatthepastcoupleofdecadesmarketshaveahabitoffrequentlycryingoutwolf.FearsovercreditcrunchmayberealisticOntheotherhandnastytalesmakegoodheadlinesandsellnewspapers.Wearecynical.Notonlyhaveinvestorsheardmoreaboutcreditcrunchfromjournaliststhanfrombankersthemselvesbutiftheconsensusoffinancialmarketeconomistsisrightincorrectlyascribing40oddstoaUSrecessionin2008thiswouldbethefirsttimeevertheyhadcorrectlypredictedsuchasharpdownturnInourviewinvestorsaremisreadingthecycle.CentralBankscausedthismid-yearilliquiditybyover-tighteningin2005-06.Thecreditsystemhasconsequentlytakenabody-blowbutitisfarfrombeingfloored.Inshortthisisatypicalcyclicaldipandnotasecularbreak.SoletsconsiderthefactsCreditdatacanbesplitintothreetypes1interestratespreads2surveyofloanofficersintentions3newcreditextendedtoborrowers.Attheendofthedayitisthethirdcategorythatisthemostimportanti.e.theproofofthecreditisinthelendingHowevertheformertwohavelatelybeeninthelimelightprobablybecausetheyareeasytomeasureandsotheydeservecloserexamination.Figures3and4showtwosetsofinterestratespreads.Thefirstmeasuresthegapbetweenlonger-termyieldsontwoquality-typesofcorporatebondsBaaandJunkandUSTreasuriesthesecondshowsthedifferencebetween3-monthEurodollarLIBORandratesofferedonriskfree3-monthUSTreasuryBillstheTEDspread.Thelatterisacrudemeasureoftheshort-termcostoffundsforbanksandtheformerisanequivalentmeasureofthepremiumindustryhastopayforlong-termfunding.Junkyieldsstoodat9.46inearlyDecember.Thiswasatadbelowtheirlate-July2007highs.Spreadsagainst10-yearTreasuriesmovedoutto549bps.Baalowestqualityinvestmentgradeyieldshit6.53atthesametimeoratadbelowearlier2007highsalthoughspreadsagainstTreasurieshita256bpshighfortheyear.Thesedataareunhelpfulratherthandisastrous.InpastcrisesJunkspreadshaveblown-outthrough1000bpsandBaaspreadshavetypicallytested350bpsover.ToputthisintocontextweestimatethatthesespreadsimplythatthefuturedefaultrateonUScorporatebondsMoodysserieswillrisetoaround2.5fromacurrentlevelof0.45.InJune1991thedefaultratehit CROSSBORDERCAPITAL0.01.02.03.04.05.06.07.07071727374757677787980818283848586878889909192939495969798990001020304050607-20-15-10-505101520TEDSpreadLHSECRIInvertedRHS0200400600800100012001400878889909192939495969798990001020304050607BaaJunkSourceCrossBorderCapitalUSFederalReserveSourceCrossBorderCapitalEconomicCycleResearchInstituteUSFederalReserveFigure3.BaaAndJunkSpreadsVersusUSTreasuries1987-2007WeeklyFigure4.TEDSpreadAndECRIUSLeadingEconomicGrowthIndicator1970-2007Weekly4.89speculativegrade12.05andinJanuary2002itreached5.07speculativegrade11.18.InotherwordsthisfinancingbackdropforindustryisconsistentwithaneconomicslowdownbutNOTarecession.TheyawninggapbetweenUSLIBORand91-dayUSTreasuryyieldsisacomparativelynewphenomenon.Bothrateshaveseeminglyde-coupledfromFedFundswhichhassomehowmanagedtosteeradownwardpathbetween.AtfirstsightthisshowsthatCentralBankshavelimitedcontroloverinterestratesapointwehavelongsuggestedanditbeliestheexistenceofasinglemoneymarketasfrequentlydescribedbytheMedia.Thespreadroughlymeasuresthepremiumbeingpaidbybanksforfunds.Itshowsthatliquidityistightbetweencreditinstitutionsasmore-and-moresitonpreciousfundstosafeguardagainstfuturecontingenciesinanenvironmentwherefewwanttobespottedatthediscountwindowaskingCentralBanksforhelp.Corporationsoperatingintherealeconomyenjoyabove-averagelevelsofcashandifAmericassurgingnetexportfigurescontinuetheywillenjoystillmore.Inshortourtravailsremainlargelyfinancialandnotyetindustrial. 6CROSSBORDERCAPITALSourceCrossBorderCapitalBankofJapanECBUSFederalReserveComputerSaysNoErrYesThesecondsetofdataconsistsoflendingsurveys.AlthoughmostofusprobablybelievethatcomplexandimpersonalcomputersnowdecideallloanstheUSFedECBandBoJstillregularlycollectinformationfromseniorloanofficersaboutthedemandandconditionsattachedtothesupplyoffunds.Latestsurveydatashowageneraldeteriorationi.e.tighteninginlendingstandardsbutalongsidetherearefewersignsthatcreditdemandisfaltering.WefocusoncommercialandindustriallendingratherthanconsumerandhomelendingbecausetheformerisanywaymoreimportantforthegeneraleconomyandthelatterismorelikelydistortedbytheemotionassociatedwiththeJulyAugustmarkethiatus.TheselendingconditionstightenedacrossallthreeregionsaccordingtothelatestOctobersurveys.ThenetbalanceofUSloanofficersadmittingtotighterstandardsjumpedfrom7.5to19.2Japansbalanceedgedfrom-5to-2butthebiggestrisecameinEurozonewhichsoaredfrom-5to31.Overallourcalendar-adjustedGlobalIndexmovedfrom14.3to20.2.Intheprevioustwocyclesthisindexpeakedat56.91990and44.12001.SeeFigure5.Ouroverallindexofloandemandmovedfrom-7.9to-6.9.Ahighnegativefigureshowsweakdemand.InAmericatheindexfellfrom-19.2to-17.3whereasinEurozoneitmovedfrom18to5.Theindexpreviouslybottomedat-29.71991and-59.82001.Figure5.GlobalLoanOfficersLendingSurveyUSFedECBBoJWeightedAverage1990-2007-30-20-10010203040506070Jun-90Jun-91Jun-92Jun-93Jun-94Jun-95Jun-96Jun-97Jun-98Jun-99Jun-00Jun-01Jun-02Jun-03Jun-04Jun-05Jun-06Jun-07TighterStandards-80-60-40-200204060WeakerDemandStandardsLoanDemandRisingNewLoanDataWearguedatthestartof2007thatGlobalLiquidityconditionsweretightnotlooseaswasthenpopularlyacclaimed.Thatiswhatourdatarevealandmoreoveritissupportedbythebehaviourofinternationalfixedincomemarketsviz.widespreadflatandsometimesinvertedyieldcurvesandbytheon-goingcollapseoftheUSandnowotherhousingmarkets.Howeverwestronglyfeelthattheworstofthecreditcyclemaybebehindus.Solvencyproblemsareusuallyhighlightedalmostbydefinitionaroundthelowerinflexionpoint CROSSBORDERCAPITAL1OurbroadmeasureofUScredittotalsaroundUS21trillioncomparedtosomeUS7trillionforUSM2moneysupply.WeincludelendingbytheGSEse.g.FannieMaeandFreddieMacandbyfinancehousese.g.carloansandcreditcardloansaswellason-balanceandoff-balancesheetsecuritisationbybanks.234567891011121314151680818283848586878889909192939495969798990001020304050607YoYChg.GlobalUSSourceCrossBorderCapitalBankofJapanECBUSFederalReserveIMFofthecycle.Moreoverthecreditcycleleadsanddoesnotfollowthecycleofwiderbusinessactivity.LookingaheadweexpecttoseecreditexpandingcertainlytakenrelativetotheneedsoftherealeconomyandthereforeweareencouragedtoseeoverallrobustcreditdatasincetheJulyAugust2007panic.Thusdespitethemediahypetheworldscreditmechanismisstillpumpingoutloansandnotyetspittingoutbolts.ForexampleTotalUSCreditbroaddefinition1looksoncoursetogrowbyUS114.1billioninDecemberfollowingaUS146.9billionjumpinNovember2007andUS204.4billionriseinOctober.AdmittedlyAugustsufferedanabsolutedropofUS51.7billion.Yetitisaheadby9.5annualisedoverthreemonthsandup7.3onayearago.Overthepast12monthsUScredithasincreasedbyanaverageofUS121.8billioneachmonth.Surprisinglythisrepresentsonly15ofthegrowthofWorldcreditovertheperiod.Globalcreditgrowthisbeinglargelydrivenbytheemergingeconomies.Latestdatashowa37.9annualisedriseinemergingmarketloansinthethreemonthstoend-November2007andan11.9annualisedgaininglobalcreditmeasuredinlocalcurrencyterms.Emergingmarketcreditcomprises19.0oftheWorldtotalcomparedto32.6fortheUS.Figure6.GlobalAndUSCreditGrowth1980-2007Themixofcreditgainsalsolookswell-balanced.Bankswhichcomprisearound45ofoverallcreditsupplygrewtheirbalancesheetsby17.4annualisedoverthethreemonthstoend-November2007orbyUS361.7billion.Eventheinfamoussecuritisationlargelyheldoff-balancesheetmanagedaUS9.7billionriseovertheperiod.Nonasset-backedcommercialpaperissuancejumpedUS70.1billionandtheGSEse.g.FannieMaeandFreddieMacsteppeduplendingbyUS186.3billion.MoreoverasFigure7highlightsFannieMaeandFreddieMachavebeenactivelyusedbytheUSauthoritiestolendanti-cyclicallyandsosupportoverallcreditgrowthsincethemid-1990s. 8CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveFigure7.GSEAndOverallLendingGrowth1994-2007949596979899000102030405060705101520250510152025YoYChg.TotalUSCreditGSEsFigure8.BreakdownOfUSUSDollarsAndInternationalLendingLocalCurrencyBasis2006-20073-MonthAnnualisedChangeUSTotalMoMChangeUSbnUSBanksSecuritisationGSEsCreditCardsAutoLoansetcCommercialPaperD0610.5159.814.42.68.40.421.5J078.5107.39.23.78.70.721.4F9.5170.110.38.19.81.515.5M7.155.25.45.011.82.911.0A6.165.05.6-4.912.04.113.2M6.4187.14.7-9.414.42.424.0J7.4100.48.2-10.313.7-1.324.7J10.0185.58.4-2.214.32.831.7A4.8-51.711.90.413.25.8-30.6S5.4132.215.74.714.66.6-42.4O5.8204.418.12.216.02.9-43.2N10.0146.917.41.516.81.8-16.2DE9.5114.112.33.416.06.7-5.9USUKEurozoneJapanEmergingMarketsChinaWorldD0610.211.48.26.834.022.612.0J078.314.79.86.328.125.611.8F9.114.27.90.528.637.111.6M6.815.210.2-3.722.221.89.8A5.911.411.2-1.131.022.910.3M6.314.912.8-0.827.69.59.8J7.213.812.1-1.430.725.010.9J9.615.610.2-1.129.222.811.3A4.814.28.52.327.728.010.6S5.419.48.31.734.319.510.9O5.817.18.1-1.134.916.110.4N10.015.010.11.337.915.111.9DE9.5NANANANANANAIncludesUSFederalReserve.EEstimate.NANotavailable.SourceCrossBorderCapitalBankofJapanECBUSFederalReserveIMF CROSSBORDERCAPITAL2The1980sUSSLCrisiscosttheAmericantaxpayeraloneUS153billionorUS245billionincurrent2007dollars.6000007000008000009000001000000110000012000001300000020304050607USMillionsAsset-BackedNonAsset-BackedOfcoursewecandigupbadnews.Figure9showsthe21stCenturyversionofthehistoricbankrunwhereinvestorsshunasset-backedcommercialpaperwhichinturnforcesbankstohoardpreciousfundsinordertocoversecuritisedassetsthatarebroughtbackontobalancesheets.Asset-backedcommercialpapercrateredbyUS140.8billionor48.1annualisedoverthesamethreemonths.HowevertheoveralllendingtotalhasstillriseneachmonthsinceAugust2007.NoevidencesofarofanycrunchSourceCrossBorderCapitalUSFederalReserveFigure9.Asset-BackedAndNonAsset-BackedCommercialPaperOutstanding2002-2007WeeklyUSDollarMillionsEstimatesfromtheUSFedscalebadsub-primeloansataroundUS150billionorasmuchas12oftheend-2006stockofsub-primedebt.ThemoreconservativeestimatefromtheBankofEnglandisUS200billioni.e.16defaultbutsomepunditsraisethistonearerUS300billioni.e.25default2.SetagainsttotalworldwidecreditofUS65trilliontheprospectivelosses0.4stilllooksmall.Moreoverlossesaretaxdeductibleandwillbespreadovermorethanoneyear.AlsoUSbankswhicharecurrentlyintheeyeofthestormmayonlyholdone-thirdofthesub-primedebtsuggestingpotentiallossestothemofUS100billion.ThiscomparestotheUS1.4trillionthatUSbanksholdinequitycapitaltheUS81billiontheyhavesquirreledawayinloanlossreservesandtheUS30billiontheytypicallyallowannuallyforwriteoffs.NobigdealPreparingTheNextMistakeInvestorsareoftencounsellednevertobetontheendoftheWorld.Inotherwordslikeeuphoriaontheupsidepessimismisoftenoverdone.Soitprobablyisforthecreditmarketsin2007-08.TheimpliedlevelofdefaultstheforecastbyoneprominentAmericaninvestmentbankthatUScreditmaydivebyUS2trillioni.e.10andtheclamouramongfinancialmarketeconomiststopredictanAmericanrecessionin2008alllooktooextreme.YetCentralBanksareapparentlylisteningtothesecriesforhelp.Theyareactivelyeasingagainandwilllikelyeasefarmore.PrivatelytheUSFedhasacknowledgedthattheirmajorconcernisthehousingmarketandtheirfearthatafurtherdown-leginpricesandsalescouldhastenforeclosuresandthusspike-upmortgagedefaultrates.Bankingworries 10CROSSBORDERCAPITALwillnotgoawayuntiltheAmericanhousingmarketshowssignsofbottoming.ThisweargueiswithintheFedsgift.Inflationisnotyetaseriousproblemandisunlikelytoblindsidethemforsometime.JudgedbytheTaylorRuletargetshowninFigure2USinterestrateshavescopeonfundamentalstofallbyanother25-50bpsbutontophistoryshowsthattheyoftenskidbyafurther150bpsbelowthisfundamentalpath.Thuscirca-3FedFundsarepossible.SeriousUSeasinghasyettobegin.SeeFigure10.CynicallyputtheweakertheUShousingmarkettheweakertheUSdollarthestrongerthegoldpriceandthebettertheprospectsforAsianmarkets.InshortCentralBanksfacearoller-coasterrideastheyinflateserialbubblesfromequitymarketstohousingmarketstocommoditymarkets.ManyforgetthatAmericanolongergoesitalonethisdecadeaboveallothershasrevealedanewlistoflargefast-growingeconomiesheadedbyChinabutalsoincludingIndiaBrazilRussiaandtheGulfstates.ThesecountriesaretheonesenjoyingfastuninterruptedcreditgrowthandthatisseeminglyundentedbyUSsub-primeworries.Thesearetheeconomieswithrisingwealthymiddle-classeseagertocopyWesternconsumerpatterns.Theseeconomiesarethefuture.Chinathelargestandstrongestofthisgroupisstrugglingtorein-backitsalreadyheadyrateofeconomicgrowththeChineseeconomymayalsoprovesurprisinglystrongin2008.Ontopfuelledbyasuper-competitiveUSdollartheconditionsareinplaceforaUSturnaround.AlreadyourliquiditydatashowthattheUSprivatesectorhasuppeditspaceofcashgeneration.SeeFigure11.Takenbyitselfthisprobablyguaranteesashort-termeconomicslowdownasspendingfallsbutlookingaheaditwillhelptoshrinkthestillwhoppingtradedeficitandultimatelyre-igniteUSprofitability.Yetinvestorsremainever-scepticaljudgingfromtheircurrenthistoricallylowexposuretoAmericanequities.InshorttheCycleisback.Theprivatesectormaybeblamedfortherun-awaytrendsincreditbutCentralBanksareresponsiblefortheCycle.TheywronglybelievetheycansetinterestratesandusetheflawedTaylorRuletosteerpolicy.Consequentlytheytightenandeaseatthewrongpointscausingmoreviolentswingsinfinancialmarkets.Theyareeasingagainnowtoextinguishaliquiditycrisistheyoriginallycreatedbutintheacttheywillinflateyetanothernewbubble.Althoughtheinter-bankmarkethasvirtuallydrieduptheunderlyingglobalcreditsituationisnotasbadasfinancialmarketsclaim.SourceCrossBorderCapitalUSFederalReserveFigure10.TheOldWorldUSFederalReserveLiquidity1980-200780818283848586878889909192939495969798990001020304050607020406080100020406080100LooseTightIndex 11CROSSBORDERCAPITALFigure11.TheNewWorldUSPrivateSectorAndForeignCentralBankLiquidity1980-200780818283848586878889909192939495969798990001020304050607020406080100020406080100LooseTightIndexForeignnon-USCentralBanksUSPrivateSectorSourceCrossBorderCapitalBankofJapanECBUSFederalReserveIMF 12CROSSBORDERCAPITALAppendixA.TheGlobalLiquidityCycle1965-2007SourceCrossBorderCapitalSoaringCommoditiesLooseTightUSCreditSqueezeSterlingCrisisPennCentralBankruptUSFiscalSpendingBoomInflationaryBoomEndOfBrettonWoodsVolkerFedReaganElectionLDCDebtCrisisFailureofContinentalIllinoisPlazaAccordWeakUS1987CrashScandinavianBankingCrisisMexicoPesoCrisisEmergingMarketBoomBondCrashAsianCrisisRussianCrisisIndexY2KLouvreAccordEnronWorldcomUSSub-primeCrisisNorthernRockOPECIOPECIISurgingDollarJohnsonMattheyJapaneseBubbleUSSLCrisisJapaneseTighteningBaringsCollapseArgentinaCrisis911RealEstateCommoditiesBoom65676971737577798183858789919395979901030507020406080100020406080100 1CROSSBORDERCAPITALRepoManVersusTheReaperMarch7th2008mayproveanauspiciousdateintheannalsofmonetarypolicy.LastFridaywithNewYorksstockandcreditmarketslurchingclosertotheabysstheFedpubliclysignalledtheirfrustrationwiththefailureofthetraditionalinterestratelevertoreversetheslideandturnedtothechequebook.AnotherU40billionpermonthinTAFTreasuryAuctionFacilitywasgiftedtomarketsmakinganewmonthlyrun-rateoUS100billionaswellastheannouncedlikelymore-than-doublingintemporaryopemarketoperationsfromprevailinglevelsofcircaUS40-50billiontoatargetofaroundanotherUS100billion.NotetheUSTreasuryprobablyaddsthesameagainthroughitsstepped-upTIOauctionsalthoughthesefundsarenotstrictlynewmoney.OnTuesdayMarch11ththeFederalReservefurtherclarifieditsintentionsbyofferingtolendanadditionalUS200billionfor28daysagainstwidercollateral.Thismaynotyetbethemuchconjecturedbailoutofbankspersebutiteffectivelybailsoutthemoreimportantrepomarket.Underscoringthismoveglobalpolicy-makersheldtheirhandstogethercollectivelyaswellastogetherinhopeandprayerandchantedthesamemonetaryrunes.ThusotherkeyCentralBanksamongthemtheECBBoJSwisNationalBankandBankofEnglandalsoinjectedfundsandincreasedswapfacilities.YouhavejustwitnessedtheCentralBankingequivalentoftheNewDeal.Atlastpolicy-makersseemtohaverecognisedthattheproblemisaboutthesupplyofliquiditynotitspriceorastheyhavealsoargueditsdistribution.Hopefullytheseactionswillbebothsustainedandnotsterilisedbyactionselsewhereinthesystem.Inshortiftheyaretoworktheymustrepresentalong-termnetboosttomarketliquidity.Fingers-crossedOurcommentarylastmontharguedthatthewiderUSandGlobalrealeconomiesarenoyetsufferingacreditcrunchdespitePressclaims.ThusbroadUScreditgrowthjumpebyanannualised7.7inthethreemonthstoend-Februarywhilecreditgrowthacrosthenowinfamousshadowbanksreboundedby8.5.IncontrastFedcreditskiddedtoabarelypositive0.1annualisedgrowthrateoverthesameperiod.Globalcreditgrowthtouched11.6spurredby24.1growthinemergingmarketlending.Figure1showsthannualgrowthofbroadUScreditalongsidethegrowthoftheFedsbalancesheet.AcreditcrunchdoesexistbetweentheCentralBanksandthebanksandshadowbankingsystembutnotbetweentheselattercreditinstitutionsandtherealeconomy.TheJanuary2008twinISMsurveysfoundthatonlyanaverage11ofUSbusinessesclaimetohavebeenadverselyaffectedbythepost-Augustcreditturmoil.Sofaritremainsjustre-financingorliquidityproblem.CROSSBORDERCAPITALGlobalViewMarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comNewYorkSlidesWashingtonWakesChicagoDreamsThepastninemonthsconfirmthatinterestratesdontmatterliquidityandre-inancingmatteralot.There-financingofprivatesectorlendinginstitutionlargelyoccursthroughtherepomarketswhichinturndancetotheCentraBankerstune.Policy-makersmismanagementofrepomarketliquiditytriggeredthisre-financingcrisis.Itisintheirgifttodigusout.CouldFridayMarch7thinallymarkthestartMarch2008 2CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveFigure1.BroadUSCreditndFederalReserveCredit1972-2008AnnuaPercentageChange72747678808284868890929496980002040608-505101520-505101520YoYChg.BroadCreditFederalReserveCreditYetwefailtounderstandwhywhenthemarketsproblemissoobviouslyaninabilitytosourcenewliquiditypolicymakerstrytofurtherworsentheimbalancebycuttinginteresratesLowerinterestratesheightenthesupplydeficiencybyfurtherincreasingthedemandforfundsandsowideningthesupply-demandgap.ThiscrisishasbeenallabouthenetlackofliquiditysupplynotanylackofdemandLyingattheheartoftodaysproblemisachangeinthewaythatourmajorcreditinstitutionsarefunded.Forexamplealargeproportionofbanksfundingnowcomesfrotheshort-termmarketse.g.commercialpaperandreposratherthanfromtraditionaldeposits.ThenetsizeofAmericasrepomarkethasgrownbyawhoppingmorethantenfoldsince1985comparedtothestillimpressivefive-foldriseinthesizeofthecommerciapapermarket.Bankfundingnowinvolvesagreaterfinancialstretchandhenceabiggerriskbecausenotonlyhastheaveragelendingperiodlengthenedbutthetermoverwhichfundsaresecuredhasdroppedradicallyprobablyfrommonthspossiblyyearstojustdays.Tomakemattersworsethequalityoftheloansonwhichthebanksgetcollateraltsecuretheirborrowingsnowvariesminute-by-minutebecausecreditsarepricedinthemarket.Paradoxicallytodaysworryisnotjustdeterioratingloanqualitye.g.risingdefaultsinthesub-primemortgagemarket.Ratheritisaself-feedingilliquiditycausedbyaninitialinabilitytofundwhichcreatesaforcedsellerofcreditse.g.MBSs.Thisinturnpushesdownsecuritypricesunderminesgeneralloancollateralandsoamplifiestheproblem.BothrisksilliquidityanddefaultmaywellbecapturedbyinterestratespreadsbuttheyareunlikelytobereflectedintheprimaryorbaseinterestratesonliquidhighqualitycreditinstrumentssuchasFedFunds.ThusoverthepastninemonthsmanyCentralBankshavefallenintothetrapoftryingtolendagainstalreadyliquiinstrumentsButthisgapbetweenliquidityandilliquiditymatters.Foryearswehavetriedtoscotchtheideathatinterestratesarethebestoronlyguidetomonetarconditions.ForexamplewhyarethepolicyactionsoftheUSTreasuryalwaysmeasureindollarswhereasthesisteractionsoftheFederalReserveareonlygaugedfromitsinterestratetargetLookingbacktheexperienceofthe200708CreditCrisishasprobablyeducatedpolicy-makersbetterthananytheoryevercouldalthoughatgreatcost.StartinglastAugustintheUSfinancialmarketssufferedaseriousliquiditycrisis CROSSBORDERCAPITALcenteringontheinabilityofthelendinginstitutionstogetre-financed.Inrecentyearsrefinancinghasincreasinglybeenundertakenintheshort-termrepomarketsorattheverypointwheretheCentralBanksmeettheprivatesector.SinceCentralBanksprovidecriticalliquiditytolubricatetherepomarketsthepre-crisisplungeinrepoactivitycanbetracedbacktopoorliquiditymanagementbypolicy-makers.Inshorttheygotusintothismessandtheyshouldnowgetusout.TherepomarketthecommercialpapermarketandtheFedFundsandinter-banmarketsarewhatgenericallycomprisethemoneymarket.Wemightquibblethatinmonetaryeconomyeverymarketisamarketformoney.IntheUStherepomarketsuppliesaroundUS2.5trillionandthecommercialpapermarketafurtherUS2trillion.Moneymarketfundsarethemainbuyersofbothinstruments.PrimarydealersinUSTreasuryandotherfixedincomesecuritieslieatthecentreoftherepomarket.TheirnepositionsaccordingtotheNewYorkFedstandataroundUS1.5trillioncomprisingnearlyUS4.5trillionofreposwithsomeUS3trillionofreversesnettedoff.BanksprovidearoundUS350billionofrepoloansandtheUSFederalReservesuppliesafurtherUS40-50billion.FluctuationsinthecombinedactivityoftherepomarketthecommercialpapermarketandtheFedFundsmarketcanbetakenasareasonableguidetomovementsintheUSfinancialsystemsnetliquidity.ThecommercialpapermarketandespeciallytheassetbackedCPmarketoftenstandsasasubstitutefortherepomarketandviceversa.Reposorsaleandrepurchaseagreementsareeffectivelyveryshort-termloansusuallyforspansofonetoaround14dayscollateralisedagainstsecuritiesmostlyUSTreasuriesandAgenciesbutsometimesalsomortgage-backedsecuritiesMBSs.Theveryshortspaofrepoloansobviouslydemandsfrequenton-goingre-financing.ThecredibilityofthiscreditismaintainedbyaLawofRe-FinancethatparallelstheClassicalLawofRe-FluxundertheGoldStandard.Signsofabreakdowninre-financemaybehighlightedbyrisininterestratevolatility.Re-financingriskisdefinedbythegapbetweendesireddurationandactualduration.More-and-morefinancialinstitutionsareexposedtoawideningdurationgapi.e.increasinglytheyhavetoborrowveryshortandlendverylongrequiringasteepyieldcurve.Alongsidethephenomenalgrowthoftherepomarkettheattractionsosecuritizationhavepushedbanksintoprovidingmore-and-morelonger-termlendingoftenviamortgagesthatendupinoff-balancesheetvehiclessuchasSIVs.ThismaybesymptomofmatureCapitalistproductiontogetherwithageingpopulations.Tensionsarisebetweenthedurationandliquidityofassetsbecausethefadingofproductivitydemandsthatmorecapitalbetiedupinlongerdurationprojectswhileanoldepopulationfacingmoreimmediateliabilitieswilldemandshorter-termcashflows.Overtimeeconomicandfinancialstabilitymayitselfbecomedestabilisingsincedurationlengthensasmoreriskyfinancingregimesareestablishedtherebyraisingtheoddsofashortfallbetweenliabilitydurationandassetduration.Thisshortfallrequiresliquidity.TheFederalReservethroughitsrelationshipwiththePrimaryDealersinTreasursecuritiestendstocontrolliquidityinboththerepomarketandtheFedFundsmarket.TheFedisnotthelargestparticipante.g.130thofthetotalbutitplaysacriticalroleatthemargininlubricatingthemarketandfacilitatingre-financingasFigure2suggests.Thischartshowschangesoverarollingsix-monthperiodinthenetsizeoftherepomarketandFederalReserverepoactivity.TheclosecorrelationbetweentheoveralmarketandFedactivitysuggestsacasualroleexistsfromthemonetaryauthoritytothmoneymarket.ConsequentlyFederalReserverepooperationsarethekeytounderstandingbothfinancialmarketliquidityandthesmoothnessoftheeconomyswidere-financingprocess. 4CROSSBORDERCAPITAL-40-20020406080122620010501200209042002010820030514200309172003012120040526200409292004020220050608200510122005021520060621200610252006022820070704200711072007Percent-40000-30000-20000-10000010000200003000040000USBillionsNetSizeOfRepoMarketFederalReserveRepoActivity506070809010011012013014015001042006021720060404200605172006063020060815200609282006111320061228200602132007032820070509200706222007080320070913200710242007112820070104200802142008USBillion14dRollingTotal6mMovingAverageFebruaryCrisisAugustCrisisOctoberCrisisJanuaryCrisisSourceCrossBorderCapitalUSFederalReserveFigure2.NetSizeOfUSRepoMarketAnnualisedSix-MonthPercentChangeAndFederalReserveRepoActivityChangeOverSixMonths2001-200WeeklyFigure3.FederalReserveTemporaryOpenMarketOperationsRepoActivity2006-2008Rolling14-DayTotalsUSDollarBillionsSourceCrossBorderCapitalUSFederalReserveFigure3showsa14-dayrollingtotalofoutstandingreposundertakenbytheUSFederalReserve.Asaguideifthistotalisdividedbyabout2itequalsthecircaUS40-50billionoftemporaryopenmarketoperationsreportedbytheFedinitsbi-weeklybalancsheetstatement.Ourseriesishigherbecauseforcomputationaleaseweuseafixed14dayrollingtotalratherthantrawlthrougheachrepoannouncementwhichcanvaryintermbetween1and14days.Thustheaveragetermtodaymustbearound5.6daysi.e.145.62.TheplainfactisthatheadingintolastAugustscrisisandalsoaheadofthemini-crisithepreviousFebruaryFedrepoactivitywassub-par.Moreworryinglyaftereachtimethemonetaryauthoritiesaddressedtheilliquidityproblembysteppinguprepoactivitytheyletliquidityquicklydrainawayagainactionsweearlierdubbedasfire-fighting. CROSSBORDERCAPITALOntoptheirsystemiccommitmenttosupplyingmoreliquiditymustbequestionedbecauseatthesametimethattemporaryreposincreaseddiscountwindowlendingumpedandthenewTAFengagedtheFedsimultaneouslycutbackonitslong-terholdingsofTreasuriesHeldOutright.AFed-Watcheroperatinginthe1970sand1980swouldalmostcertainlyhavereadthisasasubtletighteningsignal.TodaythereisnosubtletyaboutthenetresultalreadyspiedinFigure1thatuptonowtheFedsbalancsheetisbarelygrowingabizarreresponsetoamajorcreditcrisis.MarketsNeedConstantLubricationModernCapitalismisaprocessofcapitalaccumulationwithacomplexfinancialsystematitscentre.Industryandfinanceareincreasinglyinseparable.Futureeconomicgrowthrequirescapitaltobetiedupinindustrialprojectsoflonger-and-longerdurationandthvastscaleoftheseprojectsdemandsspecialistfinance.Theraisingofnewcapitalandthre-distributionofexistingcapitaloccurinfinancialmarkets.Theaggregatefinancialsystemissubjecttotwobudgetconstraintstotalassetshavetomatchtotalliabilitiestsatisfysolvencyandoverallsurplusesmustoffsetoveralldeficitstomaintainliquidity.Althoughliquiditycanbethoughtofasmeasuringtheexpostchangeinthesizeofaggregatebalancesheetsi.e.auseoffundsbothbyvolumeandpricechangesweprefertothinkofitasanexantesourceoffunds.Theprocessofbalancingindividualsurplusesanddeficitsrequiresaflowoffundsbetweensectorsoftheeconomy.Thisshorttermre-financingprocessorwhatwedubliquiditycreationiscriticaltobusinessurvival.Plainlyliquidityisdifferentfromandpotentiallyfarlargerthanconventionalmoneysupply.Moneysupplyasdefinedbybankdepositsisasubsetofaggregatebalancesheets.Itexcludesbothnon-bankdepositsandalltypesofsecuritiesandphysicalassets.Wemeasureliquiditybytheflowofcashsavingsandnewcreditextendedbythefinancialsystem.Ourfocusisonthecreationofnewspendingpower.Thereforetheissuanceoflong-termdebtandequitysecuritiesisexcludedsinceitrepresentstheusesratherthanthesourcesofnewpurchasingpower.Liquidityfindsitswayintorealinvestmentsandfinancialinvestmentsaswellasintocashdepositsandmoneymarketfunds.Sincethetwolatterpocketscaninturnbecomesourcesofnewcreditthenetchangeinliquiditystrictlycomprisesthefinancingofrealandfinancialinvestments.UsingsomealgebraicsymbolsliquidityLcanbedescribedasLSrFCSourcesofFundsLrpa.ArFDAggregateChangeinBalanceSheetssplitbyvolumeandpa.rAA.rparFDpricechangeIIfrFDUsesofFundswhereLisliquiditySsavingsFCfinancialsectorcreditFDfinancialsectordepositspassetpricesAassetsIrealinvestmentandIfcapitalgains.rdenotesthedifferenceoperator. 6CROSSBORDERCAPITALThustheUSFedsFlowofFundsdatareportafigureofUS47.9trillionforTotalCreditarketDeb.Thiscanbebetterexpressedasanettake-upofdebtbytheUSDomestiNon-FinancialSectorofUS25.1trillionofwhichanetUS19.9trillioncomesfromthUSfinancialsystemandtheremainingUS5.2trillionisprovidedbyoverseasinvestors.OurseparatemonthlyestimateforUSbroadcreditsupplyofUS21trillionisveryclostothiscomprehensivequarterlysurveyofthefinancialsectorssupplyoffunds.Itisprobablyfairtoassumethatmovementsintheliabilitiessideoftherealeconomybalancesheetroughlymatchthechangesintheassetssideofthefinancialsectorbalancsheet.ThereforeakeyquestioniswhatallowsthefinancialsectortoexpanditsbalancsheetWork1byTobiasAdrianandHyunSongShinshowthattheebbandflowofUSfinancialinstitutionsbalancesheetsarethemselveslargelyfinancedatthemargithroughtherepomarkets.UltimatelyeverynationalfinancialsystemisunderwrittenbytheStateandwhepolicy-makersattemptbail-outstheysimplyissuemoregovernmentpaper.Tohead-ofsuchcrisesCentralbanksoperatedailyandeitherinfluencethevolumeofavailableliquidityoritscost.Fiftyyearsagowhenbanksinvestedheavilyinshort-termTreasurybillsthesefinancingconstraintsrarelybit.ButincreasinglyovertheyearsasnewcreditinstrumentshaveevolvedCentralBankshavestruggledtomaintaincontrolofthere-financingprocess.Consequentlytheyhaveoftenfollowedadangerouspolicyofbrinkmanshipbywithholdingliquidityatcriticaltimes.Inperfectcapitalmarketsthismightnotseemtomatterthatmuchbecausefinanceisintheoryavailableforallprojectswithanetpresentvaluebutinimperfectcapitalmarketsaccesstoanyfinanceisnotguaranteedbecausenormalintermediarychannelsmaybedisruptedandorbecausedoubtsariseoverbalancesheetquality.Inshortdisproportionaleffectsarepossibleperhapsevenlikely.ThecollapseofLTCMin1998andthe2007sub-primeproblemsareclearexamplesofre-financingproblems.InappropriateCentralBankactionswillinevitablyhobblethere-financingprocessparticularlyduringcrisesforcingthoseentitiesthatcannotroll-overtheirdebtsintobankruptcybutalsoraisingriskpremiumsforall.Inturnhigherriskpremiaandscarcfundsfurtherlimitnewinvestmentandthisultimatelypinchesthepaceofeconomigrowth.Giventheimportanceofre-financingthepursuitofanorthogonalmonetarypolicythatrequiresbrinkmanshipmustbeconsideredmadness.HistoricCostVersusSuicidalCostOntopthelegacyoftheChicagoBoysi.e.academicsfromtheUniversityofChicagowhinfluencepolicy-makersstillhauntsinvestorsintwoimportantrespectsbothconnectedbythefalsenotionofperfectcapitalmarketsthatisembeddedinModernFinance1valueandpricearesynonymousand2anyprojectwithanetpositivepresentvalueisassuredoffinance.Thelatternotionhasgreatlyinfluencedpolicy-makers.Itsuggeststhatliquidityisendogenoustothefinancialsystemandthisdangerousidealiesbehintheill-conceivedTaylorRulethatsetsanoptimalpathforpolicyinterestrates.Wehavearguedovertheyearsthatliquidityisendogenousormorecorrectlyputpassivatcertaintimesinthebusinesscycle.HowevertherearekeyperiodsusuallydubbedcriseswhenitdoesnotflowandtheseoccasionsareoftenassociatedwithCentralBankmeddling.Forexamplethechartbelowshowstheso-calledTaylorRulegapfortheUSalongsideourmeasureofUSfinancialliquidity.1LiquidityMonetaryPolicyandFinancialCyclesFederalReserveBankofNewYorkCurrentIssuesJanFeb2008.HencetheimportanceoftheFed. CROSSBORDERCAPITALSourceCrossBorderCapitalFigure4.USImpliedTaylorRuleGapndUSLiquidity175-200875767778798081828384858687888990919293949596979899000102030405060708020406080100-800-600-400-2000200400600800IndexBasisPointsLooseTightLiquidityCycleLHSTaylorRuleGapRHSFigure4showsanincreasingdislocationbetweenactualliquidityconditionsandwherepolicy-makersbelieveliquidityconditionsarebasedonthedifferencebetweentheTaylorRuleandtheFedFundsrate.InotherwordsaloosepolicywouldbesignalledwhenFeFundsfellbelowtheTaylorRule.Howeverinrecentyearsthishasrarelycoincidedwitliquidity.Thegaphasbeenespeciallypronouncedduringthe2004-07periodwhenmarketliquidityonourmeasureswastighterthanUSpolicy-makersrecognised.WehavarguedbeforeagainsttheTaylorRulewhichweconsiderbothnaveandinaccurate.Admittedlytodaybothmeasuresaremorealigned.Howeverthreeearlieryearsoexcessivelytightpolicymayalreadyhavewroughttheirdamage.Theadoptionofmarking-to-marketorfairvalueaccountinginsteadofhistoriccostaccountingisChicagossecondlegacy.IfthereisgenuinelynodifferencebetweenpriceandvaluethemarketwillalwaysprovidethebestestimateoftruevalueThereforeilliquiditywhichofcoursetheydenyincertaininstrumentsthatcausespricestotemporarilyslumpcanhaveawidespreadeffectonoverallassetvaluesandhencecollateralunderthisregime.Althoughprofessionalinvestorsfullyacknowledgethaliquidityonlytrulyexistsinafewmarketareassuchason-the-runTreasuriesandWallStreetsmajorbluechipstocksthissuicidalnotionofmarking-to-marketisincreasinglbeingadoptedbycreditinstitutions.Infactitisperhapsthenaturalcorollaryofbanksobtaininglargepartsoftheirfundingfromthecapitalmarkets.Thecontrastbetweenthe199091SavingsandLoanCrisisandthecurrentSub-PrimCrisislargelyrestsonthisaccountingdistinction.Intheearliercrisisbanksdidnotanprobablycouldnotrevealthetruevalueoftheirloanandsecurityassets.Todaybanksarebothexpectedtoandrequiredtoestimateacurrentmarketvalue.Thismaybeareasonableguidetotheimmediateliquidationvalueoftheassetbutitoffersfewcluesttheultimaterecoveryvalue.Evenifriskofficersareobligedtolookattheformeritisthelatterfigurethatmattersmoretoshareholders.Thesecond-roundimplicationsofthisaccountingchangearecatastrophic.Crediinstitutionsrelyincreasinglyonthecapitalmarketstofundtheirbalancesheets.Forexampletheasset-backedcommercialpapermarkethasfeaturedprominentlyasasourcoffundingforMBSs.Howeveraplungeinthevalueoftheunderlyingassetbecauseof 8CROSSBORDERCAPITAL60708090100110120080220060804200608062006080820060810200608122006080220070804200708062007080820070810200708122007USBillionsTotalAsset-BackedNon-AssetBackedTheimportanceofliquiditymustbequicklyrecognisedbypolicy-makers.ItwilltakelongerforliquiditysimportancetofilterdowntoacademicsanddisplaceoratleastcorrectModernFinancetheorybuthopefullyrecenteventswillproveacatalyst.TheFedsMarch7thannouncementfollowedupafewdayslaterbysimilarco-ordinatemoveswithotherkeyCentralBanksnotonlytakesemphasisawayfromtheinterestrateleverbutalsoacknowledgesthattheproblemhasbeenalackofliquidity.ItisnotustpoordistributionofliquidityasmanyCentralBankershaveuntilrecentlybeenclaiming.Thewhoppingscaleoftheliquidityinjectionmaythistimeprovesufficient.Wehavenotedinpreviousreportsthatthenormalliquidityresponsetofinancialcrisesultimatelyresultsinacirca15jumpinCentralBankcredit.SohowwillthelatestinfusionmeasureupFigure6runsthroughthemath.InnewmoneytermstheUSFedsMarch2008announcementsadduptoanadditionalUS300billionofnewmoneyorperhapsasmuchasanadditionalUStrillionifwecounttheUSTreasurysTIOprogrammetoo.Thiscompareswithexistingfine-tuningoperationsofUS18.6billionpriortothecrisisandwiththeextraUS125billionthathadbeencommittedbylastDecemberalbeitoffsetsomewhatbylowerpermanentholdingsofTreasuries.ItalsocomparestotheprevailingandstillrealisticUS300billionestimatesoflossesfromthesub-primdebacle.ScaledbythesizeoftheFedsbalancesheetthisinjectionrepresentsa50boost.Whatsmorethelendingtermhasjumpedfromapre-crisisaverageof3.8daystanestimated16.2daysfollowingthesenewmeasuresandataninterestratsignificantlybelow32.fearsoversub-primedebtcanseriouslythreatenre-financing.Theshortdurationofthisfundingsourcemeansthatcollateralistestedandtestedagainduringthison-goingrefinancingprocess.Avoidingaviciousdebtdefaultcirclemaythereforebedifficult.SeeFigure5.SourceCrossBorderCapitalUSFederalReserveFigure5.USAsset-BackedCommercialPaperMarket2002-2008USDollarMillionsWeekly2Latest2.84forMBScollateralversus2.99FedFundsConclusionThinkLiquidityAndDuration CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveFigure6.MeasuringTheFederalReservesLiquiditySupportOperations200708USDollarBillions3Current14-dayoutstandingUS102billionbutrecentlyreachedUS225billionFeb8th2008.The200708creditcrisishighlightsproblemsattheheartofModernFinancetheoryanCentralBankpractice.Itrevealshowfarpolicy-makershavebeenhood-winkedbycertaiacademics.ParadoxicallytheexistenceoftheveryinstitutionsthatcomprisefinancialmarketsdeniesModernFinancetheorybecauseintherealworldmarketsarenoperfect.ModernFinanceignoresliquidityorstrictlyalwaysassumesperfectliquiditywheredurationautomaticallymatchesdesiredduration.Arbitragepossibilitiesarassumedtobegettherequiredliquiditytheyneedandinturntheresultingtransactionscreateanefficientmarketwhererisk-adjustedvaluesequalprices.ModernFinanceconsequentlyfocusesontimepreferencenotliquiditypreference.Inrealityliquiditycomesfirstitpermitsarbitragewhichinturnestablishesmarketefficiency.Thushedgefundsneedtotakeliquidityfromthemarkettheydonotgiveliquidityasisthepopularassertion.AttheotherextremeKeynesiansfocusonliquiditypreferenceandignoretimpreference.Bothfacetsareimportantandbothdefineduration.Durationbridgeeconomicsandfinancebycombiningtogetherliquiditypreferenceandtimepreferenceintoaconceptwedubliquidityovertime.Liquiditypreferencebyitselfcannotexplainwhythepricesoflongdurationassetsfallmorethanshorterdurationassets.Inotherwordsinafinancialcrisiswhynotsellafive-yearGovernmentsecuritytoraisecashratherthana10-yearcorporatebondEquallysellingmorelong-durationassetsratherthancurtailingthesupplyofshort-terliquiditycanprobablyhaltanassetbubble.Lookedatanotherwayliquiditypreferencedescribesaprocessofmaturitytransformationnotliquiditytransformationthelatterisexplainedbyduration.HoweverCentralBankersactasiftheformerisalwaystheproblemi.e.theyoftenignorethepossibilityofcreditdeadlockthestoryof200708.GrossMar08NetMar08NetDec07NetJun07TermDaysRepos10010056.818.46.2DiscountWindow0.20.23.80.21TAF10010060028TSLF2002000028USSwaps3636240NATIO32000003.5TOTAL636.2436.2144.618.616.2AsFedCredit73.450.316.62.2OffsetbyreductioninTreasuriesBoughtOutright-77.0-20.7 1CROSSBORDERCAPITALGlobalViewJuly2007MarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comCROSSBORDERCAPITALFaceup.Thisisanotherbubble.Muchlikeits1980sand1990scounterpartsbutwithadifferentfocusanddifferentname.RealassetshavereplacedJapanandTechnologysharesasthemaniasfocusbutthedriverofeasyandabundantcreditremainsthesame.Thusmarketsaretreadingasimilardecade-longpaththatwilllikelyendinrisinginflationcrashingassetpricesandaneconomicrecessionofuncertaindimension.Yetsomethingsaredifferent.ThescaleofthecurrentAsianandChinesecreditboomsdenominatedastheyeffectivelyareinUSdollarssuggestanotheriteration.Goldlookstobeacompellinghavenbutothercommoditiesmayalsocomeouttheothersidestrongernotweaker.TheNikkeiNASDAQNottingHillWaitingToPopDjvuWorldmarketsaretreadinga10-yearpaththatlooksremarkablysimilartothosewhorememberthe1980sand1990sbubbles.TheseearlierdecadesfeaturedstrongandoftenirrationalassetpricegainsfirstJapanesesharesandTokyorealestateandthenUStechnologyshares.Eachdecadewastoppedandtailedbyrecessionsandpunctuatedbyamid-termcorrectionthatwaslargelybroughtonbyinflationfearsamongpolicy-makers.Althoughtheseinflationfearsinitiallyprovedill-foundedbydecade-endtherealityofrisinginflationhadforcedCentralBankstotightenandsoprecipitatetheassetpriceslumpsthatledontosharpeconomicslowdowns.SourceCrossBorderCapitalFigure1.StylisedCreditAssetPriceCycleIfthethemebehindeachassetmaniadifferedineachdecadeJapan1980sTechnology1990sandRealAssetse.g.UKandUShousingcommoditiesand4Year3215678910SlowRecoveryBasedonConsumerAssetBubbleRecessionRecessionCapexBoomInflationCorrectionInflationThreatExaggeratedCentralBanksQuickToEaseInflationARealityCentralBanksTightenAssetBoomAB 2CROSSBORDERCAPITALSourceCrossBorderCapitalprivateequity2000stheunderlyingdrivernamelyeasyandabundantcreditwasunswerving.Butweshouldalsoremindourselvesofothersimilarcharacteristics.Eachdecadehadtwohalves.Householdshavefrequentlyledtheeconomyoutofitsinitialrecessionuntilburdenedbyanincreasingtake-upofdebttheirspendingslowedintothesecondhalf.Theplaceofconsumerspendingwastakenbycorporatespendingonnewcapitalinvestment.Theseinvestmentboomssubsequentlyspilledoverintoassetmarketsandultimatelytriggeredhigherinflation.Notsurprisinglybondmarketstendedtoperformwellintheearlyyearsofthedecadeandlesswellinthelateryears.Stocksontheotherhandsustainedablisteringpacetowardsthedecadeend.CouldwebeinforarepeatFigure2.GlobalLiquidityCycle1965-2007Index0-100Sharepricesareaccordingtoourresearchthemostliquidity-sensitiveassetclass.Thustheyeventuallybecomethefocalpointofeachmaniaasthecreditpeakapproaches.Moreoverexperienceshowsthatsharepricereturnsdemonstratepersistencei.e.therearestrongtrendsbothupanddownandlumpinessi.e.largegainsandlossesarelikely.Inmanywayssharepriceshavelaggedthusfarinthebullmarketandprobablyneedtocatchupwithrealestateandcommodities.Somelargeandsustainedgainsmaylieahead.ForexampleFigure3showsthatWallStreetsPEmultiplehasfallenoverthepastthreeyearsaremarkableanduniquefactinasupposedlyliquidity-drivenmarket.IssomethingunusualholdingthembackTherearetwoconstants.FreeMarketCapitalismsdefiningtraitshavefeaturedasmuchinthepastfiveyearsandinthepasttwenty-fiveyearsastheyhaveovertheentiretwohundredandfiftyorsoyearsofcapitalistevolution.Thesetwinpillarsarethe1Productivityofindustrialcapitaland2elasticityoffinancialcapital.Inshortfallingcostsandrisingcreditarethenorm.Butthisdecadetheyhavebeenservedupwithtwounusualaccompaniments3Lowrealbondyieldsand4lowfinancialmarketvolatility.656667686970717273747576777879808182838485868788899091929394959697989900010203040506070809101112020406080100020406080100LooseTightIndexIndeUKBankingCrisisDJIASellsAt6xPeakEarningsSoaringCommoditiesUSCreditSqueezeSterlingCrisisPennCentralBankruptUSFiscalSpendingBoomInflationaryBoomEndOfBrettonWoodsVolkerFedReaganElectionLDCDebtCrisisFailureofContinentalIllinoisPlazaAccordWeakUSJapaneseBubble1987CrashScandinavianBankingCrisisUSSLCrisisJapaneseTighteningMexicoPesoCrisisEmergingMarketBoomBondCrashAsianCrisisRussianCrisisY2KLouvreAccordEnronWorldcom19721977198219871992199720022008200020052010ABAABBA656667686970717273747576777879808182838485868788899091929394959697989900010203040506070809101112020406080100020406080100LooseTightIndexIndeUKBankingCrisisDJIASellsAt6xPeakEarningsSoaringCommoditiesUSCreditSqueezeSterlingCrisisPennCentralBankruptUSFiscalSpendingBoomInflationaryBoomEndOfBrettonWoodsVolkerFedReaganElectionLDCDebtCrisisFailureofContinentalIllinoisPlazaAccordWeakUSJapaneseBubble1987CrashScandinavianBankingCrisisUSSLCrisisJapaneseTighteningMexicoPesoCrisisEmergingMarketBoomBondCrashAsianCrisisRussianCrisisY2KLouvreAccordEnronWorldcom19721977198219871992199720022008200020052010ABAABBA CROSSBORDERCAPITALSourceCrossBorderCapitalSPFigure3.ChangeInUSLiquidityAndChangesInSPCompositePEMultiple1975-2007Itisthesetwolatterfeaturesthatneedexplainingratherthansky-highassetpriceswhichshouldalmostnaturallyfollow.WestronglybelievethatlowfinancialmarketvolatilityrestsalmostentirelyonthewayCentralBanksnowmanagemoney.Thismayinpartexplainlowrealbondyieldsbecauseinflationriskpremiawillbelower.Howeverlowyieldsalsolikelyhideamoresinisterthreat.Andthisprobablydemandsamorethoughtfulfutureassetallocation.BondsAsARiskBarometerCapitalismhasbeenunflatteringlydescribedasasystemofcreativedestruction.Amoreappropriatemonikeriscreativedeflation.Capitalistindustryisalwaystryingtocutcostsandreducepricessoastostealamarchoncompetitors.Rapidoutputgrowththereforetendstocoincidewithfallinginflation.OnthefaceofthingswithWorldGDPgrowthhummingata5annualclipitseemschurlishtodoubtthecurrentstrengthofproductivity.Howeverthathasbeenournaggingconcern.DespitethestrengthofglobaloutputtheWorldeconomyisnotasrobustasmanybelieve.IndeedbondmarketsarewitnesstothisforhowelsecanweexplainlowrealyieldsTheconsensusarguesthatlowrealyieldsareexplainedbythesavingsglutasinvestorsbidupbondprices.NotonlydoesthisideamuddletheconceptsofhighsavingsandexcesssavingsbutitalsofailstoaddresswhycurrentlyhighsavingsdonotalsomeanhighinvestmentCapexintheDevelopedWorldeconomyiscuriouslysubdued.Therealityisthatcausationrunstheotherwaynotfrombondmarketstotherealeconomybutfromtherealeconomytobondmarkets.ThuslowrealyieldsreflectasimilarlylowrateofcapitalproductivityacrossWorldindustry.Wehavepreviouslyestimatedthatcapitalproductivityatthemargini.e.onnewprojectsacrossthemajorindustrialeconomiesisrunningatanaverageofaround2inrealterms.PlainlyifWorldGDPisgrowingat5thistellsusthatthenetcapitalstockisexpandingatcloseto3perannumorroughlyequivalenttoanannualriseincapitalpermanofsome1.Theparadoxisthatstockmarketinvestorsoftenconfusegrowthandprofitabilityinotherwordstheextensiveandtheintensivemargin.Investorsareoftendeludedbysalesgrowth767778798081828384858687888990919293949596979899000102030405060708-70-60-50-40-30-20-10010203040506070-10-50510LooseTightPercentagePointsYoYChangeinLiquidityAdvancedby6MonthsLHSPERHSYoYChange 4CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamFigure4.RealBondYieldsAndCapitalProductivitySelectedCountries1980-2007withoutaskingwhetherprofitmarginswillholdupandwhethertheamountofcapitalemployedcanstaythesame.Thusa5GDPgrowthratetellsusnothingaboutprofitabilityorthevalue-addedbycapital.Soviet-styleeconomieslikeChinaarerenownedformarshallinglargequantitiesofresourcesintotheproductionprocessforlowrewards.Putanotherwayifyoupushenoughsausagemeatintothemachineplentyofprobablynotverygoodsausageswillcomeoutoftheotherend.Similarlyweshouldnottogettoohungupoverwhetheroneexpensiveworkeroronehundredcheapworkersareturningthemachineshandlebecausewhatreallymattersistheproductivityofcapitalnotlabour.Foritistheproductivityofcapitalthatdeterminesthelevelofinterestrates.TheseconclusionswilllikelycomeasasurprisetomanyRealinterestrateshavelittletodowithliquidityCentralBankpolicyorrealGDPgrowth.Rathertheyshouldequatewiththemarginalrateofcapitalproductivity.ChinaistheWorldsmarginalproducerandChineseindustryhasover-expandedtocreatejobsforitinerantworkers.Thesejobsarepoliticalnoteconomic.Consequentlyprofitabilityisalesserconsideration.Westernindustrysrecentsurgeinreportedprofitsisexplainedbyincreasedreturnsfromexistingcapitalratherthannewcapital.ThisalsohighlightstheattractionsofMAoverspendingonnewcapitalequipmentwhichishitbythelowprevailingmarginalreturnsThesavingsglutmustbegaugedrelativetocreditmarkets.AddingAsiascurrentaccountsurplusestothoseforotheremergingeconomiesgivesatotalofaroundUS500billion.YetwithglobalcreditofUS67.4trillionandhavingexpandedbyUS9trillionor15.1overthepastyearthisgrowthaloneisnearlytwentytimesbiggerthanthissavingspool.Wehaveacreditboomsustainingaglobalcapitalcapacityglutnotasavingsglut.ThustherecentsurgeintheShanghaistockmarketsoweslesstogreaterprospectivedomesticprofitabilityandmosttobuoyantliquidity.ThisexplainsChinassky-highPEs.AlongsideChinesebanksbalancesheetsaregettingstretchedandtheproximityoflargepartsofthebankingsystemtoinsolvencyisfastbecomingamootpoint.80818283848586878889909192939495969798990001020304050607-5-4-3-2-10123456789101112-5-4-3-2-10123456789101112PercentEurozoneUKUSJapanUSEurozoneJapanChina02468103.52.252.2581.50.250.256GDPCapitalStockAnnualChangeRealYieldsRealGDPTrendCapitalStockAndCapitalProductivity CROSSBORDERCAPITALBankloansarethemajorvirtuallysolesourceofexternalfinanceinChinaandChinasICBCisnowtheWorldssecondlargestbankbymarketcapitalisation.BankloanstoGDPexceed140inChinacomparedtolessthan40inIndia.MoreovermorethanonethirdofnewChinesebankloansstillgotofinancetheunprofitableandlumberingStateOwnedEnterprisesSOEs.Evenofficialestimatesputbaddebtsi.e.non-performingloansNPLsat18ofGDP.Unofficialestimatessuggestbetween35-60.DatashowthattheChineseStatehasinjectedUS434billionsince1998tomaintainbanksolvencywhiletheBig4ChinesebanksalonefessuptoUS358billionofNPLs.ErnstYoungin2005putbanksbaddebtsatUS911billionafigurethatwashastilywithdrawnandlaterair-brushedoutofhistoryafterpressurefromtheChineseauthorities.ButtheremaybenoeasyendtoChinascreditboombecauseitisbeingdrivenbypoliticsmorethaneconomics.TheMiddleKingdomisfastbecomingmiddle-agedlargelyasaresultofitsearlieronechildpolicywhichtragicallyskewedtheemergingpopulationtowardsyoungmales.ThusChinaisarguablygettingolderfasterthanitisgettingricher.Todayitsmedianageis33yearsandmoreliketheWests36.6thanIndias24.3years.WorryinglyChinasmedianagewilljumpto45yearsby2050orslightlyhigherthantheWeststhenaverageandsome40ofChinaspopulationwillbeaboveconventionalretirementage.TakentogetheritmeansthattheabsolutesizeofChinaslabourforcepeaksin2009andfallsbyaroundfivemillionperannumthereafter.Inthelastdecadeandahalfnearly100millionChinesehaveenteredtheindustrialworkforceinthecoming15yearsroughly80millionwillleaveit.Resourcesthereforeneedtobemobilisednowwhiletheyexisttocreatethewealthrequiredtoaffordthisfutureretirementburden.CreditcreditandstillmorecreditwillmobiliseChineselabourandcapitalthusithelpstoexplainwhycapexiscurrentlysome45ofGDP.PushingOnALiquidityStringAsthequantityofcreditrisessoitsqualityinevitablydeclines.Alongsidethepriceofgoldincreases.CoulddeterioratingChinesecreditratherthanbadUSsub-primeloansexplainwhygoldpricesaretrendinghigherInotherwordsdomesticChineseandAsianinvestorsaremovingintoassetsthatcanmaintaintheirvaluesuchasrealestatesharesandgold.Unquestionablystructurallylowrealinterestratesbolsternominalgoldpricesbyreducingthecostofcarry.AndAmericasFederalReserveisalsofanningtheflamesbyprintingmore-and-moreliquiditywhichatthemarginisspillingoutintoChinasforexcoffersandthusallowingthePBoCtosupplythedomesticbankswithmoreliquidreserves.Whateverthecombinationoflowrealinterestratesrapidcreditgrowthandfailingcreditqualityanywherewithinacurrencyblocmeansrisingnominalgoldprices.Inourmodeltheoverallvolumeofliquiditydeterminestheslopeoftheyieldcurveandthesupplyofliquidityrelativetoprivatesectorsavingsdeterminestheexchangerate.ThusmoreliquiditybothsteepenstheyieldcurveandweakenstheexchangerateinmuchthewaythatFischerBlackfirstsuggestedtwodecadesago.TraditionallyCentralBankersalteredinterestratestoensurethatmoneysupplywasconsistentwithasystemoffixedexchangeratesanchoredbygold.Nowadaystheydotheveryreverse.Openmarket-basedmonetaryoperationsi.e.liquidityinjectionsareusedtomeetshort-terminterestratetargetsthatareconsistentwithanintermediatepolicyobjectivesuchastheTaylorRule.Thislatterruleinturngovernsafinalpolicytargetsuchassay3annualinflationandora5unemploymentrate.ThewidespreadadoptionofthesepolicyrulesbythemajorCentralBankershaselevatedinterestratetargetingabovebothexchangeratemanagementandliquidityprovision.In 