November 25, 2009
The dreaded “L” word – liquidity – has once again become the word to explain every major movement in every major asset class. Don’t understand why equities are outpacing the fundamentals – liquidity! Can’t grasp why crude oil is up even though the demand outlook remains exceptionally weak – liquidity! Baffled by low or negative U.S. bond rates, the surging price of gold, and the booming Chinese real estate market - liquidity, liquidity, liquidity!
Along with all of the liquidity speculations making the rounds, another related theme is the U.S. dollar carry trade. The story here that market participants are borrowing U.S. dollar’s at almost zero percent to buy other higher yielding assets. A similar carry trade was previously seen when investor’s borrowed Yen at near-zero interest rates, sold yen for dollars, and then purchased U.S. government bonds yielding considerably higher than 0%. However, where the Yen carry funneled capital primarily into the ‘safest’ and most liquidity market in the world in U.S. Treasury bonds, the dollar is reportedly being carried across numerous currencies and asset classes.
From Excessive Liquidity To Liquidation
Even as central banks adopted increasingly easy policies in 2008 nearly all asset classes declined. The lesson from this experience was that ‘liquidity’ has a formidable foe in asset price destruction, and that no amount of liquidity can create rising asset prices if those charged with investing capital elect not to invest.
In 2009 central banks have been wildly successful in enticing investors to take on more risk. And while many have already started to warn that this rush to risk across nearly all asset classes is cause for alarm, some are encouraged by the boom:
“We have been very fortunate that the stock markets moved back” and are “re-liquifying the whole process”. Alan Greenspan
The ‘re-liquifying’ process Mr. Greenspan refers to is that of rising stock prices creating a ‘wealth effect’. Needless to say, it is this ‘process’ - as it was pushed to the extreme - that helped produce the unsustainable booms and busts that dotted Greenspan’s Fed (and just for record, most investors do not consider themselves ‘fortunate’ for having participated in this ‘process’). As for current Fed boss, Ben Bernanke, he is of the mind that no “obvious” asset price bubbles can currently be identified. Not that he would know, of course, given that he has never actually pointed one out.
With the Fed pledging to keep interest rates low well into the future, it is not unthinkable that today’s liquidity and dollar carry investment platforms will continue to attract an even larger crowd of followers. However, while everyone believes they will be able to see the exit lights before the inevitable bust arrives, the unfortunate reality is that most will perish.
In short, liquidity explains why asset prices are booming today, and the death of the dollar carry trade will be the explanation given when asset prices go bust. What can not be explained is why anyone still has faith in the idea that the Fed can orchestrate sustainable asset price booms. Save a deflationary conflagration, easy money Fed policies always fuel unsustainable asset bubbles!
1. “the integration of liquidity into standard general equilibrium macroeconomic models is still in its infancy, as it involves modeling a role for fiat and inside money on which established theory paradigms are still lacking.” http://imf.org/external/pubs/ft/wp/2009/wp0952.pdf