Liquidity trend remains negative: Asian foreign exchange reserves continued to stagnate in the final months of 2005. Even China’s forex reserves are rising less than its trade surplus. The combination of a strong dollar and a rising Fed funds rate has caused the trend.

The end of the Fed rate hikes cannot reverse the trend: US money supply and the yen drive Asian forex reserves. The Fed is unlikely to cut interest rates within 18 months, I believe, implying stagnant money supply in the US. Japan is tightening fiscal policy and maintaining its loose monetary policy – a bad combination for the yen.

Volatility, not trend, should dominate 2006: The big central banks are unwilling to add more liquidity, but are reluctant to take back the surplus liquidity. The liquidity stalemate suggests that volatility rather than trend will dominate financial markets in 2006.

It takes a shock to trigger the risk reduction trade: The declining risk premium has been self-fulfilling, with falling capital costs boosting economic activity, which in turn decreases financial distress. When the risk premium stops falling, even if it remains low, it ceases to stimulate demand and financial distress returns.

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