6CROSSBORDERCAPITALfactliquidityprovisionistheoutcomeofshort-termmonetaryopenmarketoperationsthatareundertakentotargetinterestrates.Andsincetheexchangerateisitselfdeterminedbytherelativevolumeofliquidityitishostagetoboth.Yetviciousfeedbackeffectsmaysometimesapplybecausefluctuationsintheexchangeratewillaffectthelevelofoverallpricesandinturnchangecreditdemand.Theseunexpectedshiftsincreditdemandwillhamperpolicy-makersattemptstosetinterestrateslikelyforcingthemtopressharderontheliquiditybrakeandgaspedal.Theseliquidityswingsshouldtranslateintosimilarmovementsintheexchangerate.Wehavefoundthattheseperiodsofexchangeratevolatilityleadsequentiallyperiodsoffirstbondmarketandthenstockmarketvolatility.Lookedatanotherwaylowstockmarketvolatilitysuchasthelowvaluesoftheso-calledpriceofriski.e.theVIXindexofimpliedvolatilityontheUSSP100tellsusmoreabouttheprevailingstabilityofexchangeratesthanitdoesaboutthecomplacencyofinvestors.ButwhyarecurrenciessostableifCentralBanksareignoringboththevolumeofliquidityandtheexchangerateinfavourofinterestratetargetsTheonlyexplanationsare1Policyguidelinesi.e.theTaylorRulesaremovingpro-cyclicallywithprivatesectorsavings.Inotherwordsmoreprivatesectorsavingsencouragemorenotlessliquidityparipassu.CentralBanksthereforeaccommodaterisingeconomicactivityandrisingsavings.2CentralBanksaresecretlytargetingexchangerates.InfactbothmaybetruewhiletheUSFedtheECBtheBankofJapanandtheBankofEnglandareprobablyunilaterallyfollowingTaylorRule-typepoliciesothercountriesarelikelyshadowingtheUSdollartovaryingdegrees.Thismayalsoexplainthehighervolatilityofgoldoverpapercurrencies.AmericaremainstheWorldslargestconsumermarketandtheUSdollarisstillthelynchpinoftheglobalfinancialsystem.Amoreintegratedworldeconomyrequiresamorestablecurrencysystem.ThereforeitmakeseconomicsenseformajorexporterstopegtotheUSdollaranditmakesgoodfinancialsensefortheUSasamajorinternationalborrowerinitsowncurrencytomaintainastablevaluefortheUSdollaratleastagainstregionssuchasJapanandEmergingAsiawhicharemajorUSdollarholders.WehavepreviouslydubbedthisdimensiontheAsianDollardenotingAmericaslikelydesiretokeeptheUSunitstableagainsttheChineseRMBandJapaneseYenbutmorewillingtoseeitsoftenagainsttheEuropeancurrencies.IftheTaylorRuleismakingpolicymorepro-cyclicalthenrisingliquidityismorelikelytocorrelatewithandsustaingallopingcommodityprices.Oilpricesforexamplearemovingincreasinglyin-stepwithcredit.SeeFigure5.OntoptheelasticityoftheUScreditsystemisrisingbecauseofincreasingnumbersoffinancialinstitutionsthattakemoreleverageasassetpricesrise.Inshortthesefirmscallthemhedgefundsifyoulikeacceleratethepaceofliquiditygrowth.AccordingtoFigure6usingdataextractedfromtheUSquarterlyFlowofFundsAccountsZ1each10increaseintheassetsofInvestmentBanksandGovernmentSponsoredEnterprisese.g.FannieMaeleadstoa14.7riseintheirfinancialleverage.ThisprobablyalsotellsusthattheFederalReservehaslostitspreviouscontrolovercreditandtoturnthefamiliaradagearounditbizarrelycannowpushonastringbutnotpullonitNaturallyextraliquidityaddsfueltoassetpricesbutitalsoleadstoanincreaseinthenominalpriceofgold.SeeFigure7. CROSSBORDERCAPITAL01020304050607080737475767778798081828384858687888990919293949596979899000102030405060701020304050607080OilPricesLHSTotalCredit01020304050607080737475767778798081828384858687888990919293949596979899000102030405060701020304050607080OilPricesLHSTotalCreditUSbblUSTrilliony1.4656x-0.0563R20.3495-60.0-40.0-20.00.020.040.060.0-25.0-20.0-15.0-10.0-5.00.05.010.015.020.0AssetsLeverageSourceCrossBorderCapitalUSFederalReserveSourceCrossBorderCapitalDatastreamFigure5.GlobalCreditUSDollarTermsAndOilPricesBrentCrudeUSbbl1973-2007Figure6.FinancialLeverageOfUSInvestmentBanksAndGSEs1952-2007QuarterlyChangeFigure7.GlobalCreditGrowthAndYear-On-YearChangeInNominalUSDollarGoldPrices1973-2007-50-30-10103050707374757677787980818283848586878889909192939495969798990001020304050607-30-20-100102030405060GoldPriceChangeLHSTotalCreditGrowthSourceCrossBorderCapitalDatastream 8CROSSBORDERCAPITALGoldAndOilGoldpricesarethereforerisingbecauseofanincreaseinthequantityofcreditUSstructurallylowrealinterestratesChinaandadeteriorationinthequalityofcreditChina.Goldinfluencesothercommoditiesbecausecommoditypriceshavetwomovingparts1Aphysicalexchangeratiowithgoldreflectinglong-termproductivityandtechnologyfactorse.g.oilgoldratioinbblsoz.2Nominalpriceofgold.Theproductofthesetwofactorsdeterminesthenominalcommodityprice.Figure8showsthattheoilgoldratioshowninitsmoreconventionalformastheratioofgoldtooilforexamplehasprovedremarkablystableovertimearoundanaverageofroughly12timeswithtemporaryfluctuationsawayfromequilibrium.Inshortoverthelongtermtheriseinoilpricesowesmosttotheseculardeclineinthevalueofthepaperdollarthantohigherproductivitywithineitherindustryorgreaterphysicaluse.Recentmovementsintheoilgoldratioagainstbullionlikelyreflectthegrowinginelasticityofglobaloilsupply.Withnon-OPECsupplieslikelyonaplateauOPECsupplyandparticularlySaudiArabiansupplymayhavebeencompromisedbytoorapidratesofrecentextractionusingmethodsthatdetractfromlong-termsupply.OPECmembersarenowproducingonembdmillionbarrelsperdayfewerthantheywereayearagowhileoildemandisroughlyonembdhigheratmorethan84mbd.Theinevitableresultisfallingoilinventoriesinthelastquartertheydroppedby0.14mbdcomparedtoanexpectedseasonalriseof0.84mbd.SaudiArabiafacesseveredemographicchallengeswithitsrapidlygrowingyoungandincreasinglyunemployedpopulation.Withfertilityataremarkablyhigh3.94China1.75USA2.09and38.2ofthepopulationalreadyagedunder20yearsChina20.4thesepressuresontheSaudiAuthoritieswillswell.Notsurprisinglymaximisingtheirnear-termoilrevenueshasbeencriticalbutdotheystillenjoytheflexibilitytoactastheswingproducerabletoturntheoiltapson-and-offHencetheoilgoldratiomaystayhigh.Similarcommodityratiosexistbetweengoldandsteelgoldandwheatgoldandnickeletc.Thepointhereisthatasmorecreditpushesupthenominalpriceofgolditotherthingsbeingequalmustalsopushupthenominalvalueofallcommoditypricesmeasuredinthatcurrency.Ifweaddinthelikelihoodofastrongcredit-fuelledChineseeconomythenitsvoraciousappetiteforresourceswillforceupthephysicalexchangeratiosbetweenallindustrialandfoodcommoditiesagainstgold.StrongChineseandemergingmarketeconomicgrowthmayhaveinitiallypushedupoilandcommoditypricesbuttheirrisehasbeensustainedbycontinuedinflowsofcredit.FacingcomparativelybenigndomesticinflationaslowingAmericaneconomyanddebthiccupstheUSFederalReservehasbeenabletoacceptrapidcreditgrowthandattimesencourageit.ThefactthattherestoftheWorldparticularlyemergingmarketsisfeastingfromthiscreditbubbleisstrictlyoutsideoftheUSFedsconcerns.AndjustsupposethatwearelookingatthebeginningsofthelongsecularadvanceofAsiaandthestartoftheseculardeclineofAmericaFederalReservemonetarypolicycanconsequentlystayeasierforlongertherebyfuellingapotentiallybiggerAsianboombustcycle. CROSSBORDERCAPITALOfcoursethisargumentcanworkbothways.Acreditbustwillforcecommoditypricesdown.Howeverconsidertwothings1Acreditcollapsemaythreateneconomicgrowthandthereforedentcommoditygoldratiosbutitmayalsosignificantlyboosttheshort-termattractionsofgoldasasafehaven.Goldinrealtermsmustrise.2PotentiallyweakandmaybeveryweakeconomicactivitywilllikelyforceCentralBankstoreactbyinjectingmassivedosesofliquidityintotheircash-strappedfinancialsystems.Goldinnominaltermsmustriseandothercommoditypricesshouldstabilise.SourceCrossBorderCapitalFigure9.OilGoldAndCreditCreditGoldOilChinaSaudiArabiaUSACreditCreditGoldGoldOilOilChinaSaudiArabiaUSASourceCrossBorderCapitalDatastreamFigure8.TheGoldOilPriceRatio1793-2007AnnuallyRatioGreatDepression1930sDepressionPost-WarBoomChinaBoom1987CrashExcessDemandForGoldExcessDemandForOilNormal12-15x0510152025303540179318011809181718251833184118491857186518731881188918971905191319211929193719451953196119691977198519932001 10CROSSBORDERCAPITALCROSSBORDERCAPITALLIMITEDMARCOLHOUSE289-293REGENTSTREETLONDONW1B2HJTELEPHONE02075350400FACSIMILE02075350435REGULATEDBYTHEFSACROSSBORDERCAPITALLIMITED2007.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitu-tionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.SourceCrossBorderCapitalDatastreamFigure10.GoldPricesUSDollarsoz.1980-201072747678808284868890929496980002040608100200400600800100002004006008001000USoz.ItshardtopredicttheendofassetbubblesbutjudgingfromprevailinglowinflationcontinuedcreditgrowthandtheChineseauthoritiesprioritiesashostsofthe2008Olympicsand2010WorldTradeFairwehavenotreachedtheequitypeakyet.Yetifworldeconomicgrowthisascredit-dependentaswesuspectifChinaisdepressingmarginalreturnsoncapitalgloballyatthecostofrisingNPLsinherbanksandiftheSaudishavelosttheirtraditionalcontroloveroilsupplythengoldmayultimatelyprovetheassetofchoice.TheGoldenTriangleSaudiArabiaChinaAndAmericaCapitalismfeaturesfallingcostsandrisingcredits.Usuallythesegohand-in-handbuttodayelasticAmericanliquidityishelpingtofinancestrongChineseproductivity.Wehavearguedthatthisgeographicalsplitexplainswhyrealinterestratesareatastructurallylow2andfinancialmarketvolatilityisdepressed.Thecommodity-intensivenessofChineseeconomicgrowthhashelpedpushresourcespriceshigher.ThegrowinginelasticityofoilsupplyparticularlyinSaudiArabiahasmadeoilpricesaparticularwinner.Risingcreditqualityandlowrealinterestratesinturnhavealreadyboostedthepriceofgold.ThepotentialcreditbustinChinasflakybankingsystemsuggeststhatgoldpriceshavealotfurthertogo. 1CROSSBORDERCAPITALTheymayhaveshowereduswithanavalancheofacronymsthatadduptoasmuchasUS600billionofliquiditybutitisunclearhowfartheFediscommittedtofurthermonetaryeasing.WorryinglytheMarchstep-upintemporaryopen-marketactivityisbeingoffsettosomeextentbyasharpreductioninliquidityelsewhereinthesystem.Thenetresultmaystillmeanpatheticallyweakon-goinggrowthinFederalReservecredit.TheUSdollarshouldserveasinvestorslitmustestastrongdollarreboundprobablyconfirmsthattheFedisbeinglessaccommodativethatitclaims.ButastrongUSdollarspellsbadnewsforthosecrowdedtradesemergingmarketsandcommodities.CROSSBORDERCAPITALGlobalViewMarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comDissentInsideTheFedApril2008CreditCrunchWeremainselectiveinouruseofthetermcreditcrunch.Figure1highlightsthegrowthofbroadUSprivatesectorcreditandUSFederalReservecredit.Figure2breaksdownthesourcesofbroadUSprivatesectorcreditfrombanklendingthroughtocommercialpaper.TheblacknessofthestorieswrittenaboutcreditsincelastAugustsharplycontrastswiththeconsistencyofitsexpansiondetailedhere.Thereappearsnoevidenceofanywidespreadcreditslowdownsofaryetaloneacrunch.Acrunchhasoccurredincommercialpaperandbetweenbanksbutthishasnotyetbeenpassedontothewidereconomy.BanklendingandlendingprovidedbythegovernmentsponsoredenterprisesGSEshavebeenespeciallybuoyant.Togetherthesecompriseroughlytwo-thirdsofoverallUScredit.Commercialpaperwasintheeyeofthecreditstormandsankdramaticallybuthaslatelystabilised.ConsumercreditandsecuritisationdatabothshowweaktrendsbutthesepredatedtheAugustcrisis.OverallUScredithasgrownbyanaverageUS141.6billionpermonthoverthepasthalf-yearequivalenttoanannualclipof7.3.737475767778798081828384858687888990919293949596979899000102030405060708-505101520-505101520BroadCreditFedCreditSourceCrossBorderCapitalUSFederalReserveFigure1.USPrivateSectorCreditAndFederalReserveCredit1973-2008AnnualPercentageChanges 2CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveFigure2.BroadUSCreditGrowth2007-08MonthlyUSDollarBillionsEEstimate.BanksFinanceHousesOtherConsumerCreditGSEsCommercialPaperSecurit-isationTotalCreditUSTrsMoMChg.USBnsChg.YoYChg.3mAnn.3-MonthAnnualisedChange19.7896.39.58.19.10.77.18.728.03.119.93153.19.28.910.31.5-1.79.816.57.919.9844.08.66.15.32.9-12.911.85.06.120.0466.17.95.45.54.1-9.412.012.2-2.320.22179.57.85.94.82.4-0.714.433.6-7.320.35121.37.87.68.3-1.32.813.743.9-7.620.51159.98.09.58.62.7-5.714.346.3-0.120.515.37.15.811.95.70.813.2-37.11.420.64130.97.45.915.76.64.414.6-56.33.820.78133.87.15.418.3-1.011.916.0-64.13.020.91130.97.17.917.6-4.65.516.0-43.83.320.9872.96.66.711.8-2.211.818.6-43.62.721.13148.46.87.010.0-1.18.515.6-25.23.121.24111.06.56.56.9-1.48.916.5-17.83.921.49252.87.610.113.2-2.23.013.56.96.7J07FMAMJJASONDJ08FMe CROSSBORDERCAPITALLatestdatafeatureanawesomepick-upinGSElending.Figure3showsthegrowthinFannieMaeandFreddieMacscombinedbalancesheetrelativetooverallcreditgrowth.NotforthefirsttimetheyarebeingusedbytheUSauthoritiestosupportmarkets.DespitetheconcernovertheirlackofequitycapitaltheGSEsoperateunderanimplicitUSStateguarantee.Thisattractsforeignbuyers.OftheUS435.2billionincreaseinGSElendingsinceend-August2007atleastUS132billionorroughlyone-thirdhasbeenfinancedbydebtsalestoforeignCentralBanks.CynicsmaythusnotethattheChineseGovernmentisimplicitlybailing-outtheUSmortgagemarketSourceCrossBorderCapitalUSFederalReserveFigure3.USCreditAndGSELending1994-2008AnnualisedThree-MonthPercentageChange9495969798990001020304050607080481216202404812162024YoYChg.TotalUSCreditGSEsThusatfirstsighttheoutlookforUSfinancialmarketslooksfarbetterthantheconsensusbelieves.ThetwomostimportantfinancialmarketsinAmerica1theUS14.6trillionmortgagemarketand2theUS9.2trillionrepo1andcommercialpapermarketarebeingfixed.BotharebiggerthantheUS6.8billionofbankloansandUS5.1trillionofTreasuriesoutstanding.SummarisingMortgagebailoutisbeingledbytheGSEsi.e.FannieMaeFreddieMacandFederalHomeLoanBoard.RepomarketbailoutisbeingdrivenbytheFederalReserveandTreasurye.g.TIOTAFPDLFetc.USprivatesectornetcashflowssoaringe.g.currentaccountdeficitshrinking.OntoptheadjustedTIPSindex-linkedbondyielddatashowamoreaggressivepick-upinexpectedinflation.Thisisinlinewithrecentpoorliquiditytrendsthatlikelyraisedtheactualyieldonindex-linkedsecurities.TogetherallfourfactorsareforcingUSyieldcurvestosteepenacrossallmaturities.IfpastcyclesserveasaguidethispositiveyieldspreadwillpersistforseveralquartersmaybeevenyearsSeeFigures4and5.1WehaveusedNewYorkFedgrossdataandincludedreposandreversereposoutstanding. 4CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveFigure4.USLiquidityCycleAndUS3010YieldCurve1980-2008YieldCurveSteepening8081828384858687888990919293949596979899000102030405060708020406080100-50050100150IndexBasisPointsLiquidityRisingOverallLiquidityLHS3010YieldCurveRHSSourceCrossBorderCapitalUSFederalReserveFigure5.USYieldCurvesVariousMaturitySpreads1980-20088384858687888990919293949596979899000102030405060708-200-1000100200300-200-1000100200300BasisPoints30Y10Y10Y2Y2Y3MOutsideTheFedLetusbrieflyrecaptheimportanceoftheUSrepomarket.Therepomarketanditssistermarketincommercialpapermakeupwhatiscommonlydubbedthemoneymarket.Wearesomewhatuncomfortablewiththisdescriptionbecauseeverymarketinamonetaryeconomyisstrictlyamoneymarket.Figure6showsthegrowingimportanceoftherepoandcommercialpapermarketsrelativetotheUSTreasurymarket.FortyyearsagotheUSTreasurymarketwasroughly40timeslargertodaytheTreasurymarketisroughlythesamesizeinnetterms.Thesametablehighlightshowmuchthefundingofbankshaschangedovertime.Againsomefortyyearsagovirtuallyallbankcreditwasfundedfromdeposits.Todaythefigurehasfallentobarely70butifwealsoacknowledgethatthedominanceofbanksascreditprovidershasslippedsignificantlythendepositsmakeuplessthanonethirdoftotalUS CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveFigure6.GrowthAndImportanceOfTheUSRepoMarketUSDollarTrillionsSourceCrossBorderCapitalcredit.Thegaphasbeenfilledbythewholesalemoneymarkets.Banksnowobtainsome28oftheirfundingrequirementfromthecommercialpaperandrepomarkets.AndtheUSFederalReservecontrolsthetempoofthisre-financingprocessthroughitsownrepoactivities.Figure7approximateshowthefinancialsystemhaschangedcomparedtothestandardtextbookmodel.Nolongerdoesthemoderncreditsystemrestonabaseofreservesthatstandinsomefixedrelationshiptodepositsandthatinturnlimitthegrowthoflending.Financialde-regulationscotchedthedeposit-reservemultipliermodelinthe1980sbyturningbanksintoinvestorsandinvestorsintobanks.Thislevellingofthefinancialplayingfieldforcedregulatorstode-emphasisecontrolthroughbankreservesandprecipitateditsreplacementwithcapitalratiocontroli.e.theso-calledBaselIIIrules.Sadlyfortheregulatorsclevercreditprovidersdiscoveredoff-balancesheetlendinge.g.theinfamousSIVsandside-steppedcontrol.Figure7.CreditSystemsOldAndNewUStrillions1965198019952007BankCredit0.311.273.609.16MortgagesSecurityLoans0.200.291.193.97As28.830.844.958.5BankDeposits0.301.012.596.59AsCredit96.879.571.971.9ReposCP0.010.200.672.55AsCredit1.915.818.627.8MemoRepoMarket0.00.120.662.57CPMarket0.010.120.681.79USTreasuries0.350.733.615.10TimesRepoCPMarket38.9x3.0x2.7x1.2xOldWorldNewWorldDepositsReservesAssetsLoansReservesMoneymarketsAssetsLoansCPRepo 6CROSSBORDERCAPITALInsideTheFedThepuzzlesincelastsummershiatusisthattheUSFedhaslargelyencouragedmarketsfromthesidelinesandofferedlittlerealsupport.IndeedCentralBankersinWashingtonLondonandTokyohaveconsistentlyarguedthatcreditproblemsconcernthedistributionofabundantliquidityandNOTitsoverallscarcitytheECBhavebeenmoreequivocalbutifpressedeventheywouldleanmoretowardsthedistributionargumentratherthanscarcity.Wefeeltheyarewrong.Wideningcreditspreadsandrecentlyflatinvertedyieldcurvesareunambiguousbarometersoftightliquidity.Howevermisguidedpolicy-makersarenotahelpfulbackdropforhealthyfinancialmarketsSourceCrossBorderCapitalUSFederalReserveThegyrationsofthecreditcyclearenowcommandedbyCentralBanksthroughtheirrepomarketactivities.Inturnassetvaluesfeedbacktoeitherfurtherencouragelendingbyenhancingcollateralortodestroycollateralandrestrictlending.OntopaswehavearguedelsewherethepersistentlowappetiteofWesternindustrialcompaniesforcredithasforcedlendersintounfamiliaravenuessuchassub-primemortgagesandprovidingleverageforhedgefundsviaprimebrokers.ThedauntingfinancialproductivityofWallStreethasenabledcreditprovisiontorocketoutpacingtraditionalmoneysupplyby2foldoverthepast25yearsandmakingitincreasinglysupply-driven.All-in-allthesefactorsinteracttomakethecreditcyclepotentiallyfarmorecyclical.Figure8.USFedAndRepoMarket2001-2008TheclosecorrelationbetweenFederalReserverepoactivityandthewiderswingsinoverallrepomarketactivityishighlightedinFigure8.TheFedapparentlyleadsbyaroundsixweeks.IfaswehavearguedoverrecentmonthstheFedplayssuchanimportantrolethenthedropinthescaleofFedrepoactivityakaliquidityinjectionsstartingfromFebruary2007andrecurringinJulySeptemberandJanuary2008musttakealargepartoftheblameforthecreditturmoilSeeFigure9.OntopFigure10showstheaveragelendingtermintherepomarkets.AheadoftheAugustcrisisitdroppedtoanunbelievable3.8days.Inotherwordsthemajorcreditprovidersnowforcedtofundbetween30-70oftheirbalancesheetsthroughreposratherthantraditionaldepositshadtosubjectthemselvestoaLawofRe-financeakintotheoldLawofRe-fluxundertheGoldStandardroughlytwiceeveryweek.Againstthebackdropofshrinkingcollateralinthesummerof2007thisprovedimpossible.-40-200204060801001201411200114022002140520021408200214112002140220031405200314082003141120031402200414052004140820041411200414022005140520051408200514112005140220061405200614082006141120061402200714052007140820071411200714022008-30000-20000-10000010000200003000040000500006000070000OverallReposFedReposSix-WeekLead CROSSBORDERCAPITAL3456789011920060217200603232006042520060525200606282006073120060831200610042006110620061208200601112007021420070316200704192007051820070621200707232007082120070920200710182007111520071211200701072008020520080304200803282008Days5dMovingAverage3mMovingAverage50607080901001101201301401500119200602242006040420060511200606192006072720060905200610132006112120060102200702082007031920070425200706012007071020070813200709192007102320071121200712242007012820080229200804012008USBillions14dRollingTotal6mMovingAverageFebruaryCrisisAugustCrisisOctoberCrisisJanuaryCrisisFigure9.DailyRepoMarketOperations2007-2008USDollarBillionsFigure10.AverageLendingTermInRepoMarkets2002-2008DaysSourceCrossBorderCapitalUSFederalReserveSourceCrossBorderCapitalUSFederalReserveOurcurrentconcernisthatwhatnewliquiditytheFedgiveswithonehandfollowingtheavalancheofacronymsinMarch2008e.g.TAFPDCFTSLFitistakingawaywiththeother.Figure11showsourestimatesofthelikelystep-upinso-calledtemporaryopen-marketoperationsannouncedlastmonthinbothgrossandnetornewmoneyterms.TheTAFTermAuctionCreditFacilityananonymousauctionofcollateralisedfundstosome7000bankinginstitutionsisanunambiguousinjectionoffundsthatcircumventstheapparentstigmainusingthetraditionaldiscountwindowandwasraisedtoUS100billion.AlongsidetheFedannouncedtheTSLFTermSecurityLendingFacilityprogrammethatallowsprimarydealerstoswapqualitymortgage-backedsecuritiesintoUSTreasuries.Thismakesassetsmoremarketablebutdoesnotaddtonetsystemliquidity.Howeveritmayboostliquidityiftheprimarydealersthenusethepost-BearStearnsPDCFPrimaryDealersCreditFacilityforcollateralisedborrowing.TheUSTreasurysextantTIOTermInvestmentOptionprogrammesimilarlydoesnotaddtonetsystemliquiditybutrecyclesUSGovernmentcashbacktomarketsthroughanauctionsystem. 8CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveGrossMar08NetMar08NetDec07NetJun07TermdaysRepos10010056.818.46.2DiscountWindow0.20.23.80.21TAF10010060028TSLF2002000028USSwaps3636240NATIO2000003.5TOTAL636.2436.2144.618.616.2AsFedCredit73.450.516.62.2Figure11.EstimatesOfPotentialFederalReserveLiquidityBoostMarch2008AtfirstsighttheserecentprogrammesmayboostFedCreditbyawhopping50-60.Howeverlate-Marchandearly-Aprildatarevealthattheseinjectionsarebeingoffsetbyreducedliquidityelsewhere.TheFedspermanentholdingsofUSTreasurieshavedroppedsharplyleavingoverallFedCreditgrowthlanguishing.SincethecrisisstartinglastAugustUSFedcredittomarketshasgrownbyadismal0.5annualisedrate.The196667bankingcrisissawFedCreditincreaseatanannualised4.6inthe197576crisisgrowthwas7.3in1991928.0followedbyasimilar9.4asthatcrisislingeredinto199394.The1998RussiaCrisisandsubsequentfall-outforUSbankstriggeredFedcreditgrowthof8.8aheadofY2KtheFedexpandeditsbalancesheetbyawhopping27.7andbyafurther17.6annualisedinthewakeof911.InshortduringpastcriseswhensupportwasneededtheFedrespondedbyraisingitscreditgrowthbyanaverageannualised11.9cliptodays0.5responsehardlyfiguresSeeFigure12.SourceCrossBorderCapitalUSFederalReserveFigure12.FederalReserveResponseToPreviousCreditCrisesAnnualisedGrowthInFedCreditDuringCrisisMonthsOrSixMonthsFollowingKeyEventFigure13examinestheFedsrecentactionsinmoredetail.Calculationsthroughtoearly-April2008showasizeableincreaseintemporaryopenmarketoperationsbutalsoasizeablefallinso-calledpermanentopenmarketoperations.TreasuriesboughtoutrighthavefallenbyawhoppingUS152.6billiontoUS560.8billionsinceend-05101520253027.717.69.48.88.04.67.3Y2K9119394Russia9192757666670708Growth CROSSBORDERCAPITALFebruarywhereastemporaryoperationsincludingrepostermauctioncreditfacilityTAFandtheprimarydealerscreditfacilityPDCFjumpedbyUS157.4billion.Inotherwordsaftermuchwheel-spinningtheFedsbalancesheetadvancedbyameaslyUS4.8billion.Progressyesbutnotmuch.ThepositivenewsisthattheFedisfinallyfocussedontheall-importantrepomarketsbutthedisappointingaddendumisthatfundsarebeingtakenfromelsewhereanear-zerosumgame.AdmittedlyitisstillearlydaysandprematuretoaccuratelyjudgetheFedsprogrammeyetweurgesomecautionmarketsdoubtlessdeservetobouncebutinvestorsstillfaceanamberlightandnotyetafull-ongreen.SourceCrossBorderCapitalUSFederalReserveFigure13.BreakdownOfUSFedCredit2002-2008WeeklyUSDollarBillionsWerecaughtbetweenthinkingthissluggishsupplyofFedcreditissimplyanerrororthatitisdeliberatepolicy.TheFedisweddedtotargetinginterestratesandremainsconvincedthatprovideditfindstheneutralratethemarketswillcreatesufficientoverallliquidity.YetasFigure14highlightstherehaslatelybeenlittlecorrespondencebetweentheFedsownjudgementofitsstancegaugedfromtheTaylorRulegapandthetrueliquiditypositioninUSmarkets.Howeverifwerevertbacktothepre-1995yearswhenVolckerandanunreconstructedGreenspanruledtheFedthenusedAmericanliquidityconditionstosurreptitiouslytargettheUSdollareitherthroughinfluencingaUSdollarindexofcommoditypricesandorthenominalUSdollargoldprice.ThecurrentbackdropofnaggingUSinflationandconcernsaboutrunawayfoodpriceinflationworldwidemayhavespurredpolicy-makerstodosomethingTheAprilG7Meetingsoundedunusuallyco-ordinatedintheirdesiretostabilisecurrenciesandcontainfoodpriceinflation.AndtheJapanesePressleakedpolicydiscussionsinwhichPresidentBushallegedlyvoicedtheneedforastrongUSdollar.ItisunprecedentedforthePresidenttodiscussthecurrency.SomethingmaybeupTheimplicationhereisthatthedecreaseindesiredassetdurationandtheconsequentincreaseddemandsforliquidityimpliedbysteeperUSyieldcurveswillbemore-and-moreforcedontheprivatesectorratherthanbeingsuppliedthroughanaccommodatingFed.Short-terminterestratescouldstilldropbutwealwaysfigurethatinterestratesareaparticularlyambiguousguidetothemonetarystance.Theonlywaytheprivatesectorcangarnermoreliquidityistoworkhardersellmorethingsandslowspending.ThustheoutlookforUSretailspendingandnewhiringlookbleaktheprospectsforthenarrowingtradedeficitandlowerinflationappearmuchbetter.Financialmarketsbalancetheseinfluencesandtypicallywillrespondmosttofallinginflationoncethetroughinspendingclosesin.Wemaybegettingnearerbutwerenotyetthere.0203040506070840050060070080090010004005006007008009001000USBillionsPermanentTreasuryHoldingsTemporaryTreasuryHoldings 10CROSSBORDERCAPITALSourceCrossBorderCapitalUSFederalReserveFigure14.USTaylorRuleTargetAndActualFedFundsRateAndTaylorRuleGapAndLiquidityCycle1975-20087577798183858789919395979901030507020406080100-800-600-400-2000200400600800IndexBasisPointsLooseTightLiquidityCycleLHSTaylorRuleGapRHS78808284868890929496980002040608024681012141618024681012141618PercentTaylorRuleActualInterestRateConclusionTaylorMis-RuleInshortCentralBanksaretoointerestratefixatedandrelytoomuchontheTaylorRule.WehaverailedagainsttheTaylorRuleforyears.ThecreditturmoilofthepastyearstandsasjudgeandjurythataliquidityconditionsandnotinterestratesmatterandbtheTaylorRuleisamisguidedandinaccuratewaytooperatemonetarypolicy.ManyassumethattheTaylorRulecapturestheneutraloroptimalinterestratethatdeviationsinmarketinterestrateswillrestoreequilibriumandthatCentralBankscancontrolandfine-tunemarketinterestrates.ButCentralBanksdonotsetinterestratestheysetinterestratetargetswhichcanbeverydifferent.Apursuitofthecorrectinterestratetargetscanradicallychangeliquidityconditionslargelybecausetherateofinterestisnotthepriceofmoneyandsoitisnotestablishedinthegeneralmoneymarkets.ButapursuitofthewronginterestratetargetsasgeneratedbytheTaylorRulecandevastateliquidityconditionsandgreatlyexaggeratethecreditcycle.TheTaylorRulesetsthewronginterestrateforseveralreasons.FirstitembedsthediscreditedPhillipsCurverelationshipbetweenlowerunemploymentandfasterinflationunemploymentaffectsrealwagesratherthannominalwages.Seconditassumesaclosedeconomywhereastodaysopenglobalisedeconomiescanchannelexcessdemandpressuresthroughtheirtradeaccounts.ThusintheabsenceofherwhoppingtradedeficitAmericasinflationratemightbehigher.ThirdtheTaylorRulefunctionswithanassumptionofaconstantrealinterestrateofcirca3.Webelievethattheseculardropinthemarginalproductivityofcapitalhasalreadytippedthistoalower1.Thustargetedneutralrateswillbetoohigh.FourththeTaylorRuleignoresassetprices.Rapidcreditgrowthmayfirstshowupinrisingassetpricesandonlylaterappearinhigherconsumerpriceinflation.InthiscasetheTaylorRulewouldbealaggingpolicyindicator.Monetarypolicyhasbecomehostagetotheerrorsofacademiceconomicsandbusinessschoolfinanceprogrammes.Modernfinancetheoryseesfinancialmarketsascapital-raisingmechanismswhereastheyhaveevolvedintocapital-distributionmechanismsinthematureindustrialeconomies.Thusthebusinesscycleintheselattereconomieshasbecomelargelyacycleofassetdurationnotincomegrowth.Assuchassetdurationandliquidityaremoreimportantconceptsthanthecostofcredit.Moderneconomicsisallabouttheusesoffundse.g.consumptioncapitalspendingandnotthesourcesoffundse.g.creditandsavings.Liquidityisameasureofthesourcesoffundsandthroughliquidity 11CROSSBORDERCAPITALanditsconnectiontoassetdurationwecanestablishabridgebetweenfinanceandeconomics.LiquidityiscontrolledbyCentralBanksnotinterestrates.Changesinliquidityshowupfirstinforexmarketsbecausetheexchangerateisthepriceofmoney.Lowexchangerateandlowcommoditypricevolatilityshouldsignalanequilibriummonetarypolicy.OnceCentralBanksrealisethisandthelessonsofthelastyearhavebeenstarktheWorldwillneverbethesame.TheUSdollarmayprovethelitmustestforinvestors.AstrongerdollarlikelysignalsalessaccommodativeFed.Andastrongerdollarspellsbadnewsforthosecurrentlycrowdedtradesemergingmarketsandcommodityprices.WatchitCROSSBORDERCAPITALLIMITEDMARCOLHOUSE289-293REGENTSTREETLONDONW1B2HJTELEPHONE02075350400FACSIMILE02075350435REGULATEDBYTHEFSACROSSBORDERCAPITALLIMITED2008.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitu-tionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose. 96BakerStreetTel442079082800LondonW1U6TJcrossbordercapital.comTheMessageFromAPreviousLowMichaelHowellMay2011Thecartoonsarereproducedunderlicence.CopyrightSoloSyndicationAssociatedNewspapersLtd.WearerepublishingthisreporttwoyearsafteritfirstcameoutinFebruary2009justbeforethelowinWorldstockmarkets.TheMessageFromAPreviousLowconsistsofaseriesofprescientpoliticalcartoonswithournarrativepennedbytheNewZealandsatiristDavidLow1891-1963fromthelate-1920sonwards.ThecartoonsfocusontheDepressionandsubsequenteconomicrecoverythemonetarysolutiontheriseofextremepoliticsandtheslowbutseeminglyinevitableslidetowardsinternationalconflictthroughthelate-1930s.Lowsmainthemeswere1thedominanceofstupidityoverconspiracyastherecurringchallengeinnationallife2thefragilityofexistingmonetaryarrangementsandtheinabilityofbankersandpolicy-makerstounderstandthatmoneymustkeepcirculatingandsometimeshadtobeactivelyunfrozen3theproblemofoverproductioninAmericaandJapanduringthepost-WW1economyreadpost-ColdWareconomytoday4thefalsehopeofinternationalco-operationwhichalwaysdescendedtoselfishnationalinterestsasthenewlyemergentnationsscrambledfornaturalresourcesandlivingspace.andthe5naivetyofappeasementtowardstherapaciousfascistmilitarypowersinEuropeandAsia.Politico-economicleadershipchangesarefraughttimes.CouldtheyalsoserveasaroadmapforustodayWearenotusingthesecartoonstopredictacomingglobalconflict.Rathertheyarepointsforinvestorsandassetallocatorstoponder.WearerepublishingbecauseourgreatgrandparentsfacedsimilarchallengestousandthetimelineofLowscartoonsrevealbothcloseparallelswithtodayandthefuturepitfallswemustensurethatweavoid.WehavedividedLowsinsightsintofourgroupsratherthansimplypublishthemchronologically.Eachsectiondealswithaspecificglobalproblemrelevantboththenandnow1Overproduction2FragileFinanceand3CentralBankMonetaryDeflationPolicyInertia.Theseledontoanumberof4Consequencessuchasimperialismtradeprotectionmigrationquotasre-armamentcurrencyvolatilityinflationandover-hypedstockmarkets.ThusourcentralthoughtoverthepasttwodecadeshasbeenthatthekeyeventforourgenerationistheFalloftheBerlinWallandnotthedemiseofLehmanBrothers.Theconsequencesarethenearquadruplingofthecapitalistlabourforcetheunstoppableeconomiccatch-upoftheemergingmarketsstructuralcostdeflationandtheresultingburdenfromhugeWesterndebtaccumulationanditsinevitablemonetaryi.e.liquiditysolution.Thusgoldhistorysunchallengedstoreofvalueagainlookstheoutrightwinner.Thosewhorightlyfearhigh-streetinflationshouldjumptopage26andnotethatitwasthentheultimateEndGamebutitcamesometwenty-fiveyearsaftertheWallStreetCrash. Overproduction2 TheEveningStandard-March211934GeneralOverproduction.RecallthepowerofAmericaintheearly1920sThroughoutthe1920sproductionandproductivityperworkergrewsteadilybetween1920and1929outputperworkerinmanufacturingindustriesincreasedbyaboutfortythreepercent.Wagessalariesandpricesallremainedcomparativelystableoratleastunderwentnocomparableincrease.Accordinglycostsfellandwithpricesthesameprofitsincreased.Theseprofitssustainedthespendingofthewell-to-doandtheyalsonourishedatleastsomeoftheexpectationsbehindthestockmarketboom.Mostofalltheyencouragedaveryhighlevelofcapitalinvestment.Duringthetwentiestheproductionofcapitalgoodsincreasedatanaverageannualrateof6.4percentperyear75over1920-29non-durableconsumergoodsincreasedatarateofonly2.8percent28over1920-29Alargeandincreasinginvestmentincapitalgoodswasaprincipledevicebywhichtheprofitswerebeingspent.J.K.GalbraithTheGreatCrash1954.3 TheEveningStandard-October21934OverproductionfromtheEast.TheJapaneseYenhadbeenfixedtoSterlingatcloseto10butby1935ithadfallento17.1.4 FragileFinance5 January211929Supportingthebanks.InsideeverybankchairmanthereisaChancellorwantingtocomeout.CanyouspotWinstonChurchilltheBritishChancellorFinanceMinister6 July161931BolshevikslookonwhileinternationalbankersscrambleouttheYoungPlantocontinuetheflowoflendingfollowingfailureof1924sDawesPlanforthepaymentofGermanysWW1Reparations.EuropewasanimportantsourceofdemandforAmericasfactories.Between1923and193549.1ofUSexportswenttoEurope.ItwasalsoanimportanthavenforAmericancapital.Some40ofGermancapitalinflowscamefromtheUSovertheperiod.IntriguinglythethreegreatwavesofcapitalflightfromGermanywerepartlytriggeredbyfearofCommunism7 TheEveningStandard-May241932Itsaglobalproblem.LeakappearsinMiddleEuropeandthreatenstocapsizeWorldEconomy.8 Fragilebanks............allaroundwhileunsoldgoodspileup.9 MonetaryDeflation10 February171931BankofEnglandfreezingupfinancialcirculationasmoneybaronslookon.Stockmarketsbecametheultimatebarometeroffrozenmoneyanddeflation.WallStreetaveragedanindexlevelof21.9in1929butfellto17.7in1930followingtheCrash.1931sawagreatercollapseto11.5andsharesonlyhitbottomatanindexof5.8in1932.11 December171931Thecircularflowofincomeandspending.Keepthemoneymoving12 TheEveningStandard-October241932CentralBankmoneyislockedupandnotcirculating.UKTreasuryBillratesfellto1.486in1932fromtheir19295.264peak.13 January251933Currencychaosunusedresources.........Sameproblemsnoremedyinsight.Between1931and1934SterlingfluctuatedfromUS4.859toUS3.504andbacktoUS5.041.14 TheEveningStandard-March231933Noideaofhowtounfreezefinance.UKTreasuryBillratesdroppedagainto0.591in1933.USrateshit0.52.USSteelproductionended1932at13.6mtonsdrasticallybelowits1929peakof51.3mtons.USunemploymentreached12.8min1933or24.9oftheworkforce.15 November31932BankofEnglandGovernorMontagueNormanisshownurgingeconomywhenreallymoremoneyisneeded16 April31935Policyinertia-Governmentstrytobalancethebooks.From1920-29theUSranaconsistentfiscalsurplus.1937sawanothersurplus.17 TheEveningStandard-April151943LeaduptocreationofIMFandBrettonWoodsandtheneedtofollowrules.AheadofDepressionGoldStandardsruleswerebroken.18 TheEveningStandard-May181944IdealsofUNCharterheldbackbyWorldfinance.Noticethatthetradecyclehasaflattyre.19 TheEveningStandard-July181944BrettonWoodsandthebirthoftheIMF.GoldmakesareappearancetodismayofCentralBankers.NoteKeynesUKandMorgenthauUSarethemidwives.20 Consequences21 TheEveningStandard-October91933OnesolutionThe1930swereadecadeofconflictandrisingnationalism.WW2occuredlessthan10yearsafterthe1929WallStreetCrash.22 December51933Electionofanewpresidentin1933.Printingmoneybecomesasolution.TheonlythingAmericahadtofearwas........monetaryinflation.RooseveltwaselectedonapolicyofsoundmoneywhateverthatmeantItwassaidthathewascarefultoavoidspecificallymentioningtheGoldStandard.23 TheEveningStandard-May291935RunontheFrenchFrancasdeflationarypressuresbuild.FrancewasultimatelyforcedtodevaluetheFranc1936.In1921theFrancstoodatFF51.9.By1926ithadcollapsedtoFF152.38.ItthenralliedtoFF124.06in1931andcontinuedstrengtheningtoFF74.27in1935beforeslumpingbacktoFF176.65by1939.24 TheEveningStandard-December161935JapaninvadesChina.Imperialismreappears.ThenewUSpolicyofaggressivesilverpurchasespartofRooseveltprogramofraisingcommoditypricesdevastatedChina.ChinaoperatedaSilverStandardandrisingWorldsilverpricescausedtheexportofChinesesilvertherebydraggingChinaintodeflation.Ironicallyin1934JapansentaninvitationtoChinapledgingsupportagainstAmericassilverpolicyinreturnforallChineselandNorthoftheYangtze.25 July191957Desperatelytryingtoturnoffthemoneytap.26 June11962Fromdepressiontoeuphoria.Stockmarketnowtooelevated27 1GlobalViewWere-iterateourviewthattheWorldchangedin1989withtheFalloftheBerlinWallandnotin2008withthefailureofLehmanBrothersorin2010withthedefactobankruptcyofGreece.Thelatteraremerelysymptomsofdeeperrealeconomytroubles.Inthepast150yearstheWorldhasseenthreemajorproductivitysurges1USeconomyinearlytwentiethcentury2GermanandAsianTigereconomiesin1950sand1960sand3ChinaIndiaBrazilandotherEMeconomiesfromlate-1980sonwards.Thesejumpsinproductivitydemandparallelrealexchangeratechanges.Realexchangeratescanincreaseeitherbyariseinthenominalexchangerateorthroughariseinsomenationalpricelevel.Thisdoesnothavetobeconsumerpricesandinpracticee.g.Japaninthe1980spriceleveladjustmentisoftenexpressedthroughanincreaseinassetprices.Clearlythereisatrade-off.Themorethatthenominalexchangerateadjuststhelessonustherewillbeonotherpricestorise.Equallythelessthenominalexchangerateadjuststhemoreotherpricese.g.stocksandrealestatehavetoincrease.Ontopthisworksbothways.AstrongerChineserealexchangeratemightalsooccurthroughaweakerUSdollaranddeflationofUSpricelevelsincludingfallinghighstreetpricesandatumblingWallStreet.OddsofaQE3...100MoreQElooksinevitable.Westerneconomiescannotcopebeingsaddledwithhugedebtburdens.Westernpoliticscannotcopewithpersistentlyhighunemployment.Debtmusteitherbedefaultedormoreprobablydevalued.DevaluationmeansmoremonetaryinflationwhichisjustanothertermforQE.WesterncurrenciesmusttumblefurtherandthismeansnotjusttheUSdollar.Goldaswehavemaintainedforadecadeisthemajorwinner.EconomicrebalancingalsoneedsAsianandEMcurrenciestoriseinrealterms.AsiangovernmentslikeJapanandGermanyinthelate1970swilldragtheirfeetforcingmoreadjustmentontoWesternunitsandultimatelyputtingupwardpressureonEMassetpricesanddownwardpressureonWesternassetrices.GlobalViewAugust201196BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comFigure1USSPlagged10.5yearsandtheJapaneseTopixSDRTerms1970-2011SourceCrossBorderCapitalDatastreamSPCompositeLHSTOPIXRHS0200400600800100012001400310119703101197231011974310119763101197831011980310119823101198431011986310119883101199031011992310119943101199631011998310120003101200231012004310120063101200831012010024681012141618 GlobalView2Understandingtheroleofcurrenciesinthisadjustmentpictureiscrucial.ForexampleiftheUSauthoritiesdonotwanttoseeWallStreetlowertheywillpumpinliquiditytoholditup.HoweverthiswillcausetheUSdollartoskidlowerandiftheChineseacttomaintaintheexistingRMBUSdollarparitythebulkofadjustmentmustcomefromtheUSdollarcollapsingagainstotherunitssuchastheEurotheSwissFranctheYenandmostimportantlygold.Figure1highlightsthisprocessbycomparingtheJapaneseandUSstockmarketsincommoncurrencySDRterms.AlthoughitappearsthatsinceQE1andQE2WallStreethasdecoupledfromthepathtakenbytheTokyomarketafterits1989bubblethetruthisthatoncetheweakerUSdollarisincludedAmericanassetmarketsareon-trackwithJapanspreviouslytroddenpath.InshorteitherWallStreetfallsortheUSdollarfallstorestorethebalance.Theinvestmentmessageisclear.LookingintothemediumtermEMassetmarketsinEMcurrencytermswillsignificantlyoutperformWesternassetmarketsinWesterncurrencyterms.TherearefourpotentialmovingpartswhichmovesmostisamootpointbutifpushedwewouldarguethatWesternpolicy-makerswouldratherallowtheircurrenciestoslidethantheirassetmarketscollapse.EquallyEMpolicy-makerswouldrathertheirassetmarketsrisethantheircurrenciesrockethigher.CentralBankershavebeenquickerthanmosttolearnlessonsandtounderstandjusthowtoholdtheirassetmarketsup.Theyhavere-discoveredanewlevercalledquantitativeeasingQEanddownplayedanotherlevercalledinterestrates.Wehavelongmaintainedthatinterestratesdontmatterbutliquiditydoes.Thereisonlyaloosehistoricalrelationshipbetweenthelevelofshort-terminterestratesandthevolumeofliquidity.Thelevelofinterestratesisdeterminedbyrealeconomyprofitability.Interestratesarelownotbecauseliquidityisabundantbutbecauseprofitabilityisweak.Liquidityaffectsspreadsandriskpremia.Byexpandingthevolumeofcashandcredita.k.a.accesstocashthemonetarysectorreducesriskpremia.Thefourmainriskpremiaareatheinterestrateyieldcurvebthecorporatecreditspreadctheequityriskpremiumanddtheexchangerate.NotonlycanCentralBankscontrolthevolumeofliquiditytheycanalsosetthelevelofovernightinterestrates.IfthissoundslikehavingonescakeandeatingititisFewinvestorsseemtounderstandthisprocess.Whatsmoreitisoppositetoalltheeconomictextbookswhichdiscusspolicyintermsofachoicebetweensettingthevolumeoffundsortheinterestratebutnotboth.ThechangeresultstechnicallyfromthecorridorsystemofinterestratecontrolnowadoptedbymostCentralBanks.ThroughQEpoliciesthevolumeofliquidityisexpandedoftensignificantlybutinterestratesareheldaroundtheirtargetlevelsbythewillingnessofpolicy-makerstopaybankswithsurplusfundsaninterestrateatthetargetrateonanydepositstheymakewiththeCentralBank.Inawaythismopsupliquiditybycreatinganartificialdemandforit.Buttheimportantfactisthatbyofferingthebankstheopportunitytoholdvastamountsofliquiditypolicy-makersreduceriskpremiaandsoencouragebankerstoinvestinlongerdurationassetssuchasgovernmentbonds.Ofcourselockinginajuicyyieldspreadhelpsbanksrestoretheircapitalwhileatthesametimetheyareholdinglargeamountsofcashsolvencyandliquidityconcernsnearlykilled-offwithasinglepolicystone.TheproblemofcoursecomeswhenQEstops.Riskpremiariseamongotherthingsforcingyieldcurvestoflattenwhichassumingunchangedinterestratetargetsmustforcebondyieldslower.IndeedthiswastheimmediateresponsetotheendofQE2intheUS.Theserisingriskpremiamustbeoff-setbyarenewedQE3inAmericaorviaaQE2inEuropeandJapan.TheEurozonesuffersremarkablytightliquidity.OurweeklymeasureofnetliquidityprovisionbytheECBisdramaticallylowerthanitsE722.3billionleveloflastsummertheperiodfollowingtheinitialGreekCrisis.AsaresulttheEurozonemonetarybasestandsawhopping14.4downonitsyearagolevels.NosignofQEhereToreinforcethepointaroundonefifthofECBliquidityprovisionisbeingdeliberatelychannelledintothefringeeconomiestoeasetheirfundingblightwhichitselfisworseningasdepositorsshifttheiraccounttowardsnon-domesticbanks.OurmonthlyindexofECBliquidityhitasuicidal1inJuly2011orwell-belowits84.9yearagolevel.Theindexnormalrange0-100isanormalisedz-scoreofseveral 3GlobalViewbalancesheetliquiditymeasuresscaledrelativetoGDP.Itwaslastattheselevelsinmid-2008andthelasttimeamajorCentralBankwasatsimilarlowswastheRussianCentralBankinearlysummer1998orjustbeforetheAugustCrisis.Beforeweincitepanictherearetwoimportantcaveats1in1998theRussianStatewasbankruptandhavingnodomesticsavingstotapitwasforcedtoprintmoney.Europesproblemsareintheperipheryandthecoreremainsrichinsavings2RussianprivatebankswerenostrongerthantheStatein1998buttheaverageEurozonebankstillenjoysgoodbalancesheetliquidity.Nonethelessthereisnoreasonforcomplacency.TheplainfactisthattightdomesticliquidityconditionsgosomelongwaytoexplainwhytheEuroisseeminglydefyingeconomicgravity.Wheneconomicconditionsdemandite.g.unacceptablyhighunemploymentliquiditywillberelaxedandtheEurocouldtumble.WehavepreviouslydrawntheanalogybetweenthepresentdaypositionoftheEuroandtheconditionoftheFrenchFrancinthe1930s.TheFrenchFrancwasveryverystronguntilitwasveryveryweak.Ourcrie-de-coeurremainstruejustlikethe1930sthecocktailoflargedebtsandquantitativeeasingcreatesdevastatingcurrencyvolatility.TheinterwarFrancsufferedaroller-coasterride.PuttingtheEurointhesameframeitwouldhavestartedin1933attheequivalentofUS1.25rocketedtoUS2.10withintwoyearsandthencollapsedtoUS0.80andthentoUS0.20astheGermantanksrolledin.Europesperipheryisbust.Moreimportantlythecausesofthebustnamelyapropensitytoover-spendcombinedwithafundamentaluncompetitivenessofproductionhavenotbeenaddressed.Ontopthelatestfiscalnumberssimplydonotaddup.EithertheuneconomicfringewillbebailedoutbyGermansavingsinwhichcasetheEurozonewillloseitspowerhouseitsgrowthwillcraterandtheEuroweaken.OrtheECBwillprintmoneyandtheEurowillweaken.InvestorsareplayingawaitinggamefortheEurocurrencytodrop.InvestmentImplicationsofaTwo-SpeedWorldTheseculardeclineinUSrealinterestratesoverthepastdecadeorsodoesnotshowaneverlooseningmonetarystanceassomeclaim.Ratherfallinginterestratesmeasurethedecreasingpriceofcapitalinotherwordsitsweakeningprofitability.UndertheweightoftremendouscompetitionfromEMglobalprofitabilityisskiddingandworryinglyitisskiddingfastestintheWest.Donotlosesightofthefactthatweliveinatwo-speedeconomicWorld.Thescaleofthedivergenceiseye-watering.WithEMgrowinginrealtermsby3-4fasterthanDMtheyareroughlydoublinginrelativeeconomicsizeeverytwentyyears.SomewhatflippantlywehavenotedthatthelasttwopreviousoccasionsthatthisgapoccurredonsuchascalewastheBlackDeathinthefourteenthcenturyandtheIndustrialRevolutionintheeighteenthcenturyWesternfinancialproblemsandthehugescaleofitsdomesticdebtsresultfromthefactthatthistwo-speedWorldhasreversedthepolarityoftheWesternfinancialsystemindustrialcorporationstheveryenginesofexpansionhavestoppedinvestinginnewplantandinsteadaccumulatecash.TheyhaveturnedthemselvesintolendersnotborrowersandWesterncapitalmarketshavebecomecapital-distributionmechanismsandarenolongercapital-raisingones.TheforcesofcostdeflationarerippingthroughWesternhighstreetsaddingtodebtburdensandreinforcingdolequeues.Westernpolicy-makershavelittlechoicebuttousemonetarypoliciesandparticularlyQE-stylemonetaryinflationpoliciestotrytodevaluetheirwhoppingdebts.Fiscalpoliciesareonlylikelytotightenfromheregivenalreadyvastdeficits.Centralbankscontrolmonetaryinflationnothighstreetinflation.Inotherwordstheysimplydeterminehowfasttodevaluetheirpapercurrencies.Thepriceofmoneyisnottheinterestratebuttheexchangerate.InvestorsshouldthereforetakenoteofthesoaringgoldpriceandtheflakinessofWesternpaperunits.Theover-ridingfactaboutthecurrentmarketenvironmentisthatthecocktailoflarge-scaledebtscombinedwithboutsofquantitativeeasingQEalwayscausecurrencymarketvolatility.Thereforetheprimarydutyofeveryassetallocatoristofirstselectwhichcurrencyunittoholdwealthin.Overrecentyearswehavechampionedaportfolioofgoldandemergingandcommodity-relatedpapercurrencies.Wecannothelprepeatingagainthatthetwoprinciplesthatdefineourinvestmentvieware1goldisacurrencyand2cashisanasset. GlobalView4CROSSBORDERCAPITALLIMITED96BAKERSTREETLONDONW1U6TJTELEPHONE02079082800FACSIMILE02079082835REGULATEDBYTHEFSACROSSBORDERCAPITALLIMITED2011.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.Thisnoteis180-degreesdifferentfrommostinvestorsunderstandingofhowbesttomanagemoneyoverthepast30years.Wehavebeforesetdownourviewthattheonlytwolong-termplacestoinvestare1EMforgrowthand2goldphysicalcommoditiesandEMcurrenciesforcapitalpreservation.BeforethiscrisishasfinishedtheUSgoldpricewilltestUS3000oz.andEMcountrieswillcomeclosetodoublingtheirrealpercapitaincomes.Westerneconomiesarenotabouttogobackintorecession.Itisworse.RelativetothelasttwodecadesitwillfeelliketheynevergotoutofrecessionbecausetheirGDPgrowthwillshufflealongatdismalnear1-2rates.ThenextleadershipphaseoftheWorldeconomywillbetaken-upbyChina.Alreadywesensethatpolicy-makersinBeijingarebeginningtorev-uptheeconomicenginetoavoidamajorstall.WatchChinesestockscloselyforsignsofanupwardbreak-out.ConsolidatepositionsinEMequities.ExpectWesternbondmarketstorangesideways.LookforhighergoldpricesoverthemediumtermandstarttomakeaseriouscommitmenttoEMcurrencies.TheeconomicsofrealexchangerateadjustmentsimplymeanthateitherEMcurrencyunitsorEMassetpriceshavetoriseorbetterstillboth.Inanequivalentwayourshavetodecline.InthissensewearefollowingJapanesetrendsbyaroundadecade.IfyouhadanydoubtslookcloselyagainatFigure1.Thischartspellsoutthefactthatcurrenciesarecriticallyimportanttounderstandingmarketvaluation.ManydoomsterssupposedlypredictthattheSPcompositewilltumbleto500fromitscurrentnear-1300level.InUSdollartermsitwillnotbutsimplybecausethecollapseoftheUSdollaralreadyputsitdownataround800onacurrency-adjustedindexbasisi.e.SDRterms.WallStreethasgoneupbuttheUSdollarhaslikewisegonedown.Donotbefooledbyrisesinthenominalstockpriceindexes.UnderlyingWesternpaperunitsarecrumbling.Westernpolicy-makerscannotstoptheinevitabledownwardrealexchangerateadjustment.EitherWesternassetpricesfallexchangeratesfallorboth.ButaQE3willshunttheburdenofadjustmentfurtherbackontoWesterncurrencies.Goldsboomhasnotfinishedyet. 