Financial System Liquidity

I start this comment looking on a global basis. The very sharp
contraction in the US trade deficit over the past six months means
a large decline in US dollars flowing overseas. Most economies,
now in deep recession, would welcome additional dollars to buttress
reserve holdings in a time of stress when their own currencies
may be under pressure. The contraction of US trade adds to
sovereign risk for economies in distress now, such as eastern
Europe and Taiwan. The Fed has provided about $600 bil. in
currency swap credit lines to foreign central banks as an offset.
The growing US budget deficit and a strengthening US dollar may
also work to syphon liquidity from abroad, as foreign investors
choose US Treasuries for safe haven status. As the yuan has
weakened in China, there is evidence of some capital flow from
there to the US. The US dollar in global context poses hazards
abroad in 2009. The Fed swap lines are not that popular here as
the Fed is taking credit risk abroad. Thus the Fed has to operate
with caution here.

Over the past 6 weeks or so, the Fed has drained nearly $400 bil.
from its balance sheet. January is often a "drain" month following
the holiday season, and given the current gargantuan size of the
Fed's balance sheet, well, we're now talking big numbers on the
add and drain sides. The drain resulted in substantial shrinkage of
the monetary base and the basic money supply. The liquidity here
is still strong and not a major worry at the moment. However, the
shrinkage may have bothered some stock players. By happenstance,
it might also serve as an important message to high inflation buffs
as the Fed showed it can shrink liquidity in size every bit as fast as
it pumped it up.

The broader measure of liquidity (in which I include financial co.
commercial paper) is recovering in growth. Realistically though, we
may be at a point where increased credit demand may be required to
sustain improvement over the next year or so.

There is large excess liquidity on hand relative to the current needs
of the real economy. And that excess reflects rising deposit balances
against a 10% yr /yr decline of US production and SP 500 company
sales. The much lower need for working capital could at some
point lead to a sharp run off of C&I loans and relieve stress on bank
system liquidity and capital. We'll see. The excess liquidity described
here is normally a powerful plus for stocks, although low investor
confidence has been holding players back.