Deteriorating Global Liquidity
John Mauldin's Outside the Box

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Regular readers will know that I have mentioned my London partners, Absolute Return Partners, in the past. They have a monthly letter called The Absolute Return Letter. This week we will look at some recent comments by my very good friend Niels Jensen, the president of ARP. I was just in London last week for a few days, and the topic of this week's OTB was discussed at length over dinner. Niels seems to have a gift for great restaurants and even better wines, as well as strong and thought-provoking opinions.

Niels comments on global liquidity, the dollar and liquidity. Niels sees the U.S. current account deficit as a good thing because it has helped add liquidity and stimulus to the global economy. Past downturns in global liquidity have been accompanied by a financial crisis somewhere in the world and strength in the Dollar. I strongly suggest you look at the charts included in this letter. They are quite instructive.

This is clearly a contrarian call. As you know, most observers predict that the dollar will weaken due to the large current account deficit. Thus, it is perfect for this week's Outside the Box.

- John Mauldin

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Deteriorating Global Liquidity

By Niels C. Jensen, Partner
Absolute Return Partners LLP

Below we will take a closer look at one of our favourite leading indicators, namely the global liquidity indicator. Global liquidity may be defined in numerous ways. We tend to like the way Merrill Lynch defines it, mostly because it has proven an excellent predictive measure over the years. According to Merrill Lynch, global USD liquidity equals the sum of the U.S. monetary base plus reserves held in custody by the Federal Reserve for foreigners - mostly Asian central banks.

If the U.S. current account deficit grows, as has been the case in recent years, global liquidity would be expected to improve, because the countries having a current account surplus with the United States would be expected to buy U.S government bonds for at least some of the surplus dollars.

This way, the U.S. current account deficit has played an important role in terms of providing stimulus to the global economy in recent years, a fact often ignored by those being so critical of the large deficit.

Chart 1: Global USD Liquidity

Source: Merrill Lynch

So let's take a closer look at the global liquidity indicator. As you can see from chart 1, the growth in liquidity has actually decelerated quite sharply in the last 6 months, reflecting several factors.

For a start, the U.S. monetary base itself is experiencing slower growth, which is not at all surprising given the rise in the U.S. Fed Funds rate. At the moment it grows by approximately 3% per annum, substantially less than the nominal growth of the U.S. economy.

Secondly, and perhaps more surprisingly, foreign reserves deposited with the Fed are not growing as fast as the current account situation might otherwise suggest. After all, with the U.S. current account deficit being higher than ever, you would expect foreign reserves to continue to grow rapidly. Why is that not happening? There are several reasons for this, but let's focus on two important ones.

A substantial part of foreign reserves held by the Fed belong to Asian central banks. Virtually all Asian countries are importers of oil. The sharp rise in the price of oil has created a new situation, where the growing U.S. current account deficit is not matched by a corresponding growth in the Asian surplus, simply because they are spending more dollars on their oil purchases, just like we are.

In addition to this, because of the sharp rise in the Fed Funds rate (the cost of money in the U.S.), speculators are borrowing considerably less in U.S. dollars than they used to. This, we believe, is a major contributor to the deceleration of global USD liquidity.

However, since there is little evidence of any meaningful de-leveraging going on in financial markets around the world, it is probably safe to assume that much of the speculative borrowing has simply moved from U.S. dollars to other low cost currencies such as euros and Swiss francs. This may also explain why Euroland is one of few areas in the world where the monetary base continues to grow at a healthy rate -- 10%+ per annum at the latest count.

But back to our main story. We assign much significance to the liquidity indicator, because global USD liquidity has proven so valuable in predicting the trend in financial markets. We can best illustrate this by borrowing a few more charts from Merrill Lynch.

Chart 2a: Global Liquidity v. Commodity Prices

Chart 2b: Global Liquidity v. Asian Stock Prices

Chart 2c: Global Liquidity v. Credit Spreads

Chart 2d: Global Liquidity v. Volatility

Source: Merrill Lynch

As you can clearly see from charts 2a through 2d, global USD liquidity is strongly correlated with commodity prices and Asian stock prices and strongly negatively correlated with credit spreads and stock market volatility.

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But the story gets worse. Our friends at GaveKal Research produce their own global liquidity charts. Chart 3 below is very similar to chart 1, although it covers a slightly longer period (1980-2005). As you can see, whenever the year-on-year growth in global liquidity dips below zero, the world usually finds itself in some sort of crisis.

The liquidity drain in 1981-82 sowed the seeds of the Latin American debt crisis. The slump in liquidity in 1988-89 was at least partly responsible for the most dramatic crisis the U.S. banking industry has undergone since the depression in the 1930s – the so-called savings & loans crisis. Large parts of the U.S. banking systems were on the verge of a complete collapse.

1997-98 gave us the crisis in Asia and Russia and, as a result of that, the collapse of Long Term Capital Management. Finally, the liquidity slump in 2000-01 was partly responsible for the crisis in Argentina, and we also "enjoyed" the experience of Enron and several more corporate disasters, just to round things off.