1GlobalViewGlobalViewFebruary201296BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalIMFPeoplesBankofChinaFigure11997-98CrisisReduxEmergingAsianCentralBankLiquidityIndex0-1001990-2012AsianLiquidityNoTigerintheTankAsianliquidityisbecomingreminiscentofUSliquidityin2006and2007.Whatsmoreitistheclosestithasbeentoitsowndireliquiditysituationjustaheadofthe1997-98CrisisWeremainbigfansoftheAsianassetclassandwehopewearewrongbutthesefactsofextremelytightAsianliquiditycannotandshouldnotbeignored.Needlesstosaywehavebeensearchingforsomesilver-liningbutsofarinvain.WehavemadethepointinrecentyearsthattheChineseCentralBankPBoCisnowtoobigforinternationalinvestorstoignore.HereitmaybetruethatChinaisabouttosubstantiallyeasehermonetaryconditionsanditissurelythecasethatChinaandotherEMeconomieshavecooledsubstantiallyfromtheir2010-11boutofoverheatingandsocaneaseYethardevidenceofeasingisscarce.TheEMproblemmayitselfbeahang-overfromlastyearsEuroCrisisandspecificallytheexodusofmanyEurozonebanksfromthecross-borderlendingarenawhichhasresultedinthepullingoftheircreditlines.TheBISrecentlydismissedtheserisksastrivialestimatingthepotentialpullbackattotalAsianlending.Yetinthefinalfourmonthsof2011capitaltotallinganetUS3trillionexitedEMfinancialassetsorapullbacknotdissimilartotheoutflowtriggeredbythe2008LehmanCrisis.WorryinglyJanuarysawanotherUS400billionleave.Chinaishurtingtooandlosingpreciousforeignexchange.Notethatthesetrendsrunagainsttherecentdirectionofwidely-reportedUSmutualfundflows.Ourdatacoverallinvestorsandincludebondsplusothercreditinstrumentswhatsmoreitisamuchbiggerassetpool.Mutualfunddataevenongenerousextrapolationonlycapture10-20ofallEMinflowsandJanuarymayhaveseensomecontrarianbottomfishinginequities.OntopoftheexitofforeigninvestorstighterUSliquidityfollowingtheendofQE2frommid-2011andtherecentlystrongerUSeconomyhavepulleddollarsawayfromEM.909294969800020406081012020406080100020406080100LooseTight6mMovingAverageActual GlobalView2Figure2NetCross-borderCapitalFlowsintoAsiaUSdollarbillions2008-2012SourceCrossBorderCapitalIMFFigure3ForeignHoldingsofUSTreasuriesheldinCustodyattheFedWeekly2000-2012SourceCrossBorderCapitalUSFederalReserve-1500-1000-500050010001500Jan-08Apr-08Jul-08Oct-08Jan-09Apr-09Jul-09Oct-09Jan-10Apr-10Jul-10Oct-10Jan-11Apr-11Jul-11Oct-11Jan-12EmergingAsiaexChinaChinaAnnualGrowthYoYChg.RHSHoldingsUSbillionsLHS000102030405060708091011126008001000120014001600180020002200240026002800-20-1001020304050 3GlobalViewTheseeffectsarehighlightedinthesharpretreatinthestockofforeignholdingsofUSTreasuriesheldincustodyattheFed.AddtothisstockthesizeoftheFedBalanceSheetandtheresultingseriesiswhatwecalltheUSdollarMonetaryBase.SomecommentatorstreatthisasaproxyforGlobalLiquidityplainlyitisnotbecauseitexcludesEuropeJapanandChinaamongothersbutitstillistooimportanttoignore.SeeFigure4.GiventhatthemonetarybaseofmanysmallerEMeconomiesislargelydeterminedbythesizeoftheirforeignexchangereservesandthatthesereservesaretraditionallyinvestedinUSTreasuriesandheldattheUSFedthesharpslowdownreadmodestcontractioninthequantumofthesecustodyaccountsmusthavenegativesecondroundeffectsondomesticliquidityacrosstheEM.AdmittedlyChinaBrazilandIndiaarebigenougheconomiestooffsetthisforeigndragbutakeypointisthattheyarenotyetdoingso.Chinasmonetarybasecontractedlastmonthsurprisinglysharply.ThismayprovetobeaseasonaldistortioncausedbytheearlystarttoChineseNewYearbuttraditionallyDecemberandJanuaryhavebeenstrongmonthsforChineseliquiditynotnegativeones.SeeFigure5.WearetroubledbythispersistentlypoorAsianliquiditydata.Wearealsotroubledbythefactthatthisisaconsistentpictureandnotonerestrictedtoone-or-twoeconomies.ItaffectseconomiesfromKoreathroughSingaporetoChina.SeeFigures6and7.Whatsmoreitismirroredinveryshort-termcreditspreadsanditisconsistentwiththeparallelcollapseinnetcross-borderflowstoAsia.SeeFigures8and9.AndwhatsmorethislattershiftcanbeseenintherapidslowdowninthepaceofforeignaccumulationofUSTreasuriesofficiallyheldincustodyattheFed.Themechanismisstraightforward.RatherthanallowthecapitaloutflowtodisturbtheirexchangeratesEMpolicy-makersarebeingforcedtomonetisetheoutflowstherebypushingforexreservesanddomesticliquiditybothlower.Thispolicyresponsenotonlycreatesbiggercyclesitreinforcesthepro-cyclicalityofthefinancialsystems.Ontopthistransmissionprocesswillultimatelyreproducethesesamecyclesintheindustrialeconomy.ThebottomlineisthatwemustanticipateacomingseveredeteriorationinAsianeconomicconditions.Figure4USDollarMonetaryBaseFedBalanceSheetplusTreasuriesheldinCustodyYoYChange1990-2012SourceCrossBorderCapitalUSFederalReserve9091929394959697989900010203040506070809101112-100102030405060-100102030405060 GlobalView4SourceCrossBorderCapitalPeoplesBankofChinaFigure5ChineseMonetaryBaseMonthlyChangeRMBBillions2007-2012SourceCrossBorderCapitalHKMAIMFFigure6CentralBankLiquidity-HongKongThailandandSingaporeIndexesMonthly2006-2012-1000-5000500100015002007.012007.032007.052007.072007.092007.112008.012008.032008.052008.072008.092008.112009.012009.032009.052009.072009.092009.112010.012010.032010.052010.072010.092010.112011.012011.032011.052011.072011.092011.110607080910111202040608010002040608010HongKongThailandSinaore 5GlobalViewThiswillnotonlyheightenriskaversionamonginvestorsitwillparticularlyfrightenforeigninvestorswhoareagaincommittingtheirfundstoEMtocaptureitsfasterlong-termgrowthpotential.Thislong-termuptrendlikelyremainsinplacebutasharpdown-cyclemayinterferefirst.Figure9showsthecorrelationbetweenourAsianliquidityindexexJapanandIndiaandtheOECDAsianleadingeconomicindicator.Theassociationisnotperfectcorrelationcoefficient0.4butitissufficientlycloseforustobeconcerned.GranulardataonbusinessactivityforAsiaareoftenhardtogetbutthefollowingannualrelationshipsbetweenliquiditytheOECDleadingindicatorandGDPaddfurthersupporttoourconcerns.SeeFigures10and11.WehavetakenasimpleaverageoftheIMFdataseriesforNewlyIndustrialisedAsianEconomiesandDevelopingAsiatogenerateoverallEmergingAsianexJapangrowth.Liquidityhasbeenadvancedbytwoyears.Thekeyquestioniswhetherweareabouttoseeanother199798AsianCrisisThisisimpossibletoanswerbecausemuchwilldependonhowinvestorsreact.Thereareplainlydifferencesbetweennowandthen.The199798CrisiswasaboutAsiansoverdependenceonexternalfinancetofundarunawaycapitalspendingboom.Hugeinwardforeigncapitalinvestmentswerebeingpaidforbyforeigncurrencyborrowings.Excesscapacityswelled.Theresolutionwassevererecessionanddomesticmonetisationthatinvolvedsignificantcurrencydevaluationandresultedinseveremarketturmoil.Thistimearoundtheparametersaredifferent.Asiastandsattheendofaboomnotmid-waythrough.Hercurrentaccountbalanceispositiveandunlike1997forexreservesarelargeparticularlyfortheASEANbloc.SeeFigure12.During1995-97EmergingAsiawasindeficitbutitnowenjoysanear-5surplusinGDPterms.Allthisprobablymeansthatwewillnotseeasimilarcurrencycrisisto199798.Ontheotherhandmarketsareoftentroubledbyinflexionsnotleastbecausefinancingalwaysmattersmostatthemargin.AsiascurrentaccountsurplusisturningloweranditoftencomesundergreatespressurewhentheUSdeficitisnarrowestlikenow.InadditionevenwithoutthisinternationalFigure7CentralBankLiquidity-KoreaTaiwanandChinaIndexesMonthly2006-2012SourceCrossBorderCapitalPeoplesBankofChinaIMF06070809101112020406080100020406080100KoreaTaiwanChina GlobalView6Figure9AsianexJapanLiquidityandOECDLeadingIndicatorofAsianA5EconomiesLiquidityAdvanced29Months1980-2012SourceCrossBorderCapitalPeoplesBankofChinaIMFOECDSourceCrossBorderCapitalIMFPeoplesBankofChinaFigure8EmergingAsianCentralBankLiquidityandShort-termCreditSpreadsIndexesWiderSpreadsshownasFallingIndexMonthly2006-2012LiuiditAdv29mLHSLeadingIndicatorRHS0102030405060708090Jan-2006r-2006Jul-2006Oct-2006Jan-2007r-2007Jul-2007Oct-2007Jan-2008r-200Jul-2008Oct-2008Jan-2009r-200Jul-2009Oct-2009Jan-2010r-201Jul-2010Oct-2010Jan-2011r-2011Jul-2011Oct-2011Jan-2012CreditSpreadsAsianLiquidity0102030405060708090100Jun-82Jun-84Jun-86Jun-88Jun-90Jun-92Jun-94Jun-96Jun-98Jun-00Jun-02Jun-04Jun-06Jun-08Jun-10Jun-12Jun-14-15-10-50510152025 7GlobalViewdimensionthetightandself-inflicteddomesticliquiditysituationisstilllikelytohitAsianeconomiesnegatively.AdmittedlyChinaisnowmoreablehelptheregionbyprovidingitslong-awaitedmonetaryeasing.AndtheUSFedmayevenbepromptedtore-engageQEifageneralturmoilbreaksout.ThebestcaseisthatAsianliquidityquicklyrevivesandhavingalreadydiscountedallthisbadnewsmarketsbounce.HereourinvestorexposureindexesforAsiacurrentlyshowlowbutnotultra-lowreadingsChinaaside.ThemiddlecaseisthatAsianeconomicgrowthslowsmuchmorethanexpectedequitiesskidorrangelowerbutcreditandforexmarketscomethroughlargelyunscathed.TheworsecaseisthatinvestorsbecomeskittishandAsianmarketsfirstfallbeforepolicy-makersareforcedtoease.Themessageistowatchtheliquiditynumbersandperhapsprudentlyonlybuyhalfthatintendedequitypositionnowwaitingforanotherbetterchancetotop-uplaterthisyearifwereright02468101219791981198319851987198919911993199519971999200120032005200720092011-10-505101520GDPLHSLeadingIndicatorRHSFigure10AsianGDPGrowthandOECDAsianA5LeadingIndicatorAnnual1980-2011SourceCrossBorderCapitalIMFOECDGDPAnnualGrowthRateLHSLeadingIndicatorRHS GlobalView8024681012198219841986198819901992199419961998200020022004200620082010201220140102030405060708090GDPLHSSourceCrossBorderCapitalPeoplesBankofChinaIMFOECDFigure11AsianGDPandAsianLiquidityAdvanced2YearsMonthly1982-2013SourceCrossBorderCapitalIMFOECDFigure12EmergingAsianandUSCurrentAccountBalancesPercentofGDP1980-2012-8.0-6.0-4.0-2.00.02.04.06.08.019801982198419861988199019921994199619982000200220042006200820102012USAEmerinAsiaGDPLHSLiquidityAdv2YrsRHS 1GlobalViewFebruary200996BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceSoloSyndicationAssociatedNewspapersLtdFigure1TensionsintheThirties-DejavuPressureontheDeflatingFrancMay1935GlobalViewJapanIsTheNewFranceLikenowthe1930ssawastruggleamongCentralBankstochangeliquidityconditions.Sincethepriceofmoneyistheexchangeratetheseeffortsledtoastep-upincurrencymarketvolatilityinbothabsoluteversusrealassetsandrelativetermsversusotherpaperunits.WidespreadquantitativeeasingbyCentralBankswillallaydeflationfearsandshouldunderpinalate-1930slikeoutlookfeaturingmodestconsumerinflationbuthugerelativepriceshiftsandcurrencyswings.Francecameintothe1930sinastrongerpositionthanmostotherindustrialeconomiesbutsheleftitfatallyweakenedeconomicallyandpolitically.WhileothereconomiesinflatedFrancedeflatedbeforeeventsforcedawhoppingdevaluation.JapaneseinvestorsbewareMosteconomicdatacurrentlymakedepressingreading.ButwithinthisgloomypictureJapaneseeconomicdataaretrulyawful.Machinetoolordersplunged71.8year-on-yearinDecember2008constructionorderscrateredby27.3overthesameperiodwhileoverallJapaneseindustrialproductionskiddedbyawhopping20.6.FirstestimatessuggestthattheJapaneseeconomyshrankattheincredibleannualrateofsome13inthefinalquarterof2008.Ifonesinleeconomissufferingtheequivalentofthe1930sDepressionitisJapan.Figure2showsthecloserelationshipbetweentheJapaneseleadingeconomicindicatorandoftentightBoJliquidity.InthewordsofFedChairmanBernankewritingasanacademicintheSeptemberOctober2000editionofForeignAffairs GlobalView2Japaninthe1990swasaslow-motionreplayoftheU.S.experience60yearsearlier.AftereffectivelyprecipitatingthecrashinstockandrealestatepricesthroughsharpincreasesininterestratesinmuchthesamewaythattheFedtriggeredthecrashof1929theBankofJapanseemedinnohurrytoeasemonetarypolicyanddidnotcutratessignificantlyuntil1994.AsaresultpricesinJapanhavefallenabout1percentannuallysince1992.AndmuchlikeU.S.officialsduringthe1930sJapanesepolicymakerswereunconscionablyslowintacklingtheseverebankingcrisisthatimpairedtheeconomysabilitytofunctionnormally.OnemeasureofJapanspursuitofpersistentdeflationaryeconomicpoliciesistheseeminglyendlessstrengthoftheJapaneseYen.Japanscurrencyindextrade-weightedhit161.4inJanuary2009comparedtoits1990baseof100.Theindexrosebyanincredible28.1overthelastyearfollowinga6.3risethrough2007.Thisisimportantbecausethepriceofmoneyistheexchangeratenottheinterestrate.Rememberingthisdifferenceisthekeytounderstandingfinancialmarkets.Exchangeratechangesreflectunderlyingshiftsinliquidityconditions.ThusthestrongYenlikelyreflectsthecurrentdeflationaryJapanesemonetarypolicy.Butlikethe1930stodaysCentralBankersarestrugglingalbeitatdifferentspeedstoalternationalliquidityconditionsandultimatelyshiftfrommonetardeflationtomonetaryinflation.Andlikethe1930sthisshouldmeansignificantcurrencymarketvolatilitymeasuredbothin1absoluteversusrealassetsand2relativetermsversusotherpaperunits.The1930sprovideusefulsignpoststowhatmighthappentousoverthenextfewyears.ItsdislocationsreflectedaneconomicandpoliticalpowershiftfromEuropetoAmerica.IronicallyalthoughAmericawasamongthehardesthiteconomiesintheearly1930sherproductivepotentialhadgrownhugelythroughthe1920sboomandasweknowsherecoveredandwentontodominateWorldeconomicsthroughthenexthalfcentury.CouldtodaysdislocationsthereforepresageanothersuchpowershiftperhapsfromAmericatoChinaAsweseeittheplayersatthattimecouldbegenericallybrokendownintoCountryAalargeimperialpowerindeclinemilitarilyfinanciallyandeconomicallyCountryBalargefast-growingindustrialeconomyattractingglobalsavingsflowsCountryCalargerichtraditionallyexport-focussedeconomyeconomicallyandgeographicallyclosetoCountryAstrugglingtofinditswayintheWorldbutunwillingtodevalueorinflateandCountryDacommodityexporterfinanciallytiedtoCountryAandrepresentativeofothercommodityproducersintheeconomicperiphery.EconomicType1930s2000sCountryABritainUSACountryBUSAChinaCountryCFranceJapanCountryDAustraliaArgentinaBrazilRussiaTheparallelsidentifiedinthetableareintriguing.WehaveleftoutGermanylargelybecauseitscircumstancesandpolicyactionsinthe1930swereuniqueandwecanfindnoobviouscomparisontoday.Britainstruggledthroughthe1920sasfinancialrealitybit.ChurchillsdisastrousattempttorestoretheGoldStandardin1925ledtoaGeneralStrikeandUKeconomiccollapse.HelpingBritaininlargepartlaybehindtheinitialeasingandlatertighteningofAmericanmonetarypolicyinthe1920s.ItbecamecleartothenascentFederalReservein1929thatastabledomesticpricelevelwaslikelyincompatiblewithastableinternationalfinancialsystem.AddinsomeinertiaplusasprinklingofpolicyerrorsandtheDepressionYearsareexplained.AfterallowingsterlingtocollapseandembarkingonamajorfiscalspendingprogrammetheBritisheconomysurvivedthe1930sbetterthanithadthe1920s.JapanandAmericafrom1934unconsciouslyfollowedsimilarpolicymixesandalsorecoveredstrongly.Thecommodityproducersintheeconomicperipheryrequiredhighercommodityprices.Theseultimatelyarrivedfromthemiddledecadeandtheirdomesticimpactwasoftenreinforcedbyatwistofdevaluation.Byallowingthedefactofixedlinkbetween 3GlobalViewtheAustralianandBritainpoundstowitherintheearly-1930sfrom20shillingsto16shillings-20significantlyaidedAustralia.TheLatinAmericaneconomieswerealsohelpedbydevaluationeventhoughliketheconcurrentUS-ledtariffwarsitledtoabeggar-my-neighbourdownwardspiralaseconomiesstruggledtokeepone-stepaheadofcompetitors.Figure3showstheimpactofdevaluationoninflationandeconomicactivityforthefourmainregionalLatinAmericaneconomies.Thesecountriesdevaluedbybetween40-60throughthe1930sandsoenjoyedrisingrealeconomicactivityatratesrangingbetweenonethirdand85.OverthesameperiodconsumerinflationrosebymostinChile80andleastinArgentina25.CouldsimilarcurrencyvolatilityintheperipherybeablueprintforthenextfewyearsYetFrancefeltthebruntoftheeconomicpain.Shepersistedwithmonetarydeflationforthelongesttime.HerreturntotheGoldStandardatathenundervaluedFrancinthelate-1920sgaveaninitialcushionbutascompetitor-after-competitordevaluedagainsteachotherandultimatelyagainstgoldherexportsbecamepricedoutofWorldmarketsandshesufferedthewrecking-ballofmonetarydeflation.TheSeptember1936TripartiteCurrencyAgreementbetweenBritaintheUSAandFranceultimatelyallowedtheFranctosurreptitiouslydevaluebutthisprovedtoolatetosaveeitherhereconomyorherpolity.Figure4showsthemovementsoftheoldFrenchFrancagainsttheUSdollar.Thelead-uptothe1930sDepressionstronglyparallelstodaystroublesalthoughwearelessconvincedthattheWorldfacesasubsequentandequivalentscaledeflationaryslump.Thecurrentpolicyresponseisbothbiggerandfaster.Yetitisofsuchasimilartypethatweexpecttheoutlooktobesimilartothelate-1930srecovery.Inshorttheendslookthesamethemiddlemaybeverydifferent.InertiaandmajorpolicyerrorsaretodaylesslikelyanditseemsimprobablethateconomicoutputwillcraterbyanythinglikeasmuchasitdidbetweentheWars.Fiscalpolicywasonlyengagedslowlyinthe1930sandthenlargelyatthefringesinthemajoreconomies.AgainaccordingtoBernankeanacademicexpertontheDepressiontheeconomicrepercussionsofastockmarketcrashdependlessontheseverityofthecrashitselfthanontheresponseofeconomicpolicymakersparticularlycentralbankers.Afterthe1929crashtheFederalReservemistakenlyfocuseditspoliciesonpreservingthegoldvalueofthedollarratherthanonstabilizingthedomesticeconomy.Byraisinginterestratestoprotectthedollarpolicymakerscontributedtosoaringunemploymentandseverepricedeflation.TheU.S.centralbankonlycompoundeditsmistakebyfailingtocounterthecollapseofthecountrysbankingsystemintheearly1930sbankfailuresbothintensifiedthemonetarysqueezesincebankdepositswereliquidatedandsparkedacreditcrunchthathurtconsumersandsmallfirmsinparticular.WithoutthesepolicyblundersbytheFederalReservethereislittlereasontobelievethatthe1929crashwouldhavebeenfollowedbymorethanamoderatedipinU.S.economicactivity.Amaindifferencetodayisthattheseinstrumentsarenowbeingengagedmorequickly.Forexamplemostlargeeconomieshavealreadyannouncedsizeablefiscalpackages.AtclosetoUS1trillionAmericastotalsover6ofGDP.Chinahasslatedasimilardollaramountalthoughhereconomyisaroundonethirdofthenominalsize.Inthe1930stheUSmonetarybasetookfiveyearstoexpandby75butin2008itdoubledinbarelyfivemonths.TheUSFederalReserveisthuscreatingmoremoneyinlesstimethaniteverhasbefore.WhatsmoreFedChairmanBernankeseemswillingtotaketheserisksbecausethereisarapidexitstrategylined-up1significantshrinkageoftheFedbalancesheetcanbeaccomplishedrelativelyquicklyasasubstantialportionoftheassetsthattheFederalReserveholdsareshort-terminnatureandcanbesimplyallowedtorunoffasthevariousprogramsandfacilitiesarescaledbackorshutdown.Rapidmonetaryexpansionwillwork.Figure5isreproducedfromthefinalacademicarticlewrittenbymonetaristMiltonFriedman.Itshowsthedifference1SeechLSEJanuar13th2009 GlobalView4betweenthepolicyresponsesinthisdecade1990sJapanand1930sAmerica.TodayUSmonetarygrowthremainssolidasFigure6showsUSbankdepositgrowthi.e.M2moneysupplyisnowaccelerating.Thetableconfirmsthatinthe1930sUSmonetarygrowthcollapsedcausingthedepression1990sJapansawweakbutpositivemonetarygrowthwhichledtoasimilareconomicperformanceandearly2000sandnowAmericamonetarygrowthcontinuesatahighrate.Althoughwefigurethatcreditremainsmoreimportantthatmoneymoneyi.e.bankdepositsisneededtofundfuturecreditexpansion.Inthelead-uptothetwobigglobalcrisesthe1930sandnowthreefactorslookeerilysimilar1OverproductionthenlaunchedbytheswitchofwarproductionandtheunleashingoftheUSeconomyandnowbythesurgingpost-ColdWarChineseeconomy.2FragileFinancetheninvolvingleveragedinvestmenttrustsanduninsuredbanksandnowinvolvingamorecomplexwebofbanksandshadowbanksbutbothfacingapotentialinabilitytore-financecredits.And3MonetaryDeflationthencausedbytheunwillingnessoftheUSAandFrancetofollowtherulesoftheGoldStandardandtodaybythefixationoninflation-targetingandcontrollinginterestratesviatheso-calledTaylorRuleratherthanliquidity.Thereisalsoanothersinisterecho.The1930sDepressionandsubsequentcurrencyturmoilresultedinhugesocialtensionswhichasweknowtriggeredcivilunrestnationalismmigrationquotasprotectionisttraderestrictionsandfuelledimperialistambitions.Withinadecadeofthe1929CrashWW2hadstarted.Militaryactionsinthelate-1930softenfoundtheirventinascrambleforresourceswhichWW1hadshownwerebothinshortsupplyandusuallylocatedininconvenientplaces.TodaysconcernsaboutPeakOilandthegeneralinelasticityofcommoditysupplymaythereforehaveanotherparallelGiventhatmonetaryinflationfiscalstimulusandcurrencydevaluationareagainthemainpolicysolutionsthehistoryofthelate-1930satleasteconomicallywilllikelyresonateloudly.WebelievethattherewillbethreesimilaroutcomesFast-movingrapaciouscapitalflowsandcurrencyvolatilityStronglyrisingcommoditymarketsFinancialmarketleadershipfromtheincreasinglydominantChineseeconomyChurningCapitalFlowsIneconomicslikeinmanywalksoflifewhatcountscannotalwaysbecountedandwhatcanbecounteddoesnotalwayscount.Thustheeasilycalculatedandmuchdiscussedtradeandcurrentaccountimbalancesmatterfarlessthanmanybelieve.Fast-movingspeculativecapitalmattersmuchmore.ItseemstouscurioustoattributecausationrunningfromtradeflowstocapitalflowsratherthanthereversegiventhatweliveinaWorlddominatedbyfast-movingglobalcapital.Tradeflowsjustaslikelyaccommodatecapitalflows.Soifthefast-growingAsianeconomiesdemandUSdollarsAmericamaybeforcedtorunatradedeficittoaccommodatethemAheightenedvelocityofcross-bordercapitalalsofeatured75yearsago.Theotherspookyparallelwithtodayistheknotspolicy-makerstiedthemselvesinduringthe1930stryingtounderstandandsometimestomanagethesevolatileglobalcapitalflows.ThisseeminglymuddledtheoperationofthepurGoldStandard.AmericaandlaterFranceprovedreluctanttomonetisegoldinflowsinducedbythiscross-bordercapital.Insteadbotheconomiesplacedgreateremphasisonmaintainingstableinternalpricelevelsandsosterilisedgold.Arguablytheywerecorrectindividuallybuttheoutcomeprovedbadglobally.AmericastockpiledbulliontheFortKnoxeffect2therebydenyingthefirstprincipleoftheGoldStandardthatrequiredthefree-flowofgold.InshortatensiondevelopedbetweentheaimsofAmericanmonetarypolicyandtheneedstheWorldsystemastableAmericanpricelevelandastableWorldpricelevelhadbecomeincompatible.2AlthoughFortKnoxwasonlyusedastheUSbulliondepositoryfrom1936ithasbecomeaniconforinertia. 5GlobalViewEightdecadesonandworriedbythedistortingeffectonfixedincomemarketsandultimatelyhousingofcapitalinflowsfromtheso-calledAsiansavingsglutUSpolicy-makerstightenedmonetaryconditionssharplythrough2006and2007.Ontoptheysubsequentlyprovedtooslowandhesitantinrestoringliquidityi.e.actingaslenderofthelastresortwhencredittroublesinevitablyappeared.SeeFigure7.AsaprominentUSCentralBankerconfirmedInresponsetothefinancialturmoilinthewakeofdeclininghousepricestheFedinstitutedaseriesofnewlendingfacilitiesthatincreasedtheliquidityofparticipatinginstitutionsportfolioswithoutsimultaneouslyincreasingthetotalsupplyofliquidityinthefinancialmarketatleastbeforeSeptember2008.InsodoingtheFeddepartedsignificantlyfromitshistoricalpracticeofrelyingontraditionaltoolsofopenmarketoperationsanddiscountwindowlendingtoprovideliquiditytofinancialmarketsWhateverthereasonitnowappearsthattheFedhasabandonedthestrategyofoffsettingcompletelytheeffectsofitsnewlendingprograms.IndeedtheFedhasinjectedhistoricallylargeamountsofcreditintothemarketTheFedLiquidityandCreditAllocationDanielL.ThorntonFederalReserveBankofStLouisJanuary2009.Assumingitcontinuesthispolicyreversalislikelytoprovesignificantinusavoidingarepeatofthe1930s.IrvingFishertheeconomistpartlyrememberedforhisbloatedoptimismontheverybrinkofthe1929Crashlaterfessed-uptoexplainthathiserrorsimplyfollowedfromamonetarypolicymistaketriggeredbytheuntimelydeathofUSFedGovernorStrongItistruehoweverthatIunderestimatedthisfallUSdepressionenormously.Idohumblyconfessit.ButitwaspartlybecauseIbelievedthatthepolicythatGovernorStrongUSFederalReservehadinitiatedandthepolicywhichGovernorRoothSwedishRiksbankisnowsuccessfullycarryingoutwouldbecontinued.GovernorStrongdiedin1928.Ithoroughlybelievethatifhehadlivedandhispolicieshadbeencontinuedwemighthavehadthestockmarketcrashinamilderformbutafterthecrashtherewouldnothavebeenthegreatindustrialdepression.Ibelievesomeofthecrashwasinevitablebecauseofover-indebtednessbutthatthedepressionwasnotinevitable.Thereasonisthatthedeflationthatwentwithover-indebtednesswasnotnecessary.Wecanalwayscontrolthepricelevel.IrvingFisherAnnalsoftheAmericanAcademyJanuary1934.Withglobalinterestratesclosetozeroandtheplayingfieldforspeculatorscorrespondinglyflatterthereislittletotierapaciouscross-bordercapitaltoanysinglecurrency.Swingsininvestorsentimentwilldominatedemandwhilethepaceofquantitativeeasingwilldictatesupply.SwininCurrenciesThroughthefinalquarteroflastyearweexpectedcurrenciestomovethroughtworegimes.Firstthede-leveragingoftheprivatesectorcausedstrongappreciationofthemainfundingcurrenciestheUSdollarandYenasborrowingswererepaid.Secondthere-leveragingofthegovernmentsectore.g.CentralBankmonetisationledtogeneralpapercurrencyweaknessagainstrealassetsstartingwithgoldandtheotherpreciousmetals.ThesurgeinUSdollarexposureduringlate-2008isevidentfromFigure8andranalongsidethevisiblede-leveraginghighlightedinFigure9.Thesesuggestthatthefirstadjustmentphaseisnowlargelybehindus.Thesecondphaseinvolvingarisinggoldpriceshouldbeanticipated.WebelievethatwithCentralBankscollectivelyengagedinquantitativeeasingandrealandnominalinterestratesatlowlevelsthecaseforastrongergoldpriceiscompelling.Goldwaspushedupsignificantlythroughthe1930sfromUS20.65oz.toUS34.42oz.aspartofdeliberatepolicy.AllegedlyatonetimeUSPresidentRooseveltmetwithhisadvisorseachmorningovereggstodecidethatdaysgoldpricetargetYetinthe1930spapercurrenciesdidnotdevalueagainstgoldatthesamesteadypredictablerate.Figure10showstheinitialhugedevaluationoftheJapaneseYenandthelaterdramaticcollapseoftheFranc.TheBritishpound GlobalView6movedmoreinlinewiththeUSdollarbutdevaluedfirstandendedthedecadeweakerthanthegreenback.TheGermanMarkisnotshown.Itwasacontrolledmarketandtradewasincreasinglypursuedthroughbi-lateraldeals.DespitethepublicitygiventotheUSFederalReservesrecentmassivequantitativeeasingtheUSdollarwillnotunambiguouslyweaken.Firstdollarpreferenceparticularlyamongemergingmarketresidentsislikelytohaverisenforsafehavenreasons.SecondmostothermajoreconomieswillalsohavetoeaseliquiditymassivelysoAmericamayhavestartedfirstbutsheisfarfromalone.ThirdthefateoftheUSdollarislikelytobelinkedtoprospectsfortheUSdollarzoneandparticularlytotheprospectsandpolicydecisionsofChina.TheChineseRMBislikelytobealong-termbeneficiaryoftheeconomicandpoliticalpowershiftswesuggestareunderway.HoweverwearefarfromconvincedthattheChinesecurrencywillappreciatenear-term.InfactwethinkthateventherecentgradualappreciationoftheRMBagainsttheUSdollarwillhaltasChinesepolicy-makerstrytostemcollapsingexportdemand.IftheRMBisanimportantWorldmonetaryunititispossiblethatstrappingtogethertheRMBandtheUSdollarwillitselfaddupwardimpetustotheUSdollar.Figure11showsthemovementsofthetrade-weightedUSdollarthroughthe1930s.IfChinaisthenewAmericaandtheRMBultimatelyeclipsestheUSunitthenafixedUSdollarRMBlinkmaydragtheUSdollarhigher.Sterlinghasalreadyskiddedbadlyinforeignexchangemarkets.WehaveseenthiscollapseintermsofBritainsespeciallyfragilebankingsystem.Theseproblemsarefarfromoverandmayultimatelyleadtofull-nationalisationofthemajorbanks.BritainsbankingproblemsarewhatwehavelabelledanIcelandEffect.InotherwordsthemajorUKbankshaveambitionsbeyondwhatsterlingcandeliver.WereckonthattheleverageratioofUKbanksratioofcredittocashorinsidetooutsidemoneyisawhopping54times.USbankshavelatelyde-leveragedhugelyfromapeakratioof24timestojust13times.TheIcelandicbankssawpeakleverageratiosof76timesor56timesjustpriortotheir2008bankruptcy.ThekeyissueforUKbanksistheirinabilitytogetfundingespeciallyinforeigncurrenciesgiventhelargeinternationalmulti-currencyloanbookstheyhavetofinance.Asineveryfinancialcrisistherealproblemisanasset-liabilitymismatchindurationorcurrencyratherthanasimpleoverextensionofcredit.Britainsbankingproblemsarecausingcontinualcashhoardingbythebanks.WefigurethattheonlyresolutionliesinamassiveexpansionofBankofEnglandliquidityprovision.CouldthisexplaintherecentdecisiontohaltfuturepublicationoftheBanksbalancesheeti.e.weeklyBankReturnforthefirsttimesince1844TheEuroremainsanenigmawrappedinamystery.ThreepossiblyindependentissuesneedtobeconsideredaentryandexitofeconomiesfromtheEuroblocbpotentialdefaultofEUnationalgovernmentsoftheirEurodenominateddebtandcwhatthesedevelopmentstellusaboutexchangevalueoftheEuroitselfAlthoughthefirstissueisthemostdiscusseditisnotonlytheleastlikelybutalsotheincreasinglyleastlikely.InshortthiscrisishasboundtheEuromembersevenclosertogether.Itwouldmakelittleeconomicsenseforanexistinghard-pressedEuromembertoleavebecauseitsfuturedebtissuancewouldbecomehugelyexpensive.WhatsmoreeconomicallystrongeconomieslikeGermanyprobablyhavetoomuchpoliticalcapitalnowtiedupintheEurotopullout.DebtdefaultisindependentofEuromembershipinmuchthesamewayasholdingdebtissuedbytheStateofCaliforniainnowayaffectswhetherAmericasWestCoastusesthegreenback.ThequalityofthedebtissuedbyEuromemberstatesisexpressedviayieldpremiumsanddiscounts.Thustheblow-outoftheso-calledPIGSspread.Ultimatelytheonlyresolutiontopotentialdebtdefaultisinstitutional.TheEUwouldhavetoallowtheECBtobuynewlyissuedandon-the-runbondsunhinderedandsetupanEU-widefiscalauthorityasadisciplinetocontrolpotentiallyprofligatememberstates.Liketheemergenceofmostinstitutionsthisauthoritywouldprobablyappearthroughrevolutionratherthanevolution.Thusafiscalcrisisandpotentialdefaultmust 7GlobalViewfirstshockpolicy-makersintoaction.InshorttheECBprobablycannotavoidmonetisationbutitwillnotbeasmoothprocess.Heightenedforexmarketvolatilityatleastseemsprobable.MoreoveranyprotractedfailureoftheEUtoagreewiderfiscalpowerswilladdtopressureonpolicy-makerstoallowtheEurotoweakeninordertoprotectEuropesexportindustries.SterlingsearlycollapseisbeingeyedenviouslyinBrusselsandbeyond.ButthecurrencythatstandsfarapartfromtherestistheJapaneseYen.TheYendoesnothavethesameunderlyingdemandasdotheEuroandUSdollar.TheJapaneseauthoritieslargelycontroltheYenasapolicytoolbecauseJapaneseexporterslargelyinvoiceinUSdollarsandseektooff-loadthesedollarstotheBoJ.Thustheexportsectorisalwayslongdollars.ThissaysnothingaboutthevalueorcompetitivenessoftheYen.ToustheJapanesecurrencylooksmassivelyovervaluedinaWorldofdepressedtradeslumpingUSconsumerspendingandskiddingChinesecapex.Thebottom-lineisthattheJapaneseYenmovescloselywiththeJapanesetradebalance.ThisisnotbecausetradeflowsdetermineexchangeratesbutbecauseinJapanesepolicyeyesexchangeratesdeterminetrade.SeeFigure12.DuringthelasteconomicdownturntheYencrateredtoY135US.ThistimeexpectatleastY120US.TheBoJseemsdestinedtorestartaggressivequantitativeeasingfordomesticreasons.ThisincreasedsupplywillitselfweakentheYen.AlreadybyearlyFebruary2009netliquidityprovisionbytheBoJameasurewedevisedtomonitoritsinjectionsintomoneymarketshasclimbedtoY19.1trillionorwell-aboverecentlevelsofaroundY12trillion.ItshouldbenotedthatthereisstillfartogoiftheY40trillionlevelslastseenduringthepreviousquantitativeeasingeraaretobehit.SurgingCommoditiesThelasttwoyearssurelyunderscorethefactthatcommoditiesareasoundgaugeoftheeconomiccyclebutapoorpredictoroffuturecoreinflationratesLookingaheadfirmercommoditypriceswillprovideadecentclueaboutup-comingeconomicactivityandprospectsforareboundintheindustrialprofitscycle.Commoditiestypicallymoverelativelyearlyinthemonetarytransmissionprocess.Thefirstcommoditiestoresponsetoaliquiditychangearethepreciousmetalsmostobviouslythegoldpricealthoughitisoftensuggestedbyexpertsthatsilverfrequentlyseestheinitialmove.Othercommoditiessuchasoilbasemetalsandfoodsfollowthemovesofpreciousmetalstypicallywithina6-12monthperiod.Wethinkofcommoditiesashavingtwomovingparts1acurrencyofdenominationeffectasmeasuredbythenominalgoldpriceand2arealexchangeratioreflectingphysicalextractioncostsasmeasuredbythegoldcommodityratio.Thusoilgravitatestowardsarealexchangeratioofaround12-15barrelseroz.ofoldalthouhitrangesbetween5economicboomand25timesmajorrecession.Todaythegoldoilratiostandsatcloseto28times97035.SeeFigure13.Assumingamovebacktowards15timesandassumingamassiveandenduringquantitativeeasingbyCentralBankspropelsthegoldpricetotestUS1500oz.thenwewillagainseeUS100bbloil.Viewedfromanotheranglerealassetsshouldriseinvaluerelativetopaperassetsgiventhehugevolumesofdebtoutstanding.Theonlywaysthatdebtcanberealisticallyreducedisviadefaultormonetarydevaluation.Sincemassdefaultisunlikelyonanationalorevenglobalscaledevaluationofpapermoniesisthemostlikelyoutcome.ConclusionLaBelleJapanWearealwayswatchfulaboutadoptingconsensusopinion.Todayskeychoiceisbetweenadoptingeitherinflationarytradespro-equitiescommoditiessterlingandgoldordeflationarytradespro-bondsdollarandyencash.Wefigurethatwithhighcashweightingsalongsidestilllacklustreequityandcommoditymarketsthebulkofinvestorsarestillbettingonfuturedeflation.Ouranalysissuggeststhattheinvestmentchoiceisalittlelessbinary.Investorsshoulddistinguishinflationsanddeflationsbymonetaryandcostfactors.Thusamonetaryinflationcausedbyprintingtoo GlobalView8muchmoneyisverydifferenttoacostinflationcausedbyfallingproductivityorrisingwageclaims.TodaywefacethecuriouscombinationofmonetaryinflationfuelledbyWesternCentralBanksontopofacostdeflationcausedbymassiveexcesscapacitymuchofitinAsia.Thiscombinationalsodescribedthelate-1930srecoverywhichfeaturedsoaringcommoditypricesbutamoreprosaicclimbinconsumerprices.UScommoditypricesjumpedbysome80between1933-38whereasconsumerpricesinchedhigherbybarely12.Moreovercurrencymarketvolatilityalsobecameahallmarkofthe1930s.Bothwillfeatureovercomingmonthsandyears.Inshortmonetaryinflationwilldrivegoldcommoditiesandultimatelyequitieshigherandcrushdeflationarycurrencies.Some75yearsagothedeflationaryFranccollapsedtodayalleyesareontheequallydeflationaryJaaneseYen. 9GlobalViewSourceCrossBorderCapitalBankofJapanJapanCabinetOfficeSourceCrossBorderCapitalOneHundredYearsofEconomicStatisticsTheEconomistFigure2BankofJapanLiquidityandtheJapaneseLeadingEconomicIndicatorMonthly1975-2009Figure3LatinAmericanDevaluations1932-1940757779818385878991939597990103050709020406080100020406080100KobeEarthquakeLeadingIndicatorPercentage6mMAVRHSCentralBankLiquidityIndexAdvanced9MonthsLHSCurrencyvs.USCPIInflationRealGDPGrowthArgentina-64.325.032.7Brazil-43.233.340.3Chile-57.380.084.7Mexico-56.436.051.5 GlobalView10Figure4TheGyratingFrenchFrancUSdollar1920-40SourceCrossBorderCapitalOneHundredYearsofEconomicStatisticsTheEconomistSourceMiltonFriedmanJournalofEconomicPerspectivesFall2005Figure5TheDifferencesbetweenPolicyResponses1920-2000RatioofValueAtPeakTo6YearsEarlierRatioofTerminalValuetoPeakUS1920sJapan1990sUS2000sUS1920sJapan1990sUS2000sMoney1.271.591.440.701.071.25GDP1.261.431.370.471.041.18Stocks3.333.863.200.170.370.585101520253035404550191819201922192419261928193019321934193619381940 11GlobalViewFigure6USM2MoneySupplyGrowthAnnualand3-monthAnnualisedChange1980-2009SourceCrossBorderCapitalUSFederalReserveSourceCrossBorderCapitalUSFederalReserveFigure7USFederalReserveLiquidityIndex0-1001975-2009757779818385878991939597990103050709020406080100020406080100LooseTightAnnual808284868890929496980002040608-5051015202530-50510152025303-monthAnnualisedPercentageChangeActual6-monthMovingAverage GlobalView12SourceCrossBorderCapitalSourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandIMFFigure8InvestorExposuretoUSDollarInstrumentsBasedonHoldingPatternsversus5-yearAverages1980-2009Figure9LeverageofUSandGlobalFinancialSystemsTimes1975-2009SpeculativeOptimisticRiskAversePessimistic-1sd2sd1sd-2sdMean808182838485868788899091929394959697989900010203040506070809020406080100757779818385878991939597990103050709510152025510152025GlobalUS 13GlobalViewSourceCrossBorderCapitalOneHundredYearsofEconomicStatisticsTheEconomistSourceCrossBorderCapitalOneHundredYearsofEconomicStatisticsTheEconomistFigure10MajorCurrenciesversusUSGoldTerms19301001930-1940Figure11USdollarTrade-weightedExchangeRateIndex1920-194005010015020025030035040019301931193219331934193519361937193819391940USMarkFFY0204060801001201401601910191219141916191819201922192419261928193019321934193619381940 GlobalView14-3-2-10123456Q175Q177Q179Q181Q183Q185Q187Q189Q191Q193Q195Q197Q199Q101Q103Q105Q107020406080100120140160180SourceCrossBorderCapitalBankofEnglandIMFSourceCrossBorderCapitalFigure12JapaneseTradeBalanceaspercentofGDPandYenEffectiveExchangeRate1975-2009Figure12GoldOilRatio1865-2009ExcessDemandForOilExcessDemandForGoldNormal12-15x051015202530354018651870187518801885189018951900190519101915192019251930193519401945195019551960196519701975198019851990199520002005CurrentAccountasofGDPLHSEffectiveExchangeRateIndexRHS 1GlobalViewGlobalViewMarch2014ChineseLiquidityandChinasShadowBankingSectorChinesemonetarypolicyisdominatedbyquantitativeactions.ThegrowthinChineseLiquidityhasjumpedby430sinceend-2005comparedtoan88riseinWorldLiquidityandamorepedestrian36expansioninUSLiquidityoverthesameperiod.EvendatedfromtheLehman-inducedturmoilinOctober2008ChineseLiquidityisaheadby180easilyoutpacingthe38riseinGlobalLiquidityandthepuny9riseinUSLiquidity.AlleyeshavebeenonWashingtonbuttheyshouldhavebeenfocussedonBeijing.SeeFigure1.ThecontributionofChinatotheexpansioninGlobalLiquiditycanbeseeninFigure2.Intheperiodsinceend-2005Chinacontributed34.8oftheUS42.7trillionriseinGlobalLiquiditycomparedto15.2contributedbytheUS.AfurtherbreakdownshowsthattheCentralBankPBoCmadeup9.4pointsofthisrisecommercialbankscontributed16.3pointsandshadowbanksmadeupafurther9.1points9.416.39.134.8.SincetheLehmanCrisisChinasshadowbanks169havegrowntheirlendingslightlyfasterthanconventionalbanking159.Intermsoftheoutstandingstockofloansshadowbankingcomprisesinexcessofone-quarteroftotallendingofUS18.1trillionorone-thirdofflowssince2005.Figure3highlightsthebreakdownofChinesebankingandshadowbankingoperationsaveragedoverthelastdecade.ComparedtothepopularTotalSocialFinancingmetricpublishedbythePBoCwemakeadjustmentstoeliminatedouble-countingandconcentrateonliquidity.AsacomparisonUSshadowbankingtotalsUS10.3trillionorroughlyhalfoftotalUSprivatesectorlendingofUS20.5trillion.InshortChineseshadowbankingatUS4.8trillionstandsataroundhalfofitsUScounterpartbutitisgrowingmuchfaster.USshadowbankingactivitypeakedatUS11.6trillioninOctober2008sincewhenChineseshadowbankinghasgrownby170.SourceCrossBorderCapitalUSFederalReservePeoplesBankofChinaBloombergFigure1GrowthinChineseandUSliquidityUSmillionsMonthly2006-2014MarbleArchTower55BryanstonStreetLondonW1H7AATel02078684104www.crossbordercapital.comUSChina0500000010000000150000002000000025000000300000002006-012006-052006-092007-012007-052007-092008-012008-052008-092009-012009-052009-092010-012010-052010-092011-012011-052011-092012-012012-052012-092013-012013-052013-092014-01 GlobalView2Thetwomaincategoriesofshadowbankingactivityare1acceptances8.4and2entrustorentrustedloans9.9.Theformerarecorporatebillsthatareendorsedbythecreditofacommercialbanki.e.guaranteedsothattheycanbeusedintransactionsasmeansofpayment.Thelatterconsistofintra-corporatesectorcreditstypicallybrokeredbybanksinreturnforfees.Becausethebankstakeonnocreditriskthesetransactionsaretreatedoff-balancesheet.Theseentrustloansaredifferentfromthesimilar-soundingtrustloanswhicharecreditsprovidedbyassetmanagers.Thesetrustsareforbiddentoacceptdepositsdirectlybuttheycanmanageassetsfortheprivatesector.FundsareoftenraisedthroughbanksfromwealthmanagementproductsWMPs.Theseproductsarenotguaranteedbybanksbuttheycommandhigheryieldsthatoftensitwell-abovetheregulateddepositrates.Foreigncurrencyloans5.4aresimplyloansraisedsayinUSdollartermsandconvertedbackintoRMB.Theothercategoryisanestimateofprivatelendingbysmallerfinancialintermediaries.Thislendingactivityisagreyareaonthefringesoflegalitysometimesfamily-basedandoftenassociatedwithusuriousinterestrates.Figure4showsthegrowthinChineseshadowbankingactivitysince2003.Ithasslightlyoutpacedthegrowthinconventionalcommercialbankingovertheperiodbutinterestinglyitappearstomovecounter-cyclically.Thismaybeaccidentalratherthandeliberatebecausethesurgeincommercialloangrowthfromlate-2008throughtoearly-2010wasthepurposefulresultofpolicytostimulatetheChineseandWorldeconomiesfollowingtheGreatRecession.Howeveritisclearsincethisdatethatshadowbankinghasbeengrowingatamuchfasterrate.TheroleofthePBoCinspuringlendingiscurious.NotonlyisitbyitselfamajordirectlendernotablytotheState-OwnedEnterprisesSOEsbutthePBoCwillattempttoinfluencetraditionalcommerciallendingSourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFBloombergFigure2MajorContributionstoGlobalLiquidityUSinmillionsMonthly1985-2014USAJapanEurozoneChinaRoW01000000020000000300000004000000050000000600000007000000080000000900000001000000001985-051986-031987-011987-111988-091989-071990-051991-031992-011992-111993-091994-071995-051996-031997-011997-111998-091999-072000-052001-032002-012002-112003-092004-072005-052006-032007-012007-112008-092009-072010-052011-032012-012012-112013-09 3GlobalViewthroughbothdirectivesandincentivestothehighstreetbanks.HoweverthefactthatthePBoCitselfprovidesmeansofpaymentie.legaltenderintothemarketwillalsoenabletheshadowbankstoleveruptheiroperations.InotherwordsanactivePBoCshouldgohand-in-handwithstronggrowthinshadowbanking.ThisindeedappearstobethecasefromFigure5whichcorrelatesthegrowthinthePBoCsbalancesheetwiththeriseandfallofshadowbankingactivity.ItseemsclearthatthecurrentslowgrowthinthePBoCbalancesheetisconsistentwithamuchlowerrateofexpansionandevennonetexpansioninChineseshadowbanking.WhatdoesthismeanforChineseLiquidityFigure6showsannualgrowthintotalChineselendingalongsideouraggregateliquidityindexforChina.Thetwoseriescorrelatecloselyastheyshould.Howeverweprefertousetheindexbecauseitcomprisespartofabroadfamilyofsuchindexesusingastandardtemplateandcovering80economiesWorldwide.Theseindexesstandardisetheannualgrowthratedatarelativetothesizeofthenominaleconomythismakescreditgrowthlessimportanttofinancialmarketswhenconsumerinflationishighandeconomicgrowthstrongandtheynormalisetheresultrelativetoarolling41-monthmovingaverageandstandarddeviation.Theseadjustmentsfacilitatebettercomparisonsacrosscountriesandbetweentimeperiods.TheyhighlightthefactthatChineseLiquidityatanindexscoreof24.5issignificantlybelowitsindexaverageof50andshowingnosignofimprovement.WefearthaChineseLiquiditywillremaininthedoldrumsforsomelong-timeandatleastuntilthegrowthinshadowbankingnoticeablyreduces.Figure7showsamoredetailedbreakdown.WehavepreviouslyarguedthatPolicytargetsaretorebalancetheChineseeconomyawayfromover-relianceoncapitalspendingandanover-developmentofshadowbankingFigure3BreakdownofChinesePrivateSectorLendingPerCentAverage2006-2014SourceCrossBorderCapitalBloomberg5.99.967.38.45.43.1TrustLoansEntrustLoansBankLoansAcceptancesForCurrLoansOther GlobalView4CommunistPartyiskeentoexercisegreatercontrolovertheindebtedregionalgovernmentsandtheoftenbankruptandloss-makingSOEsPBoCislikelyoperatingamedium-termpolicytocurtailliquiditythatshouldbemeasuredinyearsnotmonthsChinalikeJapaninthe1990sand2000swillsuffernomajorheadlinefinancialdefaultsorbankfailuresbutwillseethroughalong-runningcreditsqueezeTheeconomywillskidtoasub-5realGDPgrowthratebelowtrendandeconomicadjustmentwillbepushedouttotheEmergingMarketrim.WeconcludethatmuchbadeconomicnewsisstilltocomeforChinaitselfandfortheEMgiventheclosecorrelationshowninFigure8betweencross-borderfinancialflowstoEMandChineseLiquidity.Thefatladyhasyettosing....SourceCrossBorderCapitalBloombergFigure4GrowthinChineseCommercialLendingandShadowBankingAnnualChangesMonthly2003-2014CommercialBanksShadowBanks-10.00-5.000.005.0010.0015.0020.0025.0030.0035.0040.0031012003310520033009200331012004310520043009200431012005310520053009200531012006310520063009200631012007310520073009200731012008310520083009200831012009310520093009200931012010310520103009201031012011310520113009201131012012310520123009201231012013310520133009201331012014 5GlobalViewSourceCrossBorderCapitalBloombergPeoplesBankofChinaFigure5GrowthinChineseShadowBankingandPBoCBalanceSheetAnnualChangesMonthly2003-2014SourceCrossBorderCapitalBloombergPeoplesBankofChinaFigure6GrowthinChineseLiquidityandCBCChinaLiquidityIndexIndex0-100Monthly2003-2014chYoYLiquidityIndex0.05.010.015.020.025.030.035.040.045.050.001020304050607080901002003-012003-052003-092004-012004-052004-092005-012005-052005-092006-012006-052006-092007-012007-052007-092008-012008-052008-092009-012009-052009-092010-012010-052010-092011-012011-052011-092012-012012-052012-092013-012013-052013-092014-01PBoCShadowBanks-10.000.0010.0020.0030.0040.0050.0060.00310120033006200330112003300420043009200428022005310720053112200531052006311020063103200731082007310120083006200830112008300420093009200928022010310720103112201031052011311020113103201231082012310120133006201330112013 GlobalView6SourceCrossBorderCapitalBloombergPeoplesBankofChinaFigure7ChineseLiquidityDataGlobalLiquidityIndexes-GLIsSummaryFebruary2014SourceCrossBorderCapitalBloombergPeoplesBankofChinaIMFFigure8Cross-borderFlowstoEMandChineseLiquidityUSMillionsIndex2005-2014ChineseLiquidityCBFtoEM0102030405060708090100-120000-100000-80000-60000-40000-200000200004000060000800001000002005-012005-052005-092006-012006-052006-092007-012007-052007-092008-012008-052008-092009-012009-052009-092010-012010-052010-092011-012011-052011-092012-012012-052012-092013-012013-052013-092014-01ChinaGLISummaryLatestMonthPreviousMonthnormalrange0-100TOTALLIQUIDITYDecreaseslowerrate24.524.2-CentralBankDecreaseslowerrate40.139.2-PrivateSectorDecreaseslowerrate18.318-Cross-BorderFlowsIncreaseslowerrate68.570.1-FinancialConditionsImprovementfasterrate55.955.5TheGLIsarenormalisedstatisticalseriescomprisingcarefullyselectedfinancialflows.Areadingabove50showsanexpansionofliquidityandariseorfallintheindexindicatesachangeinspeed. Section3HowChinaControlsWorldInterestRatesHowChinaSetsWorldInterestRatesMarch2007HowChinaControlsWorldInterestRatesPart2June2013GoodMoneyBadMoneyandtheChineseElephantSeptember2013ChinaAmericaandCollapsingCapitalFlowstoEMSeptember2013GrossInterestRatesandtheEndofQE2April2011TheNewOldYieldCurveDecember2013 1CROSSBORDERCAPITALGlobalViewMarch2007MarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comCROSSBORDERCAPITALHowChinaSetsWorldInterestRatesMostmarketconundrumsareexplainedbyunderstandingthedifferencebetweenthecreditcycleandthelevelofinterestrates.Thelevelofinterestratesislargelyindependentofthecreditcyclealthoughcreditflowsdodeterminetimespreadsandqualityspreads.Interestisacategoryofincomethatisrelatedtothesizeoftheprofitspoolgeneratedbynewcapitalandthusinterestratesshouldmovewithratesofcapitalproductivity.SoChinaastheWorldeconomysswingproducerdeterminesmarginalproductivityandthelevelofWorldinterestrates.G7CentralBanksbecomemore-and-morefrustratedinvestorsturnmore-and-moretogoldtheoneassetthatshineswhenrealinterestratesarelowandcreditgrowthrapid.US1000oz.goldisfastapproachingGoldspansPuzzleATaleOfTwoMarketsItisthebestoftimesitistheworstoftimesitistheageofwisdomitistheageoffoolishnessitistheepochofbeliefitistheepochofincredulityitisthespringofhopeitisthewinterofdespairitistheperiodoflowrealinterestratesitistheperiodofabundantcredititisthetimeforgold.AlanGreenspana.k.a.GoldspantheformerFedChairmanwillbepartlyrememberedbyfinancialmarketsforhiscelebratedConundrums.Twoparticularconundrumshavefoxedpolicy-makersovertheyears1YieldCurveConundrumwhyFedmonetarytighteningi.e.hikingshort-terminterestratesledtofallinglongtermyieldsin2005and2GrowthConundrumwhybondyieldsoftendontreflectthepaceofnominalGDPgrowthFigure1.WorldG7YieldCurveAndGlobalLiquidityCycle1980-2007SourceCrossBorderCapitalDatastream80818283848586878889909192939495969798990001020304050607020406080100-200-1000100200300IndexBasisPointsOverallLiquidityLHSLiquidityRisingYieldCurveSteepeningYieldCurveRHSYieldCurveexJapanRHS 2CROSSBORDERCAPITALThelegacyremainsunresolvedandstrangelyithaspersisteddespitebeingbadeconomics.Firstshort-terminterestratesdonotdeterminelong-termratesratherthecausationrunsinreverse.Secondlong-terminterestratesarerelatedtotherateofcapitalproductivityandnotsimplytotherateofeconomicgrowth.AndaswewillseelaterthisiswhereChinacomesin.WehavelongquestionedthepowerthattheG7CentralBankshaveoverinterestrates.InpracticenoCentralBankactuallysetsinterestrates.Atbesttheysetinterestratetargetsthisisnotjustasubtledifference.Whatsmoreinquantitativetermseventheinfluencetheyhaveonrateshasbeendilutedbytheriseofprivatesectorcreditinstitutions.TheUSFederalReservesbalancesheetnowrepresentsbarelyonesixtiethoftheentireprivatesectorstockofdebt.ThuswhethersayGoldmanSachsandthelargehedgefundsaremorepowerfulthantheFedisaquestionthatcannolongerbeeasilydismissedItisamootpointandonelikelycolouredbytheappointmentofformerGoldmanbossHankPaulsonasnewUSTreasurySecretary.Notwithstandingwearguethatinterestratesarenottrulysetincreditmarketsanyway.Rathertheyaredeterminedintherealeconomy.Thisisbecauseinterestrepresentsanincomecategorythatisrelatedtothesizeoftheprofitspoolgeneratedbynewcapital.Liquidityismoneywaitingtobeturnedintocapital.Therateofprofitmeasuresthereturnfromtyingliquidityupascapitalitisdirectlyrelatedtoproductivityadjustedbytheextentofanyoverproductionanditislargelyindependentoftheliquiditycycle.Therateofprofitislikelytocloselydeterminetheyieldonequivalentdurationbonds.Short-terminterestratesmeasuretheaccesspriceofliquidityi.e.therentalcostofusingcredittoturnintocapital.Thuswhenliquidityisrelativelyscarceshort-terminterestrateswilllikelystandatapremiumtotherateofprofitabilityandwhenliquidityisrelativelyabundanttheywilltradeatadiscount.ThecloserelationshipbetweentheliquiditycycleandtheyieldcurveortermspreadisshowninFigure1.Asliquiditycontractssotheyieldcurveflattensandinverts.Similarlyrisingliquiditycausestheyieldcurvetosteepen.ThedatainFigure1refertotheG7ormajordevelopedeconomieswitheachmarketweightedbyitseconomicsize.Liquidityisdefinedastheflowofmoneyasmeansofpurchasei.e.sourcesoffundsandconsistsofchangesinthestockofcashandcredit.Wemeasureliquidityasanindexnormalrange0-100.Accordingtothechartaneutralliquidityreadingof50onourindexisconsistentwithapositive70bpstimespreadbetween10-yearbondsand3-monthmoney.ThustheliquiditycycledrivestheyieldcurveNOTthelevelofinterestrates.Inotherwordsshort-terminterestratesmeasurethepremiumonmoneyratherthanthepriceofmoneywhichisstrictlytheexchangerate.InourviewoftheWorldChinaastheswingproducersetsthelevelofrealinterestratesfromitslowrateofcapitalproductivityandfinancialinstitutionsdrivethetempooftheGlobalLiquidityCycle.Animportantcorollaryisthatthelong-endoftheinterestratecurvedeterminestheshort-endviatheliquiditycycle.PutbluntlythemarketnotCentralBankssetshort-terminterestrates.Short-terminterestratesarenotsetbypolicy-makersandtheydonotdeterminelong-termratesviaanexpectationsmechanismasmanycommentatorsseemtothink.Consequentlyattemptstohikeshort-terminterestrateswillhaveaminimaleffectonreallong-termyieldsandmayonlyaffectnominalrateswithalonglead-timeandthenlikelyintheoppositedirectionifhigherratesultimatelylowercoreinflation.Savingsandsavingsglutsalsodontfigurehere.JustbecauseIsavedoesntmeanthattheworldbecomesmoreliquid.Liquiditymustbecreated.Thusitisimportanttodistinguishsourcesi.e.liquidityfromusesoffundse.g.savingsanddifferentiatecapitalfromliquidity.Lowrealratesandinvertedyieldcurveslikelytellusthattoomuch 