Liquidity crunch. The mere mention of the phrase raises fear among the highly leveraged, the overextended and anyone else who’s betting heavily on the notion that the bullish momentum of recent history will last one more day.
With textbook-like regularity, yesterday’s worries over the fading of liquidity in some corners of finance replaced greed with fear, inducing a dramatic bout of selling around the world. Ground zero for the liquidity squeeze was Europe, where the ECB yesterday loaned a record $131 billion to 49 banks in an effort to minimize the fallout arising from subprime-mortgage ills in the United States, MarketWatch.com reported. The Federal Reserve was compelled to engineer a similar injection of liquidity, albeit at a much lower dosage of $12 billion. Other central banks are said to have advanced loans as well yesterday.
It’s hard to judge what the larger trend will be based on just one day. But the idea that the sea of liquidity that’s been bubbling in the 21st century might reverse, and with negative consequences, is hardly a hair-brained nightmare imagined by outcasts to mainstream economics. Much to the chagrin of some, perhaps most investors, cycles are still alive and well. Central banks, in short, haven’t dispatched cycles to oblivion, even if it’s looked otherwise in recent years.
In fact, the latest bout of credit crunching has been years in the making. The law of financial gravity predicted that the Fed’s decisions to favor easy money in the extreme earlier in this decade would come back to haunt the capital markets. In fact, the cornucopia of liquidity has been the elephant in the room for several years, setting the stage for bull markets (inflation?) across the asset spectrum. True, the elephant has been ignored, but a pachyderm won’t suffer obscurity indefinitely, as yesterday’s actions suggest.
Meanwhile, let’s be clear: the Fed and its counterparts around the world have been major players in fueling the bull markets by supplying the necessary credit. Arguably, that credit has been supplied to excess. Few have complained, at least those who’ve been long. Bull markets, after all, have a habit of quieting complaints, easing fear and elevating the demand for martinis and Ferraris. No one wants to spoil a good party, but at some point it’s time to call a cab and head home.
If the corrective power of the bears has returned for an extended stay, a new era of criticism about what central banking has wrought may be in the offing. While we wait for the debate, let’s step back and consider the broader perspective: It’s more than a little ironic that the central banking establishment’s solution for what ails markets is, so far, another dose of the same medicine that brought us to this point. Namely, yesterday’s liquidity injections follow years of the same, albeit in varying forms. Tactically, yesterday’s efforts to ease anxieties by effectively printing more money are really just more of the same policy biases that have been in effect for years. Arguably, the Fed and ECB don’t have much choice at the moment. But that raises questions anew: How did we get pushed into a corner where printing money is at once the problem and the solution? More importantly, what does the constraint imply for the future?
The answer, as always, will arrive one day at a time.

No one will be inspired by this morning’s update on initial jobless claims. Then again, the numbers won’t frighten investors either. And that, perhaps, is the point. New applications for jobless benefits aren’t necessarily encouraging, but they don’t they look especially portentous.
That, at least, is our take. But judge for yourself. For the week through August 4, initial claims rose slightly to 316,000 from 309,000 in the previous week, the Labor Department reported. In the context of recent history, 316,000 looks middling, as our chart below shows. True, the bias leans to the upside of late, if only slightly. The four-week moving average of jobless claims is 307,500, modestly below last week’s number.