Chart 3:

Source: GaveKal Research

It is virtually assured that a significant deterioration in global liquidity will cause some sort of crisis somewhere. It always does. We cannot say for sure where the skeletons will pop up this time, but urge you not to ignore the fact that Indonesia took a bit of a battering in August and September of this year. Although Indonesia is an OPEC country, it is actually a net importer of oil and it has, like many other Asian countries, a system in place whereby retail energy prices are heavily subsidised.

Although oil prices have backed down from almost $70 when the crisis in Indonesia unfolded to the mid-fifties today, the danger is by no means over. Taiwan has gone through a rough time recently, and other Asian countries are struggling to adapt to the higher energy prices.

Indonesia and Taiwan are important reminders to all concerned that investing in Asia is not a one-way street. The region is in fact quite accident prone as evidenced by the 1997-98 crisis, and many investors have had their fingers burned in Indonesia and more recently in Taiwan.

When global liquidity starts to deteriorate, according to the laws of economics, either GDP growth will slow or financial markets will suffer, or both will take a hammering. There is no other way out. Given all the yellow flags that the global liquidity indicator is throwing at us, we see no reason to be heroes. As summarized by GaveKal:

"We are rapidly moving to a period of more fools than money. And in such times, fools and their money are soon parted."

The Liquidity Driven Dollar

So what are the implications of deteriorating global liquidity for currency markets? Since the liquidity indicator we use in our analysis is USD based, we can only speak with conviction about USD but, in a nutshell, deteriorating global liquidity is bullish for the dollar. Here is why:

The majority of people we speak to are still bearish on the dollar, and since this bearishness is often based on the large U.S. current account deficit, let's begin our discussion there.

The first point we would like to make, and we wish to make it rather emphatically, is that it is too simplistic to assume that a large current account deficit automatically leads to a weaker currency. For a small country this may very well be the case, but a large country such as the U.S. could probably live with a substantial deficit almost in perpetuity.

In fact, we would argue that, as long as the U.S. dollar remains the primary reserve currency in the world, a large current account deficit is almost irrelevant. This finds support in several studies conducted over the years which show that the correlation between the dollar and the U.S. current account deficit is low.

More importantly, and contrary to what many people seem to think, countries don't freely choose which currencies to hold in reserve. These decisions are largely dictated by trade flows. Therefore in a world of rising energy prices (always priced in dollars) and increased trade between nations (most of which is traded in dollars), central bankers are forced to increase their holdings of dollars whether they like it or not.

So, unless the world agrees to price more goods and services in other currencies - Russia has in the past made a case for pricing oil in euros - the greenback is very likely to hold onto its status as the main reserve currency of the world.

The famous economist Ed Yardeni (you can find examples of his high quality work on has done a lot of work on global liquidity. He has in fact developed his own global liquidity indicator called FRODOR, and he has found a strong negative correlation between global liquidity and the U.S. dollar (see chart 4 below). In other words, when global liquidity grows strongly, the U.S. dollar tends to perform quite poorly. When growth in global liquidity slows down, the dollar starts to do better. This is consistent with the recent robust performance of USD versus EUR, GBP and JPY.

Of course, global USD liquidity is closely linked with U.S. interest rate policy (higher rates slow down growth in the monetary base), which is another way of saying that during periods of rising Fed Funds rates (i.e. the last 18 months), the dollar is likely to be quite strong. On the other hand, when the Fed is easing (which will lead to stronger growth in global liquidity), the dollar is likely to show signs of weakness.

Chart 4: Global Liquidity (FRODOR) v. USD:

During a period of rising USD rates, falling GBP rates and flattish EUR rates (an environment we find ourselves in at present) the underlying support for USD is very strong indeed.

The story gets a little bit more complex if we instead focus on the outlook for the U.S. dollar versus Asian currencies. Asian central banks have for years performed every trick in the book to prevent their currencies from appreciating against USD. When a central bank intervenes to keep the lid on its own currency, it usually buys USD against its own currency. This may cause a substantial rise in the domestic money base, which is neutralised through a so-called sterilisation process (nothing to do with the human anatomy!).

When a central bank sterilises, it issues government bonds in local currency to soak up part of the rise in the money supply caused by the interventions in the FX markets. Otherwise such interventions could be highly inflationary.

One of the "safest" bets - if it is prudent to use the word safe in the context of investments - has long been considered short USD versus Asian currencies. Many Asian currencies are, after years of central bank intervention, almost grotesquely cheap relative to Western currencies, if one applies a traditional valuation approach based on purchasing power parities. In the past, we have in fact advocated ourselves for going short USD against Asia.

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However, since the modest re-rating of the Chinese renmimbi earlier this year, Asian currencies have been remarkably weak. As a result, interventions have been few and far between. This anecdotal evidence is further supported by the global liquidity indicator. If Asian central banks had made significant interventions over the past several months, global liquidity would look a great deal stronger than it actually does.

So what is happening? The one-way traffic in USD versus Asia is not working as almost everyone expected it to. Could it be that the high oil price is starting to make a real impact on Asian economies? Only time can tell. One thing is for sure though. This is not the time to be short U.S. dollars.

© 2005 Absolute Return Partners LLP. All rights reserved.


I hope you enjoyed this week's Outside the Box. You can find out more about Absolute Return Partners and sign up for their free monthly letter at

Your always paying attention to the dollar analyst,

John F. Mauldin
[email protected]


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 11-21-2005 1:59 AM by John Mauldin