3CROSSBORDERCAPITALliquidityhasbeenconvertedintocapital.ThispotentialsourceofoverproductionmayposefutureproblemsalthoughunlikepastcyclesthebulkofthiscapitalhasbeeninstalledinChinaandotheremergingeconomiesandnotintheWest.ChineseRealEconomySetsTempoOfWesternFinancialMarketsLowrealbondyieldsarethereforetheresultofthesimilarlylowcirca2marginalproductivityofglobalcapitalitselftheconsequenceofChinesemercantilismandoverproduction.Thisstructuralfeatureisunlikelytoquicklychange.Infactlookingaheadthereisacompellingcasethatcapitalproductivitymayfallfurtherifpoliticianssucceedinrestrainingindustrysexploitationofthenaturalenvironment.ConcernforGreenissuesmaystimulatespecificinvestmentsandcouldbolsterGDPbutitwillprobablycutintogeneralprofitability.Lowrealinterestshouldpersist.Figure2showstherecentconvergenceofworldrealinterestratesmeasuredby10-yearbondyieldslesscoreinflation.Convergencehasoccurredbeforebutconvergenceatlow2realyieldsishighlyunusual.Astherighthandchartillustratesthis2realyieldmatchesthespreadbetweenthetrendratesofrealGDPgrowtheconomy-by-economyandtheunderlyingnetexpansionofthephysicalvalueofthecapitalstock.Thisspreadmeasuresneteconomicoutputlessnetcapitalinputandrepresentsthemarginalrateofcapitalproductivity.Thefactthattherateiscommonacrossallmajoreconomiessimplyillustratesthatasingleglobalcapitalmarketexists.Thuscurrentlow2reallong-terminterestrateshavelittletodowithprevailingratesofGDPgrowthasmanypunditsandevensomeCentralBanksclaim.Worldrealinterestrateswoulddivergeratherthanconvergeiftheydid.AndUSandChineserealinterestrateswouldstandnearertheirrespectiveeconomiestrendGDPgrowthratesof3and8.SourceCrossBorderCapitalDatastreamFigure2.Real10-YearBondYields1980-2006AndEstimatedCapitalProductivityVariousEconomiesLowratesofmarginalproductivitymeanalowreturnoncapitalwhichinturnmeansalowrealrateofinterest.HighprofitmarginsandrecentbumperprofitsreportedbymanyWesternCorporationsdonotdetractfromthisargument.Thereisadifferencebetweenmarginalreturnsonnewcapitalinvestmentsandaveragereturnsonexistingcapital.Marginalreturnsarelowbutaveragereturnshavebeenbolsteredbycost-restructuringbysweatingassetsmoreintensivelyandparadoxicallybecauseofcheaperinputsfromChina.Nonethelessthesemayprovetobetemporaryandwillnotpreventaninevitableconvergenceofaveragereturnstotheprevailinglowmarginalrates.EquityreturnsmaylooklikethebondyieldchartinFigure2.80818283848586878889909192939495969798990001020304050607-5-4-3-2-10123456789101112-5-4-3-2-10123456789101112PercentEurozoneUKUSJapanUSEurozoneJapanChina02468103.52.252.2581.50.250.256GDPCapitalStockAnnualChangeRealYieldsRealGDPTrendCapitalStockAndCapitalProductivity 4CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamFigure3.MajorDevelopedEconomiesG7InterestRateAndTaylorRuleandMajorDevelopedEconomiesG7LiquidityCycleAndTaylorRuleGap95969798990001020304050607123456123456PercentTaylorRuleActualInterestRateLowratesofreturnfromphysicalcapitaldrivedownrealyieldsonbondsofsimilarmaturityinfinancialmarkets.Nominalyieldsdifferfromrealyieldsbyarateofcoreinflationandbyariskpremiumthatguardsagainstunpredictablefuturepricelevelswings.Creditgrowthinfluencestheselattertwotermssinceitcanaffectboththerateandinstabilityofinflationandhencecreditspreads.Howeveritismorelikelythatonthisbasisrapidcreditgrowthwillbeassociatedwithrisingratherthanfallingnominalinterestratesbecauseofitspositivecorrelationwithgeneralinflation.TheSoWhatTestWhydoesthismatterIftheFedECBandBankofEnglanddontcontrolinterestrateswhateffectdotheiractionshaveSurelymovementsinCentralBankcreditandtheirannouncedintentionsmustshowupsomewhereOraretheregularFOMCandBankofEnglandMPCmeetingsjustpantomimesWehaveoftenarguedthatnoCentralBankhasthepowertosetshort-terminterestratesbecausethesearemarketdeterminedrates.RatherCentralBankssetinterestratetargets.Itistruethatthediscountrateisapre-announcedratebutthispolicyleverisonlyusedinextremisandnormallytinyamountsofmoneyarelentatdiscountrate.Sincethemarketisallpowerfulpolicy-makersmustbattleagainsttheprivatesectorinordertomakeaspecifictargetinterestratestick.HowevernotonlyareCentralBanksincreasinglyswampedbythesizeofprivatesectorflowsbuttherearesecondroundeffectsnotablyintheforexmarketsthatfurthermuddythewaters.LooseTight757677787980818283848586878889909192939495969798990001020304050607020406080100-600-400-2000200400600IndexBasisPointsLiquidityCycleLHSTaylorRuleGapRHS 5CROSSBORDERCAPITALForexamplesaytheFederalReservedesirestoraiseitsFedFundstarget.InstructionswillbesenttotheFederalOpenMarketDesktoreducetheamountofliquidityinmoneymarketsthroughsayoutrightsalesofUSTreasuriesorviatemporaryrepooperations.ThererarelyexistunconnectedeventsandthisreductioninUSdollarliquiditybycausingageneralshortageofUSdollarswillpushupthevalueoftheUSunitonforeignexchangemarkets.Arisingpapercurrencyvaluerepresentsamonetarydeflationthatwillbegintoreducetheoverallnominalpricestructure.Lowerpricesmakedebtholdingsunattractivewhichwillleadtoafallinthedemandfordomesticcredit.LowercreditdemandreducestheupwardpressureoninterestratestherebythwartingtheFedsinitialattempttoraiseinterestrates.OntopthegrowingsizeoftheprivatesectoranditsnewfoundabilitytosourcefundsfromthewholesalemoneymarketsandviaoverseasmarketsmeansthatfromanotherstandpointtheFedhaslesspotency.TodaytheFederalReservesbalancesheetstandsatbarelyUS0.8trillioncomparedtototalUSCreditMarketDebtofsomeUS45trillion.Awhoppingdifference.Influencingmarketinterestratesisthereforeajobthatisoftenbestdonethroughtryingtochangeinvestorsexpectationsratherthanthroughdirectlychangingthevolumeofcreditinprivatehands.Monetarytextbooksdescribeanarchaicversionoffinancialcontrolthrougharigidreservedepositconstraint.Todaythelimitsonfinancialexpansioncomeviaamoreelasticcreditcapitallink.Derivativessecuritisationandoff-balancesheettransactionsstretch-and-stretchthislinkallowingcredittogrowwell-beyondnormalandprudentcapitallimits.Ofcoursethisdoesnotsaythatthevolumeofcreditisunimportantorthatmonitoringcreditflowsisapointlesstask.RatheritsaysthatCentralBanksarebeingforcedtoactindifferentways.Specificallytheyhavebecomemorereactivethanproactiveinsettingmonetaryconditions.Moreoverparadoxicallytheyprobablyhavemorepowerovercurrenciesthanoverinterestrates.NotetherecentwordsofformerFedGovernorJerryJordan1ThetoolsavailabletoCentralBankstoinfluencethepurchasingpoweroftheircurrencyarequitefew.SinceitistheirownliabilitiesthatserveasmoneyalteringthesizeofthecentralbanksbalancesheetistheessentialmonetarytoolCentralBankscaniftheychoosecontrolthesizeoftheirbalancesheetsverypreciselyCurrentlythereisonlyonesourceofdollarstheliabilitiesofFederalReserveBanks.WritingsomeyearsagotheAmericanacademicandlaterGoldmanSachspartnerFischerBlacksimilarlybelievedthatCentralBanksexercisemorepoweroverexchangeratesthanoverinterestrates.HearguedthatCentralBanksoperatedontheyieldcurve.OutrightTreasurysaleswouldpulluplong-termyieldsandpushdownshort-termratesasextraliquidityflowedin.Thistimespreadbetweenlong-termandshort-termratesinaperfectmarketshouldequatetotheanticipateddepreciationoftheexchangerate.Thusasteepyieldcurveengineeredbyincreasingliquiditywilldepressthevalueofthecurrency.1JerryJordanMonetaryPolicyinTheTwentiethFirstCenturyFederalReserveBankofStLouisJournalNovemberDecember2006.Figure3recordsthedifferencebetweentheGlobalLiquidityCycleandtheTaylorRulegap.Thelattermeasuresthequantumbywhichmarketinterestratesdifferfromatargetleveldevisedtoroughlymirrortheunderlyingornaturalrate.PeriodswhentheTaylorRulegapiszeroarefrequentlystillassociatedwithabnormalliquidityconditions.ThismismatchhighlightsCentralBanksinabilitytocontrolthecreditmarkets. 6CROSSBORDERCAPITALConclusionGoldSoonAtUS1000ozWehavearguedthatthelevelofinterestratesisdifferentfromtheswingsinthecreditcycle.InturnneitherhavemuchtodowithCentralBanks.Liquidityboomsandslumpsarelargelydrivenbytheprivatefinancialsectorandprobablythesedaysmorebythenon-banksthanthetraditionalmoney-centrebanks.Rapidcreditgrowthisultimatelyinflationary.MeanwhilethelevelofrealinterestratesisdeterminedbythemarginalproductivityofcapitalintherealeconomyandthisiscurrentlyinthegiftofChinatheworldsswingproducerofmanymanufacturedproducts.Theinterfacebetweenliquidityandinterestratesappearsintheyieldcurve.Admittedlythemajorlistedequitieshavelatelyout-performedbondsthankslargelytobumperprofitsonexistingcapital.LookingaheaditwillbedifficultforWesterncorporationsandthusWesternequitymarketstode-couplefromthenegativeeffectsofChineseoverproduction.Thustodaysrealmarginalreturnsof2onnewinvestmentshouldbecometomorrowsmorewidespread2returnsonexistingcapitalasmore-and-moreplantequipmentandbuildingswearoutandhavetobereplaced.EquityreturnsnotnecessarilyequitymarketshavealongwaytofallTheseeconomicchallengesmayprovetougherbecausethepolicyframeworkitselfhasbeencompromisedbyeconomicandfinancialchange.Futurepolicy-errorsaremorelikelyifCentralBankswronglybelievetheycanstillsetinterestrates.CentralBanksmaybetoosmalltocontrolthemoneymarketsbuttheyarestillbigenoughtocausetroublewhentheytry.UsingnowpopularTaylorRulestoestablishinterestratetargetsortryingtoholdinterestratesabovemarketlevelstoprotecttheirwobblycurrenciespolicy-makersarecommittingseriouscrimes.TheTaylorRuleimplicitlyincorporatesawrong-headedPhillipsCurvephilosophywherebylessunemploymentcanbetraded-offagainstmoreinflation.Moreoverwidespreadconcernsoverrisingtradedeficitsseeminglyignorethefactthatweliveinaworlddominatedbycapitalflowswhichpreferstablecurrenciesandnottradeflowswhichenjoycompetitivecurrencies.Thismis-placedconcernthatcurrencyfragilityisdirectlyrelatedtosizeofcurrentaccountdeficitshasforcedsomeCentralBankerstoworrywhentheinterestratepremiumsenjoyedbydeficiteconomiesbegintowidensignificantly.LatelyinthecaseoftheYenthisisbelievedtoencourageacarrytradethatforcescapriciousspeculativeflowsintotheUSdollartherebyexposingpotentialfundingproblemsandthreateningfutureinstability.InourviewsuchattemptstoeliminatethecarrytradebyinterestratechangemayactuallyworsentheunderlyingproblemofweakdomesticdemandforYen.Overallwhatisreallyneededisbetterorsimplymoreliquiditymanagement.TheforcesshapingtheWorldeconomyaresimultaneouslystretchingtheelasticityofcreditandreducingrealinterestratesthroughmoredynamicproduction.Thisisnothingnew.ItistheveryhistoryofCapitalism.Thelatenineteenthcenturyeconomicboomcombinedtheimplementationofnewtechnologiese.g.railwaysturbinesBessemersteelandtheriseofbankingandstablecurrencieswithapost-warpoliticalimpetuse.g.followingtheAmericanCivilWarandtheFranco-PrussianWar.Equallypost-ColdWarinitiativesnewformsofcreditstablecurrenciesandtechnologicaladvancesaretodaydrivingtheWorldeconomyforward.Fasteconomicgrowthdoesnotguaranteeahighreturnoncapitalbutitlikelyfuelshopesandexpectationsandthusfacilitatesrapidcreditgrowth.Becauseofthetumblingpricesofmanufacturedimportsmore-and-moreofthiscreditservestofuelrisesinthepricesofdomesticservicesandassets.Thusinflationarypressuresareincreasinglybeinghiddenandignored. 7CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamSourceCrossBorderCapitalDatastreamFigure4.PercentageChangeInRealGoldPriceandRealInterestRates1974-2006Figure5.ProjectionOfUSDollarGoldPrice1972-2009-6-4-2024681012-100-50050100150200USRealInterestRatesRealUSGoldPriceYoYChg.Wearefacingaworldofexcessproductionlowrealyieldssurgingcreditlatentinflationrisingoddsofpolicy-errorandprobablymorebaddebtsasindustryisforciblyreshuffled.WheretoinvestGoldistheoneassetthatshineswhenrealinterestratesarestructurallylowandcreditgrowthcyclicallyrapid.SeeFigures4and5.Itsalsonottoobadasaninflationhedgeandserveswellinuncertaintimes.Wehavearguedbeforethatgoldisrisingagainstallpapercurrenciesdollarsyenandeuros.AgainsttheUSdollaritiscompoundingat10-12perannumandshouldthereforehitUS1000ozby2009.72747678808284868890929496980002040608020040060080010001200020040060080010001200USoz. 1GlobalViewGlobalViewJune201396BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceIMFCrossBorderCapitalFigure1CapitalSpending-MajorAdvancedEconomiesandChinaasGDP1990-2013HowChinaControlsWorldInterestRatesPart2Aroundtenyearsagoin2005wewrotearesearchpiecewiththeabovetitle.ThisarguedthatChinacontrolledthelevelofWorldinterestratespushingthemajorCentralBanksintosecondplace.ItwasaripostetothemythoftheSavingsGlutandtheequallypopularlaterfictionofaBalanceSheetRecession.TheWallTheWorldchangedbetweenJuneandNovember1989theeventsinTiananmenSquareinChinaandtheFalloftheBerlinWallsignalledthearrivaloftheEmergingMarkets.Theseeventseffectivelyeconomicallyenfranchised2-3billionnewproducersnotconsumers.TheyledtoavastincreaseinthesupplycapacityoftheWorldeconomyandamongotherthingsestablishedtheUSdollarasthepredominantmonetaryunitWorldwide.Capitalismwasre-lauchedwithnewimpetusbutbehindthescenesChinesepolicy-makersweremeddlingwiththecostofcapital.ChinasexplosivecapitalspendingboomwasfinancedbyStatebanksinapurposefulattemptbyformerleaderDengtorapidlyindustrialise.Moreattentionwaspaidtogettingurbanemploymentupthaninearningareturnoncapital.Thebottom-linewasthatthemarginalreturnoncapitalcollapsedandoutputleapt.EverythingthatanalystshadcriticisedJapanforinthe1980swasbecomingtruerandonanevengreaterscaleinmainlandChina.Chinaexportedthisswellingproduction.ThemainwinnerswereUSmultinationalsandhighstreetsWorldwidebecauseprocurementcostscouldbeslashedprofitmarginsfattenedandretailpricesstillbecut.Thebiggestloserswerethecapitalgoodssuppliers.0102030405060199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013ChinaAdvancedEconomies GlobalView2ChinawasinvestingfortheWorld.HeractionsfuelledbyabundantPBoCcredithammereddownthemarginalreturnsoncapitalfromnewinvestmentsincompetingeconomiesandcausedWesterncapextoskidtoavirtualhaltbarringreplacementspending.JapanandGermanywerekeylosers.Japanthemoresobecausehercoststructurebeingdependentonsmallmedium-sizedfirmsoftenlocatedinthebackstreetsofmajorcitieslikeTokyosimplycouldnotcompete.GermanycouldatleastfallbackonnewlyavailablecheapEastGermanlabouracomingdecadeoflabourlawreformandacaptivemarketintheRestofEuropethatcouldbetitillatedbycheapcredit.ThereforetheGreatChinaCostShockcanbeseeninthreeways1lowWesterncapitalinvestmentseeFigure12outperformanceofUSlargecapsharesagainstJapanesesmallcapseeFigure2and3acollapseinWorldrealinterestratesseeFigure3.InterestinglythecapexdatainFigure1comparesChinawiththeMajorAdvancedEconomiesandrevealaminus0.78negativecorrelation.InotherwordsthemoreChinainveststheLESStheWestdoes.NoSavingsGlutNoSpecialBalanceSheetRecessionThereforethebigproblemtheWorldeconomyhasfacedistoomanyproducers.InshortitisaCapacityGlutNOTaSavingsGlut.ExcesscapacityfinancedbyabundantChinesecreditpusheddownthemarginalrateofprofitonnewcapexandthisdrovedownrealbondyields.Figure4showsthechangeintheshareofcapexinChineseGDPalongsideourPBoCindexofliquidityinjectionssome18monthsearlier.ThereisaclearcausationbetweenPBoCliquidityandmoreChinesecapitalspending.Inequilibriumrealbondyieldsmustmatchthisrealreturnfromindustry.ThisistheexplanationbehindfallingWorldbondyields.Inotherwordsthemarginalproducerse.g.ChinarealreturnsdeterminethetermstructureofWorldinterestratesthroughthelong-end.ThisalsomeansthatFigure2JapaneseSmallCapTopixSecondSectionVsUSLargeCapSP500RatioLogScale1983-2013SourceCrossBorderCapitalTokyoStockExchangeStandardPoors83848586878889909192939495969798990001020304050607080910111213123571012357108384858687888990919293949596979899000102030405060708091011121312357101235710 3GlobalViewcontrarytotheconsensusbeliefthelong-endofthebondmarketdeterminestheshort-endandnotviceversa.ItisthesurgesofChineseproductionthatcauseyieldstodropnotwavesofChinesebuyingoftheUSbondmarket.InadditionthewholenotionofBalanceSheetRecessionmakesniceheadlinesbutisreallyamisinterpretation.AllrecessionsarebalancesheetrecessionssurelyTheproblemconcernsnotnecessarilytoomuchcapitalbuttoomuchunprofitablecapital.Thereforefirst-and-foremostweneedtounderstandwhyprofitabilityhasbeendestroyed.ThisasweargueistheresultofChinaspushtoindustrialisefuelledbyaSocialistbankingsystemwithlittleregardforeitherprofitabilityorconcernoverbaddebts.YetweunderstandthatitisdifficulttoseeatthesametimethatmanylargeWesterncorporationsarereportingbumperprofitsThesimplereasonhereisaconfusionbetweentheaveragereturnonexistingcapitalwhatisreportedinPLstatementsandthemarginalreturnonnewcapitalwhichoftengetsidelined.Majorcorporationsbychangingprocurementpoliciesandslashingcostscangeneratefatmarginsandreportlargeprofitsonexistingcapitalbuttheycannotgroworganically.RealRatesUpUpUpWehavearguedelsewherethatthebiggestanomalyinWorldfinancialmarketstodayistoolowrealinterestratesandnottoolittleinflation.Accordingtolong-runtrendssince1870theaverageWorldrealinterestrateis2.1andaverageinflationrate2.7.WithWorldinflationcurrentlyaround2.5andrealinterestrate0thelatteristhenumberoutofline.Realinterestratesinbondmarketsarenotsetbypolicy-makersasstandardfinancetheoryseemstosuggestbutbyprivatesectorindustryaccordingtothemarginalreturnoncapital.ThusChinasentryintotheWorldeconomyeffectivearound1990notonlycappedWorldinflationbutmoresignificantlyalteredthetrendinWorldrealinterestrates.InshortfallingrealinterestratesintheWestFigure3US5-YearRealInterestRatesTIPS5YearsOutPercentMonthly2018-2023SourceUSFederalReserve-0.500.000.501.001.502.002.503.003.504.00040120182902201825042018200620181508201810102018051220183001201927032019220520191707201911092019061120190101202026022020230420201806202013082020081020200312202028012021250320212005202115072021090920210411202130122021240220222004202215062022100820220510202230112022250120232203202317052023 GlobalView4owemoretothelegacyofDengthantheerrorsofGreenspan.InourviewthelatestpolicytwistsinChinamatteralot.Short-terminterestratesarespikingbecausethePBoCPeoplesBankappearsreluctanttocontinuefundingthecommercialandshadowbankingsystemtheymaynotdefaultbuttheycannotgrow.Inturnthissuggeststhattheeasymoneythatfuelledtwodecadesofabundantcapitalspendingisover.TheGreatChinaCostShockisprobablyconsignedtohistory.ThiswillhaveprofoundimplicationsfortheWorldandparticularlyfortheWest.AboveallthethreetrendsweearlieridentifiedastheresultoftheGreatChinaCostShockshouldnowreverse.ThereforeinnoparticularorderweshouldexpecttoseecapitalspendingrisingasaproportionofGDPrealinterestratesincreasingandJapanesesmallcapsharesbeginningtooutpacethesharesoflargecapUScorporations.ThereislittledoubtthatWesterncorporationshavetheavailablecashtospendonmorecapex.Thelast2-3yearshaveseenhugeinflowsintoCorporateTreasurydepartmentsascostshavebeencutandprofitmarginswidened.Nowlookingforwardinordertogetfurtherprofitgainstheymustreinvestratherthanrelyoncontinuallyfallingprocurementcosts.SowheredoesthisleaveBernankeetalAreCentralBankersnolongerGodsWehavealwaysarguedthatCentralBankersarecriticalfordeterminingtheriskpremiainfinancialmarketsthroughtheirbalancesheetoperations.Hereiswhereliquidityenterstheequation.TheCapitalistsystemisatitsheartamassiverefinancingsystemthatrequirestheconsistentrollingofpositionsbecausemostinstitutionslendshortandborrowlong.Thisprocessisinevitablyfragileanduncertainandneedsanoutsidebalancesheetthatcanprovideamplequantitiesoflegaltenderi.e.meansofsettlementwhencrisesoccur.ThisistheroleofCentralBanks.Whenthey010203040506070809010019921994199619982000200220042006200820102012-4-202468Figure4ChineseCapitalSpendingasShareofGDPannualchangeandPBoCLiquidity18monthsearlier1992-2013SourceIMFCrossBorderCapitalPBoCLIquidityIndexLHSChangeinCapexofGDPRHS 5GlobalViewexpandtheirbalancesheetstheyreducesystemriskpremiacausingyieldcurvestosteepenandwhentheyreducebalancesheetstheyincreaseriskpremiaandyieldcurvesflattenandsometimeseveninvert.Bondriskpremiaalwaysmoveoppositelytootherassetsbecausetheyarethelowriskasset.ThisisshowninFigure5bythestrongcorrelationbetweenUSliquidityandtheUSyieldcurvereadbondriskpremium.Thusasinvestorsmoveoutalongtheriskcurvebondriskpremiariseandequityriskpremiasayfall.Currentlypolicy-makersareeasing.Yieldcurvesaresteepeningriskpremiaonmostassetsarefallingbutthoseonbondsthelowriskassetsarerising.Hencethebondmarketsfaceadouble-whammy.ChinasactionsaresendingrealinterestratesupandQEpoliciesareaddingarisingbondriskpremia.Withormostlikelywithoutfasterinflationbondyieldsareheadingbackto4-5.LiquidityRisingYieldCurveSteepening8082848688909294969800020406081012020406080100-150-100-50050100150200250300350Figure5US10y-2yYieldCurveandUSDollarAreaLiquidityBasisPointsandIndexMonthly1980-2013SourceCrossBorderCapitalUSFederalReserveIMFUSDollarAreaLiquidityIndexLHSUS10Y-2YYieldCurveBasisPointsRHS 1GlobalViewGlobalViewSeptember201396BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comGoodMoneyBadMoneyandtheChineseElephantMarketsarebecomingobsessedwithAmericastaperingdebatetheefficacyofQEversusforwardguidance.Neitherreallymattersinceinvestorsaremissingtheelephantintheroom.ThiselephantisChinese.ItspresencewarnsofbigchangesinChinaseconomyandlargelyexplainsthecurrentplightofEmergingMarkets.ThetruthisthatUSFedtaperingmatterslittlebecausethefarmoreimportanttaperingbyChinasPBoCisalreadywellunderway.ChinaFinallyLoosensItsGriponWorldRealInterestRatesWehavepreviouslyexpresseddoubtandconcernsaboutthepathofChinaseconomy.WehavelabelledtheChineseeconomicgrowthpathSoviet-likebecauseithaslargelycomefromthemassivecorrallingofinputsintoproductionratherthangenuinevalue-addedthroughinnovationandtechnology.TodrawananalogyChinaproduceslotsoflowvalue-addedsausagesbypumpinghugevolumesofsausagemeatintothehopper.Resulteconomicindigestion.ThePeoplesBankPBoClargelyunderwrotethisprocessbyfinancingawhoppingexpansioninChinascapitalbasevirtuallyregardlessofitsprofitability.Figure1highlightsthecorrelationbetweenChinaschanginginvestmentshareofGDPandPBoCliquidityinjections.ThePBoCoperatesanear-purequantitymonetarypolicyi.e.QEenactedthroughreservemanagementanddirectloanstoStateEnterprises.Therearephysicallimitstothisinvestmentprocesswhichtherisingevidenceofbottlenecksandinflationpocketsacrosstheeconomylikelyattestto.Putbluntlythedaysof9-10annualGDPgrowtharebehindusandgoingforwardChinaismorelikelytoseemoreprosaicannualratesofcirca5-6.SourceCrossBorderCapitalPeoplesBankofChinaIMFFigure1PBoCFinancedChinasCapexBoom...UntilItStopped1990-2013010203040506070809010019921994199619982000200220042006200820102012-4-202468PBoCLiquidityIndexLHSChangeinCapexofGDPRHS GlobalView2AmajorconsequenceofChinas1990-2010money-fuelledboomwasthecollapseinthemarginalreturnonWesterncapitalastheWorldincreasinglydiscoveredthatChinawaseffectivelyinvestingforeveryoneelseandexportingsometimesdumpingtheproduction.HereinliestheexplanationforwhyWorldrealinterestratesaresolow.WehavewrittenoverthepastdecadeonthisthemewhichwedubHowChinasetsWorldinterestratesTheargumentrestsonthebroadequivalencebetweenrealbondyieldse.g.USTIPSandthemarginalreturnonWesterncapitalbothusescompeteforsavingsandtheweakerthedemandforcapexinEuropeJapanandtheUSthelowerthecosttogovernmentsofsellingTreasuriessuchasTIPS.InotherwordsitisthebadpoliciesofChinasPBoCandnotthegeniusoftheFederalReservethatexplainslowWorldinterestrates.AndbynotmatchingWesternmonetarypolicytoChinasinthemid-2000slargelyinourviewexplainsthebackdroptotheLehmanCrisisandnottheemptynotionofglobalimbalances.SeeFigure2.Therearetwocorollaries.FirstJapanthegeographicallyclosestmajoreconomyinitiallysufferedmostseverelyfromthesurgeinChinesecapex.JapanandespeciallyJapanesesmallercompaniesbecamede-linkedfromtheglobalsupplychain.ThissoonspreadtootherWesterneconomiesasFigure3highlights.InFigure3weplottheimpliedmarginalreturnoncapitalintheUSandJapanoverthe1985-2013period.Conventionalanalysisisforcedtoignorethemarginalreturnonnewcapitalandlooksinsteadatreportedprofitswhichmeasuretheaveragereturnonexistingcapital.Marginalreturnswillliewellbelowaveragereturnswhencorporationsforexamplelacknewinvestmentopportunitiesandorengageinextensivecost-restructuringexercises.ThedataweuseiscompiledbyfirstmeasuringthemarginalproductivityofcapitalfromNationalIncomeAccountsandFigure2WorldRealInterestratesandMarginalReturnonWesternCapital1985-2013SourceCrossBorderCapitalIMFMarginalReturnonKWorldRealRates-10123456719851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013 3GlobalViewFigure3USandJapaneseMarginalReturnsonCapital1985-2013thenscalingthisdownbytheaverageshareofprofitsinGDP.TheresultsnotonlyshowJapanslead-timeoverAmericainsufferinglowerreturnsbuttheyalsocorrespondtothecontemporaneousslideinWorldrealinterestrates.Overthecourseof150yearsofWesterneconomichistoryrealinterestrateshaveaveraged2.5.RecentlytheytouchedzeroandaccordingtolatestUSdataalthoughnowreboundingstillremainlow.Thishasbeenandremainsthemajoranomalyinglobalmarketsnotinflationwhichparadoxicallystandsclosetoitslong-termaverageof2.7.SeeFigure4.ImpactofGoodandBadLiquidityFlowsThesecondimplicationconcernsliquidity.Ouranalysisofflowoffundsaccountsidentifiestwobroadtypesofliquidity1privatesectorcashflowsavingsandnewcreditextendedand2CentralBankmonetaryinjections.Itissometimeshelpfultodubtheformergoodmoneyandthelatterbadmoney.Economieswithplentyofgoodmoneyworkbetter.Inotherwordscashflowgenerationbycorporationsindicatesrisingprofitabilitywhileapick-upinlendingprobablytellsusthatfundingisavailableandbankersthemselvesseeviablecapitalprojects.Typicallyprivatesectorcashflowalsoleadsfuturerealeconomicactivityby12-15months.Bymonitoringtheaccumulationofthiscashinbankaccountsandwholesalemarketsonareal-timebasiswecanoftenspotmajoreconomicturningpointslongbeforetheyappearintheofficialdata.Figure5plotsthepathofUSandChineseprivatesectorliquidityakagoodmoney.Intheearly2000sChinesegoodmoneyunambiguouslyoutpacedUSgoodmoneybutChinascashflowgenerationhassinceprogressivelyslidandtodaythegapbetweenUSandChinesegoodmoneystronglyfavoursAmerica.PartofthisextraUScashisadmittedlytheresultofAmericasShaleOilboombutmoneyismoneyitcountsinthesenumbers.TheevidenceofaUSadvantageisevenstarkerwhenwenet-offthebadmoneyflowswhichcountSourceCrossBorderCapitalIMFUSJapan012345678919851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013 GlobalView4Figure4US5-YearRealInterestrates5-YearsOutWeekly2003-2013SourceCrossBorderCapitalUSFederalReserveFigure5USVersusChineseGoodMoneyPrivateSectorCashFlowIndexNormalRange0-100Monthly2000-2013SourceCrossBorderCapitalUSFederalReservePeoplesBankofChinaUSChina0204060801001202000-012000-062000-112001-042001-092002-022002-072002-122003-052003-102004-032004-082005-012005-062005-112006-042006-092007-022007-072007-122008-052008-102009-032009-082010-012010-062010-112011-042011-092012-022012-072012-122013-05-0.500.000.501.001.502.002.503.003.504.004.500301200303052003030920030301200403052004030920040301200503052005030920050301200603052006030920060301200703052007030920070301200803052008030920080301200903052009030920090301201003052010030920100301201103052011030920110301201203052012030920120301201303052013 5GlobalViewnegativelyanycashinjectionsbytheFedandPBoC.TheasynchronouspatternsareshowninFigures6and7wherethecorrelationcoefficientbetweenChineseandUSprivatesectorliquidityisnegative0.492000-2013.TheChinesePBoCsliquiditypolicyshowsasmallnegativecorrelationtoFedactivity.ThetwochartsrevealthatthefortunesofthetwoeconomiestypicallymoveinoppositedirectionswhichmaynotbethatsurprisingsincetheyarenumberoneandnumbertwointheWorld.WhatsmorethebroaderEMcycleiscloselytiedtoChinasasthefollowingFigure8shows.EmergingMarketCentralBankliquidityhasa0.60correlationcoefficienttoPBoCactivityandEMprivatesectorliquidityhasa0.76correlationtoitsChinesecounterpart.ThislattercorrelationpatternlargelyexplainsrecentEMunderperformance.ThefortunesofEMandChinaoftenrunhand-in-handandfromthemid-1990stheyappeartomoveoppositelytoUSprospects.RealExchangesRatesandLiquidity-AdjustmentButhowshouldweusethisflowinformationSpecificallyshouldwenottakethelatestdivergencebetweentheUSandEMasasignaltobuyEMbecausethetwoseriessurelywillultimatelyconvergeagainThispartlycomesdowntoatimingquestionandpartlyaChinaquestion.Therearecompellingargumentstosuggestthattheflowdatawillmean-revertbecausethisishoweconomieswork.Howeverweprefertoseethisprocessunderwayoratleaststarting.SofarthisevidenceofanyturnisslimandmaybethisisbecauseChineseflowsthemselvesarestillweak.Seconditisworthexploringhowtheseflowdataaffectmarketsanddovetailwithconventionaleconomiccategories.OurstartingpointistoconsideradjustmentthroughproductivityandrealexchangeFigure6USVersusChina-GoodLessBadMoneyFlowsIndexNormalRange0-100Monthly2000-2013SourceCrossBorderCapitalUSFederalReservePeoplesBankofChinaUSChina-80-60-40-200204060802000-012000-062000-112001-042001-092002-022002-072002-122003-052003-102004-032004-082005-012005-062005-112006-042006-092007-022007-072007-122008-052008-102009-032009-082010-012010-062010-112011-042011-092012-022012-072012-122013-05 GlobalView6Figure7MarginalProductivityofCapital-ChinaandUS1985-2013SourceCrossBorderCapitalIMFrates.Apositivejumpinproductivityshouldcauseprivatesectorliquiditygoodmoneytogrowandthisinturnislikelytoaddupwardpressuretorealexchangerates.Amoveintherealexchangeratecaneithermeanaariseinthenominalexchangerateifthisisallowedandorbariseinpricesandherewemusttakeintoaccountallpricesbothconsumerandassetprices.Moreovermostpriceadjustmentindevelopedeconomiestendstoconcentrateinassetmarkets.Thistwinadjustmentmaybeitselfsubjecttopolicyconstraintswhenpolicy-makerstargetthecurrencyandorseektoavoidexcessiveassetpriceswingsparticularlyifthisadverselyaffectsthecollateralbaseofthecreditsystem.Thereforealongsidechangesingoodmoneyflowseconomiescanoftenfaceadditionalflowsofbadmoney.Thedatashowthatbadmoneytendstoraiseassetpricesbutatthecostofweakeningexchangerates.Goodmoneyallowsbothastrongcurrencyandstrongassetmarkets.Specificallyconsiderheretwocases.Continuingwithaneconomyenjoyingaproductivityjumpthiswillleadtosomecombinationofrisingnominalexchangeratesandrisingassetprices.Ifpolicy-makersarereluctanttoallowthenominalexchangeratetoappreciatethenbyincreasingbadmoneyflowstheycanarrestitsrisebutbyaddingmoreliquiditytheywillalmostcertainlycauseassetpricestoovershoot.ThishastraditionallybeentheEMexamplei.e.firm-to-strongcurrenciesandstrongassetmarkets...atleastuntilnow.Anoppositecaseconcernsanegativeproductivityshock.Depletingprivatesectorcashflowsputsdownwardpressureontherealexchangerateleadingtoeitherorbothofaslidingnominalexchangerateandfallingassetprices.Ifpolicy-makerswanttostopthecurrencyweakeningtheywillreducetheirliquidityinjectionsbutthiswilllikelytriggeracollapseinassetprices.AlternativelyiftheywanttoavoidfallingassetpricesforfearthatbunderminingcollateralvaluesthiscouldleadtoabankingcrashtheywilladdChinaUSA0510152025303519851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013 7GlobalViewliquiditytosupportassetpricesbutatthecostofasharpfallintheexchangerate.ThislattercasehasbeentheUSstoryi.e.decentassetmarketsbutaslidingUSdollar...atleastuntilnow.ThereforewhatliquidityflowsarecurrentlytellingusisthattheUSmixofstronggoodmoneyflowsanddecentbadmoneyinflowsisthatUSpolicy-makersarekeenertosupportassetvaluesthantoenjoyastrongUSdollarbutthegreaterthepressuretocurtailQEthegreatertheriskthattheUSdollarrises.InshortforeigninvestorsintotheUSshouldnothedgetheUSdollar.TheEMstoryisdifferent.HereEMpolicy-makersaregraduallyandunevenlymovingtowardsarealisationthattheywillhavetoallowsomeexchangerateweaknessespeciallyiftheChina-growthmodelisbroken.Wethinkitis.Thisrealityisperhapsmadeevenstarkerin2013bytherecentslideinthevalueoftheYenwhichpre-1990andChinasgreaterinvolvementintheWorldeconomywasthetraditionaldriveroftheAsianbusinesscycle.Figure9suggeststhatthemixoftightEMdomesticpolicyandskiddingprivatesectorliquidityislikelytokeepcross-borderflowsintoEMweakforsometimeyet.ConclusionMarketsaremissingtheelephantintheroomwhichismonetarytaperingbyChinasPBoC.ThishasalreadychangedthedynamicsoftheWorldeconomybyendingwhatwehavepreviouslydubbedtheGreatChinaCostShock.AsaresultChinaisfast-losingitscontrolofWorldrealinterestrates.ThereboundinUSTIPSyieldsmaywellbeearlyproofofthis.InconclusionwearemovingtowardasolutiontotheEMCrisisbutitisstilltooearlytoumpbackintoEMequitiessaveperhapsforputtingatoebackintothewater.HoweverselectedEMinvestmentsmaybeworthconsideringandheretheChinastorytakesanothertwist.ThefactthatthePBoCisnolongerfinancingaglutofChineseSourceCrossBorderCapitalIMFPeoplesBankofChinaFigure8EMandChinaGoodlessBadMoneyFlowsIndexNormalRange0-100Monthly2000-2013ChinaEM-80-60-40-200204060802000-012000-062000-112001-042001-092002-022002-072002-122003-052003-102004-032004-082005-012005-062005-112006-042006-092007-022007-072007-122008-052008-102009-032009-082010-012010-062010-112011-042011-092012-022012-072012-122013-05 GlobalView8capitalislikelytopullupthereturnoncapitalintheWestbutparticularlyintheUSwherecapexhasbeendepressedandJapanwherethesmall-capfocussedsupply-chainwasallbutdestroyed.InotherwordsinvestinginUScapitalgoodsproducersandJapanesesmall-capmaybethewaytoplaythissignificantpolicy-changeinChina.TakingafurtherstepthoseEMthatarecorrelatedtotheUScapexcyclesuchasTaiwanIsraelandtosomeextentKoreaareworthconsidering.WeacknowledgethatKoreanprospectsrestontheoutlookfortheWonparticularlyifwidespreadfearsoffurtherYendevaluationcometopass.HoweverbasedonourwayoflookingattheWorldthelateststrongreboundinJapaneseprivatesectorliquiditygoodmoneymakessignificantlymoreYenweaknessunlikely.Figure9EMPrivateSectorLiquidityGoodMoneylessCentralBankLiquidityBadMoneyandCross-BorderFlowsIntoEMIndexes1990-2013SourceCrossBorderCapitalIMFEMCBFNetEMLiquidity0102030405060708090100-100-80-60-40-200204060801001990-011990-091991-051992-011992-091993-051994-011994-091995-051996-011996-091997-051998-011998-091999-052000-012000-092001-052002-012002-092003-052004-012004-092005-052006-012006-092007-052008-012008-092009-052010-012010-092011-052012-012012-092013-05 1GlobalViewGlobalViewJanuary2014ChinaAmericaandCollapsingCapitalFlowstoEMForaslongaswecanrememberthekeystatisticforEMinvestorsisthesizeofcross-borderinflows.IfforeignersarepumpinginmoneyallmustbewellIronicallylastyearwasnottoobadforEMfinancialassetssincefollowingahugenetoutflowofUS166billionin2012onlyanotherUS31billionleftEMstocksbondsandcreditmarketsin2013.Foreigninvestorsshowedremarkableresiliencelastyeartodeterioratingeconomicfundamentals.Fortherecord2009and2010werebigpositiveyearsforEMseeingnearlyUS600billionflowin.InshortthereislotsmorecashtocomeoutfromEMand2014maybetheyearithappens.PutincontextthisistheworstbusinessenvironmentfacingEMthatwehaveseensincethemid-1990s.YetthepunditsarewrongtoblameAmericaandtheprospectoftighteningFedpolicyortapering.PlainlytaperingisnotabullishactbutwereitsuchamajorthreatthensurelythefarmorevulnerableFrontierMarketswouldbegettingcreamedRathertheculpritisChinaorputbluntlytherealityofChinesemonetarytaperingbythePBoC.TheproblemsurelylieswithdeterioratingEMbalanceofpaymentsandtheirinabilitytoaccumulateforexreservesasaresultofChinesepolicyratherthananyfuturelackofexternalfinancefromtheUSThisissomethingwehavebeenbangingonaboutforsometimeandofteninthefaceofoppositepredictionsbyothercommentatorsthatthePBoCisalwaysjustabouttoease.WethinkaChinesemonetaryeasingisunlikelymuchbefore2015.Thereasonslieinthestillunbalancedeconomyandtheattemptsbypolicy-makerstoreducethedependenceonheavycapitalinvestment.WithoutthislatterpropthedomesticChineseeconomywilllikelyskidtoatrueGDPgrowthrateofsub-5withtheassociatednegativefall-outforcommoditiesandothersupplierindustries.ForemostamongthesesupplierstoChinaaremanyEMcompanies.TheiraxisofbusinessactivityhasswungawayfromtheUSconsumerinrecentyearstowardsChinesecapital.FifteenyearsagoitwassafetoconcludethattheUSbusinesscycleandFederalReservemonetarypolicydroveEMbothSourceCrossBorderCapitalFigure1Cross-BorderFlowstoEmergingMarketsandChineseLiquidityIndexesMonthly2005-2013MarbleArchTower55BryanstonStreetLondonW1H7AATel02078684104www.crossbordercapital.comEMCBFChineseLiquidity01020304050607080901002005-012005-052005-092006-012006-052006-092007-012007-052007-092008-012008-052008-092009-012009-052009-092010-012010-052010-092011-012011-052011-092012-012012-052012-092013-012013-052013-09 GlobalView2upanddown.Thisisnowfarlesstrue.MajorcommoditysuppliessuchasBrazilSouthAfricaandIndonesiahavebecomelargelydependentonChina.OthereconomiessuchasSingaporeMalaysiaandThailandareintegratedintotheChinesesupplychain.InshortwhenChinasneezestheEmergingWorldcatchescold.ThisisnottosaythatUSrecessionFedtighteningorsayafallintheJapaneseYenwillleaveEMnonplussedbutthemostobviousconnectionistowatchtheirChinalinks.ThisisplainlyevidentfromFigure1whichmeasurescapitalflowstoallEMexChinaandtheCBCmeasureofChineseliquidityconditionscorrelationcoefficient0.542.TherelationshipappearscontemporaneousforthemostpartbutclearlyhighlightsthecloseassociationbetweenEMflowsandthehealthofChina.Theindexofcross-borderflowsisanormaliseddataseriesthathelpstoidentifytheunderlyingtrendwithoutthedistortionsofvolatilityandinflation.ItreflectsunderlyingUSamountsasFigure2showsbutiseasierontheeyeThisistheseriesplottedinFigure1too.ToquicklyrehearsethereasonsbehindourscepticismoverChinaFirstthereareseveralpastexamplesofeconomiesusingtheinvestmentgoodsindustrytodrivegrowth.Sadlyeveryonewecanthinkofhitanegativetipping-pointoncecapitalspendingapproached35-40ofGDPChinascapexshareisalreadyawhopping50.SecondgivencapexscontributiontoChineseGDPishugelylop-sideditishardtoseehowothersectorssuchasconsumerspendingcanrealisticallytakeovermomentumwithoutthenationalgrowthratetumblingbelowitslikely5long-runtrend.Thirdthemonetaryadjustmentmaybelonganddrawn-outpossiblylastingwellinto2015.Chinaseconomicimbalanceshavebeenexaggeratedbythe2008-11boomthatwasenactedtobolsterregionaldemandinthewakeofthe2007-08GlobalFinancialCrisis.PutanotherwayatumbleinChinesegrowthwilllikelymeanSourceCrossBorderCapitalPeoplesBankofChinaIMFFigure2Cross-BorderFinancialFlowstoEM-USDollarsBIllionsandIndex2006-2013Cross-BorderFlowstoEMEMCBFIndex0102030405060708090-350000-300000-250000-200000-150000-100000-500000500001000001500002000002006-062006-092006-122007-032007-062007-092007-122008-032008-062008-092008-122009-032009-062009-092009-122010-032010-062010-092010-122011-032011-062011-092011-122012-032012-062012-092012-122013-032013-062013-09CrossBorderFlowsUSBnCrossBorderFlowsIndex 3GlobalViewaneconomichard-landingfortherestofAsiaandmanyotherEMeconomies.In2013Chineseoilimportvolumesgrewbyonly4anunlikelyfigureforadevelopingeconomysupposedlygrowingatanofficial8clipgiventhatcrudeoilisanecessityWerestatethesepointsnottowinanymeritsforpresciencebuttohighlightthefactthatthehard-landingshaveonlyjuststarted.Morebadnewsliesahead.IndeedintheaboveraggedcapitalflowdatamayevenlietheseedsofthenextWorldfinancialcrisis.ThetensionpointacrossEMasalwaysisforexmarketweakness.FirstcoinedforMexicoin199495pesobust-upouroldmaximneverwearsthinEveryEMfinancialcrisisisfirst-and-foremostacurrencycrisis...Weusecurrencyriskindicatorstowarnofupcomingproblems.Thesearesimplestatisticstakenfromflow-of-fundaccountsthatmeasurethebalancebetweenprivatesectorandCentralBankliquidityprovision.Whenthedomesticprivatesectorisstronglycashgenerativee.g.corporatecashflowisbuoyanthouseholdsavingssolidandprofitabilityhighthenthecurrencyislikelytobeamagnetforinternationalcapital.HoweverwhenthenationalCentralBankisforcedtoprintmoneythesupplyofliquidityjumpsandthecurrencyslides.Itisremarkablehowwellthissimplestatisticworksoftenleadingcurrencycrisesbyaroundoneyear.AllwedoistocollectandnormalisethedataintoaForexRiskIndex.Figure3showstherelationshipbetweentheEMForexRiskIndexandcross-borderflowstoEM.Forexriskleadsbyoverayear.Figure4extendsthistoshowtherelationshipbetweentheEMForexRiskIndexandsubsequentdevaluationsagainsome6-12monthslater.GiventhattheEMForexRiskmeasureleadswhatdoesthismeanforthelikelypatternofactualUSdollarcapitalflowstoEMFigure6showsthepossiblepathbyadvancingtheriskindexforward.ItseemsthatoutflowsofasmuchasUS100-200billionatamonthlyratecouldoccur.Inotherwords2014couldbeFigure3Cross-BorderFlowstoEMIndexandEMForexRiskIndexInverted1980-2013SourceCrossBorderCapitalPeoplesBankofChinaIMFCBFtoEMIndexEMFxRiskIndexInverted-150-100-5005010001020304050607080901001980-011981-021982-031983-041984-051985-061986-071987-081988-091989-101990-111991-121993-011994-021995-031996-041997-051998-061999-072000-082001-092002-102003-112004-122006-012007-022008-032009-042010-052011-062012-072013-08CrossBorderFlowsFXRiskIndexLowRiskHighRisk GlobalView4worsethan2012intermsofnetoutflowsandpossiblyaspoorastheUS431billionthatexitedEMbetweenmid-2008andmid-2009.FortherecordinthelastCrisisin1998anetUS154billionleftEM.LookingaheadinvestorsmaybepleasedthatsomanyEMCentralBanksaretighteningmonetarypoliciestohelpsupporttheircurrenciesbutthisdisguisesthetrueproblem.TheissueisnotalwaysexcessEMdomesticdemandratheritismostlythenegativefall-outfromChina.Thereforesqueezingadomesticeconomyalreadyreelingfromanexternalshocklookstobebadeconomicsandanunsustainablepolicyerror.Whattheseeconomiesprobablyneedisalowerrealexchangeratethisrequireslowerdomesticassetandorhighstreetpricesandaweakercurrency.Impatientmarketsoftenforcethelatter...thenextEMCrisismayonlyjustbestarting.ThefollowingtableranksEMeconomiesbyourmeasuresofForexRiskbasedasdescribedonthegapbetweenprivatesectorandCentralBankliquidityprovision.Thestand-outsamongthelargerEMareTurkeyMalaysiaKoreaandIndia.TheThaiBahtlooksrelativelystableicomparisonbutitisclearjusthowstrongthefundamentalsforWesterncurrenciesare.-80-60-40-200204060801995-011996-011997-011998-011999-012000-012001-012002-012003-012004-012005-012006-012007-012008-012009-012010-012011-012012-012013-012014-01-10-505101520SourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFFigure4EMlessDMCurrencyRiskIndexAdvanced7MonthsandEMCurrencyDevaluationvs.theUSdollarMonthly1995-2014CurrencyDevaluationHighRiskLowRiskFXRiskIndex 5GlobalViewSourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFFigure5RankingofEMEconomiesbyForexRisk-60-40-2002040UKUSEuroHungaryCzechRepublicThailandIsraelEgyptSouthAfricaTaiwanPhilippinesIndonesiaRussiaBrazilMexicoSriLankaUkraineColombiaPolandIndiaKoreaArgentinaEstoniaSerbiaMalaysiaMauritiusBotswanaRomaniaMoroccoTurkeyLowRiskHighRiskFXRiskIndex GlobalView6CROSSBORDERCAPITALLIMITEDMARBLEARCHTOWER55BRYANSTONSTREETLONDONW1H7AATELEPHONE02078684104FACSIMILE02078684118AUTHORISEDANDREGULATEDBYTHEFINANCIALCONDUCTAUTHORITYCROSSBORDERCAPITALLIMITED2014.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESS26REDLIONSQUARELONDONWC1R4AGThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.Figure6Cross-BorderFlowstoEMandEMForexRiskIndexInverted2008-2013SourceCrossBorderCapitalPeoplesBankofChinaIMFEMForexRiskIndexInvertedCross-BorderFlowstoEM-120-100-80-60-40-20020406080100-350000-300000-250000-200000-150000-100000-500000500001000001500002000002008-012008-032008-052008-072008-092008-112009-012009-032009-052009-072009-092009-112010-012010-032010-052010-072010-092010-112011-012011-032011-052011-072011-092011-112012-012012-032012-052012-072012-092012-112013-012013-032013-052013-072013-092013-11CrossBorderFlowsUSBnLowRiskHighRiskFXRiskIndex 1GlobalViewGlobalViewApril201196BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalUSFederalReserveECBBankofEnglandBankofJapanIMFFigure1GlobalLiquidityCycleandYieldCurveSlopeofG20Economies10-YearBondless3-MonthInterestRatesMonthly1972-2011GrossInterestRatesandtheEndofQE2WearenotconvincedbytheconsensusviewthatUSbondyieldswillrisesignificantlyinQ3aftertheendofQE2.Bondyieldshavethreecomponentsandintheshorttermthemostimportantistheriskpremiumwhichismeas-uredinverselybytheslopeoftheyieldcurve.ExperienceoverthepasttwoyearsthroughtheQEexperimentshowsthatthevolumeofFedliquiditydrivesthisriskpremium.ThereforelessliquidityashappenedbrieflyafterQE1willcausethisriskpremiumtoriseagainandthusyieldcurvestoflatten.UnlessFedFundsarealsoforcedupthismustmeanthatbondyieldsfall.ThebigdebatingpointthisquarterwillbethemarketeffectoftheslatedendofQE2.TheWorldslargestfixed-incomemanagerPimcosBillGrosshasalreadywarnedthatUSTreasuryyieldswillriseandperhapsbyasmuchas100-150bp.OthersincludingFedChairmanBernankearguereassuringlythatthemarketsefficiencywillmeantherewillbenooveralleffectsincethisnewshasalreadybeendiscounted.Wearelessconvinced.Inourviewthemostlikelycaseisforlowerlong-termyields.Hereswhy.Themostimportantpriceinfinancialmarketsisthepriceofthedominanteconomysdebt.ThereforebenchmarkUS10-yearTreasuryyieldsarecentraltofutureWorldeconomicprospects.Thesekeylong-terminterestratesshowremarkablestabilitythroughtimeastheymustbecausetheyarethebench-markagainstwhichmostotherassetsarepriced.Ignoringshort-termwobblesandchangesineconomicleadershipoveranear300-yearhistorybondshavegravitatedarounda4yieldbase.7274767880828486889092949698000204060810020406080100-200-1000100200300LiquidityRisingYieldCurveSteepening GlobalView2Ouranalysisofthesedatahighlightedinareportlastyearshowedthatlong-termbondyieldshavethreecomponents-arealinterestrateanexpectedinflationpremiumandariskpremium.ItistheriskpremiumsignaledbyyieldcurvegyrationsthatmattersmostintheshorttermbecausetheothertwomoresecularforcestendtobestickysinceRealyieldsaredeterminedbythemarginalproductivityofcapitaloftheswingglobalproducer.ThistodaymeansChinaandwiththeChineseeconomydefactoexport-focussedandstilldumpinggoodsintheWestitisunlikelyinourviewthatrealinterestrateswillrisemuchifatall.Expectedinflationissetbytheinteractionofcostandmonetaryinflationfactors.Andspecificallyeithercostdeflationormonetarydeflationaresufficienttopushdowninflationexpectationsbutittypicallytakesbothmonetaryinflationandcostinflationpressuresactingtogethertoelevateinflationexpectations.Costinflationremainssubduedlargelythroughdepressedwagecostsdespiterecentstronggainsincommodityprices.Monetaryinflationandmonetarydeflationareverydifferenttohighstreetinflation.Theyprimarilyaffectassetmarketsandtheyarebestsignalledbymovementsinthenominalgoldpricebuttheycanalsoshowuprespectivelyinsteepeningandflatteningyieldcurves.ThislinkageisimportantbecauseourwiderresearchshowsthatthemainimpactofCentralBankmonetarypolicychangesoperatesindirectlythroughvariousriskpremiasuchastheyieldcurvethecreditspreadandtheequityriskpremiumratherthandirectlythroughtheFederalFundsrate.SeeFigure1.ConsiderhowthistransmissionprocessrecentlyplayedoutshowninFigure2TheFedinitiallyreactedtothe200708financialcrisisbyslashingshort-terminterestrates.Givennosignificantassociatedchangeinthevolumeofliquiditythismeantthattheyieldcurvechangedlittleandsolowershort-termratesledtoasimilardropinlong-termrates.StagetwoofthecrisissawthestartofQE1.Thisextraliquidityaccordingtoourthinkingshouldsteepenyieldcurveswhichitdid.Thuswithshort-termrateslowbutunchangedthismeantrisinglong-terminterestrates.TheendofQE1ledtoawithdrawalofliquidityandthisflattenedyieldcurves.Inturnwithshort-termratesunchangedlongrateshadtofall.Thefinalstageisthere-startofliquidityinjectionsthroughQE2.Thisledtoarenewedyieldcurvesteepeningandagainwithshort-termratesunchangedtheadjustmentcameviarisinglong-termyields.Itfollowsfromthisthatlong-terminterestratescanalsobebrokendowninasecondwaythatbetterhighlightsthechangingriskpremium1ashort-terminterestrateanchore.g.FederalFundsand2ayieldspreadbetweenlong-andshort-termratesthatislargelydeterminedbythevolumeofFedliquidity.Thereforeassumingthatshort-terminterestratesremainunchangedanyvariationinthevolumeofliquiditymustforcehigherriskpremiaandthisalsomeansaflatteryieldcurve.ItisamootpointwhethertherealeconomywillalsosubsequentlysufferHoweveritseemslikely.TheendofQE1causedaneconomicwobbleandonearguablylargeenoughtoinspireQE2.PerhapsQE3willnotcomequitesoquicklyafterQE2giventherecentdropintheunemploymentrateresidualfearsaboutinflationpressuresgiventhetick-upincoreCPIratesandpressureagainstmoreFedactionbypowerfulfactionsinsideCongress.OntheotherhandaseriousUSeconomicsetbackorpersistentlackofeconomictractionsurelywilltriggerafurtherliquiditysurgeInturnanyextraliquiditywillagainforcetheyieldcurvetosteepen.ThepatternoffutureUSyieldcurvemovementswillthereforeremaincyclicalbutimportantlytheamplitudeoftheseswingswillbemutedcomparedtorecenthistoryandmostsignificantlythesteepaveragecurveslopewilllikelyembedasizeablecarry. 3GlobalView0.00.51.01.52.02.53.03.54.04.50401200804032008040520080407200804092008041120080401200904032009040520090407200904092009041120090401201004032010040520100407201004092010041120100401201104032011Sub-PrimeCrisisFedFundsSlashedQE1StartsYieldSpreadQE1EndsQE2StartsQE2AnticipatedtoEndCROSSBORDERCAPITALLIMITED96BAKERSTREETLONDONW1U6TJTELEPHONE02079082800FACSIMILE02079082835REGULATEDBYTHEFSACROSSBORDERCAPITALLIMITED2011.