Judging by the broader trend, the news for jobless claims is that there’s no news. And that, arguably, is good news.
Betting on the status quo is a popular choice these days among movers and shakers, including the mover-and-shaker-in-chief: Fed Chairman Ben Bernanke. The central bank on Tuesday continued to hold steady on interest rates, keeping Fed funds at 5.25%, the prevailing number since June 2006. What’s striking about the ongoing preference for doing nothing with the price of money is the fact that in recent weeks the calls for a rate cut have grown louder. Subprime mortgage anxiety has been the immediate catalyst for the thinking that the economy needs a fresh injection of liquidity to keep growth bubbling. But the Fed has resisted, a decision that’s gaining support among pundits, including today’s lead editorial in The Wall Street Journal:
“…Mr. Bernanke did the right thing on Tuesday and refused to pander to the many pleas to rescue credit markets by printing more money.”
The economy, in short, continues to bubble, despite the recent fears driven by the real estate sector. A recession will eventually arrive. The central bank, for all its powers, is run by mortals, not gods. For the immediate future, however, it’s folly to think the economy will contract. There’s ample support for the idea that GDP growth for all of 2007, once the final number is published, will look decent by recent standards.
The “catch” is that time will inexorably take a toll on growth. That’s the nature of business cycles: eventually, they plant the seeds of their own destruction. True, the Fed has learned how to minimize the cyclical risk. Volatility in GDP is a shadow of its former variance. Some ambitious types have even advanced the idea that central banks have assumed the talents to dispatch business cycles to the dustbin of history. We’re highly skeptical of the belief, although for the foreseeable future the inherent allure of that notion will continue to resonate with the bulls.
But financial sobriety is quickly restored if one remembers that ours is a world where the overwhelming majority of forecasts are dependent on the past, and that the past informs the future until it suddenly doesn’t. At some point tomorrow will offer a sharp break with yesterday. The reversal will, of course, look obvious in hindsight while remaining virtually invisible in the here and now. Only by overlooking that monster of a caveat can we say with confidence that the status quo looks likely to prevail. That and $2, as they say, gets you a cup of coffee. And that, dear readers, is why diversification is still your only friend today, tomorrow and forever and regardless of what tomorrow’s headlines proclaim.

The stock market was surprised and shocked yesterday to learn that the Fed wasn’t cutting interest rates. The initial reaction to the news of standing pat with Fed funds: sell first and ask questions later. But the surprise and shock was fleeting, and investors did a volte face and decided that holding rates steady was the best course after all. Buyers proceeded to bid prices up.
The net effect was that the stock market was on a roller coaster yesterday even though the central bank continued its long-standing policy of sitting on its hands, as defined by Fed funds, which still stands at 5.25%. For those who watch Fed funds futures for clues, yesterday’s news of letting it ride was a yawn. The futures market has long anticipated that 5.25% would remain the standard.
But if futures prices can be trusted, a cut of 25 basis points to 5.0% is coming by late this year or early in ’08. One school of thought thinks a cut makes sense in part because of the current credit crunch that’s thrown the capital markets into a tizzy. But while the Fed has a history of coming to the rescue in times of liquidity squeezes, there’s reason to wonder if erring on the side of monetary caution remains the better choice at this juncture. The credit crunch for the time being isn’t all that crunchy. Liquidity has dried up some, but that’s only relative to the recent levels of excess. In any case, so far there’s still lots of cash looking for a home in the global markets.

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Your editor has been absent from these digital pages for just 11 days, but a lot can happen in 11 days.
Consider the table below, which summarizes the performance of the major asset classes of late. In particular, note the prevalence of red under the 4-weeks column. Risk has been showing its other face to investors, many of whom formerly thought that there was but one outcome to embracing the four-letter word.

The fact that markets have retreated in earnest should come as no surprise. After a multi-year run of dispensing mostly gains, the major asset classes have reintroduced the notion of humility to the masses. As readers of this site will recall, we’ve been expecting no less for some time. Granted, even a broken clock is right twice a day, and so we’re vulnerable to criticism that our warnings were early. True, although we’ve advised all along that our preferred strategy has been one of raising cash methodically as markets continued moving higher.
As a result, our own personal allocation to cash is well above levels we’re comfortable with as a long-term proposition. The idea of continuing to elevate the cash weighting was always with an eye toward redeploying it when prospects looked more attractive elsewhere. Now that red ink has arrived, is it time to redeploy? Yes, sort of. But in addition to diversifying across asset classes, we’re of a mind to diversify across time as well, for both buying and selling. The reason: we can’t see the future. Yes, we can make some educated guesses, in part driven by quantitative clues handed down by the markets. Those clues, however, aren’t foolproof.
Meantime, let’s be clear: the correction so far, painful as it seems, hardly amounts to an earth-shattering buy signal across the board. Blood is starting to trickle, but it’s still not running in the streets.

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The market’s down and your editor is out–out of town. As we depart for a bit of R&R, the equity market’s getting roughed up. Although a post or two may pop up on these digital pages, yours truly will be returning to the regular grind on August 7. Meantime, we’ll be watching the usual suspects (and looking out for bears) from an undisclosed location on the California coast.