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.SourceCrossBorderCapitalUSFederalReserveFigure2US10-YearBondYieldandFederalFundsRatePercentWeekly2008-2011FedFundsRate10-YearBondYield 1GlobalViewGlobalViewDecember2013TheNewOldYieldCurveBondinvestorshavefacedabearishyieldcurvesteepeningoverthepastyearorso.Thisriskonmovehassimultaneouslypushedthemintocreditsandhighyielddebt.Thecreditbullmarketiswell-advanced.NextupwillbeaninflectioninUSprivatesectorliquiditygrowthsometimebeforemid-2014.ThiswillwarnaboutexcessiveexposuretocreditriskbutshouldultimatelysignalafuturerallyinTreasurieslaterin2014.ThemostimportantpriceinWesternfinancialmarketsistheyieldonthedominanteconomysgovernmentdebt.TheNetherlandsFranceandBritainpreviouslysharedthishonourbuttodayunquestionablytheyieldonUSTreasurydebtiseveryinvestorsfocus.TheUSyieldprovidesaneutralbenchmarkagainstwhichtopriceallothersecuritiesofvaryingdurationsrisksandprovenances.ButwhatdeterminesAmericanyieldsOnevitalcomponentisthebehaviourofthetermstructure.Viewingthisovertimewecanidentifytwokeytraits1theslopeoftheyieldcurveorthespreadbetweenlong-termandshort-termTreasuryyieldsvariesandpivotsthroughtimebutboththeamplitudeofitsswingsandtheirscaleandconnectivitytoliquidityinflowsseemtoremainremarkablyconstant.2thetimingsofshiftsoftheentirecurveupanddownarenotconstantbutappeartovaryconsiderablyandalmostbyregime.Twenty-yearsagoforexampletheentireyieldstructureoftentendedtomoveoppositelytothedirectionofthespreadbetweenlong-andshort-termrates.Inshortbullishsteepeningswerethenmorecommon.7577798183858789919395979901030507091113020406080100-200-1000100200300400LiquidityRisingYieldCurveSteepeningSourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandIMFFigure1G20YieldCurveandDevelopedMarketDomesticLiquidityBasisPointsandIndexMonthly1975-2013DevelopedMarketsDomesticLiquidityIndexAdv6mLHSYieldCurveBasisPointsRHSMarbleArchTower55BryanstonStreetLondonW1H7AATel02078684104www.crossbordercapital.com GlobalView2Thustwenty-fiveyearsagoWallStreeteconomistHenryKaufmanseeInterestRatestheMarketsandtheNewFinancialWorld1986wasabletoshattertheconventionalbeliefaboutyieldcurvesandbondtradingstrategies.NolongerwasitalwaysprofitabletobuyTreasurieswhentheyieldcurvewasstronglyinverted.OftenKaufmannotedtheyieldcurverenormalisedthroughlong-ratesstayingputandshort-ratesfalling.MoreoverastrategyofbuyingTreasurieswhenthecurvewasupwardslopingandsettoflattenwasprettycertaintolosemoneyandbuyinganalreadyflatcurvethatmightinvertwassimplyidiotic.Timesmayhavechanged.AlthoughevidencestronglylinkscurvemovementswithoverallflowsofliquiditythekeytoabetterunderstandingliesinanalysingtherelativemovementsofprivatesectorliquidityandCentralBankliquidity.Weregularlymonitorthesetwoindexeseconomy-by-economy.Theinformationcontainedinthissplitalsohappenstobecriticalforcurrenciestoo.LeavinginflationexpectationstoonesidefornowwetendtothinkoftheTreasuryyieldcurvecomprisingtwomovingpartsReallong-termratesandshort-termpolicyrates.ThelattermovesinverselywithourindexesofCentralBankliquidityandtheformermovescloselywithourprivatesectorliquidityindexes.Whenprivatesectorliquidityisstrongrealinterestratesaretypicallyhighandrisingreflectingtheincreasedprofitabilityofcapital.Whenpolicyliquidityisbeingtightenedshort-termratestendtorise.Thustheyieldcurveislikelytomovepro-cyclicallyandslightlyaheadofthebusinesscycle.Infinance-speakthegreateravailableliquidityreducesriskspushesinvestorsoutalongthenotionalriskcurveandsodemandsagreaterpremiumtoholdlow-riskGovernmentdebt.Thenewpost-LehmanfinancialWorldismorelikethepre-Kaufmanperiodandlargelybecausefornowatleastinflationdoesnotfigure.Whatdistortedthemarketstwodecadesagowasthelikelihoodthatstickyinflationcausedlong-datedyieldstobehaveabnormally.Forexamplethelowpointofthecreditcyclewhentodaysinvestorsmightenvisionabullishcurveflatteningwasthentransformedintoanevensharperpolicytighteningtocrackstubborninflationexpectationswiththeresultthatlong-datedyieldstooksometimetofall.Inflationtendedtomoveacyclicallywithliquidityconditionsandsotheupswingoftheliquiditycycleoftensawfallingyieldsleadingperverselytoabullishsteepening.Whatisunchangedthroughoutisthelinkbetweentheslopeofthecurveandtheebbandflowofliquidity.Indeedremarkablytheamplitudeofyieldcurveswingshasalsoremainedprettystable.ThisrelationshipishighlightedinFigure1fortheentireG20groupofrichdevelopedeconomies.Whathaschangedishowweinterpretcurveshifts.Thusasteepeningcurvetodayisonethatislikelytoshiftupwardswhereasinthe1980sitfrequentlyshifteddownwardsbecausepolicyeasingsthencoincidedwithloweinflationexpectations.Wearemorelikelytoseebearcurvesteepeningsandbullflatteningtodaythanthereversei.e.bullsteepeningsorbearflattenings.Thishasimplicationsforconvexity.Convexityorthebulgeinyieldsaroundthemid-durationyearslargelyreflectsexpectedmovementsinlongrates.Ifacurvesteepeningprecedesorcoincideswithrisinglong-termratesasnowasteepercurveshouldmeanthatconvexityriseswiththeyieldcurveandconvexitybecomesmorenegativeasthecurveflattens.Howeverearlierperiodsoffallinginflationhavetendedtomeanthereversewithgreaterconvexitysometimescoincidingwithaflatteningcurve.TherationalecanbeexplainedusingourfundsflowdivisionbetweenCentralBankorpolicyliquidityandprivatesectorliquiditywhichcomprisesbothcreditprovidedbybanksandshadowbanksandthesavingsofthecorporateandhousehold 3GlobalViewsectors.Strongprivatesectorliquiditytypicallycoincideswithrisingprofitabilityandahigherreturnonindustrialcapitalwhichinturndrivesrealmarketratesupwards.Policyliquidityhoweverhasvaryinggoals.DuringperiodsofhighinflationCentralBankskeepliquiditytightandoftentightenmore.Thiswithdrawalofpolicyliquiditycausestheyieldcurvetoflattenagainstabackdropwhereinflationexpectationsmaycausethenominalyieldstructuretorise.Thisleadsthelevelofyieldstocorrelatenegativelywiththedirectionoftheyieldspread.Howeverinastructurallylowinflationenvironmentliketodaypolicy-makersaremorelikelytoeaseliquidityduringtimesofslowgrowthandlowprofitability.InotherwordsasteeperTreasuryyieldcurveshouldcorrelateifpolicyissuccessfulwithrisingrealinterestratesandmaybeatadmoreinflation.TheFutureLookingaheadwhatdoesthefutureyieldcurveholdfortodaysinvestorsTheUScurveisalreadyelevated.Thecurrentspreadof258bpbetween10sand2sliesatthetopofabroad250bpto-50bphistoricrange.Admittedlywefigurethatforwardguidancemayhaveartificiallyadded125bptothisspreadbutnotwithstandingitishardtoenvisionmuchfurtherwidening.OntheotherhandstrongerUSeconomicgrowthin2014andalikelyrisingreturnoncapitalshouldforcerealinterestrateshigher.Inotherwordstheyieldcurvemaystaysteepandshifthigheralongitsentirelengthasinvestorsdiscountsomereturntonormalityinrates.Thesepotentialcapitallossesatlongerdurationswillbealsofeltthroughconvexitywhichshouldbegintodiminish.ATreasurytermstructurecharacterisedbyasteepyieldcurveandrelativelylessconvexityisonethatistypicallyassociatedwithrisk-seekinginvestors.Inotherwordstheydiscountapermanentreturntoahigherstructurallevelofratesanddonotbuildinanyprospectivefutureratefalls.ThisbackdropischaracteristicofFigure2USMedium-TermInflationExpectations5-YearsForward5-YearsOutPercentWeekly2003-2013SourceCrossBorderCapitalUSFederalReserve0.000.501.001.502.002.503.003.500301200303042003030720030310200303012004030420040307200403102004030120050304200503072005031020050301200603042006030720060310200603012007030420070307200703102007030120080304200803072008031020080301200903042009030720090310200903012010030420100307201003102010030120110304201103072011031020110301201203042012030720120310201203012013030420130307201303102013 GlobalView4twoeconomicfeatures.FirstUSinflationexpectationsappearstableandwell-grounded.DespitesomefearsthatwearereturningtodeflationtheimpliedUSinflationrate5-yearsforward5-yearsoutislatelytickingslightlyhighernotlower.SeeFigure2.SecondtherealyieldpictureisbeingdrivenwethinkbythechangingdynamicsoftheChineseeconomy.InaseriesofresearchstudiesoverthepastdecadeallbroadlyentitledHowChinaSetsWorldInterestRateswearguethatbycompetinghead-onwithWesterncapitalusingoncecheapandabundantStatefundsChinesefirmshaveforceddownthemarginalreturnoninvestmentintheWesttherebycrunchingrealinterestratesinTIPSmarkets.SeeFigure3.LatestevidencesuggeststhatasChinahasforciblyshutoffthemoneytaptohercapitalgoodsindustrysoWesternrealreturnsandcapitalinvestmentprospectshavejumpedandwithitTIPSyields.FurtherrisesinTIPSyieldsmaybeinprospectandpacedampenedinflationexpectationsthisshouldpushuplong-datedTreasuryyields.Sincewearebelieversintheideathatlong-terminterestratesdriveshort-terminterestratesratherthanthereversethesetrendsmaybesufficienttoraisetheentireyieldstructure.AlthoughthesecommentsarelargelydirectedatUSTreasuriestheywillalsoapplytootherWesternbondmarketstovaryingdegrees.RealinterestratesmayseelessofanupliftintheEurozoneandtheJapaneseyieldcurveislikelytosteepenmore.HoweverthesearelargelytimingissuessinceallarelikelyfollowingtheUSleadsetbyQE3.Figure3MarginalReturnsonCapitalUSJapanandChinaPercentAnnual1985-2014ESourceCrossBorderCapitalOECDJapanChinaUS0123456789198519861987198819891990199119921993199419951996199719981999200020012002200320042005200620072008200920102011201220132014 5GlobalViewWitherCorporateDebtOnestepfurtheronalongtheriskcurvewefindinvestmentgradecorporatedebtandtwostepsonhighyieldandEMdebt.WehavearguedelsewherethatourconcernsaboutthecurrentfragilityofEMcurrenciesitselfpartlytheresultofthechangesweareseeinginChinamakeslocalcurrencybondinvestmentunappealingatpresent.HowevertheoutlookfordomesticWesterncorporatedebtatleastoverthefirsthalfof2014lookstobesomewhatbettersupported.Thetwokeyfactorsbehindthecorporatecreditmarketare1macro-liquidityconditionsand2riskappetite.Riskappetiteisanobviousfactorthatmattersincreasinglymorethemorethatinvestorsextendoutalongthenotionalriskcurve.ThusithasgreaterimportanceforhighyieldthanforAaacreditsandisevenmoreimportantforequitiesthanforhighyield.Wecanmeasureriskappetitethroughtherelativepositioningofinvestorportfolios.SeeFigure4.ThesedatashowthenormalisedportfolioexposureofinvestorstoUSequitieslessUSbonds.WecouldequivalentlyshowthisexposuredatafordifferenteconomiesandfortheWorld.Riskappetitedataarepersistentandaccordingtolatestreadingsthereappearsamplescopeforriskappetitetoincreasefurthergiventhatexposuretoriskassetsstandswell-belowpastextremes.Howeverlookingatthemacro-liquidityconditionstheothermovingpartnotedearliertheremaybelessscopeoratleastmorefactorstowatchoutfor.Liquidityconditionstellbondinvestorstwoimportantthings.OntheonehandbysteepeningtheyieldcurveandliftingriskpremiarisingliquiditypushesinvestorsoutalongtheriskcurvetherebynarrowingspreadsbetweensayUShighyieldand5-yearTreasuries.ButwithintheoverallliquiditymixthemorethatprivatesectorliquidityisdepletedbyrisingdemandsformorecapexthegreatertheriskpremiathatneedstobebuiltintoSourceCrossBorderCapitalUSFederalReserveDatastreamFigure4RiskAppetiteofUSInvestorsinvertedandUSHighYieldSpreadMonthly1987-2013-113579111315-80-60-40-200204060801987-011987-101988-071989-041990-011990-101991-071992-041993-011993-101994-071995-041996-011996-101997-071998-041999-011999-102000-072001-042002-012002-102003-072004-042005-012005-102006-072007-042008-012008-102009-072010-042011-012011-102012-072013-04 GlobalView6high-yieldspreadstoguardagainstrisingcapitaldemandsfromissuersandgreaterbalancesheetleverage.Thereforeakeysignalforthehigh-yieldmarkettobewaryofiswhenourdataseriesonprivatesectorliquiditystartstoinflectdownwards.Thisisrarelyagoodtimeforhighyieldanditmayormaynotcoincidewithamoregeneraldownturnofliquiditydata.Figure5summarisestheprevailingyieldspreadpicture.Wethinkofeachspreadcomponentasanincrementalstepalongtheriskcurve.Thushighyieldversus5-yearTreasuriescomprisesaseriesofspreadsubcomponentsincludingBaa-Aaa.MostcreditspreadsaremovingtowardstheirlowsalthoughtheAaacomponenthasbeendistortedbyashiftofissuancetowardslongerdurationbonds.Figure6showsthenetbalancebetweenUSprivatesectorliquidityandUSFedliquiditytohighlightthesensitivityofthecreditmarket.ThelongperiodofrecentsharpgainsinnetUSprivatesectorliquidityhavematchedtherallyinUShighyieldcredits.Thereforeinvestorsmustwatchforsignsthatthiscouldturnlower.Wearefairlyconvincedthatitwillsometimebeforemid-2014.AlreadytheISMnewordersdataseriesispointingmuchhigherasFigure7showssuggestingthatpurchasingmanagersaregettingreadytospendbig.Goodnewsfortheeconomyisrarelysuchgoodnewsforfinancialassets.SourceCrossBorderCapitalUSFederalReserveFigure5LatestUSYieldCreditSpreadsHistoricRangesPercent2000-2013R10-R5Aaa-R10Aaa-R5Baa-AaaHighYld-BaaEMBI-BaaMean0.8141.5702.3841.1642.7480.942-1sd0.3871.0771.5090.6680.565-0.1561sd1.2412.0633.2591.6604.9312.040Latest1.2501.9103.1600.7800.3300.416 7GlobalViewSourceCrossBorderCapitalUSFederalReserveInstituteforSupplyManagementFigure7USISMNewOrdersandUSLiquidityadvanced15monthsMonthly1980-2013SourceCrossBorderCapitalUSFederalReserveFigure6USFedLiquiditylessPrivateSectorLiquidityandMovementsinUSHigh-YieldSpreadMonthly1987-2013-113579111315-80-60-40-200204060801987-011987-101988-071989-041990-011990-101991-071992-041993-011993-101994-071995-041996-011996-101997-071998-041999-011999-102000-072001-042002-012002-102003-072004-042005-012005-102006-072007-042008-012008-102009-072010-042011-012011-102012-072013-04CentralBanklessPrivateSectorHighYieldSpread40455055606570758001020304050607080901001980-011980-111981-091982-071983-051984-031985-011985-111986-091987-071988-051989-031990-011990-111991-091992-071993-051994-031995-011995-111996-091997-071998-051999-032000-012000-112001-092002-072003-052004-032005-012005-112006-092007-072008-052009-032010-012010-112011-092012-072013-05USLiquidity15mISMNewOrders Section4StyleSelectionVsAssetAllocationMoneyMoneyMoney.ADifferentAssetAllocationAugust2006Macro-FinanceOrWhatTheyDontTeachYouattheChicagoBusinessSchoolSeptember2010Stylesvs.AssetsTheQuantumTheoryofMoneyJune2004WhatCanYaleTeachUsJuly2011TheVolatilityofVolatilityMay2010TheReturnofTAADecember2012LiquidityandModernFinanceLookingInsidethePE-August2004LostintheBrettonWoodsMay2010TheBearMarketinValuationsandtheBullMarketinHistoryJune2011TheBearMarketinValuations.Part2September2011 1CROSSBORDERCAPITALGlobalViewAugust2006MarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comMoneyMoneyMoney...ADifferentAssetAllocationCROSSBORDERCAPITALThisreportexamineseconomicandfinancialdevelopment.Itexplainswhyweusefi-nancialratherthaneconomicvariablesforassetallocation.TherelationshipbetweenstockmarketvalueandeitherGDPorearningsisshowntobeunboundedandthere-foreunusableattheaggregatelevel.Theratiobetweenmarketcapandmoneyisstableandthereforeabetterassetallocationbenchmark.Latestdatareaffirmourcautiousequityoutlook.StockMarketsAndGDPFinancialandeconomicdevelopmentdoesnotalwaysgohand-in-handfrequentlyfi-nancialdevelopmentracesahead.Globalstockmarketdatarevealanon-linearrela-tionshipthatpointstoamorethanonethirdadditionalexpansioninstockmarketcapi-talizationperheadforeverypercentagepointincreaseinnominalpercapitaGDP.Figure1showstheregressionanalysisbetweenmarketcapperheadandGDPpercapitafor53developedandemergingeconomies.Averagecross-sectionaldatafor2004-06hasbeenusedandconvertedintoUSdollarsandexpressedinnaturallogarithms.AccordingtothecharteachUS1increaseinpercapitaincomeleadstoalargerUS1.38increaseinpercapitamarketcapasthemarginalsavingsraterises.LookedatanotherwaytheratiobetweenmarketcapitalizationandGDPisnotcon-stantbutitselftendstotrendhigherovertimeandseeminglywithoutlimit.Thisisanimportantresultintworespects.Firstittellsusthatmatureeconomiesareheavyinfinancialassetsandrichinfinancialinfrastructure.SeconditquestionswhetherPEmultiplesaretheappropriatetoolwithwhichtovaluestockmarketsbecausetheytoolikethemarketcapGDPmultiplearelikelytobeunbounded.Theaggregatemar-ketPEmultipleisderivedbydividingthemarketcapGDPmultiplebyaverageprofitmargins.PGDPPE________mwheremEGDPandErepresentspost-taxearningsIfthemarketcapGDPratiocanrisewithoutlimitsocantheaggregatemarketPEmultiple.ThismakesitimpossibletosaywhetheramarketPEof20xor15xor35xisexpensiveornot.PEsmayworkatthemicro-levelforindividualstocksbuttheaboveresultsuggeststhattheymaynotworkefficientlyatthemarketlevel. 2CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamFigure1.FinancialAndEconomicDevelopment2004-06USDollarTermslogPH-3.90391.3805logGDPHR-squared88.03wherelogdenotesthenaturallogarithmPreferstomarketcapitalizationHispopulationandGDPnationalincome.567891011122468101214AuOeFrCnDkFnBgBdIrItJpNlNZNwEsSwSzUKUSAgBnBzClChCoCzEyGrHKHuInIdIsJoKuMyMaMxMoPkPePhPoPtRuSdASgSAKoSLTwThTkVzZmGDPperHeadMarketCapperHead 3CROSSBORDERCAPITALStockMarketsandMoneyHowcanwesalvageassetallocationThereisahope.FurtheranalysisshowsthatthemarketcapGDPrelationshipcanbebrokendownintotwosub-componentratios1moneyi.e.liquidassetstoGDPand2marketcaptomoney.Theformerisusuallyknownasbyeconomistsasinvertedmonetaryvelocity.Experienceshowsthatmonetaryvelocitytendstofallovertimeinotherwordsittakesalarger-and-largerquantumofmoneytogenerateeachdollarofGDP.Thesecondtermshowshowallinvestorsholdtheirassetsbetweenquotedinvestmentsi.e.sharesandcash.Assetallocationwilllikelyvaryovertimeastheriskenvironmentchangesbutthisvariationislikelytoberegularandcentredaroundafixedpoint.Instatisticaltermsthisisdubbedastationarydataseries.Statisticalanalysisofthesamecross-sectionaldatafor2004-06revealsarobustrelation-shipbetweenmarketcapandmoneylogPH0.68160.9331logMHR-squared84.81wherelogdenotesthenaturallogarithmPreferstomarketcapitalizationandHispopu-lation.Re-expressingthisestimatedequationinlevelsitisapproximatelyequaltoP1.98MThisisanimportantresultforassetallocation.Ittellsusthatthemarketcapmoneyratioisstableoverthelong-run.Thuswhenthemarketcapmoneyratioisclosetoitstargetlevelofroughlytwotimeschangesinthevolumeofmoneyaredirectlytransformedintosimilarchangesinstockmarketcapitalization.Intheshorttermstockmarketperfor-mancewillberelatedbothtochangesinthevolumeofliquidityandtothesizeofdevia-tionsinthePMratioawayfromitstwotimestrendvalue.Theselattershiftscanbeex-plainedbychangesintheperceivedriskenvironmentorwhatwedubsentimenteffects.Ourworkshowsthatinflationplaysakeyinfluenceonsentiment.ItseemsreasonabletoconcludethatfinancialmarketmovementsPconsistlargelyofbothliquidityMandsentimentPMeffects.HistoryOfThePMTherootsofthePMratiolieintheworkofUSeconomistRaymondGoldsmithofYaleUniversitywhostudiedthepatternoffinancialevolutionforseveralcountries.AccordingtoGoldsmiththefinancialstructureisacrucialdeterminantofnationalproductivitytrendsandlivingstandardsontopeachcountrytendstoexperienceverysimilarfinancialdevel-opment.Goldsmithsworkshowsthatfinancialassetsanddebtbothrisefasterthantan-gibleassetsandnationalincomeastheeconomydevelops.Goldsmithanalysed200countriesspanningatimeperiodofalmost300years.Hefoundthatmostprimitivesocietieshaveaverylowratiooffinancialtotangibleassetsorfinan-cialinterrelationsratio.Butaseconomiesmaturesothisratiorisesalong...theonemajorpathoffinancialdevelopment.Formostadvancedeconomiesitreachesavalueofbe-tween1-1.25timesbeforelevellingoff.Britainfirsthitthisvalueinthe1880swhiletheUSandJapantookuntilthe1920storeachafinancialinterrelationsratioofunity.FewcountriesapartfromSwitzerlandhavemanagedtosustainhigherratiosalthoughBrit-ainrecordedapeakorfreakquotientof2.7timesin1939. 4CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamFigure2.StockMarketCapitalisationVs.Money2004-06USDollarTerms24681012142468101214AuOeBgCnDkFnFrBdIrItJpNlNZNwEsSwSzUKUSAgBnBzClChCoCzGrHKHuInIdIsJoKuMyMaMxMoPkPePhPoPtRuSdASgSAKoSLTwThTkVzZmLiquidityperHeadMarketCapperHead 5CROSSBORDERCAPITALThecreationofamodernfinancialsuperstructurenotinitsdetailsbutinitsessentialswasgenerallyaccomplishedatafairlyearlystageofacountryseconomicdevelopmentusuallywithinfivetosevendecadesfromthestartofmoderneconomicgrowth.Thusitwasessentiallycompletedinmostnow-developedcountriesbytheendofthe19thcenturyortheeveofWorldWarIthoughsomewhatearlierinGreatBritain.Duringthisperiodthefinan-cialinterrelationsratiothequotientoffinancialandtangibleassetsincreasefairlycon-tinuouslyandsharply.SinceWorldWarIortheGreatDepressionhowevertheratioinmostofthesecountrieshasshownnoupwardtrendthoughconsiderablemovementshaveoccurredovershorterperiodssuchassharpreductionsduringinflationsandthoughsig-nificantchangeshavetakenplaceintherelativeimportanceofthevarioustypesoffinan-cialinstitutionsandoffinancialinstruments.Amonglessdevelopedcountriesontheotherhandthefinancialinterrelationsratiohasincreasedsubstantiallyparticularlyinthepost-warperiodthoughitgenerallyisstillwellbelowthelevelreachedbythenow-developedcountriesearlyinthe20thcentury.RaymondGoldsmith1984.OneimportantcorollaryofGoldsmithsworkisthatthesizeofthefinancialsuperstruc-tureasmeasuredbythefinancialinterrelationsratiochangesonlyslowly.Inotherwordsthesecularvalueoffinancialassetsrarelyexpandsbymorethanabout2-3perannumfasterthannationalincome.Thismaynotsounddramaticbuttakenoverthelong-terma2.5annualgrowthratewouldcompoundintoanear12-foldjumpinthefinancialinterre-lationsratioeverycentury.Goldsmithssecondimportantfindingwasthattherelativeimportanceoffinancialinsti-tutionsespeciallynon-banksasholdersoffinancialassetshastrendedupwardsovertimebutitalsotendstoflattenoutataroundthe40-50levelaseconomiesmature1muchaswefoundforthePMratio.Thisratioisdubbedthefinancialintermediationratio.Whatsmorethesharesofdifferentfinancialassetsshowedsomedegreeofconsistencyovertimebankcreditpublicdebtforeignsecuritiesandcorporatestockseachroughlyaccountforaroundone-fifthofaggregatefinancialassetswhileinsuranceandpensionclaimsmakeupafast-growingtenthandtradecreditandcorporatebondscomprisealessrobusttenth.InvestorPowerVs.EarningsPowerThesestablebalancesheettrendsallowustomakesomejudgementsaboutotherfinan-cialratiosmostimportantlytheprice-to-moneyratioandtodeveloptheconceptofinves-torpower.Investorpowermeasurestheabilityandwillingnessofinvestorstobuy.ItisanalternativetotheconventionalnotionofearningspowerwhichisusedtojustifyusingPEmultiplestovaluestocksandmaturityyieldstovaluebonds.InvestorpowerandthePMconsiderassetallocationfromthestandpointofinvestorswealthearningspowerandthePEanalyseitfromthelesssatisfactorypositionoftheintrinsicworthofthesecurity.WesawearlierthatthePEmultipleitselfisacompositemeasurethatcanbeunbundledintothreesub-componentswiththePMrationestedinsidethePEasonecomponentaexposuresentimentbfinancialliquidityandcprofitabilityi.e.PEPMxMGDPwhereeEGDP___________________e1Goldsmithnotedthatthisratiowaslesswell-definedthanthefinancialinterrelationsratio.Hisre-searchshoweditrangedroughlybetweenaquarterandonehalfofallfinancialassetsandfortheUSafinanciallysophisticatedeconomyithadavalueof26.8in1978.MeanwhileBritainsratiowas40.8Japans29.9andGermanys38.5. 6CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamSourceCrossBorderCapitalOrExposureSentimentxFinancialLiquidityValuation________________________________________ProfitabilityAtthemarketlevelthePEisdefinedasthemarketvalueofequitiesdividedbytotalnetprofits.SimilarlythePMratioisthetotalvalueofequitiesdividedbytheavailablepoolofliquidassets.Thenumeratoristhesamebutthedivisorisdifferent.LiquidityavailableforfinancialinvestmentisshownbytheMGDPtermorinvertedmonetaryvelocityandprofitabilityismeasuredbyprofitmarginsEGDP.GDPdenotesNationalIncomeandEisaggregatepost-taxprofits.ThePMorprice-to-moneyratiomeasuresinvestorpower.ConclusionMarketsNeedCashWhatdoesthePMapproachtellusaboutthelatestmarketoutlookFirstassetalloca-tionremainsheavilyskewedtowardsstocks.Inotherwordsinvestorsentimentisbullishandthereseemslittleshort-termscopetoincreaseequitymarketexposure.OnecuriousexceptionistheUSstockmarket.Figures3and4showstatisticaldeviationsofthePMratiosawayfromtheirtrendsforthedevelopedandemergingstockmarketsandWallStreetrespectively.Highvaluesshowhighexposureandbullishsentiment.Figure3.StockMarketExposureIndexesPMDevelopedAndEmergingMarkets1980-2006Index0-100Figure4.StockMarketExposureIndexPMUSA1980-2006Index0-100SpeculativeOptimisticRiskAversePessimistic-1sd2sd1sd-2sdMeanDEVELOPEDEMERGING1987CrashBusinessWeekDeathofEquities1997AsianCrisisRussianCrisisY2K808182838485868788899091929394959697989900010203040506020406080100IndexStandardDeviation808182838485868788899091929394959697989900010203040506SpeculativeOptimisticRiskAversePessimistic2sd1sd-1sd-2sdMean2sd1sd-1sd-2sdMean 7CROSSBORDERCAPITALSourceCrossBorderCapitalSecondliquidityconditionsaregenerallytightUSandJapanortighteningEurozoneandEmergingMarkets.Figures5and6showourproprietaryfinancialliquidityindexesfortheWorldandtheCentralBankpolicysub-componentforthemajorfourinvestmentregionsrespectively.Bothsetsofchartstellusnottoexpecthighstockmarketre-turnsovercomingmonths.Eithermarketexposuremustfirstfallbydefinitionhurtingnear-termreturnsorliquidityconditionsmustjumphigher.Asourresearchhaswarnedelsewherestubborninflationsignificantlyclipstheoddsofanymajorliquidityexpansion.Figure5.GlobalLiquidityCycle1965-2006Index0-100SourceCrossBorderCapitalFigure6.BreakdownOfGlobalCentralBankLiquidityUSJapanEurozoneAndEmergingMarkets1980-2006Index0-100ReferencesGoldsmithRaymondW.1984ComparativeNationalBalanceSheetsAStudyofTwentyCountries1688-1979SoaringCommoditiesLooseTightUSCreditSqueezeSterlingCrisisPennCentralBankruptUSFiscalSpendingBoomInflationaryBoomEndOfBrettonWoodsVolkerFedReaganElectionLDCDebtCrisisFailureofContinentalIllinoisPlazaAccordWeakUSJapaneseBubble1987CrashScandinavianBankingCrisisUSSLCrisisJapaneseTighteningMexicoPesoCrisisEmergingMarketBoomBondCrashAsianCrisisRussianCrisisIndexY2KIndexLouvreAccordEnronWorldcom656667686970717273747576777879808182838485868788899091929394959697989900010203040506020406080100020406080100808182838485868788899091929394959697989900010203040506020406080100020406080100USIndexIndexJapanEurozoneEmergingMarkets 1GlobalViewGlobalViewSeptember201096BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comFigure1GlobalLiquidityCycleIndexNormalRange0-1001965-2010MacroFinanceOrWhatTheyDontTeachYouatChicagoBusinessSchoolSomuchthenfortheEMHandMFT.Inthewakeofthe200708financialcrisisconventionalassetpricingtheoriesbasedonbondyieldsandstableriskpremiumsdontseemtoworkwell.Somethingelseisneeded.Wedescribeourinvestmentmethodologyandshowwhyliquidityanddurationareessentialcomponentsofassetallocation.AfundamentalproblemwithmodernfinancetheoryMFThighlightedbytherecentmarketturmoilisthatvaluingonefinancialassete.g.equitiesagainstanothere.g.bondsleavesthevaluationquestionopen-endedbecausethereisnoyardstickofabsolutevalue.Wehavelongtakenadifferentpath.WestronglybelieveintwothingsfirstliquiditydrivesmarketsandparticularlyCentralBankliquidityinjections.Secondtop-downcountryandglobalsectorallocationsaccountforthebulkofinvestmentreturns.Inshortwesubscribetothe8020rulethatsaysassetallocationisfarmoreimportantthansecurityselection.Timenotvolatilityistherealriskforinvestorsandsochoosingtheirdesiredinvestmenthorizonistheirkeydecisionvariable.Cautiousinvestorswillshortentheirtimehorizonswhereasastheybecomemoreupbeatinvestorswilldiscountnewsforwardoveralonger-and-longerspan.Allthisbecomescrystallizedintheirchoiceofassets.Thusbullishinvestorsholdportfoliosoflongdurationassetsandbearishinvestorswhodemandthecertaintyofcashholdshortdurationportfolios.Portfoliodurationisattheendofthedayanchoredbysaypensionorfuturespendingliabilitiesandsomustmean-revert.65676971737577798183858789919395979901030507091102040608010002040608010019721977198219871993199820032008LooseTight1967USRealEstateCommoditiesGoldNEAsianStocksRealEstateGlobalBondsEquityMarketsTechnologySharesUSRealEstateGoldGlobalEquitiesUSPennSquareUKBankingCrisisLatAmDebtContinentalIllinoisUSSLScandinavianBanksJapaneseBanksBaringsWorldcomEnronUSSubPrimeUKBanksIcelandSourceCrossBorderCapitalUSFederalReserveECBBankofEnglandBankofJapanIMF GlobalView2Forexamlemaninstitutionalinvestorscurrentlyassumeanaverage15-yeartimehorizonforpensionliabilities.Knowingthisfactanyextremeswingsinthesebullishandbearishchoicesprovideuswithgreatopportunitiestogoagainstthecrowd.Ourallocationprocessfavoursassetmarketswhichareunpopularandthereforecheapwhereliquidityisexpandingandwhereinflationisstable.Welikebuyingout-of-favourassetsandparticularlythosethatnormallycompriseanintegralpartofportfolios.ThustounderstandwhattobuyweshouldquestionwhoisgoingtobuyorequallywhocouldbeforcedtosellUnderstandingthesupplyanddemandwithinassetmarketsrequiresstudyingthebehaviourofcrowdsandthemovementofmoney.ThefirstquestionweneedtoansweriswhereareinvestorscurrentlyinvestedWedubthisinvestorsentimentexposurewhenthecrowdismostconvincedwearemostsceptical.Secondinunderstandingwheremoneyissubsequentlygoingtoflowtowealsoneedtounderstandwhereitislikelytocomefrom.Thisrequiresanalysingthe4-5yearGlobalLiquidityCycleandcloselymonitoringCentralBankbehaviour.TheoriginofmanyofourideascanbetracedbacktotheResearchDepartmentofSalomonBrotherstheformerUSinvestmentbank.LedbyHenryKaufmanandMartyLeibowitzandofteninspiredbytheearlierscrituresofSidneHomerviz.HistoryofInterestRatesSalomonsresearchfocussedontwokeyideas1flowoffundsanalysisandthestructureoffinanceHenryKaufman2durationmanagementMartyLeibowitz.Putthemtogetherandtheybecomeevenmorepowerful.Andtheyparticularlyhelpustounderstandmodernfinancialmarketsandthenear-regularcycleoffinancialcrisese.g.197419808119871994200001200708.FlowofFundsAnalysisKaufmanusedflowoffundsanalysistounderstandboththecreditcreationprocessandthechangingpositionoftheyieldcurvethroughthecreditcycle.Flowoffundsanalysisprovidesperspectiveandlikedouble-entrybookkeepingcontainsbuilt-infeaturesthathelppreventerrorsinlogictheamountoffundssuppliedmustequaltheamountdemandedbecauseitisimpossibletolendmoneyunlesssomeoneborrowsitthefunctionofinterestratesistoallocatethefundssuppliedbylendersamongthosewhowanttoborrow.InstandardNationalIncomeaccountingincomeequateswithexpenditurebutfinancialassetsanddebtsandtheirrelationshiptotransactionsoccurringonthecurrentandcapitalaccountsareignored.Similarlyfinancialmarketsarenotintegratedintotraditionaleconomicanalsisandthisspillsoverintoaforcedreductionintheimportanceoffinance.Flowoffundsaccountingincontrastlinksincomeandexpenditureflowstotheircounterpartchangesinstocksofassetsandliabilities.Inotherwordsflowoffundsaccountsarethebridebetweenbalancesheetsandincomeexpenditurerelationships.Theyeffectivelyensurethatallmoneythatisanywhereisaccountedforsomewhere.Thestockconsequencesofflowsarethereforeincorporatedintotheflowoffundsarithmetice.g.governmentbudgetconstraintsaresatisfiedandtheconsequencesofrunawaygovernmentdebtsacknowledged.Thesetoolsprovedusefulinuntanglingtheincreasingconvolutednatureoffinance.TheygaveinsightsthatallowedKaufmantoforeseeupcomingfinancialturmoil.Hewarnedinthemid-1980sthatVastimprovementsincommunicationsandfinancialtechnologyhavecreatedcloselinkageswithintheUScreditmarketsandwithmarketsabroad.DistinctionsamonginstitutionshavebeensoblurredthatitwouldbeimpossibletoputHumpty-Dumptytogetheragain.Weneedtoimplementthebestaspectsofderegulationandthebestapplicablesafeguardsofregulation.Byandlargethiswillrequireinjectingsomefrictionintothedebtcreationprocessnotmorelubricants. 3GlobalViewOurliuiditanalsissimilarlderivesfromthestudyofflowsoffundsandinparticularthedivisionbetweensourcesoffundsandusesoffunds.Weputgreatestemphasisonthesourcesoffundsorsocalledfundingliquidity.Crisesoftenresultfromabruptstopsinfundingliquiditythatpreventessentialprojectsandassetholdingsfrombeingre-financed.Conventionaleconomicsfocusesinsteadalmostexclusivelyontheusesoffunds.Conceptssuchasgovernmentspendingretailsalesandmoneysupplyarealldifferentusesoffunds.Modernindustrialeconomiesaredominatedbythecapitalexpenditurecycle.Economicgrowthdependsoncapitalaccumulation.Capitalisraisedoverseveralyearsandthusfundinghastobefrequentlyre-financedoverthelifeofaproject.Thisre-financingprocessisakeysourceofweaknessandthisfactforcesCentralBankstoactivelyprovideandmanageliquidity.CentralBankerrorsexplainliquiditycycles.Theliquiditycyclemeasuresthetempoofmoneyflowsthroughfinancialandassetmarkets.Itmovesinphasesthatreflectperiodsofmonetaryre-flationandmonetaryinflationmonetarydisinflationandultimatelymonetarydeflation.ThesephasesbroadlycorrespondtowhatKaufmandescribesasthemanyfacesoftheyieldcurveYieldcurvesprovideasweepingpictureofcreditmarketconditionsataglanceHeobservedthatswinsfromanextremenegativeslopetoflatgenerallyledtohigherlong-termyields.Flattoextremepositiveontheotherhandresultedinlowerlong-termyieldsbutmuchlowershort-termrates.Swingsfromextremepositivetoflatandfromflattoextremenegativeledtohigherlong-termyieldswiththelatterlate-cyclephasethemostdangerousofallforinvestorsinlongbonds.TheCrossBorderCapitalGlobalLiquidityIndexmeasuresfundingliquidity.Ithasbeencontinuouslyrefinedanddevelopedsinceitsinceptionintheearly1980s.Theindexcomprisesaround30underlyingdataseriesforeachof80countriesthatarecombinedtogether.Theindexismeasuredrelativetothesizeofeconomiesandstandardisedtomoveinanormalrangeof0-100witha50mean.Regionalnationalandsectoralsub-componentsalsoexist.Thedataaresourcedfromnationalflowoffundsaccountsthattypicallymake-upthemonthlyreportingsystemfortheIMF.Liquidityisdefinedastheflowsofallcashandcredit.Theanalyticalframeworkisbasedontheflowoffundsidentitythatseparatessourcesoffundsfromusesoffunds.FundamentalequationofflowoffundswhereLreresentsliuiditSiscashsavingsBCbankcreditandCBCCentralBankcreditIiscapitalspendingIfisnetpurchasesoffinancialassetsBDsymbolisesbankdepositsandrepresentsthedifferenceoperator.Liquidityimpliestwothings1marketabilityand2accesstocashi.e.meansofsettlementwithoutlimitwithoutdelayandwithoutunduecost.Aliquidmarketmeansthatlargeblocksofstockscanbesoldrapidlywithoutsignificantlydisturbingprices.Lookedatinreverseilliquidityimpliestheriskofcapitallosswhentheassetneedstobequicklyrealised.Liquidityisacharacteristicofmoney.Moneyitselfhastwofunctionsastandardofvalueandbmeansofcirculationandexistsintwoqualitativeformsas1meansofpurchasee.g.creditand2meansofsettlemente.g.savings.CrossBorderCapitalsliquidityanalysisessentiallymeasureschangesintheflowofmeansofpurchasemoney.Thisincludesbothincreasesinpuremeansofpurchasesuchascommercialandshadowbankcreditplusanynewmeansofsettlementthatcanbeusedasmeansofpurchasee.g.savingsandbasemoney.ThestandardofvaluefunctionisprobablybestrLSBCCBCIIfBDLiquiditySourcesUsesFundingLiquidityMarketLiquidity GlobalView4monitoredinconjunctionwithchangesinthenominalpriceofgold.Toomuchmoneyresultsinmonetaryinflationi.e.thedepreciationofpapermoneyandarisinggoldprice.Ourresearchclearlyidentifiesa45-yearornear-60monthliquiditycycle.Thelasttroughoccurredinearly-2006andthelatestpeaktookplaceinJanuary2009.Wealsofindstrongevidencethatthesub-cycleinUSCentralBankorFedliquidityisdominantandittendstoleadtheGlobalLiquidityCyclebysome2-3months.Thepeaksandtroughsoftheliquiditycycletendtoprecedebothassetboomsandbankingcrisesrespectivelybyaround1-2years.Thecharacterofassetboomschangesbyinstrumenteachcyclesometimesthemaniafocusesoncommoditiesatothertimesemergingmarketstocksattractspeculatorsandmorerecentlythebubbleshavebeenintechnologystocksandresidentialrealestate.Similarlybankingcrisestendtodifferbygeography.SometimesEuropeanbankssuffermostatothertimesthebaddebtsoccurinAsianbanksorasduring200708itwastheBritishandAmericanbanksthatexperiencedsolvencyproblems.Monetarytheoryisnowstartingtothinkaboutfinancialstructureagain.ItwasignoredbyMiltonFriedmanmonetarists.TheyshunnedtheinnovationsofGurleyandShaw1960whoarguedyearsagothatthenon-bankfinancialsectorwasnotsimplyapassiveintermediarybutactivelycreatedcredit.Atthetimecreditasamonetaryaggregatewasout-of-fashion.Manyarguedthatdepositscreatedcreditswhereasinrealitycreditcreatesdeposits.Aftertheturmoilofthe20072008financialcrisistheroleofthecreditmarketsinprovidingfundingandliquidityforthegeneralcapitalmarketsisnowbetterappreciated.NosingleinterestraterepresentsallassetpricesandcertainlythereisnoonemarketratethatisundertheunambiguouscontroloftheCentralBank1asmanyacademicsstillseeminglyassume.Generalmarketliquiditydependsuponso-calledfundingliquidity.Itwaseverthusbuttoomanypunditswereseducedbythemathematicalbeautyderivedfrominterestrateformulae.Consequentlyboththeassetsideandmoreimportantlytheliabilitysideofthefinancialsectorbalancesheethavebeenignoredfortoolong.PortfolioDurationDurationmeasuresthetimehorizonofanassetorliabilitybasedonthepresentvalue-weightedaveragetimetoreceiptorpaymentofincomeandprincipal.FromthisformulationHicks1939andMacaulay1938inthelate1930sdemonstratedthatdurationistheelasticityofthevalueofacapitalassetwithrespecttochangesinthediscountfactor.Theimportanceofdurationisthatitreferstothetimingofthe1Discountrateisnotamarketrateaveragecashpaymentandnotthefinalcashpaymentaswithsaythematuritydateofabond.Bondmaturitywillaffectbonddurationbutitisadifferentandlessusefulconceptforplanninginvestmentneeds.IntheSalomonworldthereisacontinuumbetweenstocksandbondswherethebridgeisduration.Modernfinancetheoryseesthemarketasthesystematicriskfactorforequitiesandthisinturnisexplainedbymacroeconomicvariables.Forfixedincomesecuritiesinterestratedurationisthemainsystematicriskfactor.Inturninterestratesarelinkedtothecreditcycle.Equitiesexperiencemanyotherrisksbothsystematicandunsystematicalthoughinterestrateriskisalsoanimportantfactor.Webelievethatequitiesarealsolargelyinfluencedbythissamecreditorliquiditycycle.Onepossibilitymuch-ignoredinconventionalequitypricingmodelsisthatdurationtheinvestmenttimehorizonmayitselfchange.Whatsmorethesechangesmaybealsosystematicallylinkedtotheliquiditycycle.Thedurationofafixedincomesecurityisanchoredclosetoitsstatedmaturity.Thusa10-yearbondwilltypicallyhavedurationofaround6-7years.Equitiesbeingundatedsecuritiesdonotconformtothisrule.Theirtimehorizonvarieslargelyaccordingtotheoptimismandpessimismofinvestorsandaccordingtohowfarforwardtheyarepreparedtodiscount. 5GlobalViewAll-in-alldurationlasasurprisinglylargeroleinexplainingtotalportfoliorisk.Assetallocationisthedeploymentofinvestmentswhosecashreturnse.g.futuredividendreceiptsandpotentialsaleproceedsbestmatchtheanticipatedprofileofaninvestorsfutureliabilities.Thebestsinglemeasureofthistimeprofileisduration.Durationmeasurestheinvestmenttimehorizonorroundaboutnessi.e.howlongmoneyistiedupfor.Itmightbethoughtofasliquidityovertimebecauseitisdefinedasthetime-weightedaveragecashreceiptsorpaymentsinpresentvalueterms.Durationcanbecalculatedforliabilitiesaswellasassetsandwefigurethatinvestorshaveatargetdurationbasedontheirexpectedfutureliabilities.Theseliabilitieswillvaryaccordingtoagei.e.demographicsinflationandtaxpolicyamongotherthings.Investorsliabilitiesorcashoutflowsareunlikelytobegreatlyaffectedbychangesinliquidityconditionsbutfuturecashinflowswillbealteredsignificantly.Thischanginggapbetweenliabilitydurationandassetdurationmeasuresliquidityrisk.Liquidityriskistheantithesisofpossessingliquidity.Investorsattempttomatchassetdurationandliabilitydurationandtherebyreduceliquidityriskbybuyingandsellingassetsinvaryingquantities.Moreliquidityreducesliquidityriskandcausesdurationtorise.Equallyifliquidityrisksriseinvestorsthenneedtoshortenthedurationoftheirassets.Thisinturncausesareshufflingofexistingportfoliosasinvestorsmovefromlongertoshorterdurationinstrumentsandmaybeeventomoveintocashitself.Assetscanbegraduatedbytheirdegreeofduration.Cashisthezerodurationasset.Equitiesandrealestatearetypicallylongdurationassets.Bondsliesomewhereinbetween.Inaggregatethesetransactionswillleadtoariseinthepriceoflong-durationassetswhenliquidityisabundantandtoafallwhenliquidityisscarce.Thusmoreliquidityencouragesinvestorstolengthentheirdesiredinvestmenttimehorizonlessliquidityforcesthemtoshortenit.Forexampleifthebusinesssectorissufferingacreditsqueezetheflowofcorporatedividendswillsloworstopcompletelyandtheneedfornewcapitalissuesmayrisesharply.Similarlyasystem-wideshortageofliquiditywilllowerthemarketabilityofexistingassetsandresulteitherintheinabilitytosellorthechancetosellbutonlyatgreatlydepressedprices.Facedwitheithercaseinvestorswilllikelyshiftintomorecertainmoreliquidandhigheryieldingcurrentinvestmentsthatdonotrequireadditionalfunding.SeeFigure2.Thisdefensiveshiftisusuallydescribedintermsofinvestorsavoidingamoreriskylong-termoutlookratherthancorrectlyastheirdemandforamorecertainshort-termoutlook.Equallyinflationanddeflationwilllikelybothshortenliabilitydurationbecauseofmoreuncertainty.Thereforetakentogetherstablepricesandmoreliquiditypromotelonginvestmenthorizons.Thusextendingassetdurationleadstohigherinvestmentreturnsbutthecostoftyingupcapitalisthatitcannotbeusedelsewhere.Industrialcapitalalwaysseekstolengthenitsdurationsoastoreapgreaterproductivitygainsfinancialcapitalsimultaneouslytriestoreducedurationandmakecaitalmoreliuid.Thetensionbetweenthesetwodimensionsalsorepresentsliquidityrisk.Itexplainsthebusinesscycleandinextremisitcantriggerfinancialcrises.Yetcontrarytopopularbeliefmarketvolatilityshouldnotmattertoinvestmentchoiceprovidedthatassetandliabilitydurationarematched.Thereforeweshouldassumethatinvestorsseektoatleastmatchassetandliabilityduration.Infactaprudentinvestorwillnotwanttoholdanassetmixwithgreaterdurationthanthatrequiredbyfutureliabilities.Insummarytheoptimalassetallocationisaportfoliostructurewhereassetdurationaneverexceedsliabilitdurationandbrecognisesthatliabilitydurationitselfchangessometimessystematicallyandsometimesrandomly.Assetallocationmustthereforeretaingreaterthanrequiredliquidityasamarginofsafety. GlobalView6LiquidityDurationandCapitalAssetPricingLeibowitzmathematicallyre-workedthetraditionalearningsdiscountmodelintoaformthatexplicitlyincorporatedassetdurationwherePdenotesassetpricesristhediscountfactorDisassetorliabilitydurationgistheannualgrowthofincomeandE0representstheinitiallevelofincomeorearnings.InotherwordsstockpricesrisedirectlywithdurationD.TheproductofdurationandgrowthD.gdescribesthepaceofgrowthandthetimeperiodoverwhichitlasts.Wehavearguedelsewherethattypicallytrendgrowthgtendstochangeslowlywhereasdurationtendstoseelargerandmorefrequentshifts.Inotherwordsitcanbeassumedthatgrowthisconstant.ToseehowliquidityandflowoffundsinfluenceassetpricesweneedfirsttomovetoamoregeneralformofthecapitalassetpricingmodelAndsecondtore-express1ingrowthterms.AssumingthatbothE0andgareconstantThisisanextensionofthemodeloriginallyintroducedbyHicksinValueCapital1939.ItlinksmovementsinassetricestoaninterestrateeffectscaledbyacoefficientrepresentingdurationDandthepercentagechangeindurationitself.Wehaveignoredthesecondandhigherderivativesthatdefineconvexit.InHicksformulationdurationwassurprisinglyassumedtobeconstanteventhoughheadmittedthatduringdepressionsdurationmightbeunusuallylowandsolessentheimpactofinterestratecuts.SourceCrossBorderCapitalUSFederalReserveSPFigure2USLiquidityCycleandDurationAbsoluteAnnualChangeMonthly1986-2010PE0r-gstandardGordonmodelPE0.1D.grrevisedLeibowitzmodelPPrDgE01P-D.rDconvexitytermsignored2DurationLHSChangeinLiquidityAdvanced6monthsRHS-6-4-20246Jan-86Jan-87Jan-88Jan-89Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08Jan-09Jan-10-80-60-40-20020406080 7GlobalViewUsinourearlierdescritionofthetransmissionprocesswheretheadjustmentofassetdurationdependsuponthegapbetweenassetandliabilitydurationthefinaltermin3canbere-writtenusingthesubscriptsAandLtorefertoassetsandliabilitiesandtheasterisktorefertodesiredamountsasInotherwordsthepercentagechangeindurationdependsonthedifferencebetweenliabilitydurationandassetdurationorequivalentlytheratiobetweendesireddurationDandactualduration.Thusthelargerthedurationgapinyearsthegreatertherequiredscaleofadjustment.Overthelontermdesireddurationliabilitydurationwillberoughlyfixed.Thereforethespeedofadjustmentofdurationlargelydependsuponthestartingpointthereciprocalofcurrentassetduration.Thefirsttermin2involvesthechangeininterestrates.ItisreasonabletoassumethatthespeedofadjustmentininterestratesdependsupontheslopeoftheinterestrateyieldcurvewhereRrepresentslong-termyieldsTheseexressionsallowustoroughlyre-write2asalinearfunctionThefirsttermrepresentsacollectionofslowlychangingfactorsthatgoverntheunderlyingassetreturnsuchastrendearningsgrowth.GrowthinturnwillbegovernedbystructuralfactorssuchasthestateoftechnologythequalityoflabourdemographicstheincidenceoftaxationandinflationexpectationsandmanyofthefactorsthatalsoaffectliabilityordesireddurationD.SourceCrossBorderCapitalUSFederalReserveECBBankofEnglandBankofJapanIMFrfRr4P.1D.Rr5Figure3GlobalLiquidityIndexandG7YieldCurve10Yrless3Mth1972-20107274767880828486889092949698000204060810020406080100-200-1000100200300LiquidityRisingYieldCurveSteepeningOverallLiquidityIndexLHSYieldCurveBasisPointsRHSDfDLDADfDDDfDD3 GlobalView8Thesecondtermisastatevariablethatrelatesfutureequityreturnstothereciprocalofthecurrentlevelofduration.ForequitiesdurationcanbemeasuredbythePEmultipleaccordingtotheGordongrowthmodel.SothelowerthePEmultipleandthehigherthestartingequityearningsyieldthehighertheprospectivereturn.Thethirdtermistheyieldcurve.Thismovesdirectlywiththecreditorliquiditycycle.Periodsofexpandingliquidityareassociatedwithasteepyieldcurvewherelongyieldstradeaboveshortdatedyields.Similarlyperiodsoftightliquiditycorrespondtotimesofflatoreveninvertedyieldcurves.SeeFigure3.FinancialCyclesInpracticethePEandyieldcurvetermsofteninteractsometimescreatingfinancialturmoil.Inotherwordstheyieldcurvedescribesso-calledfundingliquidityriskorwhatsomemightcallcreditriskandthePEmultiplemeasuresdurationriskorwhatcouldalsobedubbedvaluationrisk.Takentogetherthesetworiskcomponentslargelyexplaintotalmarketrisk.Infundingmarketsboththequalityandquantityofliquidityisimportant.ThereforeCentralBankliquiditytakesongreaterimportanceevenoutsideofcrisis-ledlenderofthelastresortactivitiessinceitaloneservesasmeansofsettlementorlegaltender.MeansofsettlementandCentralBankcreditsaremorelikelytobeeasilyre-hypothecatedthanothercredits.ThustheroleofCentralBanksincreditmarketsneedstobecloselymonitored.Thisshowsagainwhyfinancialstructureisimportant.Desireddurationdescribesfutureliquidityrequirementstosettleliabilities.Themoreliquiditythatisavailablethemorethatassetdurationcanbestretchedout.Butdurationandliquidityremaindistinctfactors.Sometimesliquidityisplentifulandsometimesbecauseofthebusinesscycleitisscarce.Thesedifferentfinancingregimesmaybestableorunstabledependingonthedemandsforduration.Periodswhendurationistoohighi.e.excessivePEsandwhentheyieldcurveisnegativelyslopedindicatingtightliquidityconditionsdescribeunstablefinancingregimesandsoflagpotentialcrises.ThusinthespiritofMinskysFinancialInstabilityHypothesiswearguethatcapitalismisessentiallyafinancingsystemcharacterisedbystableandunstablefinancingregimes.OurresearchpointstofoursuchfinancingregimesthatwenameasCalmSpeculationTurbulenceandReboundwitheachdefinedbyitsdegreeoffundingriskanddurationrisk.Volatilityandthecorrelationamongassetsvarybyregime.Moreoverourstudiesshowthatwithinregimesthereturndistributionsareapproximatelynormalwhereasbetweenreimesthearenot.Thissuggeststhatassetallocationisalsoaboutunderstandingregimeshifts.Theseregimeshiftscanexplainwhyfinancialreturndataexhibitfeaturessuchaspersistenceandfattailsi.e.highlycorrelatedextremeeventsbecausethearereallanewregime-dependentdistributionnotagenuinetail.SeeFigure4.Thisinstabilitysuggeststhatthetwoparametersandshownineuation5mathemselveschangeorinteractinanon-linearfashion.Forexamlewesusectthatdurationcanhaveagreaterorsmallereffectonassetreturnsdependingontheinflationbackground.Inotherwordsthearametermabeattimesskewedbinflation.Wehavetriedtomodelthiseffectforbothbondandstockmarkets.Figure5showstheresultsforUSmarkets.EuitPEsdurationtraceoutabell-shapedcurvethatiscentredonanormalinflationratee..2.BothhigherandlowerinflationratescausePEsandthusdurationtodropsuddenly.Bondmarketsresonddifferentlandinfactreactsmoothltochanininflationrates.Lowinflationevendeflationforcebondieldsdowntoverlowlevels.Thisdifferenceintheresponseofbondandeuitmarketstoinflationiseseciallrelevantforassetallocationbecauseitexlainswhbothmarketsarehihlcorrelatedinmediumandhighinflationregimesbutneativelcorrelatedinlowinflationanddeflationregimes. 9GlobalViewSourceCrossBorderCapitalUSFederalReserveDatastreamSourceCrossBorderCapitalFigure5USPEInverted10-YearBondYieldandCPIInflation1881-2010Figure4StatisticalTestsofNormalitybyRiskRegimeandSchematicDistributionofReturnsverageNormalityandStudent-tTestsonReturnsoSelectedAssetsBasedonWeeklyDatasince19860.00.10.20.30.40.50.6YieldCurvesCurrencyDevelopedEquitiesEmergingEquitiesSectorsGoldMSCIIndexShapiro-WilkTestofUnconditionalDataShapiro-WilkTestConditionalonRegimeandVolatilityKolmogorov-SmirnovTestConditionalonRegimeandVolatilityPEorInvertedYieldInflationDeflationEquities2inflationBondEquityThresholdTheoreticalRelationshipBetweenEquitiesBondsandInflationBondsCalmSpeculationTurbulenceReboundFULLCYCLE0102030405060-30-20-100102030CPIInflationPEMultiple2.5 GlobalView10Secondtheparameterwhichmeasurestheimpactofliquidityonreturnsmayitselfalsodependuponthelevelofliquidity.ThiscanbeseenthroughmovementsintheVIXindexwherebothhighandlowlevelsofliquiditycorrespondtoahigherVIXreadingbutalower-and-lowerliquidityreadingcausestheVIXtospikehighersotracingoutaJ-curveeffect.SeeFigure6.Thisexplainswhatwedescribeasthevolatilityofvolatility.ItneatlydescribesthreeriskregimescorrespondingtohighmediumandlowmarketriskwhichinturnsupportsourpreviousdescriptionoftheCalmSpeculationTurbulenceandReboundriskstates.NotethatSpeculationandReboundarebothassociatedwithmediumrisk.AssetAllocationUltimatelyhowmuchliquiditygoesintostocksratherthanbondsdependsonanumberoffactorsincludingfutureprofitexpectationsinflationandinvestorexposureallofwhichdirectlyaffectdurationaswellasthecurrentphaseoftheliquiditycycle.Inotherwordstheandparametersinequation5willtakedifferentvaluesfordifferentassets.Inpracticetheseusesofliquiditytendtofollowastablepattern.WedescribethispatternastheInvestmentClockinFigure7.Thishighlightshowassetandgoodsmarketstypicallyrespondsequentiallytochangesintheliquiditycomponentinequation5.Risinglevelsofliquidityleadtoincreasingflowsintoassetsoflonger-and-longerduration.Bondstypicallyhaveashorterdurationthanequitiesparticularlyindifficulteconomictimeswhenfutureearningsgrowthbecomesmoreuncertain.Consequentlyrisingfinancialliquidityraisesbondpricesbeforeequityprices.Portfoliomanagersarealsomorelikeltobuanassetclassthattheyhavelowexposuretoandshunanassetclassthattheyalreadyhavelotsof.TheseassetexposuresarewhatweelsewheredescribeasPMorprice-to-moneyratios.TheyarecloselyrelatedtoPEmultiplesandthereforecorrespondtothedurationanddurationriskcomponentofequation5describedearlier.Iftheinvestmentcommunithasalowoverallexposuretostocksevenasmallchangeinliquiditymayalterthesupplydemandbalanceinsuchawaythatittriggersasizeableriseinshareprices.SourceCrossBorderCapitalCBOEUSFederalReserveFigure6VolatilityandLiquidityMonthly1990-2010VolatilityVIXLiquidityTurbulenceReboundCalmSpeculationHighvolatilityrisk----------------------Mediumvolatilityrisk----------------------Lowvolatilityrisk010203040506070020406080100VIXUSLiquidityIndex 11GlobalViewAusefulrule-of-thumbforTacticalAssetAllocationTAAisthatbondmarketsarestrongestduringperiodsofrisingliquiditywhileequitymarketsoutperformduringperiodsofaboveaverageliquidity.Itfollowsthatrisingliquidityfavoursgrowthstocksandfallingliquidityfavoursvaluestocks.Similarlycyclicalsoutperformwhenliquidityisabove-averageanddefensivestocksdobestwhenliquidityissub-par.Thushighandrisingliquidityisassociatedwithcyclicalgrowthequitiese.g.technologymediaandbycorollarydirectionalhedgefundse.g.globalmacroemergingmarkets.Lowandfallingliquidityincontrastfavoursmoreshortdurationbondsdefensivevalueequitiese.g.utilitiesfoodcompaniesandagainbycorollarymarketneutralhedgefunds.Figure7TheInvestmentClockPreciousMetalsandCurrenciesConsumerInflationFixedIncomeCreditSpreadsIndustrialCommoditiesEquitiesRealEstateRealEconomyPreciousMetalsandCurrenciesConsumerInflationFixedIncomeCreditSpreadsIndustrialCommoditiesEquitiesRealEstateRealEconomySourceCrossBorderCapitalFinalThoughtsRe-ThinkingCAPMThetraditionalcapitalassetpricingmodelCAPMrelatesrisktoinvestmentreturns.Inanefficientmarkethigherreturnsrequiretakingonmoreriskwhereriskismeasuredbyreturnvolatility.Thisframeworkhasvaluebutitisincomplete.Firstriskisnotreturnvolatilitybutadurationshortfallwheretherequireddurationofliabilitiesfallsbelowtheavailabledurationofassets.Secondallvolatilityisnotnecessarilybad.Upsidevolatilityisplainlygoodasissystematicandpredictablevolatilitye.g.ifmarketsalwaysrisestronglyonMondaysandfallheavilyonTuesdays.Thirdifassetandliabilitydurationarematchedthevolatilityofinvestmentreturnsshouldnotmuchmatteruptotheinvestmenthorizon.Allthissuggeststhatratherthanrelatingreturnsandvolatilityreturnsshouldbelinkedtoduration.ThecapitalmarketlineinthisrevisedCAPMwilllikelyslopeupwardstotherightindicatingthathigherreturnsrequirealonger-termcommitmentofcapital. GlobalView12Thelineshouldalsohaveaninterceptatleastabovetherateofreturnoncashthezerodurationasset.Thisgapmeasurestheexcessreturn.SeeFigure8.Increasingdurationdiminishesthecertaintyofreturnsbutincreasestheabsolutesize.Whenliquidityanddesireddurationincreaseitisnotthemostriskyi.e.volatileassetsthatrisemostbutthosewithlongestduration.Riskstillmattersbutitcannotbeunambiguouslymeasuredbyvolatility.Riskistime-relatedanditisaffectedbyuncertaintyandlock-up.Herewecanethiherreturnsfromlowvolatilitybutnotinanefficientmarketfromlowduration.IndeedisntthistheveryattractionofprivateequityHigherprofitsarerelatedtotheroundaboutnessoftheproductionprocesslongerandmorecapital-intensiveprojectsaretypicallymoreproductiveandinvestorsactuallychoosetheirdesireddurationorinvestmenthorizonbasedonexpectedfutureliabilitiesratherthantheirexpostvolatility.Thusbyrelatingreturnstodurationthisassetpricingmodelnotonlymakesmoreeconomicandfinancialsenseitalsocoversmoreassetsandliabilitiessuchasrealestateprivateequityhedgefundscommoditiesandbondsandnotjustthoselistedassetssuchasstocks.Whatsmoreaswehaveseendurationandliquidityarebed-fellows.SourceCrossBorderCapitalDurationyearsReturnalphabetacashDRaDeDurationyearsReturnalphabetacashDRaDeFigure8ReturnsandDuration 13GlobalViewCROSSBORDERCAPITALLIMITED96BAKERSTREETLONDONW1U6TJTELEPHONE02079082800FACSIMILE02079082835REGULATEDBYTHEFSACROSSBORDERCAPITALLIMITED2010.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.References1GurleyJ.andE.ShawMoneyinaTheoryofFinance1960Brookings.2JohnHicksValueCapital1939ClarendonPress3SidneyHomerAHistoryofInterestRates1991Rutgers4HenryKaufmanDebtTheThreattoEconomicandFinancialStabilityFederalReserveofKansasEconomicReview19865HenryKaufmanInterestRatestheMarketsandNewFinancialWorld1986TimeBooks6MartinLeibowitzTotalPortfolioDuration1986fromInvesting1992Probus7MartinLeibowitzATotalDifferentialApproachtoEquityDuration1989fromInvesting1992Probus8MartinLeibowitzFranchiseValue2004Wiley.9FrederickMacaulaySomeTheoreticalProblemssuggestedbyTheMovementsofInterestRatesBondYieldsandStockPricesintheUnitedStatesSince18561938NBER 1CROSSBORDERCAPITALCROSSBORDERCAPITALHEDGEFUNDRESEARCHJune2004StylesvsAssetsTheQuantumTheoryofMoneyMoneyormorecorrectlyliquiditylargelydeterminesinvestmentrisk.Howevertherelationshipisneithersmoothnorlinearandinfactseesdiscreteorquantumjumpsasthemonetaryenvironmentshiftsbetweenfourpossibleregimes.Eachregimeisassociatedwithaspecificriskbackdropandinturnriskdeterminesthecharacterofinvestmentreturns.ThusinCalmriskisgenerallylowandDirectionalmanagementstylesperformbest.IntheoppositeTurbulencezonerisksarehighandmanagersthatavoidvolatilityperformwell.Thisanalysishasbothlong-termandshort-termapplications.Theapproachisdifferentbecauseitfocusesonliquidityriskregimesregimeshiftsandinvestmentstylesnotassets.TheBackgroundGrowingandShiftingInvestmentRisksOverthelastfewyearsprobablyourmainresearchthemehascentredontheideathatgrowingfinancialmarketsmeanever-greaterinvestmentrisk.Essentiallyastheworldgetssmallerrisksgetbigger.Butalongthewaythecharacterofriskmayalsochange.Specificallycreditriskbecomesmuchmoreimportantandoftenfollowingonlyasmallchangeinthemonetaryclimate.ThisistheessenceoftheQuantumTheoryofMoney.Figure1WhereIsWallStreetUSStockMarketPerformance1946-2000ByRegimeSourceCrossBorderCapitalFigure1teststhisview.ItshowsmonthlyUSequitymarketperformancesince1946splitintofourregimesdescribedlaterinmoredetail.Eachregimehasagenericnamethatroughlydescribestheunderlyingmarketstatethatgeneratedthereturns.Noticetheradicaldifferencesinthereturndistributionsbetweeneachregime.ForexamplethehighestreturnsoccurinReboundandthelowestinSpeculation.CalmistheleastvolatileregimeandTurbulencecontainsboththehighestincidenceofbestmonthlygainsandworstmonthlyfallsinstockprices.ThecriticalquestioniswherearewenowPutintermsofachoiceofwhichoneoffourregimeswearenowpositionedinweventurethatmostinvestorswouldnotplumforCalm.IronicallytheirexistinginvestmenttechniquesarenotwellsuitedtoanythingapartfromCalm.Thisisourcentralpoint.Itimpliesthattheriskenvironmenthaschangedperhapssignificantly.WhatyouseeisnotwhatyouwantREBOUND19oftimeCALM33TURBULENCE31SPECULATION19MarketRiskLowHighCreditLowHighRiskReturn33.6Volatility13.7BestMonths33WorstMonths7EconomicRecession23EconomicBoom17Return9.0Volatility15.6BestMonths45WorstMonths60EconomicRecession8EconomicBoom43Return14.6Volatility11.3BestMonths13WorstMonths13EconomicRecession4EconomicBoom44Return1.4Volatility13.1BestMonths10WorstMonths20EconomicRecession0EconomicBoom61 2CROSSBORDERCAPITALInvestmentrisklargelyconsistsoftwocomponents1marketriskand2creditrisk.Weexplainbothlater.Investmentpolicyinthelastquarterofthetwentiethcenturywasversedintermsofavoidingmarketrisktypicallybydiversificationbutthenexttwenty-fiveyearsmaybeaboutavoidingcreditrisk.Aheightenedstateofcreditriskmaynoteasilylenditselftodiversificationandalmostcertainlynotdiversificationacrossthesamearrayofassets.Forexampleassetsthatareuncorrelatedbymarketriskmaybehighlycorrelatedwhenjudgedbycreditrisk.Allofusaretoocomplacentabouttheprospectsforageneraldeteriorationofcreditrisk.TheswellingdebtburdensofJapanesebanksEuropeancorporationsandAmericanhouseholdshavebeenwellflagged.Buttheoddsofsovereigndefaultbyoneormorenationalgovernmentsarebarelywhisperedabout.DowereallyexpectpoliticianstosuddenlybecomeparagonsoffiscalprudenceShouldweanticipateinflationtoonceagaindevaluestatedebtsFourtrendsseriouslyquestiontheseassumptions.FirstthebalancesheetofmanyWesterncorporationsmaysufferasdomesticeconomicgrowthslowsandascompetitionfromproducersinemergingeconomiesgrow.SecondthedemandshoulderedbyStateBudgetsintheWestwillthemselvesswelldramaticallyasdemographicpressurescausewelfarespendingtosoar.ThirdthereisnascentevidenceofStatesponsoredtaxavoidanceattheregionallevel.ThiscanalreadybeseenwithintheEuropeanUnionwheregiventhechoiceregionsandstateschoosetousetheirtaxreceiptslocallynotcommunally.FinallythewidespreadexistenceofindependentCentralBanksprobablysignificantlyreducesthechancesofmonetisationandthedevaluationofdebtliabilitiesthroughinflation.Inshorttheoddsofgovernmentdefaultaretodaysomewhathighere.g.Russia1998Argentina2000andpossiblyCaliforniaandwilllikelyswellastheburdensofguaranteedfuturepensionandwelfareprovisionescalate.Ifgovernmentsdefaultthevalueofgovernmentliabilitiesi.e.theassetbaseofthefinancialsystemmustfallandwithitthecredit-creationmechanismwillcrumble.Asnewcreditcannotbeextendednoroldcreditsrolledoverandascreditcostsspiralsocreditriskswillskyrocket.Andascreditriskchangessomusttheassetmanagementlandscape.Spurredbythebenignforceoffallinginflationthepasttwodecadeshavefavoureddirectionalstrategiesortrendfollowingimplementedwidelyacrossadiversifiedarrayofassets.Thisbuyandholdphilosophywherenewmoneyisalwaysinvestedclosetoheadlinebenchmarkindexesandrarelyalteredthereafterisunderpressure.Manyalreadybelievethatthislong-standingbusinessmodelforassetmanagementmustchangeirrevocably.ButwheredoestheindustrygoinsteadThesimplealternativetobuyandholdBAHisbuyandsell.Butmanytraditionalmanagerseschewthispositionbydeclaringthattheyarenotmarkettimers.WewouldcounterbyaskingifthisalsomeansthattheyarenotriskmanagersABAHstrategyinavolatilesidewaysmarketwilldeliverzeroreturns.Clearlyinadirectionalortrendingmarketthereisnoneedtotimepurchasesandhighinter-assetcorrelationsmeanthatassetselectionislessimportant.Henceriskcontrolbecomesalesserfunction.InaperiodofTurbulencewheremarketriskcreditriskandvolatilitiesarehighandcorrelationslowitbecomesessential.Evenignoringmarketriskmaynotlessentheneedforoverallriskmanagementifaswesuspectcreditriskisplayinganincreasinglyimportantrole.Itcouldbearguedthatriskresemblesaballoonsqueezingitinonespotmarketriskmaycauseittobulgeinanothercreditrisk.InfactBAHisparticularlywellsuitedtoaCalmworldoflowmarketriskandlowcreditrisk.AnywhereoutsidetheseboundariesandtheeffectivenessofBAHisreduced.WeventurethatmostinvestorsandmanagerswouldbesympathetictotheviewthattheCalmregimeishistoryatleastfornow.Theworldfacesgreaterrisksandchallengesthanitdid. 3CROSSBORDERCAPITALMostinvestorstypicallyseeriskasone-dimensionalandanothertermforvolatility.Botharedeemedtobebad.Consequentlyvolatilityisdiscardedmostlybydiversificationacrossalternativeassets.Todayhedgefundsandparticularlyfundsofhedgefundsareseenasthealternativeassets.Inthe1970sthealternativeassetwasrealestate.Inthe1980sitwasotherG7stockandbondmarkets.Bythe1990semergingmarketshadbecomethealternativeasset.Hedgefundsareanestablishedwayofmanagingvolatilityandsoonthefaceofthingstheirinclusionmakessense.Volatilityisnotallbadthereisgoodsaysystematicvolatilityaswellasbadvolatilityornoise.Manyhedgefundscansuccessfullytradevolatilityandboostreturns.Butwealsohavefundamentaldoubtsovertheefficacyofthisstrategynotleastifthebalanceofriskchangesbetweenmarketriske.g.volatilityandcreditrisk.Manyhedgefundsareasillequippedtomanagecreditriskastraditionalinvestors1.SowhyswaponeBAHtechniqueintraditionalassetsforanotherinhedgefundsIfriskmanagementissoimportantthenweshoulduseitmorewidely.Hedgefundsshouldbeboughtandsoldjustlikeotherassetsastheriskparameterschange2.TheNatureofRiskFigure2LiquidityMarketRiskandCreditRiskThetwomainriskdimensionsaremarketriskandcreditrisk.Marketriskmightotherwisebethoughtofaspriceriskordurationriskandcreditriskastheriskofdefault.Botharecloselyrelatedtomonetaryfactorsandbothchangesystematically.SeeFigure2.Togethercreditriskandmarketriskuniquelydescribetheriskenvironmentandinturndeterminethecharacterofassetmarketreturns.Thuscertainperiodsofriskfavourparticularassetsoverothers.MarketRisk83848586878889909192939495969798990001020304-2-1012-2-1012Liquidity8384858687888990919293949596979899000102030402040608010020304050607080IndexIndexLooseTightCreditRisk83848586878889909192939495969798990001020304-3-2-101234-3-2-1012341Hedgefundsdeliverpoorreturnswhenamarketinterestratesarelowblevelsofmarketriskandcreditriskarelowandccreditriskisrisingstrongly.SeeWhatDrivesHedgeFundReturnsAugust20032SeeAddingValueThroughTacticalStyleSelectionTSSDecember2002SourceCrossBorderCapital 4CROSSBORDERCAPITALFigure2showshowliquidityleadsbothmarketriskmeasuredinthechartbyabasketofvolatilitiesofkeyassetsandcurrenciesandcreditriskmeasuredbyabasketofsensitivecreditspreadse.g.mortgagespreadsUScorporatespreadsandtheEMBIspreadalljudgedrelativetoUSTreasuryBonds.Figure3TheRiskCycleCreditRiskMarketRiskHoweverinpracticethelinkagebetweenriskandreturnisneithersmoothnorlinear.Liquidityandriskoftenseequantumjumpsintheirrelationship.SeeFigure3.Specificallycertaintriggerpointsexistwheretheriskenvironmentchangessignificantly.Weidentifyfourdiscreteinvestmentriskregimesineachregimeassetperformancesshowstarkdifferences.ThisistheQuantumTheoryofMoneylikethescienceofparticlephysicsriskjumpsdiscretelybetweendifferentlevelsasthestatevariablehereliquiditychangesatthemargin.Thussmallchangesinliquidityareoftenassociatedwithlargechangesinrisk.Thecreditriskmarketriskdimensionsdescribefourriskregimese.g.highcreditrisklowmarketriskorSpeculationlowcreditrisklowmarketriskorCalmetc.witheachregimetaggedbyagenericnameCalmReboundSpeculationandTurbulence.SeeFigure4.Associatedwitheachregimearedifferentvarianceandco-variancepatterns.ForexampleCalmtypicallyseeslowvolatilitiesandhighcorrelations.Oppositequadrantstypicallyreversethecharacterofreturns.ThusTurbulenceseeshighvolatilitylowcorrelationsandanarrowingintherangeofinvestmentopportunitieswhichmakesdiversificationevenmoreessential.Figure4InvestmentZonesRiskRegimesREBOUNDCALMTURBULENCESPECULATIONMarketRiskLowHighCreditRiskLowHighCorrelationsrisingVolatilityfallingDiversifyPortfolioButfewgoodinvestmentsexistConcentratePortfolioButmanygoodinvestmentsexisCorrelationslowVolatilitypeakCorrelationshighVolatilitylowCorrelationsfallingVolatilityrisingSourceCrossBorderCapitalSourceCrossBorderCapital 5CROSSBORDERCAPITALAcorollaryexplainsthesimilarpatternofvarianceandco-variancesamongindividualmanagerreturns.InCalmperformancestatisticsconvergeandinTurbulencetheydiverge.ThevalueofBenchmarkindexesissurelygreatestintheCalmregimewhenmanagersarecloselyclusteredaroundacentralvaluebecausetheindexescanaccuratelypinpointminorbasispointdeviationsfrombenchmark.IntheTurbulenceregimewhenperformanceisdisparatetheperformancedistributionitselfisanaccuratemeasureoftheinvestmentrisks.Outliersshouldbeobvious.Benchmarkindexeshavelessvalueifmostmanagersmissthemi.e.havelargetrackingerrormostofthetime.StyleAnalysisFigure5showsanimportantresultforassetallocators.Itreportstheresultsofatestforthenormalityofreturnsacrosstwentyindependentassetclasses.Tofacilitategoodpredictionthereturndistributionsshouldapproximatelyfollowthenormalprobabilitydistributionorbellcurve.Inotherwordspredictingandmanagingassetreturnsthathavefattailsi.e.occasionallargedrawdownsisdifficult.TheresultsinFigure5coverasampleperiodofmonthlyreturnsforthe1994-2003period.Thisrepresentsapproximatelytwofullinvestmentcycles.Fortheentiresampleperiodveryfewassetreturnsappearednormallydistributedthecriticalpointsinstatisticaltermslieabove0.3ontheleftaxis.OnlythreeEquityMarketNeutralStatisticalArbitrageandShortSellerHedgeFundswerestatisticallysignificant.HoweverifthedataarerecompiledintothepreviouslydefinedfourriskregimesandtheShapiro-Wilketestre-runforeachcompleteregimethentheresultslookverydifferent.VirtuallyeveryassetclasspassesthenormalitytestwiththeclearandprobablyintuitiveexceptionofMergerArbitrageHedgeFunds.Theconclusionisimportant.Ittellsusthatthemostimportantaspectofassetallocationisunderstandingregimeshifts.Assetreturnsarenormalwithinriskregimestheyarenon-normalbetweenthem.Thecentralroleofriskandthechoiceoffourpossibleriskstateshighlighttheneedtomanageandcontrolinvestmentrisk.Theseriskregimesarecharacterisedmorebydifferencesofmanagementstylethanassetchoice.Gettingthemanagementstylerighti.e.whichriskstotakeandwhichtoavoidisoftenmoreimportantthanchoosingfromamongasimplerangeofassetse.g.stocksbondsandcash.Forexampleadirectionalstylemightincludebothlongdurationbondandequityassetswhereasastrategythatavoidsvolatilitymightincludeshortdurationbondshighyieldbluechipequitiesandsomemanagedfuturesfunds.Thusinvestmentstyleswilllikelycombinethesebasicassetsincertainpermutationsratherthanfocusexclusivelyononetype.Todrawananalogybystyleinvestorswechoosetoinvestintheracingdriversratherthantheracingcarsi.e.theassets.Investmentsmustbejudgedontheoveralldistributionoftheirreturnsandnotsimplyontheaveragereturn.Inotherwordsotherparameterssuchasstandarddeviationvolatilityskewnessdrawdownandkurtosislumpinessarealsoimportant.Itistheseotherriskstatisticsthatchangemostbetweenregimes.Eachofthefourriskregimesisassociatedwithacertainreturndistributionandthereforeisbestsuitedtoaspecificmanagementstyle.ForexamplethelowmarketriskandlowcreditriskassociatedwiththeCalmriskregimefavoursdirectionalinvestmentstrategiese.g.theBAHwenotedearlier.Theimportantcorollaryisthatthereturndistributionsformanagementstylesarenormallydistributedeventhoughtheunderlyingassetsmaynotbe.Investmenttechniquestypicallyfallintotwobroadtypesatrendfollowingandbmean-reversion.Directionalstrategiesareatrendfollowingtechnique.Mean-revertingtechniquestypicallycompriseicreditarbitrageiiequityarbitrageandiiivolatilityarbitrage.Eachtechniqueisuniquelylinkedtoariskregime.ThusTurbulenceismostassociatedwithvolatility-basedstrategies.Reboundwhenliquidityconditionsarerisingfromlowsfavourscreditarbitragetechniquese.g.spreadandyieldcurvetrades.Speculationalate-cycleperiodwhencreditrisksarerisingfavoursequityarbitragee.g.mergerarbitragevalueinvesting.SeeFigure5. 6CROSSBORDERCAPITALSourceCrossBorderCapitalFigure5RiskRegimesFavourCertainInvestmentTechniquesConvertibleBondArbBondEmergingEquitiesDevelopedEquitiesCyclicalValueDefensiveValueDefensiveGrowthCyclicalGrowthFixedIncomeArbEquityMktNeutralStatisticalArbitrageEquityLongShortEmergingHedgeManagedFuturesMacroDistressedShortSellingEventDrivenMergerArbitrageAllHedgeFunds00.10.20.30.40.50.60.70.8AllPeriodsAverageOfSeparateRegimesMarketriskandcreditriskaresystematicallydeterminedbyliquidity.Liquiditymeasurestheflowofmeansofpurchasemoneyi.e.cashplusborrowings.Itisnottheso-calledmoneysupplywhichmeasuresusesnotsourcesoffunds.Ourresearchfindsthatthelevelofliquidityispositivelycorrelatedtodurationandnegativelycorrelatedwithvolatility.Thushighlevelsofliquidityfavourlongdurationassetsandlowvolatility.Creditriskasreflectedbycreditspreadsanddefaultratesisdeterminedmorebythedirectionofliquidity.Risingliquiditytendsthereforetobeassociatedwithfallingcreditrisk.Themonetaryenvironmentchangescyclically.Cyclescanbebothlong-30-50yrsandshort-term5-10years.AssuchStrategicAssetAllocationSAAneedstofocusonthelong-termcycleandTacticalAssetAllocationTAAneedstolookattheshort-termcycle.Figure6showsthephasesoftheliquiditycycleandhowtheylineupwithourfourriskregimes.Figure6TheGlobalLiquidityCycle-TheoreticalandActual1980-2004LooseTightIndexReaganElectionLDCDebtCrisisVolckerFedFailureofContinentalIllinoisPlazaAccordWeakUSJapaneseBubble1987CrashScandinavianBankingCrisisUSSLCrisisJapaneseTighteningMexicoPesoCrisisEmergingMarketBoomBondCrashAsianCrisisRussianCrisisY2K80818283848586878889909192939495969798990001020304020406080100020406080100ABCDABCCalmTurbulenceSpeculationReboundD33.018Months21.812Months19.711Months25.514MonthsTheoryActualGivenapriorithatanequaltimeisspentineachphaseofthecycleaneutralinvestmentpositionwillprobablyequallybalanceassetsbetweenthefourmanagementstyles.Inotherwordsitwillgivesimilari.e.25oddstoeachofthefourunderlyingriskregimes.Yethistoryshowsthatthetimespentineachzonevariesconsiderably.Bydefinitionthisdescribesthecharacteroftheinvestmentperiod.Forexampleduringthevolatile1970smarketsspent42.1oftimeintheTurbulencezoneandonly18.7inCalmnotsurprisinglydirectionalstrategiesdidpoorly.SimilarlyweestimatethatintheDepressionyears1929-1933marketsspentover50ofthetimeinTurbulence.SourceCrossBorderCapital 7CROSSBORDERCAPITALInthe1980sand1990sdirectionalstrategiesperformedfarbetter.ThisisnotsurprisingwhenweconsiderthattheCalmregimelasted29.8and34.5ofthetimerespectively.Moreoverthe1995-1999BubbleYearssawCalmoccurringfor38.7oftheperiod.TheoddsofCalmarecurrentlyinshort-termcyclicaldecline.Figure7highlightstheestimatedprobabilitiesoftheCalmandTurbulenceperiods.TheseestimatesderivedirectlyfromthelevelandmomentumoftheliquiditycycleshowninFigure6.Figure7ProbabilitiesofCalmandTurbulenceRiskRegimes1978-2004SourceCrossBorderCapital787980818283848586878889909192939495969798990001020304020406080100CalmTurbulence787980818283848586878889909192939495969798990001020304020406080100StrategicVersusTacticalAssetAllocationSAAVs.TAAOurapproachtoTAAispurelyquantitative.Liquiditydeterminesriskandriskinturndeterminesinvestmentstyle.Figure7showstheoddsoftworiskregimesandeachregimehasanappropriateinvestmenttechniquewhichisuniquelyassociatedwithit.Short-termliquiditycyclesarebasedonCentralBanksresponsetotheprivatesectorbusinesscycle.Theytendtoaverage5yearswithmorepronouncedmovesevery10years.Monitoringmonthlyliquiditycanpinpointthecurrentpositionintheshort-termcycleandhelptopredicthowthecyclewillunfoldoverthecoming6-18months.ThiswillfacilitatetacticalinvestmentstooverlayontheSAA.Figure8showsourtacticalallocationsfirsttobroadinvestmentstylese.g.directionalvolatility-basedandthensecondtobasicassetclassese.g.bondequities.Inourframeworkthebond-equitydecisionislogicallysecondarytothemanagementstyledecision.Figure8TacticalAssetAllocation-StylesNotAssetsREBOUNDCALMTURBULENCESPECULATIONDirectionalVolatility-BasedCredit-ArbitrageEquity-ArbitrageMarketRiskLowHighCreditLowHighRiske.g.HighYieldBondsDefensiveGrowthStocksDistressedSecuritiesFixedIncomeArbHedgeFundse.g.EquitiesEmergingMarketsCyclicalGrowthStocksLongShortEquityHedgeFundse.g.CashBondsDefensiveValueStocksManagedFuturesConvertibleArbitrageHedgeFundse.g.CyclicalValueStocksCommoditiesMergerArbitrageHedgeFundsRealEstateSourceCrossBorderCapital 8CROSSBORDERCAPITALTheSAAdecisionisnecessarilymorequalitative.Itmightbebasedonfactorsthatdeterminethelong-termmonetaryenvironmentsuchasdemographicsdebtandtaxation.Althoughbydefinitionlong-termallfarsightedstrategicdecisionsneedtobesystematicallyandperiodicallyreviewedintheshortterm.Figure9showshowsensitiveWallStreetsvaluationhasbeentodifferentinflationaryenvironments.ThechartdemonstratesthatUSPEsarehighestatthosetimeswhentheinflationrateisaround3.Whatsmoresmallchangesintheinflationrateeithersideofthiscriticallevelcancauseadramaticcollapseinvaluationlevels.Figure9PEMultipleofUSEquitiesAndInflation1914-2003MonthlyData-20-100102030010203040501914-2003monthlydataInflationPEMultiple3equitiesde-ratedequitiesre-ratedInflationisamonetaryphenomenon.Figure9showsthatoptimalSAAisdependentonthemonetaryenvironment.Thefour-quadrantriskregimeframeworkcanfurtherrefinethismodel.Inflationisplainlyimportantbutcreditriskandmarketriskaremorespecificthreatsandtheseshouldbeaddressedbychangingmanagementstyleratherthanjustassetmix.Figure10highlightstheaveragetimespentineachregimebydecade.ThekeyquestiontoaskiswillthefuturebelikethepastMostassetallocatorswouldagreethatlookingaheadthe1980sand1990stypeCalmmarketswereunusualandwillnotbeeasilyrepeated.ForexampletheworseningdebtbackdropandpossibilityofrisingcreditrisksurelypointtolowerthanbenchmarkoddsofCalmandfarhigheroddsofTurbulence.InotherwordsSAAshouldallocategreaterfundstovolatility-basedmanagersthandirectionalmanagers.Whatsmoreanassumptionofgreatercreditriskwouldnotnecessarilyfavourgreaterbondexposure.Ratheritwouldencourageareducedexposuretocreditarbitragetradesandageneralshrinkageofassetduration.Greaterallocationsshouldbemadetomanagersthatexcelatshort-termtradinge.g.managedfuturesfundshighercashholdingsandoverlaystrategiesthatarelongvolatility.Figure10TimeSpentinRiskRegimesByPeriod1929-3470s80s90s2000Average020406080100CalmReboundSpeculationTurbulenceSourceCrossBorderCapitalSourceCrossBorderCapital 9CROSSBORDERCAPITALCROSSBORDERCAPITALLIMITEDMARCOLHOUSE289-293REGENTSTREETLONDONW1B2HJTELEPHONE02075350400FACSIMILE02075350435REGULATEDBYTHEFINANCIALSERVICESAUTHORITYCROSSBORDERCAPITALLIMITED2004.ALLRIGHTSRESERVEDThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinfundsmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.Futureinvestmentpolicywillhingeonunderstandingprocessesnotassets.Inotherwordsmanagementstylewillbekeyandtheappropriatemanagementstylewillchangeastheinvestmentbackdroporriskregimechanges.Thusassetallocationshouldtakeaccountofriskregimesandmorespecificallytheimplicationofregimeshifts.AnassetallocationandinvestmenttechniquethatiswellsuitedtotheCalmregimewilllikelydopoorlyduringotherriskregimessuchasTurbulence.TacticalAssetAllocationTAAshouldmanageriskbymonitoringthemonetaryliquiditycycle.AttheveryleastitshouldtrytospotupcomingperiodsofTurbulencewhenexistingreturnpatternsmaybesuddenlyanddamaginglyderailedsuchas19878819942000and2004.Thisisnotmarkettimingratheritisriskmanagementandspecificallyinvolvesundiversifiablecreditriskmanagement.StrategicAssetAllocationSAAismoredifficulttoimplementandnecessarilymorequalitative.Theriskregimeframeworkisagainimportant.Strategicriskcouldbemanagedbyinvestingwithrespecttoanormalcyclewherenormalisdefinedbylong-termhistory.Thustakinga20-yearcycleifmarketshavealreadyusedupsay19oftheirtypical33timespaninCalmintheprevious3.8yearsi.e.0.19x20theyonlyhaveanother2.8years0.33-0.19x20or17lefti.e.2.820-3.8.Otherstrategiesshouldbeaccordinglyrebalancedi.e.raisedfroma67to83probabilityallocation.Figure11SummaryFutureAssetAllocationStylesNotAssetsRegimesfavourinvestmentstylesandregimeshiftcriticaltoassetallocationStrategicInvestmentinManagementStylesTacticalOverlaysUndiversifiablecreditrisksettoincreaseGoodandbadvolatilityexists.Usevolatilitytoimproveperformance.DonotdiscarditasModernPortfolioTheoryMPTsuggestsSAAmustbesubjecttofrequentshort-termreview 1GlobalViewGlobalViewJuly201196BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalFigure1YaleEndowmentandItsPeersAllocationsTargetsandAnnualRiskReturnAssumptionsPercentWhatCanYaleTeachUsLecture2NearlytenyearsagowewrotearesearchreportentitledWhatCanYaleTeachUsItanalysedtheunorthodoxassetallocationpolicyofTheYaleEndowmentFundaninstitutionthatledinnovationinassetallocationoverthepreviousdecadewithgreatpracticalsuccess.Itsallocationtoalternativese.g.hedgefundsprivateequityandrealassetswasatthetimenearlythreetimeshigherthanotherinstitutionalinvestors.Wethenarguedthatitstargetallocationwasremarkablyclosetoourtheoreticalidealbaseduponlikelyfutureinvestmentregimes.UnliketheTraditionalassetallocationmixtheYalemodelwasthenwellprotectedagainstrisingcreditriskandlessde-pendentonthecontinuationoftherecentCalminvestmentregime.HoweverthefollowingyearshaveseenYalesassetallocationmovefurtherawayfromtheconventionalpeergroupbenchmarksbutintheprocessitsportfoliohaslatelybecomemuchtooskewedintospecificfutureinvestmentregimes.InshortintryingtobecomemorediversifiedacrossassetsYalehasbecomelessdiversifiedacrossprobableevents.TheYaleEndowmentTheunusualassetallocationoftheUS16.7billionYaleEndow-menthaslongbeenatalkingpointinAmericabutthegrowingresponsibilitiesoftrusteesinEuropeismakingitanissueheretoo.TheYaleEndowmentshunstraditionalbenchmarks.Thisboldmovehasallowedittodramaticallyoutperformitspeersanddeliverreturnswell-aboveinflationandthisdespiteawhopping24.6declineinvalueinFY2009OverthepasttenyearstheEndowmentgrewfrom10.1billionto16.7billion.Withannualnetinvestmentreturnsof8.9percenttheEndowmentsperformanceexceededitsbenchmarkandoutpacedinstitutionalfundindices.TheYaleEndowmentstwenty-yearrecordof13.1percentperannumproduceda2010En-dowmentvalueofoversixtimesthatof1990.YaleEndowmentReport2010NoteIntherangegivenforForeignEquitylowerfiguredenotesDevelopedMarketsandhigherfigureEmergingMarkets.IntherangegivenforHedgeFundslowerfiguredenotesEventDrivenstrategiesandhigherfigureValueDriven.EducationalInstitutionMeanisYalepeergroup.TraditionalAssetAllocationisanotionalfigurethatissupposedtoreflectthemedianpensionfund.ExpectedRealReturnsVolatilityYaleTargetAllocationYaleActualAllocationEducationalInstitutionMeanTraditionalAssetAllocationDomesticEquity6.0020.0077.0017.1045DomesticFixed2.0010.0044.0015.3015ForeignEquity6-721.3099.9018.1015HedgeFunds5-5.55.001921.0026.4010PrivateEquity10.5027.703330.3010.205Realassets6.0015.502827.5011.605Cash--00.402.805TOTAL6.2014.70100100100100 GlobalView2YalessixchosenassetclassesseeFigure1arecharacterisedbydifferencesintheirexpectedresponsetoeconomicconditionssuchaspriceinflationorchangesininterestratesandareweightedintheEndowmentportfoliobyconsideringtheirrisk-adjustedreturnsandcorrelations.Thetheoreticalframeworkreliesonamean-varianceapproachdevelopedbyNobellaureatesJamesTobinandHarryMarkowitz.NotsurprisinglytheEndowmentexpectsitsrecentexcellentresultstocontinueThetargetmixofassetsproducesanexpectedrealafter-inflationlong-termgrowthrateof6.2percentwithariskstandarddeviationofreturnsof14.7percent.YaleEndowmentReport2010With10-yearUSTreasuriescurrentlyyieldingonlyatadabovelatestconsumerinflationthesearemouth-wateringprospectivereturns.WhatliesbehindthesenumbersisYalesuniqueapproachtoendowmentmanagementwhichischaracterisedbyafocusonequitiesandastrongemphasisonalternativesOverthepasttwodecadesYaledramaticallyreducedtheEndowmentsdependenceondomesticmarketablesecuritiesbyreallocatingassetstonontraditionalassetclasses.In1990almostthree-fourthsoftheEndowmentwascommittedtoU.S.stocksbondsandcash.Todaytargetallocationscallfor11.0percentindomesticmarketablesecuritieswhilethediversifyingassetsofforeignequityprivateequityabsolutereturnstrategiesandrealassetsdominatetheEndowmentrepresenting89.0percentofthetargetportfolio.YalejustifiesthisTheheavyallocationtonontraditionalassetclassesstemsfromtheirreturnpotentialanddiversifyingpower.Todaysactualandtargetportfolioshavesignificantlyhigherexpectedreturnsandlowervolatilitythanthe1990portfolio.Alternativeassetsbytheirverynaturetendtobelessefficientlypricedthantraditionalmarketablesecuritiesprovidinganopportunitytoexploitmarketinefficienciesthroughactivemanagement.TheEndowmentslongtimehorizoniswellsuitedtoexploitingilliquidlessefficientmarketssuchasventurecapitalleveragedbuyoutsoilandgastimberandrealestate.YaleEndowmentReport2010TheaverageUSeducationalinstitutionstillinvestsover17ofassetsinlisteddomesticUSequitiesbutYalestargetallocationisjust7.SeeFigure1.Thealternativeflavourisalsocontinuedwithintheequityportfoliowitharoundhalfofforeigninvestmentsdevotedtoemergingmarketstocks.NeitherisYaleparticularlyattractedtofixedincomeassetswhichareslashedtoa4allocationfromthemoretraditionallevelof15.BondshavethelowesthistoricalandexpectedreturnsoftheEndowmentssixassetclassesandaredeemedtobemoreliquidandthusmoreefficientlypricedmarkets.TheilliquiditypremiumiskeytoYalesoptimisticalphaprojections.Yetthemanagersalsopitchthefundtowardsequity-likerisksforpracticalbudgetingreasons.TheneedtoprovideresourcesforcurrentoperationsaswellaspreservepurchasingpowerofassetsdictatesinvestingforhighreturnscausingtheEndowmenttobebiasedtowardsequity.InadditiontheUniversitysvulnerabilitytoinflationfurtherdirectstheEndowmentawayfromfixedincomeandtowardsequityinstruments.Hence92.5percentnow962010oftheEndowmentistargetedforinvestmentinsomeformofequitythroughholdingsofdomesticandinternationalsecuritiesrealassetsandprivateequity.YaleEndowmentReport2003TheTraditionalassetmanagementmodelcanbecrudelydescribedbyan8020rulesinceroughly80oftheportfolioisallocatedtomarketableassetssuchaslistedstocksandbondsandonlysome20oroftensometimeslessisallocatedtocashandlessliquidalternativeinvestments.Weshowanotionalallocationtorepresentthismix.Bydefinitionprobablynosinglefundhasthisexactallocation.Itshouldbetakenasatendencyandonemoreoverthatcanadaptthroughtime.ForexampleadecadeagoTraditionalinvestorshadanevengreateremphasisondomesticmarketableassetsandfarlessthanthis20allocationgivenovertoalternatives.Timeschange.YaleEndowmentscurrentallocationtoalternativese.g.hedgefundsprivateequityandrealassetsisremarkablyfourtimesthisfigure. 3GlobalViewAccordingtotheEndowmentAlternativeassetstendtobelessefficientlypricedthantraditionalmarketablesecuritiesprovidinganopportunitytoexploitmarketinefficienciesthroughactivemanagement.OverthepasttenyearsYalesportfolioofhedgefundsreturned11.5perannumwithlowcorrelation0.16todomesticUSstocksandbonds.Realestateoilandgasandtimberlandinvestmentssharesimilarsensitivitiestoinflationandhighcashflows.TheyprovidestabilitytotheEndowmentduringperiodsoffinancialmarketturmoilalbeitatthecostofunderperformanceduringbullmarkets.Yalesabilitytotakealongviewallowsthemtoaddtotheirprospectivealphaopportunisticallywhensayforcedsellingbyotherscreatesassetmispricing.Yalesmanagersnotethatnotablyduringfinancialcrisesinvestorsoftennarrowtheirperspectivetoanunreasonablyshorttimehorizonandoftenengageincounter-productiveactivities.ThismeritsYaleslonger-termfocusandallowsthemtobenefitfromanilliquiditypremiumViewedinthenarrowtimeframeofthe2008crisisliquidassetsperformedbetterthanilliquidassetsandsafeassetsperformedbetterthanriskyassets.Viewedinatimeframemoreappropriateforalong-terminvestorwell-chosenpositionsinilliquidassetsperformbetterthanotherwisecomparableliquidassetsandwell-selectedportfoliosofriskyassetsproducebetterreturnsthanrisk-freeU.S.Treasurysecurities.YaleEndowmentReport2010Nothingsucceedslikesuccess.Theforcesofcompetitionhaveforcedotherstothinkboldlytoo.Investmentstrategyisshiftingawayfromstraightperformancemanagementtoriskmanagement.Trusteesnowcarelessaboutbeingafewbasispointsbelowtraditionalbenchmarksandaremoreconcernedwithpreservingcapitalinadownmarket.CouldtheYaleEndowmentmodelofvirtuallynobondsfewmarketableassetsandaheavyrelianceonalternativesbecomethenewbenchmarkInsideTheBlackBoxWhatdrivesYalesaudaciousallocationisaradicallydifferentviewoftheworldandthelikelyfuturerisks.Everyassetallocationimpliesasetofunderlyingriskassumptions.SocanwereconstructYaleEndowmentsimplicitriskassumptionsOnewaytounlocktheassumptionsbehindtheYalemodelistouseascenarioanalysis.Variousstatesoftheworldcanbedescribedbytheireconomicandfinancialfeaturese.g.recessionexpansionhighlowreturnsvolatilityskewdrawdownandpersistenceofitsoutliers.WeusetheCrossBorderCapitalfourregimetaxonomyofinvestmentmarketstodescribethelikelystatesoftheWorld.Anidealassetallocationcanthenbecreatedforeachstate.Forexampletraditionalequitieswilllikelyperformbestinacalmlowvolatilityregimewhereasamorevolatilebackdropmightfavourcashandcertainhedgefundstrategies.NormallytheprobabilitiesofeachriskregimearebasedonourquantitativeassessmentofoverallfinancialliquidityconditionsfromthehistorictimespentineachphaseoftheGlobalLiquidityCycleseeFigure2butinthiscaseYaleschosenassetmiximpliesthem.Yalesriskassumptionsarereverse-engineeredfromamean-varianceanalysisconditionaloneachregimewiththeweightsattributedtoeachstatebasedontheimpliedYaleprobability.Weessentiallyusethisapproachalthoughwetargetdurationriskratherthanvarianceorvolatilityriskandassessoptimalexposurestoeachregimefromaqualitativeinvestorsurvey1.Theidealassetallocationwithineachriskregimeisdecidedqualitativelyfromaselectedsamplegroupofmajorinvestorseachbeingaskedtochooseallocationstoeachassetclassthatbestsatisfiedasetdurationtargetregime-by-regimeroundedtothenearest5.OurphilosophyarguesthatinvestorstargetaspecificdesireddurationDandwilltrytobestmeetthisdurationtargetbychangingtheirassetmixthroughtimeandacrossinvestmentregimes.Durationisformallydefinedasthetime-weightedpresentvalueoffuturecashreceiptsandcashpayments.Itsummarisesinasinglestatistictheaverageinvestmenttimehorizone.g.11.8years.1InmathematicaltermsH.prswprsH-1.wwhereHisamatrixthatincorporatestheassetallocationmodelsdenotesthestatesoftheWorldorinvestmentregimesprsrepresentstheprobabilityofthesestatesandwisavectorofassetallocationweights. GlobalView4SourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFFigure2TheGlobalLiquidityCycleandSchematicTaxonomyIndex0-100Monthly1965-201165676971737577798183858789919395979901030507091102040608010002040608010019721977198219871993199820032008LooseTight1967USRealEstateCommoditiesGoldNEAsianStocksRealEstateGlobalBondsEquityMarketsTechnologySharesUSRealEstateGoldGlobalEquitiesUSPennSquareUKBankingCrisisLatAmDebtContinentalIllinoisUSSLScandinavianBanksJapaneseBanksBaringsWorldcomEnronUSSubPrimeUKBanksIcelandABCDTurbulenceABCDACalmSpeculationRebound 5GlobalViewThedurationtargetissensitivetotheassumedstateoftheWorldandthisinturncanbedescribedbyliquidityconditions.Thelinktoliquidityisprovidedbydurationbecausecashisthezerodurationasset.Thereforeduringperiodsofverytightliquiditythedurationtargetwouldlikelyshrink.Wedefineriskasthegapbetweenactualportfoliodurationandtargeteddesiredduration.Riskaversionandtheabilitytoreshuffleassetswilldictatehowquicklyittakesactualassetdurationtoconvergebacktothistarget.Inshortbecauseallassetsyielddurationthetargetassetmixmustbedeterminedbytheassessmentoffutureliquidityneeds.LiquidityfluctuatescyclicallyandtobetterappreciateitseffectswedivideuptheliquiditycycleintofourcontiguousphasesReboundCalmSpeculationandTurbulence.Eachnameisagenericdescriptionofthetypicalinvestmentclimate.Thetimespentineachphasetendstochangefromcycle-to-cycle.ThusperiodsofgenerallyscarceliquiditytendtoseeextendedTurbulencephases.Eachofthefourphasesoftheliquiditycyclecanbeidentifiedbytheirdifferentrisklevels.TheCalmphaseischaracterizedbygenerallylowriskbothcreditriskandmarketrisk.Creditriskreferstotheabilitytoraisefundingliquidity.Marketriskisameaureoftheabilitytotradeinsizeatclosetoprevailingprices.ThusTurbulenceisastatewherebothcreditriskandmarketriskarehigh.ReboundandSpeculationaretransitionalregimes.ReboundfeatureslowcreditriskandhighmarketriskandSpeculationseeshighcreditriskandlowmarketrisk.Weequatethetraditionalinvestmentcyclewiththeliquiditycycle.Ourliquidity-basedriskregimeframeworkemphasisestheimportanceofcorrectlyidentifyingtheprevailinginvestmentclimateratherthanforecastingspecificreturns.Investmentperformancedependsonprobabilitydistributionsnotaccuratepointforecasts.Forexamplegreyskiesincreasetheoddsofgettingsoakedbuttheydontalwayspredictrain.Thebroadcharacteristicsofeachregimeaverageproportionoftimespentineachphase1970-2011isshowninbracketsareRebound20.4Liquiditybelowaveragebutrising.Creditrisklowandmarketriskhigh.Volatilitiesfallingandcorrelationsamongassetclassesrising.Returnstendtobepositivelyskewed.Goodreturnsfromcredit-basedstrategies.EconomyinrecessionbutCentralBanksundertakingmonetaryeasing.Inflationlow.Calm29.8Liquidityaboveaverageandrising.Creditriskandmarketrisklow.Intra-assetcorrelationshighbutvolatilitieslow.Returnsondirectionalassetshighandsteady.Economyinearlygrowthphase.Speculation22.8Liquidityaboveaveragebutfalling.Creditriskrisingandmarketriskstilllow.Correlationsamongassetclassesbreakingdownandvolatilitystartingtorise.Returnstendtobeoflowqualityandnegativelyskewed.Valuationsstretchedandpossibilityofsharpcorrection.Late-cycleinvestmentssuchasrealassetsperformingwell.Economyinstrongrecovery.Inflationaccelerating.CentralBanksstarttotighten.Turbulence27.1Liquiditybelowaverageandfalling.Creditriskhighandmarketriskhigh.Volatilitynearpeaklevelsandcorrelationsamongassetclasseslow.EconomyatpeaklevelsandinflationunderattackbyaggressiveCentralBanks.Yieldcurvesinverted.Non-directionalinvestmentbest.Stockmarketshavetraditionallyseenmanyoftheirworstmonthsbutalsoseveraloftheirbest.Returntailsfatandpersistent.Onaveragereturnslow.Figure3highlightshowtheshapeoftheliquiditycyclehadchangedovertime.Duringthemid-to-late1970stheproportionoftimespentintheTurbulencephasejumpeddramaticallyto46.8.Themorefavourableinvestmentclimateofthe1990ssawCalmaverage33.0.OverthefiftyyearhistoryofourdatabasetheCalmregimehasdominated.Moreimportantlythegenerallymorebenigninvestmentphasesthatseeeitherabove-averageoratleastrisingliquiditymakeup72.9ofthehistory.PlainlythismayormaynotbeausefulfutureguidebutitisinterestingtonotethatmosttraditionalassetallocationbenchmarkswiththeirheavycommitmenttolistedequitiesweremostlydevisedduringCalminvestmentperiodsandthereforeitseemslikelythattheyarebest-suitedtothisphase.Figure4showsexamplesoftheunderlyingprobabilitydistributionsforglobalequitiessplitbyregime.Thedistributionsvaryasindicatedearliernotonlybytheiraveragemonthlyreturnandvolatilitybutalsobytheirskewdrawdownandbythefatnessoftheirreturntails. GlobalView601020304050607080901001970s1980s1990s2000sAverageSourceCrossBorderCapitalDatastreamFigure4RegimeReturns-GlobalEquities1985-2011SourceCrossBorderCapitalFigure3ProbabilitiesofRiskRegimesBasedonFinancialCycle1970-2011TurbulenceSpeculationCalmReboundEquitybestassetclassgoodqualityofreturnsHighdiversificationbenefitsCommoditiesandbondsunderperformersAver.weeklyreturn0.22Aver.weeklyvol.3.08GoodforTAAhighdispersionacrosswinnersandlaggardsWorstqualityofreturnsVeryfattailsJumpyvolatility.YieldcurvetendstoinvertAver.weeklyreturn0.15Aver.weeklyvol.3.48CalmSpeculationTurbulenceGoodforTAAhighdispersionacrosswinnersandlaggardsBestqualityofreturnsforequityandcommoditiesYieldcurvesteepensGoodforcommoditiesAver.weeklyreturn0.44Aver.weeklyvol.3.46-0.4-0.20.00.20.405101520ReboundUSMSCIWeeklyRealReturns-0.2-0.10.00.10.205101520USMSCIWeeklyRealReturns-0.2-0.10.00.10.205101520USMSCIWeeklyRealReturns-0.2-0.10.00.10.205101520USMSCIWeeklyRealReturnsBadqualityofreturnslowreturnriskHighdiversificationbenefitsHighlikelihoodofsell-offsnegativeskewnessFattailsBadenvironmentfortraditionalVaRmodelsAver.weeklyreturn0.17Aver.weeklyvol.3.12 7GlobalViewThesefourdistributionscanthenbecombinedtoformanotionalhybridreturndistributionwheretheweightsareassignedaccordingtotheregimeprobability.Thehybriddistributionismoreflexiblethantraditionalnormaldistributionsorbellcurvesinthatbyalteringtheunderlyingregimeweightsitcanhavesayfattertailsandmore-or-lessskew.Itistheseimpliedweightsperassetallocationthatweareinterestedinuncovering.Co-incidentallyasfaraswecantellYaleappearstouseasimilarphilosophyindecidingitsstrategicassetallocationEmpiricallyfinancialeconomistsfindthatmarketreturnsexhibitfattailsagreaterfrequencyofextremeresultsthanwouldbefoundinnormaldistributionswiththesamemeanandvariance.ThoughMonteCarlosimulationsoftenusenormallydistributedrandomnumbersYalenormallyaddressedthisweaknessbyrunningsimulationsthattransitionbetweendifferentworldstateseachwithitsowndistinctunderlyingnormaldistribution.DefiningvariousworldstatessuchasbearandbullmarketsallowsYaletoimprovespecificationoftheassetclasscharacterizations.ForexamplebyincreasingthelikelihoodofabearmarketstateYalecancontroltheskewandfatnessofthelefttailintheoveralldistributionimprovingthedescriptionoffinancialmarketrealityrelativetoanunadjustednormaldistribution.YaleEndowmentReport2010.ConclusionAlphaOrPhiBetaKappaIdeallyinvestorsshoulddiversifytheirportfoliosacrossstatesoftheWorldoreventsratherthanassets.Havingawidespreadofassetsisanecessarybutitisnotasufficientconditiontoberiskneutral.Assetallocationisnotaboutpointforecastingi.e.gettingthebestitisalsoaboutavoidingtheworstoutcomesandnotendingupinthelowerperformancedeciles.Inpracticethismaymeandeliberatelychoosingthesecondbeststrategiesineachinvestmentregimebecausethesemaywellprovetobebestonaverageoverall.Statisticallytheyhavethehighestconditionaloutcomes.Orinsporting-speakthedecathlongoldmedalistmaynotwinanysingleoneoftheteneventsbutheorsheisstillvictoriousonoverallpoints.SourceCrossBorderCapitalFigure5CreatingaHybridReturnDistributionfromUnderlyingRegimeReturnsSchematicCalmSpeculationTurbulenceReboundFULLCYCLE GlobalView8AccordingtotheliquiditycycledatashowninFigure3theCalminvestmentregimetheonebest-suitedtoTraditionalassetallocationoccursonlyaround29.8ofthetime.Understandablywiththeirabilitytotakealonger-termviewYaleEndowmenthavesoughttomoveawayfromthisassetmixandsobenefitfromtheexcessreturnsavailablefromlessliquidalternativeinvestments.HoweverwhenanalysedbytheirimpliedallocationtoinvestmentriskregimesFigure6showsthatinnoblyseekingtoavoidexcessiveexposuretotheCalmphaseYaleEndowmentsassetallocationhasovershotintheotherdirection.TheirlatestFY2010assetallocationimpliesaskewtowardsjusttwooutofourfourinvestmentregimesCalmandSpeculation.OnpapertheEndowmentappearstobewidelydiversifiedacrosstheirsixassetclassesbuttheirchosenmixmakesthemverypolarisedtospecificevents.Accordingtoourclassificationtheyareover-exposedtomarketrisk.Thismightseemparadoxicalbecauseonpapertheyhavefewmarketableassets.Butmarketriskheightensvolatilitywhichisoftenanegativeforhedgefundreturns.Ontophighmarketriskisoftenassociatedwithaninabilitytoraisenewequityfundingparticularlylateintheinvestmentcycleandthiscanhitprivateequityreturnshard.Yalecurrentlyhasawhopping52ofitsassetstargetedtothesetwoassetclasses.Lastyearsdecisiontoswitchasizeable9pointsoftheportfoliofromrealassetslargelyintoprivateequityandhedgefundsexplainsthehugeregimeskewtoSpeculation.AyearagoYalehadonlya22.2exposuretoSpeculationandalargeexposuretoTurbulence.Nowtheyhave67.7inSpeculationandzeroallocatedtotheTurbulenceregime.InpracticeourcalculationsshowthatYalemighthavebeenbettertorebuilditstraditionalfixedincomeholdings.Thusunconsciouslytheyhavedramaticallyreducedtheirdiversificationacrosspossibleeventsmakingthemselvesexposedindirectlytohighmarketriskandtolatebusinesscyclerisks.TheyhavelittleornoexposuretoeithertheTurbulenceorReboundphasesperiodswhencredit-sensitivestrategiestendtoperformwell.ThustheYaleEndowmentwilltypicallyoutperformintheupperhalfoftheinvestmentcyclei.e.suchasoccurredinFY2006andFY2007buttheywillbombinthelowerhalfthatfeaturesTurbulenceandReboundi.e.FY2008FY2009andFY2010.HowdoesYalecomparetotheidealUsingtheaverageregimeprobabilitiesreportedinFigure3wecanderiveanidealassetallocation.TheresultisshowninFigure7.Around40ofthisidealportfolioisallocatedtomarketableassetsspreadequallyacrossdomesticequitydomesticfixedincomeandforeignequity23goesintohedgefunds20intorealassetsand11.2intoprivateequity.ComparedtothecurrentYaleEndowmenttheidealmixhastwiceasmuchinmarketableassetsandathirdoftheamountinprivateequity.Howeverthisportfolioismuchbetterdiversifiedacrosslikelyevents.OnemeasureofrelativediversificationisshowninFigure8.TheidealportfolioshowninFigure7istakenasthebenchmark.Thegraphreportsthemean-squarederrorofeachportfoliosdivergencefromthebenchmarkallocationtoregimes.ThecurrentUSEducationalMeani.e.theportfolioofYalespeersappearstobeclosesttoouridealmixgivenitslow2.84mean-squaredivergence.Inotherwordsitisbetterdiversifiedacrossevents.TheTraditionalfundscoresamean-squarederrorof3.11.Yale2010infactcomesoutworstat7.89.AsthetimeseriesplotinFigure9demonstratesthisistheworstresultovertheentire1990-2010periodandannoyinglyonethatentirelyreversesthegoodresultinFY2009.Howdotheotherportfoliochoices-TraditionalandEducationalInstitutionMean-squareupinotherrespectsBoththeTraditionalandEducationalInstitutionMeanassetallocationsgenerallyimplyamorebenignviewofworldprospectsthanourbenchmark.Over70oddsareimplicitlyascribedtothecombinedReboundandCalmregimesbytheothereducationalendowmentswiththeremainderallocatedtotheSpeculationregime.ZeropercentisallocatedtoTurbulenceatimewhenbothmarketriskandcreditriskarehigh.Giventhatthisistypicallyaperiodofnegativereturnssometimeswithpersistentfattailsitwouldbebetteriftherewasmoreprotection.OverallYalespeersarelikelytoenjoybetterinvestmentperformancethroughtheupswingoftheinvestmentcyclewhencreditriskisloworfalling. 