Real estate’s still in a slump, as yesterday’s report on June sales of existing homes reminds. The National Association of Realtors reported that sales of single-family homes tumbled 3.8% last month to an annualized rate of 5.75 million units–the lowest in almost five years.
More weakness may be coming, predicted Thomas Higgins, chief economist at money manager Payden & Rygel, in a research note sent to clients yesterday. He reasoned that the recent jump in mortgage rates will keep the pressure on sales in the coming months. He explained that a high correlation (77%) between mortgage rates and a two-month lag on existing home sales suggest as much, as per his chart below.

Source: Payden & Rygel
“Between May 11 and July 13, the rate on a 30-year fixed-rate mortgage surged from 6.15% to 6.75%,” Higgins wrote. “As the chart above shows, a rise in mortgage rates tends to impact existing home sales with a two month lag.” As a result, he warned that existing home sales “could see another down leg in July and August.”
This line of thinking throws a potential wrench into the machine of optimism, which of late has espoused the idea that the worst of real estate’s ills had passed. The sector isn’t necessarily poised for boom or even modest rebound. But if the market would simply stop bleeding, the flat-lining would go a long way toward boosting the economy in the second half of 2007 into 2008.

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Risk continues to pay off handsomely in the world’s equities markets. As our table below shows, reaching for more has delivered more, reinforcing the notion in 2007 that higher risk equates only to higher reward.

The top-performing region through last night’s close was Latin America, which has climbed an astonishing 41% in dollar terms (this and all data are courtesy of S&P/Citigroup Global Equity Indices). In fact, double-digit gains remain the norm for much of the planet’s stock markets, with Japan being the conspicuous exception.
This year’s rally may reflect rational pricing of assets, but the gains in Latin America are inducing some head scratching. Indeed, the region’s relative strength is conspicuous this year, but it’s hardly a new trend. BCA Research last week observed that Latin America has outperformed Asian markets for nearly 20 years. “This is remarkable, given strikingly superior economic performance in Asia relative to Latin America,” the consultancy wrote.
Some of Latin America’s equity leadership can be attributed to the fact that the region is relatively rich in commodities compared to Asia. Among the obvious examples: Chile is a major copper producer and Venezuela is among the world’s biggest exporters of crude oil. The bull market in commodities, then, solves the puzzle for why Latin American stocks are running hot for so long, right? Well, only partly. The commodities rationale isn’t completely persuasive, BCA advised, noting that Latin America also outperformed in the 1990s even though commodities prices were weak in the decade.

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The academic literature is long and deep in favoring core inflation as a superior predictor of headline inflation. By that reasoning, the recent dip in core indices gives hope to the prospect that the Federal Reserve has contained the beast. As the chart below shows, the Fed’s preferred measure of inflation (the price index for core rate of change in personal consumption expenditures) is showing signs of behaving lately.

But as we’ve been discussing this week, there’s still plenty of anxiety about inflationary trends, in part driven by the rise in headline gauges. In fact, the anxiety that springs from the conflicting signals of headline vs. core has been front and center in debates within the Fed. Yesterday’s release of the minutes from the FOMC meeting of June 27-28 details the worries in the meeting’s conversations, as the following excerpt reveals:

The incoming data on core consumer prices were viewed as favorable, but were not seen as convincing evidence that the recent moderation of core inflation would be sustained. Participants noted that monthly data on consumer prices are noisy, and recent readings on core inflation seemed to have been depressed by transitory factors. Moreover, a number of forces could sustain inflation pressures, including the generally high level of resource utilization, elevated energy and commodity prices, the decline in the exchange value of the dollar over recent quarters, and slower productivity growth. In addition, while core consumer price inflation had moderated of late, total consumer price inflation had moved substantially higher, boosted by rising energy and food prices. While total inflation was expected to slow toward the pace of core inflation over time, a number of participants noted that recent elevated readings posed some risk of a deterioration in inflation expectations. On this point, several participants cited the uptick in forward measures of inflation compensation over the intermeeting period derived from Treasury inflation-indexed securities. However, a portion of this increase might be attributed to technical factors, and survey measures of long-term inflation expectations had held steady over recent weeks. Nonetheless, several participants emphasized that holding long-run inflation expectations at or below current levels would likely be necessary for core inflation to moderate as expected over coming quarters.

The voices worrying about inflation are all the more timely with oil prices rallying anew, perhaps to a new all-time high in the near future. The question then becomes whether the public thinks inflationary pressures are on the rise. If the answer is “yes,” then the fear may become a self-fulfilling prophecy. After all, there’s a lot of consumers out there paying more for food and energy who are behind the times when it comes to reading the academic literature on core.