9GlobalViewTheTraditionalassetallocationwheresomethree-quartersofthefundareallocatedtomarketableassetsisagainwell-suitedtoReboundandCalm.NotsurprisinglyTraditionalinvestorsassign48.7oddstoCalmbutthereisalsoahigh42.4allocationtocovereventsintheTurbulenceregime.Thislatterbenefitderivesfromtheportfolios15allocationtohedgefundsandrealassetsandparticularlytoitshigh20cashandbondexposure.Pressuretoreducebondexposurecomingfromprevailinglowyieldsshouldberesistedonthisbasis.WherethisTraditionalallocationlikelyfallsdownisduringthelate-cycleSpeculationphaseatimewhencreditriskisrisingbutmarketriskstillremainslow.TocounterthisTraditionalmanagerscouldbeefuptheirholdingsofrealassetspossiblyaddatadmoreprivateequityandreducemarketableassets.TheEducationalInstitutionMeantheallocationadoptedbyYalespeersstandsupwelloverall.Justoverhalftheportfolioisinvestedinmarketableassetscomparedto70forTraditional20forYaleitselfand40inouridealbenchmark.Hedgefundscomprise26.4oftheaveragefundafigurehigherthantheothertwoportfoliosbutnottoofarawayfromYalesallocationandfromtheideal.WheretheseeducationalfundsdiffermarkedlyfromYaleandalsofromtheidealisintheirlowerexposuretoprivateequityandparticularlytorealassets.Accordingtoourcalculationstheidealfundshouldhave20inrealassetsandjustover10inprivateequity.Theeducationalfundsallocationtoprivateequityisinlinehere.TakentogetherYalehasmorethantwicetheexposuretotheseassetclassesasitspeers.Thismayofcourse.bedowntothefactthatYalesinternalprivateequitypipelinesofcommercialacademicspin-offsarebulgingItseemsthatanaverageoftheTraditionalandEducationalInstitutionMeanwithslightlymoreemphasisonthelatteroffersthebestextantassetallocationmix.SourceCrossBorderCapitalFigure6ImpliedAllocationsacrossRiskRegimesSelectedFundsReboundCalmSpeculationTurbulenceActualIdeal1970-201120.429.822.827.0Traditional9.048.70.042.4EducationalInstitutionMean39.731.928.40.0YaleEndowment0.032.467.50.1 GlobalView10InotherwordstheeducationalfundsshouldallocateproportionatelymoretorealassetscashandbondsandTraditionalinvestorsshouldswapmarketableassetsforhedgefunds.TheformerhastoomuchriskintheTurbulenceregimeandthelatterhastoomuchallocatedforSpeculation.IncontrasttothisbenchmarkidealallocationtheYaleEndowmentiscurrentlywell-diversifiedacrosscreditriskstatesbutveryexposedtomarketrisk.IronicallytheoriginalYaleEndowmentmodellooksmorerobust.Yalesmid-1990sallocationisclosesttoouridealbenchmark.SeeFigure9.Giventhemould-breakingachievementsofYaleitseemschurlishtocriticise.Howevertheirlatestdepartureandshiftintoprivateequitylookstooureyesahighriskstrategy.SourceCrossBorderCapitalFigure8DeviationfromIdealAllocationSelectedFundsMean-SquaredErrorSourceCrossBorderCapitalFigure7IdealAssetAllocationbasedonRegimePercentages0.01.02.03.04.05.06.07.08.09.0BaseYaleEdMeanTraditionalUSEquity14USFixedIncome14DomesticEquity14HedgeFunds22PrivateEquity11RealAssets20Cash5 11GlobalViewSourceCrossBorderCapitalFigure9DeviationfromYaleEndowmentfromIdealPortfolioMean-SquaredError1985-20100.01.02.03.04.05.06.07.08.09.019851990199520002001200220032004200520062007200820092010SourceCrossBorderCapitalFigure10SummaryAssetAllocationIdealYaleEducationalMeanTraditional01020304050607080MarketableDomesticEquityDomesticFixedIncomeForeignEquityHedgeFundsPrivateEquityRealAssets 1GlobalViewGlobalViewMay201096BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comFigure1TheVolatilityofVolatilityVIXIndexand13-weekAnnualisedStandardDeviation1990-2010SourceCrossBorderCapitalCBOETheVolatilityofVolatilityTheVIXindexiswidelyrecognisedasthepriceofrisk.Foryearsthisindexmovedslowlyaveragingaround18.7untilmid-2007butithitanaverage28.5thereafter.Moreoverthisjumpintherateofvolatilitycoincidedwithamorethandoublinginthevolatilityofvolatilityfrom16.2to35.1.Thisinstabilityinthepriceofriskhasbecomeanunpleasantandpersistentfactoflifebutweshowherethatitisaconsequenceoffast-changingliquidityconditions.Inshortliquidityhasrecentlybeentightening.Highvolatilitylookssettocontinue.Increasinglyfinancialassetmarketstradelikecommoditymarkets.Periodsofquiescenceandrange-boundpricessuddenlyandseeminglywithoutwarninggivewaytosharpjumpsupanddown.Investorshavebecomevictimsofthisfast-changingvolatility.SeeFigure1.Wehavearguedbeforethatthisisbecauseoftwothings1thematuringofthefinancialsectorfromacapital-raisingvehicleintoacapital-distributionmechanism.Thishascausedmoremoneytobeemployedasspeculativecapitalandradicallyalteredthefundingstructureofcredit-providers.And2thiscombinesoftenmalevolentlywithsignificantswingsintheliquiditycyclecausedinlargepartbyerrantCentralBankpolicies.Inshortthevolatilityofvolatilityisacreditcyclephenomenonandspecificallyitisafeatureassociatedwithsub-parliquidityconditions.Turbulentmarketsarecausedbyilliquidity.Theyaresettocontinue.Understandingliquidityisthereforeakeyfactorinriskmanagement.TheGlobalLiquidityCycleisplottedinFigure2.Thisshowsa45yearrecurringfluctuationintheflowofliquidityi.e.cashpluscreditthroughWorldfinancialmarkets.Peaksinliquiditytendtoprecedeassetmarketboomsby1-2yearsandtroughsleadbankingcrisesbyasimilar1-2years.Thegeographyofbankingcriseschangesasdoesthetypeofeachassetboom.0102030405060708090300319903003199130031992300319933003199430031995300319963003199730031998300319993003200030032001300320023003200330032004300320053003200630032007300320083003200930032010020406080100120140160180VolatilityofVolatilityRHSVIXLHS GlobalView2Sometimesemergingmarketsboomsometimesrealestateorcommoditiesandin1999technologysharessky-rocketedhigher.EquallyUKbankssufferedin1974LatinAmericanbankshittheskidsin1982Scandinavianbanksin1992Japanesebanksin1995andin2007-08manyWesternbankshittrouble.Liquidityhaslatelyfallenbelowaveragelargelybecausethestrongrealeconomyispullingfundsawayfasterthanpolicy-makershavebeenpreparedtoaddnewcash.Thistighteningofliquidityshouldleadtoheightenedvolatilityinfinancialmarkets.ProbablyitdidifWallStreetsnear-1000pointdroponThursdayMay6thisanythingtogoby.ThesharpjumpintheVIXindexfromlevelsofaround18priortothesell-offtoapeakof41.5suggeststhatvolatilityrespondsinanon-linearwaytochangesinliquidity.Indeedthisiswhatthedatashow.Figure3fitsaquadraticfunctionbetweenmonthlyUSliquiditydataandtheVIXfrom1990todate.AccordingtotheresultingJ-curverelationshipchangesinliquiditymatterfarmorewhenthelevelofliquidityislowthanwhenitishigh.Volatilityislowestandmarketsmoststablewhenliquidityconditionsareclosetotheirlong-runnorm.Above-averageliquidityforceshighervolatilitybutlowerlevelsofliquiditytriggervolatilityspikes.Thusa10pointdropinourUSliquidityindexfroman80indexvalueactuallyreducestheVIXby5.0point.Asimilardropfromthe50indexlevelalsoreducestheVIXalbeitbyaslimmer1.9points.Howeverafallinliquidityfromthe40indexlevelcausesa4.2riseintheVIXandfromthe20indexleveltheVIXjumpsby6.2points.TheVIXhitsitslowestvalueof16.3accordingtothechartwhenourUSliquidityindexisatadaboveaverageat58.4.Thisconclusionfitsneatlywithourlong-heldperceptionthatfinancialmarketperformanceclustersintoriskregimes.ThesefourregimesasdescribedbytheliquiditycyclearedubbedReboundCalmSpeculativeandTurbulence.Theycorrespondtoperiodsofhighmediumandlowvolatilitywitheachdisplayingslightlydifferentcorrelationproperties.SeeFigure4.65676971737577798183858789919395979901030507091102040608010002040608010019721977198219871993199820032008LooseTight1967USRealEstateCommoditiesGoldNEAsianStocksRealEstateGlobalBondsEquityMarketsTechnologySharesUSRealEstateGoldGlobalEquitiesUSPennSquareUKBankingCrisisLatAmDebtContinentalIllinoisUSSLScandinavianBanksJapaneseBanksBaringsWorldcomEnronUSSubPrimeUKBanksIcelandSourceCrossBorderCapitalUSFederalReserveECBBankofEnglandBankofJapanIMFFigure2GlobalLiquidityCycleand5-YearCycleIndexNormalRange0-1001965-2010 3GlobalView010203040506070020406080100SourceCrossBorderCapitalCBOEUSFederalReserveFigure3VolatilityandLiquidityMonthly1990-2010SourceCrossBorderCapitalFigure4VolatilityLiquidityandRiskRegimesVolatilityVIXLiquidityTurbulenceReboundCalmSpeculationVIXUSLiquidityIndexHighvolatilityrisk----------------------Mediumvolatilityrisk----------------------Lowvolatilityrisk GlobalView4Wehaveshownelsewherethateachoftheseriskregimesdemonstratesinternalnormalityofreturnsi.e.returnswithinaregimearenormallydistributedbuttheregimescombimetogetherovertheinvestmentcycletogenerateanon-normaloveralldistributionwithfattailspersistenceandskew.ThisisestablishedinFigure5usingaShapiro-Wilkstatisticaltestfornormality.Thistellsusthatassetallocationdependssignificantlyuponregimeshift.OntopcloserexaminationofthedatanotonlyshowsthattheliquiditycycleleadsvolatilityinfactsometimesbyuptotwoyearsbutvolatilityistransmittedsequentiallyacrossassetclassesconsistentwithourschematicInvestmentClockshowninFigure6.Thusfixedincomeandcurrencyvolatilitytendtoleadequitymarketvolatility.Eveninthisshort-termsell-offthisfeaturehasbeenapparentwithEuropeanbondsandtheEuromovingdownslightlyaheadofcollapsingstocks.WhattodoOurmainmessageisthatmarketriskdependsuponliquidity.Ahighpriceofriski.e.VIXindexisassociatedwithlowliquidity.Volatilityspikessimplyarisefromstilllowerliquiditylevels.Thusvolatilemarketstellusalotabouttheliquiditybackdropandlikeliquiditya45yearcyclevolatilityislikelytochangeslowly.Inotherwordsvolatilitywillshowpersistence.Asignalofafuturecalmermarketrequirespolicy-makerstopumpinliquidity.ManyofushopethattheMay10thdecisionbytheEUandECBtosupportEuropeandebtmarketsmayproveascatharticastheAugust1982cutsfollowingMexicosAugust12thdefault.TheensuingLatinAmericandebtcrisisforcedtheUSFedtoslashinterestratesby250bpthroughAugust1982andbyafurther100bpthroughyear-end.BypumpinginextraliquidityandeffectivelyshelvingChairmanVolckerstightcontrolofmoneysupplytheFedmoveusheredinthelong-bullmarketinequities.Butthesesurgesintheliquiditycycleguaranteethatvolatilitywillremainvolatile.SourceCrossBorderCapitalFigure5RegimeShiftNormalityTestandSchematicDistributionofReturnsverageNormalityandStudent-tTestsonReturnsoSelectedAssetsBasedonWeeklyDatasince19860.00.10.20.30.40.50.6YieldCurvesCurrencyDevelopedEquitiesEmergingEquitiesSectorsGoldMSCIIndexShapiro-WilkTestofUnconditionalDataShapiro-WilkTestConditionalonRegimeandVolatilityKolmogorov-SmirnovTestConditionalonRegimeandVolatilityCalmReboundTurbulenceSpeculationFULLCYCLE 5GlobalViewCROSSBORDERCAPITALLIMITED96BAKERSTREETLONDONW1U6TJTELEPHONE02079082800FACSIMILE02079082835AUTHORISEDANDREGULATEDBYTHEFINANCIALSERVICESAUTHORITYCROSSBORDERCAPITALLIMITED2010.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.Figure6TheInvestmentClockPreciousMetalsandCurrenciesConsumerInflationFixedIncomeCreditSpreadsIndustrialCommoditiesEquitiesRealEstateRealEconomyPreciousMetalsandCurrenciesConsumerInflationFixedIncomeCreditSpreadsIndustrialCommoditiesEquitiesRealEstateRealEconomySourceCrossBorderCapital 1GlobalViewGlobalViewDecember201296BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFDatastreamFigure1GlobalInvestorsCommitmenttoRiskAssetsIndexNormalRange0-1001980-2012TheReturnofTAATherecentjumpinthepopularityofmulti-assetinvestingmightsuggestthattacticalassetallocationTAAhascomebackintovogueTheparadoxisthatmanyofthesefundsareeffectivelystaticassetallocationproductsthatsimplydiversifyacrossdifferentassetclassesbutrarelyaltertheirportfoliomixinordertoboostreturnsorbettermanagerisk.InshorttheyareFerrarisstuckinalowgear.Thisisstrangebecausecurrentopportunitiestoaddalphaabound.Thetwoclearestandmouth-wateringfactsforanyTAAmanagermustbeainvestorherdingandbCentralBanksurrenderi.e.moneyprinting.Latestevidenceontheformercomesfromend-November2012assetownershistatistics.Ourmeasuressuggestthatglobalinvestorscommitmenttoriskassetsremainsbelowitsthree-yearrollingaverages.SeeFigure1.Moreworryinglythiscomprisesaneartwo-standarddeviationpositiveallocationtogovernmentbondsandapartlyoff-settingneartwo-standarddeviationunder-exposuretoEMequitiesbothexpressedrelativetotheirthree-yeartrends.SeeFigure2.Thescaleofthisbiasmayowesomethingtothedarkartofso-calledfinancialrepressionwhereencroachingregulationforcesinstitutionstoholdmore-and-morelow-yieldinggovernmentdebt.Howeverevenlookingthroughthisbiasthehugespreadshowsanimplicitbutstilldisturbingbetonanothercoupleofyearsoffragileglobaleconomicgrowth.Ofcoursethemarketsmaybecorrectbutthiswouldseeminglydenythenewfounddeterminationamongpolicy-makerstostimulateeconomicactivityandcutjoblessnumbers.Werecallapolicy-makersomeyearsagodescribinghiseffortstostimulatetheBritisheconomybycomparingtheeconomywithabrickandpolicymeasurestoanelasticropetiedaroundit.Themorehetuggedthelessthathappeneduntilhewasunexpectedlyhospitalisedbyahigh-speedflyingbrick.Sopolicytakestimetoworkandthemorefrustratedpolicy-makersgetthemoreriskstheytake.Wefigurethat2014couldthereforeseesomeveryhealthyeconomicdataandmarketsmaybegintodiscountthisthrouhnextear.SpeculativeOptimisticRiskAversePessimistic-1sd2sd1sd-2sdMean1987CrashLatAmDebtCrisisPre-AsianCrisisPost-RussianCrisisY2KIraqWarMexicanPesoCrisis911USCreditBoomLehmanCrisis808182838485868788899091929394959697989900010203040506070809101112020406080100 GlobalView2Risingliquiditydataareapre-conditionforfastereconomicactivity.Herethejuryisstilloutbuttherearestillmoreencouragingthantherearediscouragingsigns.ThereforeweenvisageagatheringRiskOnclimatethrough2013.WehavearguedbeforehowtheGlobalLiquidityCycletypicallymovesinanM-shapedcyclewithabankingcrisismarkingthestartandacommodityboomsignallingtheendofthecycle.InbetweentherearetwomajorperiodsofeasethefirstfocussedonrestoringbankintegritynamelyQE1andQE2andthesecondQE3targetedonrevivingeconomicgrowth.Bondsandequitiesoftenbothdowellinthefirstphaseequitiesandcommoditiesoutperforminthesecond.SeeFigure3.HowcouldthisaffectTAAWehavewrittenmuchovertheyearsaboutalternativewaysofthinkingaboutassetallocationandparticularlyitsrelationshiptoliquidityandtoinflation.Foremostistheneedtolookatassetvaluationinabsolutetermsagainstthevalueofmoneyandnotinrelativetermsmeasuredagainstotherassets.Thelattermaybecomfortingbutitisrarelyasafebenchmark.ConsidertheassetallocationdiagraminFigure4.Thisshowsthechangingvaluationofthethreekeyassetclassesbondsequitiesandcommoditiesallmeasuredrelativetothevalueofmoneyintheformoftheinflationrate.Bondandcommodityvaluationsbehavenormallyinsofarthatbondshateinflationandlovedeflationwhereascommoditiespreferthereverse.Thusbondsandcommoditypricesaretypicallyalwaysnegativelycorrelatedtogether.Equitiesaredifficultandtrickytounderstandbecausetheyaresometimespositivelycorrelatedtobondsandsometimesnegativelycorrelated.Thisfactplainlythrowsmanyconventionalassetvaluationyardsticksout-of-syncanditquestionsthevalidityofthosemean-variancemodelsthatusehistoricaldatatakenfromthepasttwentyyears.TheWorldchangesandmoveson.Forexampletheequity-bondyieldgapandyieldratiometricsthatprovedusefulinthe1980sand1990sareashopelesstodayastheywereinthe1930sbecausewhenbondsriseinvalueequitiesnowfall.Yetnegativeequity-bondcorrelationswerealmostunheardof20-yearsago.SeeFigure5.Figure2GlobalInvestorsCommitmenttoRiskAssetsbyMajorAssetTypeEnd-November2012SourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFDatastream-30-25-20-15-10-50510152025EmergingMarketEquitiesDevelopedMarketEquitiesGoldEmergingMarketBondsDevelopedMarketBonds 3GlobalViewFigure3TheMShapedCycleGlobalLiquidityIndexandTheoreticalTrend2002-2012SourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFSourceCrossBorderCapitalFigure4RelationshipBetweenEquitiesBondsCommoditiesandInflationSchematicPEorInvertedYieldInflationDeflationEquities2.5InflationBondEquityThresholdBondsBACommoditiesDEFLATIONARYPRESSUREHighBondEquityCorrelationNegativeEquityBondCorrelationHighVolatility GlobalView4Webelievethatequityvaluationstrace-outabell-curvepatternwithrespecttoinflation.AsFigure4highlightsthismeansthatPEmultiplespeakatlowratesofinflationcirca3butfallawaysharplyeithersideofthisthreshold.Bondmarketsontheotherhandrevealasimplemonotonicrelationshipwithinflationthatalmostdescribesabackwards-Jshape.ThesedifferenceshighlightaninterestingdivisiontheregimetotheleftofthelowinflationpeakPEthresholddemonstratesanegativecorrelationbetweenequitiesandbonds.Callthisperioddis-inflation.Itreflectsthepost-2000financialmarketsintheWestandthepost-1990financialmarketsinJapan.TheregimetotherightoftheinflationPEthresholdcallthistheinflationzoneseespositivecorrelationbetweenbondsandequities.Immediatelyeithersideofthethresholdequityvaluationsfallawaysignificantlyindicatingthatsmallinflectionsintheinflationratecancauseheightenedequitypricevolatility.Moreoverthecharthighlightshowplungingequityvaluationscancoincidewithbothhighandlowbondyields.Thismayexplainthetwinphenomenawedubcrisesofmonetaryinflationandcrisesofmonetarydeflationwheresometimesequitiescrashathighinflationratese.g.1929and1987andsometimestheycrashatlowinflationratese.g.1931and2008.Inshortallvaluationsandmarketbehaviourareconditionaloninflationindisinflationsi.e.nowriskassetsarepro-cyclicalbutininflationsi.e.1980sand1990stheybecomemoreanti-cyclical.Regressionanalysisallowsustotaketheseobservationsastagefurther.Inthe1980-99periodUSequityPEswerecloselycorrelatedtoinvertedTreasuryyieldswithacoefficientof86.4reflectingthepositiveequitybondrelationshipthroughaperiodofinflation.Noothersignificanteffectswereobvious.Inparticularneitherthebusinesscyclee.g.ISMdatanortheyieldcurvee.g.10-2yearTreasuryspreadregisteredmuchinfluenceonUSequityvaluations.Wemustconcludethattheimpactoffallinginflationout-weightedbusinesscycleandmonetaryeffectsatleastasregardsvaluations.Thusatmanytimesthestockmarketmovedoppositelytothebusinesscycleandinthoseperiodswhereslowereconomicgrowthcoincidedwithfallinginflationitdidsomoreoften.SourceCrossBorderCapitalFigure5ValuationandInflationOverTimeSchematic198019861992199920022008InflationValuationBondsEquitiesImpliedequitybondyieldgapValuation 5GlobalViewIncontrastthe2000-2012periodshowsastronglynegativecorrelationof76.3betweenUSPEsandinvertedbondyields.Moreovertheyieldcurvelatelyprovestobeaverysignificantinfluencewiththeregressionshowingthateach100bpofcurvesteepeningadds1.8multiplepointstoUSPEs.Inshortbusinesscycleandmonetaryeffectshaveagainbecomemoreimportantthaninflation.Thebottomlineisthateach100bprisein10-yearTreasuryyieldsduringsaythe1980sshouldhavereducedUSPEsbyaround2multiplepointswhereasa100bprisetodaycouldaddaround6multiplepointstobeaten-downUSvaluations.SeeFigure6.Allthiscomesontopoftraditionalbusinesscycleeffects.Figure7showsthestrongleadingeffectoftheGlobalLiquidityCycleoncorporateearningsgrowthwithalead-timeof15-18monthsonreportedprofitnumbers.Giventhatwecanalsoidentifyaclearandlong-standingcorrelationbetweentheliquiditycycleandtheslopeoftheyieldcurveseeFigure8moreliquidityisconsistentwithasteepeningcurveandbyassociationinadis-inflationregimewithrisingbondyieldsandarisingUSmarketPEmultiple.Sinceweexpectaround100bpofyieldcurvesteepeningnextyearweremainupbeatonprospectsforriskassets.Althoughgiventheselonglead-timesweshouldnotexpectreportedearningstoshowmuchupliftbefore2014valuationshoweverarelikelytorisesignificantlywell-beforethisdate.AddingtheseeffectstogetherexplainsthebinarynatureofRiskOnandRiskOff.RiskOnimpliesexpandingliquidityrisingstocksfallingbondsandimprovingprofitabilityandbusinessconditions.Assumingapersistentdisinflationregimetheups-and-downsoftheliquiditycyclecanexplaintheto-and-fromovementandresultingtacticalassetshiftsonthelefthandsideofFigure4.Inshortriskassetmarketshaveagainbecomepro-cyclical.Anotherconfirmationofthisistheheightenedpositivecorrelationbetweenthenewlyfashionableeconomicsurpriseindexese.g.Citigroupandriskassets.ButthenwhatistrueforUSstocksislikelytoproveevenmoresoforhigherbetaEMequities.TheirbusinesscyclesdovetailcloselywiththoseoftheUSandtheirliquidityconditionshighlycorrelate.InvestorsexposuretoEMequitiesiswenotedextremelylowandthemoreUSdollarArealiquiditythatiscollectivelyproducedbytheFedandChinasPBoCamongothersthemorecashwilllikelyfinditswayintoEM.Figure6USPEMultipleMultiplePointsMonthly1975-2012SourceCrossBorderCapitalDatastream757779818385878991939597990103050709111351015202530355101520253035 GlobalView6Liquidityisakeyleadingindicator.ThusbuyingEMequitiesandsellingdevelopedmarketbondsmaybetheultimateTAAshiftfornextyear.Thosemulti-assetfundsthatmakethiscommitmentcouldoutperformsignificantly.Figure7GlobalLiquidityCycleGLIandEPSGrowthIndexandYoYPercentChangeMonthly1971-2012SourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandPeoplesBankofChinaIMFDatastream71737577798183858789919395979901030507091113020406080100-40-200204060LooseTightLiquidityIndexAdvanced20MonthsLHSEarningsGrowthYoYChg.RHSFigure8GlobalLiquidityCycleGLIandG20YieldCurvePercentandIndexMonthly1980-2012SourceCrossBorderCapitalUSFederalReserveBankofJapanECBBankofEnglandOECDIMF727476788082848688909294969800020406081012020406080100-200-1000100200300LiquidityRisingYieldCurveSteepeningOverallLiquidityIndexLHSYieldCurveBasisPointsRHS 1CROSSBORDERCAPITALMrMarketAndMissValuationGlobalViewAugust2004MarcolHouse289-293RegentStreetLondonW1B2HJwww.liquidity.comTel0207535-0400Emailwwwliquidity.comLiquidityAndModernFinanceLookingInsideThePEMultipleSourceCrossBorderCapitalDatastreamCROSSBORDERCAPITALThedemiseofLTCMLongTermCapitalManagementin1998punctuatedasevereUSdollardebtcrisis.MuchofemergingAsiaandRussiahadbeenpreviousvictims.Thefirmhadtakenlongpositionsinilliquidsecuritiesandshortpositionsinliquidonesbelievingtheformertobecheaper.Thepartnerswerewidelyseenasculpable.Theirsinwastousevaluationmodelsthatignoredliquidity.Butthensodideveryoneelse.SeparateanddistinctthingsnottobeconfusedaseverythoughtfulinvestorknowsarerealworthandmarketpriceJohnBurrWilliamsTheTheoryofInvestmentValue1938.inthelong-termthemarketactslikeaweighingmachineweightingtheamountofvalueineveryissuebutintheshort-termitactslikeavotingmachinewherethevotesaremoneyGrahamandDoddSecurityAnalysis1934.Figure1.PEMultiplesVariousMarkets1974-2003TimesHistoricEarnings7476788082848688909294969800022351020305010023510203050100TimesLogScaleUSUKJapanEurozoneWorldSeparatingthemarketPEratiointothreeseparatecomponentsthisreportshowstheimportanceofthe1ownershipsentimentand2liquidityfactorsover3profitabil-ity.Inshortbuyingpowerisatleastasimportantasearningspowerindeterminingvaluation.Thereportgoesontoexplainwhyrichandnotnecessarilyfastgrowingecono-mieshavedeepcapitalmarkets.Bylinkingtogetherdemographicsliquidityanddura-tionwegoontosuggestthattheprogressiveageingofWesternpopulationsmayresultinlowervaluationlevels.GrowthapparentlydisappearsfromthemarketPEmultipleliquiditycomestothefore. 2CROSSBORDERCAPITALModernFinancetheoryrestsontwowobblyfoundations.Firstitscentralconceptofriskisexpressedsolelyintermsofmarketrisk.Thisisassumedtobenormallydistributedstatisticallyandmeasurablebyvolatility.Whatsmoreinstrongversionsofthetheorypastvolatilityservesasaguidetofuturevolatility.Asaresultofitslinktoriskvolatilityisnotdifferentiatedintogoodandbadelements.Consequentlyitisdiscardedbyportfo-liodiversification.SecondModernFinanceassumesthatinvestorscantransactcostlesslyinwhateversizeandfrequencytheyrequirewhichparadoxicallyiftheefficientmarkethypothesisholdsisnever.Itsupposesthatthisstateofperfectliquidityisacorollaryofarbitrage.Inotherwordscyclicalandsystemicshortagesofmarketliquidityareignored.ExplodethesetwomythsandModernFinancetheorytakesastepclosertotherealworldofinvestmentandbankingtherebyenablingittoincorporatecreditrisk.ThisisimportantbecausethefailureofLTCMwasacreditriskevent.LTCMwastheepitomeofModernFinancetheoryitsinvestmentphilosophyseparatedliquidityfromvaluationandignoredtheshort-termliquiditycycle.Whentherefinancingwindowslammedshutinthewakeofthe1997AsianCrisisthefirmwasleftexposed.LTCMsdemiseshouldsoundthedeath-knellofModernFinancetheory.Valuationneedstoincorporateliquiditythetwocannotbedivorced.Weshowinthisreportthattraditionalvaluationmeasuresalreadyincludehiddenliquid-ityvariables.Thesevariablesmustbebroughttotheforeandliquiditymustbeunderstoodasanintegralpartofvaluation.Liquidityactsoverboththelongtermandtheshortterm.Short-termchangesinsystem-wideliquiditydirectlyaffectvaluationinthesensethatassetsshouldbepricedmorecheaplyinlessliquidmarketsbecauseriskisgreater.Long-termliquidityeffectsoperatethroughchangesinassetownership.Forexampleaprefer-encetoholdmorewealthintheformofequitiesmustaffecttheirprice.Thisfactwillbecomeincreasinglyrelevantasimpendingdemographicshiftsbegintochangeassetpref-erences.Japanmayalreadybesufferingfromthegrowingdemandsofretireesforliquid-ity.TheUSandultimatelyEuropewillsoonfacesimilardemandsfromtheirswellingranksofretirees.AssuchtheeffectofwidespreadassetsalesmustatsomestagefigurenegativelyforWesternassetmarkets.Ouranalysisprovidesaframeworktomakesuchconjectures.ThreeComponentsPopularisedbySecurityAnalysis1934theprice-to-earningsmultiplePEhasbecomethestandardvaluationbenchmarkforWesterninvestors.ThemajorityoftheseinvestorsbelievethatreturnscanbemaximisedbybuyingcheaporlowPEstocksandbysellingoravoidingexpensiveorhighPEstocks.Indeedexperienceshowsthatthebulkofshortandmedium-termvolatilityinstockpricesisexplainedbychangesinthePEratio.UnderstandingthePEiscrucial.TodaysdevelopedWorldmarketPEisaround22timescurrentearnings.Figure1showsthatthePEratioliesaboveitslong-runaverageof17.5times.Onthefaceofthingsequi-tieslooktobeprettyexpensive.Yetexpensivestocksfrequentlygetmoreexpensiveandcheapstocksdontalwaysgoupinprice.Somethingelsemustbegoingon.TounderstandvaluationweneedtolookinsidethemarketPEmultiple.ThetraditionalwayofexplainingthePEiswithrelativeratesofreturnandspecificallythroughearningsgrowth.ThisapproachpioneeredbyJohnBurrWilliams1938intheTheoryofInvestmentValueassumesthatrisk-adjustedequityreturnsmustequatewith 3CROSSBORDERCAPITALSourceCrossBorderCapitalDatastreamPPMS____x__x__EMSEValuationOwnershipExcessProfitMarginsLiquidityinvertedwherewedefinePastotalmarketcapitalisationMasmoneyorliquiditySistotalsalesrevenuesorGDPandEisaggregatepost-taxprofits.Figure2.ComponentsofWorldPEPMMGDPandProfitMargins1974-2003therisk-freeinterestrate.EquitypricesandhencePEmultiplescorrespondinglyriseandfallwiththegrowthrateassumedforfutureearnings.Yetthiswidelyusedapproachisnotwithoutitsflaws.Wenotedearlierthattheframeworkfalselyassumesperfectlyliquidmarkets.AnalternativeapproachistothinkofthemarketPEmultipleasacom-positemeasureofthreefactorstwothatarerelatedtofinancialmarketsandoneprofit-abilitywhichderivesfromtherealeconomy.YearPEPMMGDPEGDPMemoPE748.90.610.624.288.37512.60.780.593.669.87612.10.790.614.0210.37710.80.680.684.278.87810.70.670.654.088.5799.60.650.674.536.18011.00.700.704.508.88110.50.610.764.408.88211.90.600.824.209.48313.40.690.834.2811.08412.60.670.874.5811.28516.40.780.884.1813.08619.20.930.894.2916.68717.40.860.954.6717.68817.00.940.925.0417.38918.81.080.925.2919.29016.30.840.954.9315.39120.00.990.934.6217.09220.41.020.894.4516.49322.61.240.844.6018.39418.81.170.865.3418.19519.11.350.906.3718.99620.41.500.916.7019.99723.11.701.047.6222.69826.41.911.148.2625.29931.12.261.178.5428.90026.32.011.259.5724.70125.91.621.358.4521.20220.01.211.348.1016.10321.91.481.298.7019.0Average17.51.080.915.5515.6 4CROSSBORDERCAPITAL1Fundsusedintheasseteconomynotintheindustrialandcommercialeconomy2WeuseabroadmoneymeasuresuchasM3andM4whichincludesdepositsheldatnon-bankfinancialinstitutionsSourceCrossBorderCapitalBylookinginsidethemarketPEratiowecanseethatmacro-economicandliquidityfac-torsplayacriticalroleinvaluation.AbreakdownofthedevelopedworldPEintoitsthreecomponents1ownershipPM2excessliquidityMSand3profitmarginsESisshowninFigure2.Profitmarginsi.e.totalpost-taxprofitsovertotalsalesaretheonlycomponentdeterminedsolelybydevelopmentsintherealeconomy.Thismeasureofag-gregateprofitabilitymaydemonstratesecularshiftsbutmoreusuallyitswingswiththebusinesscycle.SeeFigure3.Figure3.AggregateProfitMargins1974-2003PercentofGDP7476788082848688909294969800020246810121402468101214PercentofGDPUSUKJapanEurozoneWorldRe-expressingthePEmodelandusingpeakprofitmarginsastheproxyforpeakearningslessensthedistortingeffectsoftheshort-termbusinesscycleonvaluationPPMxMS_____________________EmLetEdenotepeakearningsandmpeakprofitmargins.Peakprofitmarginsareas-sumedtobeconstantwithinacyclebutpossiblychangebetweencycles.Peakearningsshouldchangelessoftenandassuchtheprice-to-peakearningsratioPEisamorestablevaluationbenchmark.InthisrevisedequationthesecondterminthenumeratorMSmeasuresexcessorfi-nancialliquidity1.Thisisdefinedbytheratiobetweenaggregatemoney2intheeconomyandtotalsalesorGDP.SometimesdubbedMarshalliankandinvertedmonetaryvelocitythisratioshowstheamountofmoneycirculatingperunitofnationalincome.SeeFigure4.OvertimeMarshalliankenjoysarisingtrendacrossmostcountries.Moreefficientpay-mentssystemsreducetheneedforphysicalmoneyandspeedupthecirculationprocess.Becausemoneynowadaysconsistsoffinancialcreditbankandsavingsdepositsarisingratioseemstonaturallyaccompanyincreasingwealth.MinorcyclicalswingsdooccurinMarshalliankbutthetrendappearstodominate.Majorinterruptionsinthetrendcanoccurifthevalueofmoneychangessignificantlyrapidinflationcausesafallintheratiowhereasdeflationwouldtriggerhoardingandariseintheratio. 5CROSSBORDERCAPITALSourceCrossBorderCapitalFigure4.ExcessLiquidityOrMarshalliank1974-2003TimesGDP7476788082848688909294969800020.00.51.01.52.00.00.51.01.52.0TimesGDPUSUKJapanEurozoneWorldThefirstterminthenumeratoristhePMorprice-to-moneyratio.Thismeasuresassetownership.ThePMratiotellsushowinvestorsholdtheirwealthbetweencashandin-vestmentshereequities.Long-termfactorssuchasdemographicsgrowthexpectationsinflationandtaxationaffectthetrendbutshort-termshiftsaremorelikelycausedbytwofactors1moodswingsofinvestorse.g.frombullishnesstobearishnessand2requiredmovesinassetdurationtriggeredbychangesintheeconomicandfinancialclimate.Forexampleachangeinnear-termdividendprospectsmightleadinvestorstoswitchfromhigh-PEgrowthstockstohigh-yieldvaluestocksorevenintoshorterdurationbonds.ThereforethemajorvaluationtoolofWesterninvestorsthePEmultipleisdeterminedbyacombinationofmonetarydemographicandpsychologicalfactors.Simplyputvalua-tionequalssentimentakaownershiptimesliquidity.StructuralandCulturalDifferencesTheremaybesomecorrelationbetweenthethreePEcomponentsi.e.ownershipliquid-ityandpeakprofitabilitybutforthemostparttheyarelikelytomoveindependentlyofeachotherovertimeandtodifferbetweencountries.Itisreasonabletosupposethatforcompetitivereasonsprofitmarginsshouldbesimilaracrossthedevelopedworld.Ontheotherhandthereislessreasontobelievethatprice-to-moneyratiosandMarshalliankvaluesbearanyresemblanceifcultureagestructureeconomicdevelopmentinflationandthetaxbasesalldiffer.Yetdespitetheirsignificantstructuraleconomicandculturaldifferencesthebroadsimi-larityofthePMratiosbetweenthemajorstockmarketsissurprising.TheUSaverageat1.06liesclosetothe1974-2003average1.35ratioforBritainandthe1.12averagePMinJapan.MoreoverthelatestEurozonePMratioof1.3timesisexactlyinlinewiththecurrentBritishPMratio.HongKongslatestPMisalso1.3times.AustraliascurrentPMat1.6timesisremarkablyclosetoAmericas.LookingaheadFigure5showsthatthePMratiosofthesemarketsappeartobeconvergingaroundatrendvalueof1.5times.Paradoxicallythegreatestdifferencebetweennationsoccursintheliquidityandpeakprofitabilityterms.Marshalliankaveraged0.49inBritainoverthe1974-2003periodcomparedto1.18inAmericaand1.21inJapan.Thisalonecouldexplainanear-threetimeslargerPEintheTokyostockmarketcomparedtoLondon. 6CROSSBORDERCAPITALProfitmarginsalsodiffersignificantly.The1974-2003averageat7.6ofUSGDPcomparesto4.89forBritain3.48forJapan1.59fortheEurozoneandawhopping10.58forSouthAfrica.InotherwordsotherthingsbeingequaltheJapanesePEmultipledeservestobemorethantwicetheUSequivalent.SeeAppendix.CombiningdifferentpermutationsofthethreePEcomponentsstarklyhighlightstheseanomalies.ItshowsthatpartoftheexplanationbehindtraditionallyhighJapanesePEmultiplesislowprofitabilityandhighliquidity.ForexampleusingJapaneseexcessli-quidityof1.53timesGDPandprofitmarginsof4.1withaUS-typeassetstructurecharacterisedbya1.62timesPMmultipleyieldsanotionalUSPEmultipleof60.5timesearnings.AttheotherextremeusingaJapanese-likeassetstructuredepictedbythecur-rent1.03timesPMratiowiththeUKs0.93timesmeasureofexcessliquidityandwithUSprofitmarginsof11.55producesahypothetical8.3timesJapanesePEmultiple.TheWorldPEi.e.price-to-peakearningsmultiplesoaredfromalowof6.1timesin1979toapeakof28.9in1999beforeendinglastyearon19.0times.Whereasregionalvaluationdifferencesarelargelyexplainedbytheliquidityandprofitabilitycomponentsvaluationdifferencesovertimetendtobetheresultofchangesinownership.AstatisticalanalysisofthevarianceinthePEmultiplearounditsmeanoverthe1974-2003periodshowsthat41.4wasattributabletochangesinthePMratio3.Another28.9camefromchangesintheMarshallianktermwhichisasimplemeasureofexcessliquidity.Wenotedearlierthatexcessliquiditytendstoriseaseconomiesmature.ThisalonewilldrivePEshigher.Butontopassetallocationisalsolikelytoincreasinglyfavourlongerdurationassetsasaveragewealthlevelsrise.SourceCrossBorderCapitalFigure5.AssetPreferencesPMRatio1974-2003MarketCap-To-Liquidity74767880828486889092949698000201230123TimesGDPUSUKJapanEurozoneWorld3AnanalysisofthevarianceofannualchangesinthePEratioshowsthatannualmovementsinthePMcontributedaremarkable93.2.BuyingPowerVersusEarningPowerAssetownershipandliquidityareapotentcombination.Inotherwordsbuyingpowerislikelytobeatleastasimportantasearningspowerindrivingassetpriceshigher.IndeedtheYaleeconomistRaymondGoldsmithfirstnotedthisphenomenoninthe1960s.Follow-inganextensiveglobalstudyoffinancialevolutionGoldsmith1985uncoveredtwokeytrends1arisingthenflatteningratiobetweenfinancialandtangibleassets.Thistheso-calledfinancialinterrelationsratioFIRreachesmaturityatavalueofaround1-1.25times.And2arisingshareofnon-bankfinancialinstitutionsintotalfinancialassets. 7CROSSBORDERCAPITALGoldsmithssecondobservationcanbeuseddirectlyasevidencetosupporttherisingPMratioandassumingaconstantcapital-outputratiointherealeconomythistakento-getherwithhisfirstobservationisconsistentwitharisingmarketcap-to-GDPratio.ThusGoldsmithprovidesasophisticatedexplanationofrisingpropensitiestosaveasourin-comesgetbigger.Thisfinancialdeepeningi.e.risingfinancialassettoGDPratiocanclearlybeseenacrossglobalstockmarkets.InourearlierbreakdownofthePEmultiplethenumeratorPSmeasurestheratiobetweenmarketcapitalisationandaggregatesalesorGDPi.e.totaleconomicvalue-added.Aspercapitaincomelevelsrisesodoequityassetsperheadbutatanacceleratedrate.ThisrelationshipyieldsarisingPSratioovertime.Figure7showsthetightnessofthecorrelationbetweenmarketcapitalisationperheadandGDPperheadusingcross-countrydatafor2003acrossboththedevelopedandemergingecono-mies.ThefollowingregressionlinehasbeenfittedtothechartLogMCiHi-4.0841.404xLogGDPiHi19.42t-statisticinbracketsStandarderrorofLogMCiHi0.7612RSquared87.68Observations55whereMCiismarketcapitalisationHiispopulationandGDPiisgrossdomesticprod-uctfortheithcountry.AllmeasurementareincurrentUSdollars.Somenine-tenthsofthevariabilityinmarketcapitalisationperheadisexplainablebymovementsinpercapitaGDP.Inotherwordsricheconomiesshouldhavelargestockmarkets.Admittedlythecausationmightruninreversesinceeconomicprosperitymayspringfromdeepcapitalmarkets.Notwithstandingtherelationshipsuggeststhateach1riseinpercapitaGDPisassociatedwitha1.4increaseinstockmarketcapitalisationperhead.Thedatarevealscalabilityi.e.apowerlaw.InshorteverydoublingofGDPmeansaneartriplingofstockmarketsizeforbothrichandpoorcountriesalike.SourceCrossBorderCapitalFigure6.WorldPEMultipleFactorBreakdown1979-2003Rolling6-YearAttributions7980818283848586878889909192939495969798990001020301020304050607080901000102030405060708090100PercentShareOwnershipLiquidityProfitability CROSSBORDERCAPITAL8Figure7.StockmarketCapitalisationAndGDPPerCapita2003USDollarsGDPperCapitaUSThousandsStockmarketCapitalisationperCapitaUSThousands1001000100001000001101001000100001000001000000AuOeBgCnDkFnFrBdIrItJpNlNZNwEsSwSzUKUSAgBnBzClChCoCzEyGrHKHuInIdIsJoKuMyMaMxMoPkPePhPoPtRuSdASgSAKoSLTwThTkVzZmAustraliaAuAustriaOeBelgiumBgCanadaCnDenmarkDkFinlandFnFranceFrGermanyBdIrelandIrItalyItJapanJpNetherlandsNlNewZealandNZNorwayNwSpainEsSwedenSwSwitzerlandSzUKUKUSUSArgentinaAgBangladeshBnBrazilBzChileClChinaChColombiaCoCzechRepublicCzEgyptEyGreeceGrHongKongHKHungaryHuIndonesiaIdIsraelIsIndiaInJordanJoKuwaitKuMalaysiaMyMauritiusMaMexicoMxMoroccoMoPakistanPkPeruPePolandPoPortugalPtPhilippinesPhRussiaRuSaudiArabiaSdASingaporeSgSouthAfricaSASouthKoreaKoSriLankaSLTaiwanTwThailandThTurkeyTkVenezuelaVzZimbabweZm.RegressionOutputConstant-4.08394StdErrofYEst0.761168RSquared0.876808No.ofObservations55DegreesofFreedom53XCoefficients1.404251StdErrofCoef.0.072301SourceCrossBorderCapital 9CROSSBORDERCAPITALArethePSorPGDPPMMSandhencePEratiosboundedorpredictableCanhis-torygiveusanycluestowardstheidealorsustainablePMandthusmarketPEratioLetusexamineeachmajorregion.TheUSPMratiolookssettoremainina1.5-2.0xbandwhilethetrendinitsMGDPratiopointstoavaluearound1.65times.Togethertheseapproximatelyresultina2.9timesmarketcap-to-GDPratiocomparedtotodays2.7times.UsingUSpeakprofitmarginsof12.8givesaPEofaround22timesorroughlyinlinewithtodaysfigure.USshareslookfullyvalued.SeeFigure8.SourceCrossBorderCapitalFigure8.PEMultiplesVariousMarkets1974-2003TimesHistoricEarnings747678808284868890929496980002010203040506070010203040506070TimesUSUKJapanEurozoneWorldUsingsimilarcalculationsJapansfairvaluePEstandsaround44timesandcompareswiththecurrent29.1timesmultiple.ForBritainthecorrespondingPEratiois16.6timesversusacurrentvalueof13.9times.EurozoneshouldsustainaPEratioofcloseto18timesbutitiscurrentlyratedatunder12times.EurozoneandJapaneseequitiesap-pearundervaluedoratleastunder-ownedrelativetocash.SimilarcommentsapplytoBritainalbeitlessstrongly.Aggregatingacrossanumberofmajoreconomies4theWorldmarketPEturnsoutat25.6timesagainstacurrentvalueof19times.Thecommonthemeacrossallworldmarketsisthatstockownershiprelativetoliquiditygenerallyliesbelowtrend.InshortnationalPMratiosoughttoriseatleastintheshortterm.Theseshort-andlonger-terminfluencescaninturnbeanalysedifthePMratioisconcep-tuallybrokendownintoanextensivefactorwhichmeasuresthechangingnumberofsharesheldperinvestorandanintensivemarginshowinghowmuchtheywillpayforeachshareperdollarofcashheld4USJapanEurozoneBritainSwitzerlandAustraliaHongKongSingaporeandSouthAfrica.Ppini____x__MjimjNjwherepidenotestheaveragesharepricenithenumberofsharesinissuesmjtheaver-agecashbalanceperinvestorandNjtheoverallnumberofinvestors. 10CROSSBORDERCAPITALSourceCrossBorderCapitalTheimportanceofarisingPMratiotohigherassetpricespimaybedampenedbutitisunlikelytobecompletelydevaluedbyarisingpoolofnewcapitalissuesni.Itwouldofcoursebesurprisingifhigherassetpricesdidnotencouragearaftofcapitalraisings.Howeverthiswillprobablybereactiveandwillthereforelagtheriseinassetprices.InotherwordsNjnifortheithshareandjthinvestorItmightbearguedthattheunderlyingtrendinbuyingpowerisrepresentedbythetermniNjorsharesheldperinvestor.Thisisakintotheextensivemarginandchangessecu-larlyinlinewithsaydemographicsratherthancyclicallywiththetempoofmoneyandbusiness.Cyclicalswingsinbuyingpoweraremorelikelygovernedbythepimjtermorintensivemargin.Thusatrend-adjustedPMmultipleisagoodguidetomarketsentimentasFigure9drawnintermsofstandarddeviationsshowsforWallStreet.Manyofthemajorturningpointsinstockpricesoccurreassuringlyattheextremesofthecharti.e.atplusandminustwostandarddeviationswhensentimentpositiveandnegativeisclosetosaturation.Figure9.USEquityInvestorSentiment1978-2004DeviationsOfUSPMRatioFromTrendLiquidityDurationandValuationOnthebasisthatbuyingpowerisatleastasimportantasearningspowerforstockmar-ketvaluationwemustexpectthattherichestandmostfinanciallysophisticatedecono-miesenjoythehigheststockmarketratingsalmostregardlessoftheirgrowthprospects.Thiswasalsothemessagefromthecross-countrydatareportedinFigure7.InshortgrowthseemstohaveslippedunnoticedfromthePEmultiple.WestartedthisarticlebynotingtheshortcomingsofModernFinancesearningspowermodel.ThisflawmustbeaddressedbyrelatingbacktoliquidityandownershipvariablessuchasthePMratio.Thesolutiontothegrowthliquiditypuzzledoesnotnecessarilylieincontinuallychangingthediscountfactorappliedtofutureearningsasissometimessuggested.AnotherpossibilityfollowsfromtheworkofLeibowitz1991.Thisre-expressestheconstantgrowthearningsdiscountmodelSpeculativeOptimisticRiskAversePessimistic2sd1sd-1sd-2sdMean2sd1sd-1sd-2sdMean7879808182838485868788899091929394959697989900010203047879808182838485868788899091929394959697989900010203040200400600800100012001400160002004006008001000120014001600SPCompositeIndex1987CrashLatAmDebtCrisisRussianCrisisY2K 11CROSSBORDERCAPITALSourceCrossBorderCapitalFigure10.USEarningsGrowth1885-2003AnnualRateReportedBasisP1____.1GErWhereGgr-gthepresentvalueofallfuturegrowthopportunitiesorwhatwedubBigBanggrowthristhediscountfactorandgistheconstantgrowthrateofearningsinperpetuity.TheG-factorintheaboveexpressioncanitselfbeshowntobetheproductoftwotermsgtheconstantgrowthrateofearningsandDduration.Thusifdurationistenyearsandgrowthcompoundsat5perannumthentheG-factorbecomes0.5times.Correspond-inglythePEratioisthen1.5timesthereciprocalofthediscountfactor.Adiscountfactorof10wouldthereforemeanaPEmultipleof15times.P1____.1D.gErTheimportanceofthismodelcomesfromrecognisingthatvariationsinthePElargelyderivefromchangesintheG-factorandthatthesechangesinturnarisefromchangesineitherdurationDandorcompoundgrowthg.SincebydefinitiongisconstantswingsindurationDmustbecentraltochangesinassetvaluation.InfactFigure10showstheremarkablestabilityofUSearningsgrowthoverthelongtermparticularlypostthe1930sDepressionWehaveshownelsewherethatthevalueofDisdeterminedbytheinteractionofavailabledurationatechnicalphenomenonrelatedtotheprofileofphysicalcapitalacrosstheeconomyandrequireddurationafinancialconstraintimposedbyfutureliabilitieslesscashandborrowingsi.e.liquidity.AriseinliabilitieswillreducedurationDperse.Aswillanageingpopulationstructure.Ariseinliquidityandanincreaseintheproductivityofcapitalwillbothlengthenduration.ThisisshowninFigure11bythecorrespondingshiftsintheTT-curveavailabledurationandtheLD-curverequiredduration.1885189519051915192519351945195519651975198519950.10.20.51251020500.10.20.5125102050IndexLogScale4.5TrendGrowthRate 12CROSSBORDERCAPITALSourceCrossBorderCapitalFigure11.DurationGrowthandLiquidityTheTTcurve5relatesdurationtothegrowthrateoftheeconomyandearnings.Thisslopesupwardstotherightandisdrawnconcavetothedurationaxisbecausegrowthopportuni-tiesareassumedtoultimatelyfizzleout.TheshadedareainthechartmeasurestheG-factorG0.TheLDcurve6isdownwardslopingreflectingthefactthatliabilitiestendtogrowwiththesizeoftheeconomy.Thepointofintersectiondeterminesoptimalduration.Changesinliquidityi.e.cashplusborrowingscanbeclearlyseentoaffectdurationbyshiftingtheLD-curveeithertotheleftfallingliquidityortotherightrisingliquidity.BesidestherelationbetweentheflowofliquidityanddurationthereisalsoanotherlinktoexplorenamelybetweendurationandthePMratio.Thisquotientbetweenthemarketvalueofsecuritiesandliquidassetsitselfservesasacrudemeasureofassetduration.Cashhasadurationofzeroandsecuritieshaveadurationsomewhatabovezero.There-foreitisreasonabletoassumethatahighPMratiocorrespondstoalongdurationassetstructure.Thisroadhastakenusbacktoourstartingpoint.Traditionalvaluationmeasureshavebeenshowntobeafunctionofdurationanddurationitselfispositivelyaffectedbytheflowofliquidity.Liquidityaffectsvaluation.Indeedthetwoareinseparable.Buyingpowerisatleastasimportantasearningspower.Indeedinpracticebuyingpowerprobablychangesmoreoftenandbymorethanunderlyingearningspower.Itfollowsthatvaluationbench-marksarenotfixedmeasuringrodslikethemetreandthemile.Ratherthesebench-markswillthemselvesalterasliquidityandthemonetaryclimatechange.Atightmon-etaryclimatewarrantsalessdemandingvaluationbenchmarkthananeasymonetarycli-mate.Thisopensupthepossibilityofconditionalvaluationmeasuresandregimeshifts.OurapproachisalsoconsistentwithmoderntheoriesoffinancialcrisessuchasMinsky1978.Inotherwordsaperiodofmonetarydeflatione.g.LDinFigure11aboveshouldbeassociatedwithlowerPEratiosandshorterdurationD0thanamonetaryinflatione.g.LDinFigure11above.Yettheunderlyinggrowthrateofearningsg0andg1maybesurprisinglysimilarbetweenthetworegimes.5Namedafteritstwokeyparameterstaxationandtechnology6NamedafteritstwokeyparametersliquidityanddebtGrowthgLLTg1g0DDTDurationDD0D1 13CROSSBORDERCAPITALValuationmeasuressuchasPEratiosarethereforefirst-and-foremostmeasuresoftheshort-termriskappetiteofinvestorsandnotlong-termgrowthmetrics.Theirlong-termpathismorelikelytobedrivenbythesavingshabitsofinvestors.Theseareinturnpri-marilygovernedbyfactorssuchasinflationtaxationanddemographics.Oftheseinflu-encesthelattermaybecrucialasFigure12warns.Theshareofpre-retireesi.e.thoseaged40-54savingforpendingretirementintheAmericanpopulationappearstocloselycorrelatewiththeUSPMandthusPEratios.Ageingpopulationscanthereforesignifi-cantlyaffectassetmarketvaluationsfirstfavourablythenunfavourably.WitherWesternassetmarketsSourceCrossBorderCapitalDatastreamFigure12.SecularMovementsInPMandPERatios.USDemographicsofPopulationAged40-54AndValuation1950-2050ReferencesGoldsmithRaymondWComparativeNationalBalanceSheetsAStudyofTwentyCoun-tries1688-1978UniversityofChicagoPress1985.GrahamBenjaminandDoddDavidSecurityAnalysisMcGrawHill1934.HowellMichaelJWhatDrivesHedgeFundReturnsCrossBorderCapital2003LeibowitzMartinLandFabozziFrankJInvestingtheCollectedWorksofMartinL.LeibowitzMcGrawHill1992MinskyHymanPTheFinancialInstabilityHypothesisARestatementThamesPapersinPoliticalEconomyAutumn1978.WilliamsJohnBurrTheTheoryofInvestmentValueHarvardUniversityPress1938PMRatioLHSPopulationAged40-54RHSPERatioLHSPopulationAged40-54RHS5055606570758085909500051015202530354045500.00.51.01.52.02.53.0141618202224USLong-runPM5055606570758085909500051015202530354045505.010.015.020.025.030.035.040.0141618202224USLong-runPETimesPercentTimesPercent 14CROSSBORDERCAPITALAppendixB.DifferencesInPMRatiosOwnershipAcrossEconomies1974-2003AverageandLatestValue2003SourceCrossBorderCapitalDatastreamAppendixA.DifferencesInPERatiosValuationAcrossEconomies1974-2003AverageandLatestValue2003USUKJapanEurozoneBrazilMexicoKoreaHongKongSingaporeSouthAfricaAustraliaSwitzerland01020304050TimesLatestAverageSourceCrossBorderCapitalUSUKJapanEurozoneBrazilMexicoKoreaHongKongSingaporeSouthAfricaAustraliaSwitzerland012345TimesLatestAverageSourceCrossBorderCapitalAppendixC.DifferencesInMGDPRatiosExcessLiquidityAcrossEcono-mies1974-2003AverageandLatestValue2003USUKJapanEurozoneBrazilMexicoKoreaHongKongSingaporeSouthAfricaAustraliaSwitzerland0.00.51.01.52.02.5TimesLatestAverage 15CROSSBORDERCAPITALCROSSBORDERCAPITALLIMITEDMARCOLHOUSE289-293REGENTSTREETLONDONW1B2HJTELEPHONE02075350400FACSIMILE02075350435REGULATEDBYTHESECURITIESANDFUTURESAUTHORITYCROSSBORDERCAPITALLIMITED2004.ALLRIGHTSRESERVEDThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.SourceCrossBorderCapitalAppendixD.DifferencesInEGDPRatiosProfitMarginsAcrossEconomies1974-2003AverageandLatestValue2003USUKJapanEurozoneBrazilMexicoKoreaHongKongSingaporeSouthAfricaAustraliaSwitzerland0246810121416182022PercentLatestAverage 1GlobalViewGlobalViewMay201096BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comFigure1USandUKBondYieldsAnnually1872-2009SourceCrossBorderCapitalHomerAHistoryofInterestRatesLostintheBrettonWoodsFromGlobalLiquidityCrisisToGlobalDebtCrisis.WillWorldBondYieldsSpikeManybelievethatnominalbondyieldswillrisestronglyunderpressurefromdeterioratingdemographicsandbankruptgovernments.Buttheymaynot.Weseeabiggerthreatfromvolatilepapercurrencies.Bondyieldsdependmoreontheissuanceofshort-termpaperthanthesupplyoflong-termpaper.ThebigwinnersfromanyWesternmonetizationwillbethenominalgoldpriceandmaybeunitsliketheSingaporedollar.Despitetheriskoffurtherwidespreadfallsinthevalueofpapermoneycostdeflationshouldrestrainconsumerpricesinthebigeconomies.Ontoprealinterestratesmayremainlow.EquityyieldscouldriseasGDPgrowthfades.Butthatisanotherstory.Worryaboutcurrenciesnotbonds.FromaCrisisofGlobalLiquiditytoaCrisisofGlobalDebtThecentralpriceintheglobalfinancialsystemistheyieldofthedominanteconomiesdebt.Itisabarometerofoverallhealthameasureofgeo-politicalstabilityandtotheextentthatitreflectsanabilitytofinancecapitalcheaplyapredictoroffutureeconomicgrowth.DespitecurrentconcernsthestarkfactculledfromtheWestslongfinancialhistoryisthestabilityofthisbenchmarkyield.SeeFigure1.Long-termbondyieldshavetradedatremarkablylowlevelsthroughoutdecadesofeconomicandoftenpoliticaldislocation.ForexampleacademicsReinhartandRogoffshowthatsince1800therehavebeenfivewavesofdefaultsintheinternationaldebtmarketseachroughly40yearsapartandwitheachlullfollowedbyanewwaveoffailures.Yetyieldsinmajorfinancialcentresthelendersbarelyblinkedifanythingtheyfell.SeeFigure2.WithoutdoubtthisstablefinancingbackgroundunderpinnedavastcapitalinvestmentbythecorporatesectorandinparallelfacilitatedtheenlargementoftheState.024681012141618721878188418901896190219081914192019261932193819441950195619621968197419801986199219982004UKConsolUSBond GlobalView2051015202530354045180018121824183618481860187218841896190819201932194419561968198019922004TheoriginsofstablefinancecanbetracedbacktotheseventeenthcenturyDutchEmpire.Thislegacyoflowandstablelong-terminterestratesorso-calledDutchFinancewaspassedontotheBritishintheseventeenhundredsandcementedduringthenineteenthcentury.Picked-upandnextledbyUSmarketsstablefinancepersistedthroughouttheWestuntilthelate-twentiethcentury.WhenaccordingtoReinhartandRogoffsinceWW2inflationanddefaulthavegonehand-in-hand.Themid-to-late1970ssawtheseparticularconcernsbothheightenandwiden-outtoincludethecoreeconomieswithUKbondyieldspeakingin1974andUSbondyieldshittingtheirhighsin1982.Somethirty-oddyearslatertheWestagainfacessimilarfearsbudgetdeficitshaveexplodedanddebtburdenslooksettogetheavier-and-heavier.Ontopdemographicpressureswillmakethestruggletoreversethesetrendsthatmuchharder.Manysuggestthatnationalbankruptcyanddouble-digitinflationareinevitablecostsnotjustforIcelandandGreecebutperhapsforthemajorWesterneconomiestooBondmarketvigilanteswillsurelyforcebenchmarkyieldsmuchhighertocompensateformoreriskInthewakeofagloballiquiditycrisisdowenowfaceafast-approachingcrisisofglobaldebtWeexaminethesefears.ItseemslikelytousthattheWestcanmuddlethroughwithoutradicallyhigherbondyields.IntheorythelevelofnominalbondyieldsiseffectivelynebulousbecausefuturerealbondreturnsareunknowninaWorldwhereinflationshockscanbelargeandunpredictableInflationanddefaultbeingthemajorriskfactorforbonds.Thereforeinpracticerulesofthumbareused.HistoryforexampleFigure1showsthatthisconventionalbasisofvaluationislargelyunaffectedbytherateofhouseholdsavingsandbythescaleofbondissuancebutitcanbeupsetbychangesinthemonetaryregime.ThesemonetaryregimeshiftsleadtoboutsofmonetaryinflationandmonetarydeflationandtypicallyoccuroutsideoffixedexchangeratearrangementssuchasBrettonWoodsandtheGoldStandard.Specificallywefindthathigherbondyieldsrequirebothmonetaryinflationandcostinflationbutlowerbondyieldscanresultfromeithermonetarydeflationorcostdeflation.Wedefinecostinflationasthecontributiontohigherpricescomingfromhigherwageslowerproductivityorsayrisingoilprices.SourceSuter1992CrossBorderCapitalFigure2The4050YearDebtCyclePercentageofNationalBorrowersinDefaultUnweightedbySizeofDebt1800-2006 3GlobalViewMonetaryinflationmeasurestheeffectonpricesofdepreciationsinthequalityofthemonetarystandardandisthesoleresponsibilityofCentralBanks.Monetaryinflationisanecessaryconditionforhigherbondyieldsbutitisasufficientconditionforrisingassetpricesrisingcommoditypricesandweakerpapercurrencies.Thethreatofdebttrapsnotleastbecauseoftherisingburdenofinterestpaymentswillpushmoregovernmentstowardsmonetaryinflationratherthanmorebondissuance.Thisboosttoliquiditywillsteepenyieldcurvesbutmaynotsignificantlypushupbondyieldsbecausecostdeflationmaylimittheriseinsensitiveconsumerprices.Howevermonetaryinflationwillmeanthatnominalequitypricesrealestatevaluesandcommoditypricesshouldriseandpapercurrencieswilldevalue.Aweakpapercurrencyismorecertaininourviewthanaweakbondmarket.Consequentlyinvestorsshoulddiversifyintogoldandup-comingreservecurrenciessuchastheSingaporeandmaybetheAustralianandCanadiandollars.DebtCrisesDebtsolvencycrisesoccurwhenthereisinsufficientincomeoratleasttheperceptionsofinsufficientincometopaybackeithertheoutstandingdebtprincipalandortheinterestpayments.Inturnifsolvencycrisessuggestfuturefinancingdifficultiesthendebttrapssuggestimpossiblesituations.Manygovernmentsareclosetodebttraps.AdebttrapoccurswhendebtgrowsatafasterpacethanthegapbetweenGDPgrowthandthenominalinterestrate.ThusifGDPrisesat4-5innominaltermsincludinginflationandinterestratesi.e.fundingcostsare3-4thisputsarounda1pointceilingonthegrowthofnominaldebt.FasterdebtgrowthwillseeanexplosivedebtGDPratio.JapanalreadysuffersawhoppingdebtGDPratioof223.FortheborrowersdebtcrisesandrisingyieldsgotogetherjustaskGreece.Andasyieldsrisetheypileontheagonybyratchetingupthecostofdebtfinancetherebycompoundingtherepaymentburden.GivencurrentlargedebtGDPratiositonlytakesasmallriseininterestratestoswellbudgetdeficitsthroughhigherfinancingcosts.Thusa100debtGDPratiomeansthateach100bpriseininterestratespushesupthedeficitby1pointofGDP.OntopadditionalresearchbyReinhartandRogoffshowsthatGDPgrowthisitselfshavedby1pointwheneverthedebtGDPratioexceeds85.Alreadyevenattodayslowinterestratesinterestpaymentsoftenmakeupaquartertoathirdofbudgetdeficits1.Theknife-edgedilemmashowninFigure3seemsfarremovedfromthetranquilityrevealedbytwohundredyearsofdebtmarkethistory.Thechartillustratesthisthreateningtrade-offbetweenbudgetdeficitsandfiscaldebt.Thefurthertotherightaneconomyispositionedtheneareritstandstotheacceleratingmiseryofthedebttrapthemoretothetop-leftaneconomythecloseritistothehavenofsolvency.ThemorethatdebtbuildsthehighertheinterestburdenandunlessprimarybudgetdeficitsarecutthemorethedebtburdenwillspiralupwardsasapercentageofGDP.Awareoftherisinginterestburdenandfast-approachingdebttrappolicy-makerswillatsomepointswitchawayfromfurtherdebtissuancetoprintingmoneytherebymonetizingtheirdebts.UnlikebeforetodaysdebtproblemsincreasinglylieinthecoreOECDeconomiesandnointheemergingmarketperipherythetraditionalnetborrowers.FewWesterngovernmentsyetseeitthiswayorprobablytrulyunderstandtheglobalnatureofthecrisis.1OECDestimatesthatthe2011interestproportionfortheentireOECDwillbe28.9fortheEUmembers46.716.0forJapan28.0forBritainand24.5fortheUS. 4GlobalViewSourceIMFFigure3DebtTrapsBudgetDeficitsandGrossDebtOutstandingPercentofGDP2011Projections-15-10-5051015050100150200250NwHKSgCnLxOeNlMaBdCzNZAuSzSveTwFnKoDkSwSvaJpIcGrUKEsUSItIrBgFrPtSurplusDeficitFiscalBalanceGDPGrossDebttoGDPHighsolvencyLowsolvencyDebtTrapDebtMonetisationUSAUSUKUKTaiwanTwSwitzerlandSzSwedenSwSpainEsSloveniaSveSlovakiaSvaSingaporeSgPortugalPtNorwayNwNewZealandNZNetherlandsNlMaltaMaLuxembourgLxKoreaKoJapanJpItalyItIsraelIsIrelandIrIcelandIcHKHKGreeceGrGermanyBdFranceFrFinlandFnDenmarkDkCzechCzCanadaCnBelgiumBgAustriaOeAustraliaAuUSAUSUKUKTaiwanTwSwitzerlandSzSwedenSwSpainEsSloveniaSveSlovakiaSvaSingaporeSgPortugalPtNorwayNwNewZealandNZNetherlandsNlMaltaMaLuxembourgLxKoreaKoJapanJpItalyItIsraelIsIrelandIrIcelandIcHKHKGreeceGrGermanyBdFranceFrFinlandFnDenmarkDkCzechCzCanadaCnBelgiumBgAustriaOeAustraliaAu 5GlobalViewFigure4givesthecynicalviewofcartoonistDavidLowfromapreviousdebtcrisisin1932.Allnationsareinvolvedbothbecausetheinternationalisationoffinancemeansthatborrowersaccessaglobalsavingspoolbutalsobecausethe200708financialcrisishasmeantthatmanymoregovernmentsnowsimultaneouslyhavelargedebtburdenstofund.SourceDavidLowThecartoonsarereproducedunderlicence.CopyrightSoloSyndicationAssociatedNewspapersLtd.Figure4TheLeakIsNotAtOurEndOfTheBoat1932 GlobalView601020304050601900190519101915192019251930193519401945195019551960196519701975198019851990199520002005PublicdebtswerehighevenpriortothiscrisisbecauseageingpopulationsandslowingeconomicgrowthbothcappedtaxreceiptsandpushedupStatespending.Thesestructuralproblemsmeanthatthedaysofbalancedbudgetsarewell-and-trulyover.Debtcrisestypicallyfollowpreviouscreditbooms.Figure2aboveshowedthatmajorcrisesobeya40-50yearcycle.Creditboomshaveoftenbeenassociatedwithwarfinance.AlthoughdebtGDPratiosarehighgoingintosuchcrisestheprospectoflargemilitaryspendingcutsandpredictablefallsinbudgetdeficitsenabledebtstoberestructuredandtheeconomiestomuddlethrough.Thistimethedebtburdensoriginatedinsteadfromahouseholdandbankingsectorborrowingbinge.Lurkingbehindthisglobalcreditbingeironicallylaytheriseoftheemergingmarkets.TheheightenedcompetitivepressuresfacingWesternfirmssqueezedtheirprofitability.Corporationsfocusedongrowingtheircashflowsinternallyandstartedtodumpsurplusinvestmentfundsintowholesalemoneymarkets.Banksandotherrapaciouscreditprovidersweredis-intermediatedforcingtheminturntoleverageskinnyreturnsandtochaselowqualityborrowerssuchashedgefundsandsub-primeloans.Bankslentlongerandborrowedshorterthannormalstretchingthedurationoftheirassetsandtherebywideningthedurationmismatchbetweentheirassetsandliabilities.Hencetheinitialliquidityproblemhighlightedbyaninabilitytore-financeshort-termdebtssoonbecamealong-termsolvencyproblemforthebanks.ThesedebtshavenowbeennationalisedbytheState.Inshortwehavemovedfromglobalprivatesectorliquiditycrisistoaglobalsovereigndebtcrisis.Butitwaseverthus.Economicempirestypicallyfailbecausebloatedgovernmentsexhausttheircredit.ThedebttrapthreatposedbytheprospectofrisinginterestratesandtheunpalatablethoughtoflargecutstoStateentitlementspendingwilllikelyforcegovernmentstoprintmoneyinstead.TheirCentralBanksenjoythepowertocreatenewlegaltenderandforceitintocirculation.FromtheRomantotheAmericanempiresgovernmentsalwaysusedsuchmeanstoovervaluetheircurrencies.ButultimatelytherapaciousdemandsoftheStatepurseforcethemintodebtover-issuance.SourceCrossBorderCapitalFigure5TheVolatilityofMajorCurrenciesAnnualPercentageStandardDeviations1900-2009 7GlobalView0246810121416172717391751176317751787179918111823183518471859187118831895190719191931194319551967197919912003Thedestructioninthevalueofpapermoneythroughover-issuanceisdubbedmonetaryinflation.Monetaryinflationscausecurrenciestotumbleinvalue.IthappenedtotheRomandenariusithappenedalsototheFrenchFrancandtotheBritishpoundandmanyexpectittosoonhappentotheUSdollar.Rapidlychangingpolicyperceptionsmonetaryinflationthreatsanddenialsandswingsintheabilityandsuccessofvariousgovernmentstotapglobalsaverswillshowupintheheightenedvelocityofcapitalflowsandinevergreatercurrencymarketvolatility.Figure5highlightsthevolatilityofpapercurrenciesthroughthetwentiethcentury.IntheturmoilfollowingtheGreatDepressiontheUSdollarsoaredby29.4againsttheBritishpoundbetween1931-32butthenskiddedby30.4intheyears1932-34.From193-1940theUSdollarclimbedagainby37.6againststerling.Intheyears1931-33theUSdollarrocketedbyawhopping95againsttheJapaneseYen.Yetittumbledby39.8between1932-34versustheFrenchFranc.Intheyears1934-38theUSdollarjumpeddramaticallyby128.7againstaweakFrenchFranc.Itevenmusteredamoreprosaicbutfurther32.1appreciationfrom1938-40asEuropebecameengulfedinwar.DutchFinanceHowtangibletodayarethesethreatsofnationalbankruptcyinflationarybustandcurrencyturmoilBenchmarklongbondyieldsarealreadystartingtobreakhighercouldtheyevenbeabouttoskyrocketTohelpanswerthisquestionweneedtostudydebtmarkethistory.EveryschoolchildknowsthattheBritishEmpirewasforgedfromthecheapnessofManchestercottontheheroismofAdmiralNelsontheplunderedtreasuresfromIndiaandthejingoismofKipling.ButthetruebedrockofVictoriancapitalismandthepillarofEmpirewasasmallpieceofpaperinventedalmostaccidentallyin1752bytheeconomyofChancellorSirHenryPelham.The3consolidatedannuitiesweretheoriginoftheundatedUKGovernmentconsolidatedstockorConsolforshort.ThereputationofLondonasafinancialcentrewaslargelybuiltontheintegrityofthethree-monthtradebillandthepredominanceandstabilityoftheConsol.UKConsolsprovidedthebenchmarkinanuncertainWorldagainstwhichtovaluespeculativerailwaybondsgovernmentbondsfromtheUSandColoniesandbondsraisedbyBritishlocalauthorityandpublicutilities.SourceCrossBorderCapitalHomerAHistoryofInterestRatesFigure6UKConsolYieldsAnnually1727-2009 GlobalView8Stillinexistencetodaythelong-termsteadinessofUKConsolsisstarklyapparentfromFigure6.FormostofthepastthreecenturiesBritishbondyieldsstayedwithinanarrow200bpbandfrom2.75to4.75.Thisstabilitywasonlyrecentlychallengedfromthemid-1960sthroughthelate-1990salbeityieldsdidpreviouslypokeabovethisrangewhenthegoldstandardmonetaryanchorwassuspendedduringtheNapoleonicandtheFirstWorldWars.Bondyieldsmovedupalongsidethedevaluationofsterlingwhichinthelatercasefellagainstgoldthrough1919-20.TherestorationsoftheGoldStandardin1819andagainin1925precededafallinbondyields.The1936Tri-partiteAgreementbetweentheUSBritainandFrancetheprecursortothe1944BrettonWoodsfixedexchangeratesystemattemptedtostabilizetheUSdollarPoundsterlingandFrenchFrancpapercross-rateswhiletheUSdollarbecametheanchorunitthatwasfixedtogoldatUS34.80oz.Thebackdroptothisagreementwasgrowingcurrencyturmoil.Itcreatedastablecurrencybasethatinturnhelpedtomaintaintheintegrityofthebondmarkets.FollowingWorldWarTwotheBrettonWoodsgoldexchangestandardextendedthisstabilitythroughtothelate-1960s.RemarkablyitallowedWesterngovernmentstofinancehugedeficitsatlownominalyieldsdespitewhoppingdebtGDPratiosevenmeasuredbyourlatestextendedstandards.Figure7showsthescantcorrelationbetweenhighdebtsandUSbondyields.Butiftheover-supplyofbondsisnotaproblemwhataboutdemandwhowillbuyupthisdebtTheWestischallengeddemographicallybypeakpopulationageing.Manyarguethatsavingsratioswillsoonfallasretireesspendtheiraccumulatednest-eggssoforcinguprealinterestrates.Althoughthereisintuitiveappealintheideathatageingpopulationshaverisingsavingsratiosasopposedtooldpopulationshavinglowsavingsratiosempiricalevidencefailstofindastronglink.SourceUSTreasuryFigure7USDebtGDPRatioandBondYieldsPercentage1792-2010DebtGDPRatioLHSBondYieldRHS020406080100120140179218051818183118441857187018831896190919221935194819611974198720000246810121416 9GlobalViewFigure8showstheabsenceofcorrelationacrosstheOECDeconomiesbetweenhouseholdsavingsratesandmedianpopulationagesoverthepasttwodecades.Evencountinganudgefromrisinglife-spansasolderpopulationsreachretirementageweshouldnotexpectfewernetsavingsasnesteggsarerun-down.Japanisstillsomewayoffherpeakprospectivemedianpopulationagebutshehasalreadysufferedacollapseinheroncehighhouseholdsavingsratio.ThefallinJapanesesavingsowesmuchmoretoabysmallylowwagegrowth.IndeedwhatweshouldconcludefromthedataisthatolderpopulationsmeanhigherStatespendinglowerproductivitygainsandhencesluggisheconomicgrowth.Itistruethatthissuggestsweakfuturetaxpaymentsandpotentiallymoredebtissuancebutslowereconomicgrowthisfarmorelikelytonegativelyaffectequitiesthanbondsviz.post-1990Japan.Inotherwordsaverageassetdurationmayfallbecauseofdemographicsnotsavingsratiosandbondyieldsmaynotnecessarilyriseasaresult.Overalltheissuanceoflong-termpaperandthesupplyofhouseholdsavingsseemtomakelittledifferencetobondyields.Ratherbondyieldsrevealersistenceorstickiness.Investorsappeartoestablishapsychologicalnormorconventionalbasisofvaluation.Yetatcertaintimesthisconventioncanbeoverturned.Yieldpersistencefollowedbylargestep-changesinbondyieldssuggestboththeexistenceofinvestmentregimesandmoreimportantlyregimeshifts.Theseregimesarecloselyrelatedtoexchangeratepolicyandspecificallytoperiodsofmonetaryinflationandmonetarydeflation.Inshortthereismorethanonetypeofinflationordeflationwedistinguishbetweenmonetaryinflationconsumerinflationcostinflationassetpriceinflationandcommoditypriceinflation.Thinkofconsumerorhigh-streetinflationdeflationconsistingoftwopartscostinflationdeflationfromtheeffectofhigherwagesandmaterialpricesandmonetaryinflationdeflationfromtheunderminingofthemonetarystandardthroughtheover-issuanceofshort-termpaperaka.printingmoney.Assetpriceinflationandcommodityinflationaredifferentagainbutbothtendtobemostinfluencedbythepaceofmonetaryinflation.Inadditionunilateralmonetaryinflationalsoshowsupinbi-lateralexchangeratevolatility.SoiftheUSFedaloneprintsmoneytheUSdollarwillslideagainstotherpapercurrencies.Monetaryinflationisthecommondenominatorinallformsofinflationbutuniquelycostinflationordeflationalonehasafurthermajoreffectonconsumerprices.PutdifferentlywithdueapologiestoMiltonFriedmanassetpriceandcommoditypriceinflationarealwaysandeverywheremonetaryphenomenacostinflationisalwaysandeverywherearealeconomyphenomenonandconsumerpriceinflationissometimesonesometimestheotherandoftenboth.Concernoverinflationisamodernproblem.Acrosshistorythedominanttrendhasbeendeflationormoreaccuratelycostdeflationourlong-termvisionmayhavebeenblindedbytheinflationary1970swhenprivatesectorcostswerechallengedbyexpandinggovernmentmilitantlabourunionsandswampedwithyoungcapital-hungrybutinexperiencedbaby-boomerswhodraggeddownproductivity.WehaveforgottenthatCapitalismexcelsatslashingcosts.LookingaheadunlessthepublicsectorisabletogainsignificanttractionitseemsmorelikelythatcompetitiveforcesintheWorldeconomyandparticularlyfromemergingmarketswillforcethepricesoftradedgoodsevenlower.Thismayofcoursestillmeanhigherpricesfornon-tradedgoodsservicesandassetsbutofficialindexesofconsumerpricesandhenceperceptionsofinflationaregreatlyaffectedbytradedgoods.Theimpactofmonetaryinflationonconsumerpricescanoftenbeoffsetbyacostdeflation.Itiswhenthisdownwardflexibilityofcostsfailstooccurthatbondmarketsbecomeunhinged.Figure9showsbenchmarkglobalyieldsusingaweightedaverageofUSandUKbondyieldsagainstchangesinaverageconsumerinflation. 02468101214160.05.010.015.020.025.030.035.040.0EsSzFrBgSwFnKoSRDkUKItUSAuNwCzIrCnJpBdOePlPtNlHnAverageHouseholdSavingsRatiopointsChangeinMedianPopulationAgeYearsFigure8ChangeinOECDMedianPopulationAgesandAverageHouseholdSavingsRations20002010Source-OECDUnitedStatesUSUnitedKingdomUKSwitzerlandSzSwedenSwSpainEsSlovakRepublicSRPortugalPtPolandPlNorwayNwNetherlandsNlKoreaKoJapanJpItalyItIrelandIrHungaryHnGermanyBdFranceFrFinlandFnDenmarkDkCzechCzCanadaCnBelgiumBgAustriaOeAustraliaAuGlobalView10 11GlobalView0246810121418761882188818941900190619121918192419301936194219481954196019661972197819841990199620022008-10-505101520SourceCrossBorderCapitalFigure9GlobalBondYieldsandConsumerInflation1872-2009BondYieldLHSCPIInflationRHSYieldCurvesCurrenciesandLessonsfromtheHistoryofBondMarketsBondyieldsareinfluencedbyperceptionsoffutureinflation.Historyshowsthattheyarenotdeterminedbyexpectationsofshort-termratesovertimeasmanyacademicsandsomepolicy-makerstodaystillassert.Long-termyieldsaresimplynotlowbecauseshort-terminterestratesarelow.Ratherlowshort-terminterestratescanreflectbothabundantliquidityandlowlong-termyields.Long-terminterestratesarelowbecauseofeithercostdeflationormonetarydeflationbutbydefinitionthecomingmonetaryinflationimpliedbyabundantliquiditymayquicklyreverseanypreviousmonetarydeflation.Papermoneyinlargepartmakesupliquidity.ThemorethatCentralBanksexpandthevolumeoftheirpapermoniesthegreatertheriskthatthecurrencyunitwilldevalueagainstgoldtherebycreatingmonetaryinflation.Inotherwordsover-useofliquiditywillultimatelysavageacurrencyandsohelppushupnominalbondyields.Thusthepersistenceoflowshort-terminterestratesowesmosttoabundantliquidity.Liquidityforcesshort-terminterestratestotradeatapremiumandatadiscounttolong-termyields.Abundantliquidityforcesastronglypositivespreadbetweenlong-andshort-termrateswhereastightliquiditycausesanegativespread.Liquiditydrivestheyieldcurve.Despiteoftenfrequentchangestoshort-terminterestratestheyhavemaintainedaremarkablystablerangeoffluctuationsrelativetobondyieldsovertime.Since1900thedatashowanaveragecycleofaround8.3yearsandaslightlylongeroneof8.9yearssince1760.Thesefluctuationsmirrorthemonetaryorliquiditycycle.Inotherwordsyieldcurveshavealsobeenastonishinglywell-behavedinthefaceofrecessiondepressionWorldWarandhighinflation.Bondmarkethistorythereforesupportsourcontentionthatitistheleveloflong-terminterestratesthatultimatelydeterminesthelevelofshort-termratesandnotviceversa. GlobalView12Keepingshort-termratesbelowbondyieldscannotpermanentlystopbondyieldsfromrising.Trueshort-termratesultimatelygravitatebacktowardslongratesbuttheyfollowratherthanlead.Alsoforlongperiodsoftimeevendecadesshortratescantradeabovelong-termyieldsasinthe1919-30period.FallingasopposedtorisingUSlong-termyieldsthroughthe1920sprobablyresultedfromthesehighshort-termratesandamonetarysqueeze.MoreovertheonlywaytobreakrisingyieldsasFedChairmanVolckerfoundintheearly-1980sistosharplytightenliquiditysufficienttocrushinflationexpectationsbetweenaninvertedyieldcurveastrongpapercurrencyexchangerateandrisingunemploymenttocurtailcosts.Thusthemainfactordrivingbondyieldsisinflationexpectationsandtheymustremainanchoredatlowlevelstokeepyieldsdown.Disciplinedexpectationsinturndependsignificantlyontheintegrityofthemonetarystandard.Astablecurrencyisaclearsignalthatneithertoomuchnortoolittlemoneyhasbeencreated.ItisnocoincidencethatlowyieldsoccurduringperiodsofstablemoneyandwhenpapercurrencyvolatilityislargelyabsentsuchastheBritishGoldStandardfrom1717defactoand1821dejureuntil1914InternationalGoldStandard1870-1914andtheBrettonWoodsfixedexchangeratesystem1944-71.Remarkablytheintegrityofthemonetarystandardhasbeenmaintainedforroughlythree-quartersofthetimesincethestartoftheeighteenthcentury.IdeallyweneedanewBrettonWoods-stylefixedexchangeratesystemtoensurefuturedisciplinebutatpresentthislookstooimpracticaltowishfor.Withoutthisformalmonetaryruleitseemsinevitablethatmonetaryinflationwilltakeholdtosomedegreenotleastbecausesluggisheconomiesmayneedtobegoosedforwardbyliquidityinjections.Butaswearguedearlieritisbynomeanscertainthatfastermonetaryinflationwillpassthroughintomorerapidincreasesinconsumerpricesbecausefallingcostsmayintervene.Althoughassetpricesandcommoditypricesshouldgenerallyincreasebyfarthebestbarometerofmonetaryinflationisarisingnominalgoldprice.Ofcoursefuturepolicy-makersmighttrytode-monetisegoldbypublicallydisparagingitsroleasastoreofvalueandorbymakingitdifficulttoserveasastandardofvalue.Onedirtytrickmightbeforgovernmentstoperiodicallydumpsomeoftheirremainingofficialgoldholdingsintomarketstosharplyweakenthegoldprice.Ignoringgoldandalwaysthinkingintermsofpapercurrencycross-ratesdisguisesmonetaryinflationparticularlyifbeleagueredWesterngovernmentsinflatetheirpapemoniesatsimilarrates.Theriseinheadlineconsumerinflationratesmightthenbemitigated.Notwithstandinggoldandemergingmarketcurrencieswouldappreciate.Arguablythisiswhathasbeenhappeningforthepastdecade.SeeFigure10.Overthisperiodthepotentialstrengthincertainemergingmarketcurrenciese.g.ChineseRMBwassacrificedbylocalpolicy-makerseagertomaintaintradecompetitivenessandtobuildforexreservesinstead.Thesehistorylessonsteachusthatthekeydecisionforinvestorsisnotaboutbuyingorsellingbonds.RatheritiswhichcurrenciesshouldtheyholdtheirwealthinMonetaryinflationandweakpapercurrenciesareafarmorecertainprospectthanmuchhigherbondyields.Whetherornotbondyieldsreflectmonetaryinflationdependsonprevailingcostdeflation.Ourcentralconclusionisthatgoldmustremainachoiceinvestmentoverthemediumterm.Theprospectofwidespreadmonetizationevenlatentmonetizationwillcauseittoappreciateinvalue.Equallyup-comingemergingmarketandcommodity-basedreservecurrenciesshouldbeaccumulated.FornowthemostobviousaretheSingaporeAustralianandCanadiandollars. 13GlobalViewInadditionthoseWesterneconomiesthatcanstillgarnerseignioragegainsorhavecurrenciesthatserveasgeneralmeansofsettlementwilldorelativelybetter.SeignioragedefinesthedifferencebetweenthefacevalueofnotesandthecostofproducingthemexamplesaretheoverseasorexternalcirculationofhighdenominationbanknotessuchastheE500andtheSFr1000banknotesandtheUS100bill.ThemostobviouswinnerisAmericabecausepacetheEurotheUSdollarremainstheWorldsmainstandardofvalue.WorryinglyJapanwithitswhoppingdebtburdencanfindleastshelterherebecausetheYenisnotaninternationallytradedcurrency.WehavearguedelsewherethattheonlywaythatastrongWorldeconomyoratleastastrongAsiacangettheUSdollarsneededtolubricateitsmarketsisbytheUSrunningasizeablecurrentaccountdeficit.Americaobligedinthemid-2000sviagreedyinvestmentbanksparceling-upandrebrandingsub-primemortgagesastriple-Asecuritiesthatcouldsubstituteforshort-termgovernmentpaper.SourceCrossBorderCapitalFigure10EvidenceofMonetaryInflationNominalGoldPriceUSdollarsperOunce1979-201022IthasbeenarguedthattheUScouldinsteadoraswellrunacapitalaccountdeficit.Howeverthisignoresanimportantasymmetry.WhenforeignersholdUSdollarassetsthisincreasesthenetliabilitiesoftheUSeconomyandispostedinthebalanceofpaymentstatisticsasacapitalinflowmuchequivalenttoaloan.BecauseAmericainpracticetendsnottomanageherforexreservesthisnetcapitalinflowmuchmatchanequivalentpaymentsoutflowwhichbydefinitionmustmeanacurrentaccountdeficit.Howeverwhatthedemandforshort-termUSdollarpapercouldbemetfromlong-termUSdollaroutflowsofsayFDI.ThusifforeignersdemandedUS100billioninshort-termUSdollarinstrumentsandUSfirmsinvestedUS120billionthroughFDIthecapitalaccountwouldrecordanetnilbalanceaswouldthecurrentaccount.Inpracticethistendsnottohappen.Theadjustmentfactortendstobethecurrentaccount.798081828384858687888990919293949596979899000102030405060708091020030050010002003005001000DeflationandFinancialMarketCrisesAsianCrisisRussianCrisisArgentinaCrisisBrazilCrisisDec5th96IrrationalExuberanceLTCMENRONFedEasingLiquidityNeutralMoneyGoldspanMonetaryDeflationIrrationalExuberanceStructurallyLowRealInterestRatesWorldcomBriefPeriodsofMonetaryInflationFedTighteningLiquidityBernankeBoomMonetaryInflationMonetaryDeflationTargetMoneySupplyTargetPriceofGoldTargetInflationSustainedMonetaryInflationIIIIIIIVTargetAvoidanceofDeflationVolckerGreenspanGreenspanBernankeVolatilegoldStablegoldFallinggoldRisinggold GlobalView14ThisfacilitatedaUScurrentaccountdeficitofcirca6ofGDPbutalsorequiredtheAmericanprivatesectortotake-onimprudentlylargedebts.Thisoptionisnowimpossible.ThereforegiventhattheUSdeficithassinceshrunkto2-3ofGDPwefigurethatthissmalldeficitisincompatiblewiththeWorldeconomygrowingatthe5-6clipthattheIMFpredictsoverthemediumtermwithouttheUSdollarrisinginvalue.SeeFigure11.-8-6-4-2024198019821984198619881990199219941996199820002002200420062008201020122014-2-10123456SourceCrossBorderCapitalIMFFigure11WorldEconomicGrowthandUSCurrentAccountBalance1980-2014PUSCurrentAccountBalanceasofGDPScaleinvertedLHSWorldGDPGrowthRHS 15GlobalViewConclusionTheLongHistoryofBondMarketsThelonghistoryofbondsshowsfourdistinctfeatures1SupplyNeithertheavailablepoolofsavingsnordebtsupplyappearstotroubleyieldsverymuch.Instancesexistwhereover-issueandshortagesofdebtmakeadifferencebutgenerallyitishardtofindcompellinglong-termcorrelations.HighdebtGDPratiosintheimmediatepost-WW2periodwerelinkedtoverylowyields.Whatmattersmoreisthesupplyofshort-termpaperi.e.monetaryinflation.2NecessityMonetaryinflationandcostinflationtogetherarerequiredtopushbondyieldshigher.Inshortbothformsofinflationarenecessarytoraiseyields.Contrastthecostandmonetaryinflationsoftheearly1970swiththepost-1990costdeflation.TheFallofCommunismandthejumpinthenumbersofhard-workingmiddle-agedprofessionalsintheWestdroveupglobalcapitalproductivitythroughthe1990s.ThereforeWorldrealinterestratesandcostpressuresweremarkedlyhigherinthelate-1970sandearly-1980sthantheyaretoday.3SufficiencyMonetarydeflationandcostdeflationareeventakenalonepowerfuldriversoflowerbondyields.Inotherwordsbythemselveseitheracostdeflationoramonetarydeflationissufficienttopushdownyieldse.g.1930s1980sand2000s.4PolicyRisesinlongyieldscanbemitigatedatleastovertheshorttermifCentralBankspumpenoughliquidityintotheirfinancialsystemstoforceyieldcurvestosteepensignificantly.ForexampletherecentextremesteepnessoftheUKyieldcurvemayhavesubtractedasmuchas175-200bpoffBritishgiltyieldsbyloweringtheshort-termcostofcarry.Butinthelongtermbondyieldsdeterminethelevelofshort-termratesandnotviceversa.LookingaheadWesterngovernmentsmaybeultimatelyforcedtomonetizetheirdebtsbutoverthenext45yearsweexpectthatbenchmarkbondyieldswillonlyedgeupandnotsoarhigher.Wedonotyetseethedangerouscocktailoffastermonetaryinflationandrisingcosts.ConsumerinflationexpectationswillbeheldincheckbycontinuedcostdeflationfromemergingmarketsandatleastinitiallybysomechecktothecurrentheadypaceofWesternmonetaryinflation.ThedemandforUSdollarsfromtheemergingWorldshouldhelptheUScurrencytomaintainitsvaluebothagainstgoldandagainstotherpaperunits.Historyalsoconfirmsthatreservecurrenciestendtodieslowly.TheUKwaseclipsedeconomicallybytheUSin1870butittookuntil1955eighty-fiveyearslaterbeforesterlingwasovertakeninofficialreservesbytheUSdollar.Ageingdemographicswilladdsomedownwardpressuretobondyieldsaseconomicgrowthslipsbutthismaysimplyoffsetupwardpressurecomingfromthedemandssuchagedpopulationsputonbudgetdeficits.OverallitismorelikelythatequitieswillsufferthanbondsmuchasJapanhasexperiencedsince1990althoughinfairnessmuchofthislatterexperiencehasbeendowntotheBoJspolicyofdeliberatemonetarydeflation. 1GlobalViewGlobalViewJune201196BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalUSFederalReserveFigure1USFive-YearTIPSYieldFive-YearsOutWeekly2003-2011TheBearMarketinValuationsandTheBullMarketinHistoryPost-bubbleJapanandPre-WW2Europearehistorylessonsinvestorsneedtoponder.Deflationarytrendsthenweakenedeconomiesupsetfinancialmarketsanddevastatedexistingcurrencyrelationships.Theyweretheprecursortosoaringcommoditypricesandmarkedasignificantchangeineconomicleadership.LookingaheadwiththisperspectiveunderscoresourbeliefinrisingcommoditypricesandbuoyantEmergingMarkets.Westerninvestmentsmayremainstuckinthedoldrums.Thetwobestinvestmentareasfromasecularperspectiveremaincommoditiesandemergingmarkets.Theirattractionswillbeenhancedbytheon-goingbearmarketinWesterninvestmentvaluations.ThevaluationthreatisspelledoutbythreenumbersThevisibledowntrendinthelong-termrealinterestratemeasuredinFigure1bytheUSfiveyearTIPSyieldfive-yearsoutfromover3in2003tounder2now.Thelatestcyclicalpull-backinUSlong-terminflationexpectationsinrecentweeksfrom2.97inmid-April2011to2.44nowadropof53bp.SeeFigure2.Thecontinuingnegativecorrelationbetweentheperformanceofglobalstockandbondmarketsafeatureclearlyvisibleforadecade.SeeFigure3.Thesedatatellusrespectivelythat1themarginalreturnonglobalcapitalissliding2thereislimitedornopass-throughfromrecentQEpoliciestocoreinflationand3thetraditionalFedmodelorequivalentGordonGrowthmodelusedfordecadestovalueinvestmentsnolongerworks.WhyOurthesisisasimpleone.The1989FalloftheBerlinWallradicallychangedtheWorld.The2008collapseofLehmanBrotherswasasymptomofthisandnotacause.1.01.52.02.53.03.54.00301200303052003030920030301200403052004030920040301200503052005030920050301200603052006030920060301200703052007030920070301200803052008030920080301200903052009030920090301201003052010030920100301201103052011 GlobalView2Byeconomicallyenfranchising3-4billionpeopletheensuingdemiseofCommunismpropelledEmergingMarketsintotheforefrontofgrowthandatthesametimecreatedanewdominantproducerregionthatquicklychallengedthecompetitivenessoftheWest.ToomuchcapitalratherthanthesillyideaofaglobalsavingsglutdestroyedWesternmarginalprofitabilityandunderminedtheintegrityofmuchassociateddebt.TorelievetheirbeleagueredprivatesectorsthisdebtwasultimatelyabsorbedontothebalancesheetsofWesterngovernments.Despiteattemptstoboostgrowththrougheasycreditpoliciesandfinancialde-regulationtheWestsunderlyinggrowthtrendsshudderedtoanear-standstill.HighstreetpriceshammeredlowerbygoodsoftendumpedfromtheEMthreatenedadownwardspiralofdebtdeflation.Policy-makersreactedatvaryingspeedstocreateoffsettingboutsofmonetaryinflation.Monetaryinflationisnotthesamethingascostinflation.Becauseitdoesnotnecessarilyaffectproductioncostsmonetaryinflationtendstoinfluenceassetpricesfarmorethanitdoestherealeconomy.Consequentlywefacesecularhighstreetdeflationalongsidecyclicalassetpriceinflation.Bondmarketspriceoffthefallingmarginalreturnoncapitalandconsequentlyperformwell.Equitymarketspriceoffthewobblyaveragereturnoncapitalandsofailtoseeorunderstandthesetrendsuntilitistoolate.Notsurprisinglyequityperformancefrequentlysuffersairpocketsasup-beatexectationsaresuddenlforcedbacktoreality.Saggingdebtburdensneedtobeeliminatedandthemosteffectivewaytodothisisthroughinflationbutpolicy-makerscanonlycreatemonetaryinflationi.e.bytrashingtheirpapercurrencies.Theimmediatebeneficiaryofthisisgoldbutaswehaveoftennotedallothercommoditiesmoveinacloseorbitwithgold.Withagoldoilratioof13-14timesitslong-termaverageaUS1500oz.goldpriceisconsistentwithaUS110bbloilprice.SourceCrossBorderCapitalUSFederalReserveFigure2USLong-TermInflationExpectations5-YearImpliedInflation5YearsOutWeekly2003-20110.00.51.01.52.02.53.03.50301200303052003030920030301200403052004030920040301200503052005030920050301200603052006030920060301200703052007030920070301200803052008030920080301200903052009030920090301201003052010030920100301201103052011 3GlobalViewMeanwhileemergingmarketeconomieshelpedbyeconomiccatch-upenjoyrealpercapitagrowthratesatleast3-4aboveequivalentWesternrates.Aswehavearguedextrapolatingitsstubborn18up-trendseeFigure4thenominalgoldpricelookssettodoublefromherewithinfiveyearssohittingUS3000oz.andtheemergingeconomieslooksettodoubletheirrealpercapitaincomesby2030seeFigure5.BenBernankeoughttobecelebrated.HisfamousDeflationMakingSureItDoesntHappenHerespeechin2002markedthebeginningofamoreactiveFedquantitymonetarypolicy.ItinadvertentlyhelpedgoosetheshadowbankboombutitdiditsjobindevaluingtheUSdollaranddestroyingdebt.Figure6showsthevalueofalloutstandingUSdebtpublicandprivateincludingfinancialsingoldterms.LookingaheadWesterninvestmentvaluationswillbeadverselyaffected.Themajorriskishighlightedbythediagrambelow.SeeFigure7.Itshowsthatequityvaluationsfollowabell-curvewithpeakreadingsatalowinflationrateandwithratingsfallingawayeithersideaseitherinflationacceleratesordeflationapproaches.Therearetwocriticalpointsonthechart.FirstpointBwheretheequityvaluationchartspeaks.TotherightofpointBequitiesandbondsarepositivelycorrelatedtothelefttheyarenegativelycorrelated.SecondpointAshowsthecross-overpointbetweenequityandbondvaluationsandtotheleftofthispointthevalueofeachunitofequityincomefallsbelowtheequivalentvalueofaunitofbondincome.TheJapanesestockmarketpeakedin1990anditbegantocorrelatenegativelywithJapanesebondsaroundtheearly1990s.EquityvaluationsfellbelowJapanesebondvaluationsintheearly2000sastheeconomymovedclosetooutrightdeflation.ThemajorWesternmarketsarearoundadecadebehindJapan.Equityvaluationspeakedin2000justaftertheY2Kbubble.Throughoutthefollowingdecadestockandbondmarketshavemovednegatively.ThusaseconomiescooledandbondmarketsralliedsoequityPEscontracteddealinganegativedouble-whammytostockprices.SourceCrossBorderCapitalDatastream-0.8-0.6-0.4-0.20.00.20.40.60.8010187010188010189010190010191010192010193010194010195010196010197010198010199010100010101010102010103010104010105010106010107010108010109010110010111USJapanFigure3CorrelationBetweenStockandBondMarketsThree-YearRollingCorrelationofMonthlyPercentageChange1987-2011 GlobalView4SourceCrossBorderCapitalDatastreamFigure4NominalGoldPricesUSdollaroz.1980-2011SourceCrossBorderCapitalIMFFigure5EmergingEconomiesGrowthPathofRealPerCapitaIncomesRealUSDollarsandIMFEstimates1950-20300500010000150002000025000199019931996199920022005200820112014201720202023202620291950195319561959196219651968197119741977198019831986198941.158.9IdealisedGrowthPathIMFEstimatesBRICsDevelopedEmergingGDP2030IIIIIIIV79808182838485868788899091929394959697989900010203040506070809101120030050010002003005001000DeflationandFinancialMarketCrisesAsianCrisisRussianCrisisArgentinaCrisisBrazilCrisisDec5th96IrrationalExuberanceLTCMENRONFedEasingLiquidityNeutralMoneyGoldspanMonetaryDeflationIrrationalExuberanceStructurallyLowRealInterestRatesWorldcomBriefPeriodsofMonetaryInflationFedTighteningLiquidityBernankeBoomMonetaryInflationMonetaryDeflationTargetMoneySupplyTargetPriceofGoldTargetInflationSustainedMonetaryInflationTargetAvoidanceofDeflationVolckerGreenspanGreenspanBernanke 5GlobalView0200004000060000800001000001200001922Q41926Q41930Q41934Q41938Q41942Q41946Q41950Q41954Q41958Q41962Q41966Q41970Q41974Q41978Q41982Q41986Q41990Q41994Q40200004000060000800001000001200001922Q41926Q41930Q41934Q41938Q41942Q41946Q41950Q41954Q41958Q41962Q41966Q41970Q41974Q41978Q41982Q41986Q41990Q41994Q41998Q42002Q42006Q42010Q4VolckerGreenspanBurnsMillerMcChesneyEcclesBernankeAlsoFedGovernor2002-05DeflationMakingSureItDoesntHappenHereYetthereversealsooccurredcausingstockmarketstomovepro-cyclicallyafactthatmayhavebeenfurtherreinforcedintheWestbytherapaciouspro-cyclicalgrowthofthenowinfamousshadowbankingsystem.Inshortwhatgoesupcomesdown...andoftenwithabump.Infactacloselookatthedatashowstwocuriousfeatures.Firstemergingmarketsseemtodemonstratethesamepro-cyclicalityeventhoughtheysuffermuchhighercoreinflationratesandhavefarlesswell-developedbondmarkets.Secondasimilarpro-cyclicalityhasnearlyalwaysbeenseeninmainlandEuropewhereastheUKfollowsthebehaviouroftheUS.HerethereasoningisthatlowerPEmultiplesprobablytellusthatlowinflationhaslongbeenafactfortheEuropeaneconomy.ConsequentlytheyhavealwaysoperatedtotheleftofpointBwherestocksandbondscorrelatenegatively.EmergingMarketsbehaviourishardertorationalisebutwefigurethatvaluationsarepro-cyclicalbecauseofthenatureofthecapitalflowstheyreceive.ForeigninvestorstendtoaccumulateEMsharesduringbooms.MoreovertheoverallEmergingMarketeconomiestendtoenjoystrongpaymentssurpluseswhentheWorldeconomyisbuoyantbecauseexportsgrowandcommoditypricesincreaseoftensubstantially.Alltheseinflowstendtobemonetizedbylocalmonetarypolicy-makerspartlybecausetheylackthenecessaryarrayofmarketinstrumentstosterilisethemandpartlybecauseintheirinsistenceontrackingtheUSdollartheyallowliquiditytofluctuateratherthantheirexchangerates.Theconclusiontodayisthatriskmarketsareincreasinglypro-cyclical.Ifthatisthecasethenthebetterlong-termprospectsforEmergingMarketsshouldseetheirequityvaluationsexpandwhereastheWestlikeJapanbeforeitwillseeitsvaluationsbeatendownstilllower.Figure8showsthedepressinglong-runtrendinUSindustrialoutputgrowthandcapacityutilization.Theso-calledGreatModerationhasdisappearedEvenwatchingtheso-calledShillerPEwillnotmuchhelptounderstandthesetrends.Asenseofhistoryismoreimportantandinthisregardwecannothelpthinkingabouttwothings1990sJapanand1930sAmericaandEurope.IsitnocoincidencethatJapanarguablythegeographicallyclosestmajordevelopedeconomytoChinawasthefirsttoimportdeflation.SourceCrossBorderCapitalUSFederalReserveUSTreasuryFigure6RealUSDebtPublicandPrivateincludingFinancials-TermsofFederalReserveChairmenIdentifiedGoldTermsMillionsoz.1922-2011 GlobalView6PEorInvertedYieldInflationDeflationEquities2inflationBondEquityThresholdBondsBACommoditiesPEorInvertedYieldInflationDeflationEquities2inflationBondEquityThresholdBondsBACommoditiesItisnotunreasonableofcoursetolaytheblameforJapanswoesonthe1980sbubbleeconomyherrapidlyageingdemographicsherweakbanksandtheoftenviciouslytightmonetarystanceadoptedbytheBoJ.ButAmericahaslatelyfollowedJapanspathadecadelaterandwithoutmostoftheseotherimpediments.ThereforeshouldweexpectdeflationarypressuresinthehighstreettoworsenWiththeCapitalistlabourforcehavingtripledsincetheendofCommunismitisathoughtworthholding.Theexitfromasimilaroverproductionprobleminthe1930sprovedugly.Excesscapitalwasdestroyedbywar.The1930sdecadesawtheriseofFascismnotablyinseveralofthosesamecountriescurrentlyinthegripofhugedebtproblems.Italsohighlightedtheeffectivenessofmonetaryinflationpoliciesalbeitatthecostofmassivepapercurrencydevaluationwhoppingboutsofcurrencyvolatilityandsurgesinthepricesofcommodities.Thenasnowthesoaringgoldpricewasatthecentreofthesechanges.YetthedescentintotheabyssofWorldWar2wasessentiallytriggeredbytheneedtosecurenationalsuppliesoftheseincreasinglypreciousresourcese.g.RussianandIndonesianoilandbythedesireforlivingspacebynewlyemergenteconomiese.g.GermanyJapanandtheUS.WherewillfutureimperialismstrikeMonetaryinflationremainswithus.ItremainstheonlyreasonablesolutionfortheWesttoeliminateitshugedebtproblems.BritainandAmericahaveacted.Eurozoneisputtingofftheinevitable.Itistryingtostruggleonbyextendingandpretendingthatitswhoppingdebtscanbepaidback.Withouttheunlikelydevelopmentsofapan-EuropeanfiscalUnioninvolvingvastannualtransfersfromrichtopoorandapan-EuropeanbankingregulatortheEurozonetoomustbowtotheinevitableandprint.ThinkoftheEuroastheFrenchFrancofthe1930sVerystrongandthenveryveryweak.Wehavestressedthatmonetaryinflationneednotmeanfasterhighstreetinflationbecausethisalsodependsonwhatishappeningtocosts.Moreovermonetaryinflationdoesnotmoveinastraightline.ItactsasacyclepunctuatedaccordingtohowmuchdevaluationtheWesternmonetaryauthoritiescanfoistontherestoftheWorldandhowmuchpainandimbalanceitsownbankingsystemscantakebeforetheyinevitablyandperiodicallycollapse.Thehistoryofthepastcoupleofdecadeshasbeenpunctuatedbyanearregularfinancialbankingcrisis.ThenextWesternbankingcrisisisslatedfor2016SourceCrossBorderCapitalFigure7TheoreticalRelationshipBetweenEquitiesBondsCommoditiesandInflationSchematic 7GlobalViewCROSSBORDERCAPITALLIMITED96BAKERSTREETLONDONW1U6TJTELEPHONE02079082800FACSIMILE02079082835REGULATEDBYTHEFSACROSSBORDERCAPITALLIMITED2011.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.SourceCrossBorderCapitalUSFederalReserveFigure8TheGreatModerationortheGreatDeclineUSIndustrialOutputandCapacityUtilisationAnnualGrowthandPercent1960-2011IndustrialProductionLHSCapacityUtilizationRateRHS19601965197019751980198519901995200020052010-15-10-5051015657075808590 1GlobalViewGlobalViewSeptember201196BakerStreetLondonW1U6TJTel442079082800crossbordercapital.comSourceCrossBorderCapitalTheBearMarketinValuations...Part2Economiesmaylacktractionbutmoreworryinglythevaluationsoftheirriskassetsareseeminglyinfree-fall.Thusthecrie-de-coeurofmanyportfoliomanagersisthatstocksarecheapat15timesorisitnow14timesearningsanditisthereforerighttobuythedips.Wecautionthatthesamemessagewasdeliveredyear-after-yearpost-BubbleaboutJapanesestocksandyettheystillslidundeterredtowardslower-and-lowervaluationmultiples.Weadaptedourassetallocationmodelstocopewiththischangebyvaluingsecuritiesagainsttheprevailingmonetarystandardandnotagainsteachothere.g.throughrelativeyields.Inotherwordsinflationanddeflationmatteralot.Figure1showsourstandardvaluationdiagram.SomehavenoteditsresemblancetoNapoleonshatThisdiagramnotonlycanexplainmanyoftheMarketsrecenttensionsbutithasalsoworkedwellinhelpingusunderstandJapanoverthepasttwodecades.Thechartshowsthreeseparatelinesoneforthevaluationlevelsofeachofthethreemainassetclasses-bondsstocksandcommodities.Bondsandcommoditiesbothbehaveinstableandpredictableways.Commoditypricestypicallyrisealongsideinflationmovingoppositelytobondpriceswhichfavourdeflation.Throughoutperiodsofdeflationandinflationbondandcommoditypricesseeanegativecorrection.Thespannerintheenginecomesfromequities.Thebell-shapedcurveinFigure1showsthechangingvaluationofstocksi.e.PEmultiples.Thereisasweet-spotinequityvaluationsataround2-3inflation.HerePEsreachamaximumandatinflationratesbothhigherandlowerincludingdeflationtheirvaluationsfallaway.WedenotethepeakPEmultiplebytheletterB.TheletterAisassignedtothepointwherethevaluationofstocksfallsbelowtheequivalentvaluationofbonds.Thisoccursatverylowinflationratesorossibldeflation.PEorInvertedYieldInflationDeflationEquities2inflationBondEquityThresholdBondsBACommoditiesPEorInvertedYieldInflationDeflationEquities2inflationBondEquityThresholdBondsBACommoditiesFigure1TheoreticalRelationshipBetweenEquitiesBondsCommoditiesandInflationSchematic GlobalView2Figure2showstherecenthistoryofJapanesevaluations.InJapanpeakprospectivePEmultiplespointBoccurredaroundthemid-1990si.e.ignoringtherecession-induceddropinearningsin2000wheninflationwasaround2.Thecross-overofbondandequityvaluationspointAtookplacein2001roughlyaroundthetimethattheeconomyentereddeflation.Exactlywhyequityvaluationscollectivelybehaveinthiswayisnotcertainbutwecanconjecture.Firsthighinflationratescangeneratesizeableinventoryprofitssimplyfromtheholdingofgoodsinstorethatsubsequentlyriseinprice.Thesegainsarestillrecordedasprofitsbuttheirsustainabilityandhencequalitymustbeseverelyquestioned.Notsurprisinglytheycommandalowervaluation.Secondinadeflationtherealvalueofdebtbeginstoescalate.Thereforehighlyleveragedfirmsstrugglebecauseprofitsflagandbothrealinterestratesandtherealvalueofprincipalrepaymentsrise.Theresultingheightenedriskofbankruptcyforcesthestocktosellatalargerdiscountthanmightotherwisehavebeenthecase.Admittedlyitcouldbearguedthatboththeseincomeandbalancesheeteffectsaresymmetricbutinpracticeitappearsthateachsufficientlydominatestoexplainthebell-shapedpatternindicatedinFigure1.ReturningtotherecentJapaneseexperiencethisalsoconfirmsthreeimportantobservationsfromFigure1.FirsttotherightofpointBstocksandbondmovementsarepositivelycorrelatedbutoncetotheleftofpointAtheybecomeincreasinglynegativelycorrelated.ThisistrueforJapanfrommid-1996onwards.SeeFigure2.Clearlythisflip-flopbehaviourofcorrelationsupsetstraditionalmean-varianceassetallocationmodelsthatrequirestablevariancecovariancematricesofreturns.Seconditalsofollowsthatrelativeyield-basedvaluationmodelsdonotworktotheleftofpointB.Buyingstocksasinflationfallsfromhighlevelsbacktothe2-3areaidentifiedbypointBisalwaysasuccessfulstrategy.Indeedthisbuyondipsphilosophywasgenerallyembracedwithaplombthroughthe1980sand1990s.Figure2JapanesePEsInvertedBondYieldandCPICoreInflation1974-2010SourceCrossBorderCapitalDatastreamPEInvertedBondYieldCoreCPILHS-50510152025Jan-74Jan-76Jan-78Jan-80Jan-82Jan-8Jan-86Jan-8Jan-90Jan-92Jan-94Jan-96Jan-98Jan-00Jan-02Jan-04Jan-06Jan-08Jan-10020406080100120140160180200PositiveCorrelationNegativeCorrelationPositiveequityyieldspread 3GlobalViewHoweveritcompletelyfailstoidentifyvaluetotheleftofBasinflationratescontinuetofall.Ratherstockssimplygetcheaper-and-cheaper.ThusyieldratiosyieldgapsanddividenddiscountmodelsthatembodyconstantriskpremiasuchasthecelebratedFedmodelthatisfollowedbyUSpolicy-makersarenolongeruseful.ThirdtheJapanesedataalsohighlightanothermarketphenomenon.Thespikinessoftheequityvaluationbell-curvesuggeststhatsmallchangesintheinflationrateclosetothe2-3thresholdtriggersharpjumpsandcollapsesinequityprices.Wehavelabelledthesezonesbeforerespectivelyascrisesofmonetaryinflationandcrisesofmonetarydeflation.Inotherwordsthemovefromanideal2-3inflationratetowardsdeflationisaslikelytotriggeranequitymarketcrashasanaccelerationupwardstowardsaslightlyhigherinflationratee.g.5.InthisregardformerFedChairmanPaulVolckersrecentwarningsthatalittlemoreinflationisadangerousthingareasprescientascurrentincumbentBenBernankesparallelfixationwithavoidingdeflation.Lookingbackinhistorywecanthereforeidentifythe1929WallStreetCrashthe1987Crashandthe1990JapaneseBubbleascrisesofmonetaryinflation.Similarlythe1931collapseonWallStreetthe1997-98AsianCrisistheY2KBubbleandthe2007-2011FinancialCrisisareallmorelikelycrisesofmonetarydeflation.Figure3showsanannotatedchartofUSmedianandtrimmedmeaninflationascalculatedbytheFederalReserveofCleveland.TheareasoftensionandsubsequentcrisisslightlyprecedethesemovementsinUScoreinflation.Lookingaheadalthoughcoreinflationhaslatelypickedupfromitslowsitsabilittokeeprisingisquestionable.Inflationanddeflationareclearlycriticalfactorsbehindequityvaluation.Lookedatanotherwayforbondsandcommoditiesthedirectionofinflationmattersbutforstocksboththedirectionandthelevelofinflationmustbeknown.Thisfactmeansthatequitiesareoftenadifficultassettoincorporateintoanassetallocationprocessbecauseultimatesuccesssignificantlydependsongettingtheinflationlevelcorrect.0.01.02.03.04.05.06.08486889092949698000204060810MonetaryInflationMonetaryDeflationMonetaryDeflationSourceCrossBorderCapitalUSFederalReserveMedianCPI16Trimmed-MeanFigure3USCoreInflationAnnualPercentageChangesinMedianandTrimmedMeanCPIMonthly1984-2011 GlobalView4Incontrastanequally-weightedportfolioofbondsandcommoditieswilllikelybeimmunisedagainstunforeseenchangesintheinflationrate.InotherwordstrusteesshouldcloselyquestionwhetherlargeequityweightingscanstillbejustifiedIndeedlookingatFigure4wemightbeevenmorewaryofstrategicallycommittingtoholdinglargeproportionsofportfoliosinstocks.ThischartshowstheclosecorrelationbetweenTokyostocksandWallStreetlaggedby1012yearswithbothindexesexpressedinthecommoncurrencyofSDRs.InotherwordswemustnotbefooledintomuddlingupanominalriseinWallStreetwithafallinthevalueoftheUSdollarthinkofthischartasmeasuringthetruevalueofeachmarketsayforinternationalinvestors.ThecommonpathcurrentlybeingtroddenbybothindexesnotonlysuggeststhatWallStreetmaypossesstodaylessvaluethancommonly-supposedbutthattheforcesofdeflationmaynotbesoeasilybeatenIndeedthisisourfear.Tacticallyashiftintoriskassetssuchasequitiesfeelsrightbutseeninthislightthestrategiccasestillremainsweak.OurCentralBankersmaywellaspiretocreatemoreinflationtohelpeaseourcurrentplightbutasJapanshowsusandinfactasthe1930sspelled-outmoredramaticallycreatinginflationisofteneasiersaidthandone.ThehistoryofCapitalismisthehistoryofdeflationsimplybecauseitsinherentcompetitiveprocesshastenscost-cuttinginnovationandproductivitygrowthallofwhichacttoreduceprices.OnlywhenindustrialcompetitionissuspendedaswiththeexpansionoftheStateinthe1970sdoesinflationbegintorise.TheFalloftheBerlinWallin1989byeconomicallyenfranchisingsome3-4billionpeopleandeffectivelyquadruplingthesizeoftheCapitalistlabourforcesounleashedanewhugedeflationarywavetowardstheWest.Oneofourfavouriteandmostprescienteconomiccommentatorsonthe1920-60periodwasthepoliticalcartoonistDavidLow.Heworkedinasimilarperiodhauntedbyindustrialoverproductioncostdeflationmassunemploymentandpoliticalturmoil.Lowsworkhighlightedthestupidityofbankersinthe1920sthearroganceandnaivetyofpoliticiansinthe1930sandtheinevitabilityofinflationfromthe1950s.0200400600800100012001400310119703101197231011974310119763101197831011980310119823101198431011986310119883101199031011992310119943101199631011998310120003101200231012004310120063101200831012010024681012141618SourceCrossBorderCapitalDatastreamFigure4USSPlagged10.5yearsandtheJapaneseTopixSDRTerms1970-2011SPCompositeLHSTOPIXRHS 5GlobalViewCROSSBORDERCAPITALLIMITED96BAKERSTREETLONDONW1U6TJTELEPHONE02079082800FACSIMILE02079082835REGULATEDBYTHEFSACROSSBORDERCAPITALLIMITED2011.ALLRIGHTSRESERVEDREGISTEREDINENGLANDCOMPANYNUMBER2687676REGISTEREDADDRESSFAIRFAXHOUSE15FULWOODPLACELONDONWC1V6AYThisdocumentisforinformationpurposesonlyanddoesnotofferanyspecificinvestmentadvice.Undernocircumstancesshoulditbeusedorconsideredasanadvisoryoroffertosellorasolicitationofanyofferoradvisorytobuyanysecurities.Theinformationinthisdocumenthasbeenobtainedfromsourcesbelievedreliablebutwedonotrepresentthatitisaccurateorcompleteanditshouldnotberelieduponassuch.Whilstgiveningoodfaithneitherwenoranyofficeremployeeoragentofoursshallbeliableforlossordamagewhetherdirectorindirectwhichmaybesufferedbyusingorrelyingontheinformationresearchopinionsadviceorrecommendationscontainedhereinorinanypriororsubsequentwrittenorverbalpresentations.Thisreportisprovidedsolelyfortheinformationofprofessionalinstitutionaladvisorswhoareexpectedtomaketheirowninvestmentdecisionswithoutunduerelianceonthisreportandisnotforusebyprivatecustomers.TheemployeesofCrossBorderCapitalLimitedmayhaveapositionorotherwisebeinterestedinstocksmentionedinthisreport.Thisreportmaynotbereproduceddistributedorpublishedbyanyrecipientforanypurpose.Thekeypointhereisthatfollowingasimilartime-linewestandattheequivalentofthe1930stodaywearewatchingwell-meaningbutineffectivepoliticiansandwithanoticeableandhopedforinflationperhapsstillsome25yearsawayHaveweequityinvestorsalreadybeenrecentlywarnedbyJapanWhetherthisprovestobeabearmarketinriskassetsitalmostcertainlyisabearmarketinvaluations.Deflationmaysimplyoverwhelm. 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