Page 5 of 5 Liquidity boom and looming
crisis By
Henry C K Liu
not expect positive
returns on investments, so they hoard cash to
preserve capital. Capital then becomes idle
assets.
As the decade-long US consumption
collapses from exhaustion, a secular bear market
arises in which the bullish rebounds are smaller
and do not wipe out the losses of the previous
bear market. Because Asia's growth has been driven
by low-wage exports, it will not be ready fill in
as the global growth engine in
time
to prevent a global crash. China is just beginning
to change its development model to boost worker
income and household consumption and may take as
long as a decade to see the full effects of the
new policy. China's only option is to insulate
itself from a global meltdown by resisting US
pressure to speed up the opening of its financial
markets. China's purchasing power is too weak to
save the global economy from a deflationary
depression.
A global financial crisis is
inevitable. So much investment has been sunk into
increasing commodity production that a
commodity-market bust, while having the effect of
a sudden tax cut for the consuming economies, will
cause bankruptcies that will wipe out massive
amounts of global capital.
A financial
crisis could trigger a global economic hard
landing. Global financial markets look
suspiciously like a pyramid game in this
overextended secular bull market. The
proliferation of complex derivative products
catering to short-term trading strategies that aim
to get the biggest bang for the buck creates
massive uncertainty surrounding leverage in the
global financial system. A commodity burst could
cause correlation trades to unwind in other
markets, which could snowball quickly into a
massive financial crisis.
When markets are
hot, fund-manager companies tend to market funds
aggressively, especially ones with hot concepts.
Commodities, BRIC, etc, have been the hot concepts
in this cycle. Tens of billions of dollars have
been raised by such funds from the less
experienced retail investors over the past three
quarters in Japan, South Korea, Taiwan, Hong Kong,
etc. This source of money has fueled rapid price
appreciation in the recipient markets.
Starved of good returns in the US,
long-term investors have been allocating funds to
emerging-market and commodity specialists to chase
the good performance. Such funds have flowed
disproportionately into small and illiquid stocks,
causing them to rise in rapid multiples. Their
good performance attracts more funds and
reinforces the virtuous cycle.
Rising
leverage is another technical factor that has
artificially boosted liquidity in the hot markets.
Derivative products such as warrants are a major
factor. Some funds leverage up to increase
exposure to high-beta assets. Beta is a
coefficient measuring a stock's relative
volatility, a covariance of a stock in relation to
the rest of the stock market. Capital preservation
strategies prefer low-beta stocks. High-beta
assets offer high returns for taking high risks.
Before finance globalization, if
short-term dollar interest rates were higher than
longer-term interest rates, a condition reflected
by an inverted yield curve, US Treasury bond
prices could not be boosted by carry trades
between currencies. Today, borrowing short-term
low-interest currency to invest in longer-term
debt in high-interest currencies, thus earning the
"carry", or interest rate spread, between the two
types of debt denominated in separate currencies
is routine. If short-term rates in the US are
prohibitively high, or higher than long-term
rates, then carry-traders can simply do most of
their borrowing overseas in a foreign currency.
Furthermore, if the 4% spread between short-term
Japanese interest rates and US T-bond yields is
not sufficiently rewarding, the return can be
boosted to 40% using routine 10:1 leverage.
More lucrative still, borrow in Japanese
yen to invest in Brazilian or Turkish bonds, using
various derivatives to hedge currency or credit
risk and pass it on to counter-parties at the cost
of a relatively small insurance premium. The
supply of "hot money", money that can be shifted
around rapidly in response to changes in expected
returns, now seems to be endless, because if
monetary conditions start to get tighter in one
part of the world, then the speculators can always
find a source of low-cost financing somewhere
else. And the Bank of Japan (BOJ), later joined by
the Federal Reserve, with their zero, near-zero,
or at least below-neutral interest rates, in
effect underwrite the whole process.
The
financial markets experienced minor shocks
recently when the BOJ soaked up a lot of liquidity
and hinted at the need to commence a rate-hike
program. The minor shocks in fact forced the BOJ
to back away from its planned monetary tightening
to keep the speculative frenzy going. This is the
reason the inversion of the US yield curve, which
normally mean liquidity is about to contract, has
not yet triggered a liquidity recession. A
liquidity boom will continue as long as a major
central bank with large foreign reserves, such as
the BOJ, continues to price short-term credit at
bargain-basement levels and leaves its borrowing
window open to all comers.
The People's
Bank of China also contributes to the global
liquidity boom by its willingness to continue to
buy long-term US T-bonds even if rates fall.
The US current-account deficit is the key
driver of the liquidity boom. Those who clamor for
a reduction of the US trade deficit are
unwittingly calling for a US recession.
When the ongoing meltdown in the subprime
mortgage market spreads to other parts of the
credit markets, the Federal Reserve will be forced
to implement a monetary ease. But a liquidity trap
will activate the dynamics of an inverted yield
curve, with long-term rates falling faster than
the Fed Funds Rate. When demand for bank reserves
decreases because of a general slump in loan
demand, then the Fed has to destroy bank
reserves to prevent a collapse of Fed Funds Rate
to zero.
Doomsday machine A
liquidity trap can be a serious problem because
the world is still plagued with excess liquidity
potential: massive foreign reserves held by
central banks, bulging petrodollars, hedge funds
and private-equity funds, massive increases in
global monetary base, $4 trillion in low-yielding
Chinese bank deposits ready for release for higher
yields, $5 trillion in low-yielding US time
deposits maturing, $10 trillion in low-yielding
Japanese financial net worth, plus $27 trillion in
medium-yielding US household financial net worth
waiting to be monetized for aggressive yields. A
global liquidity trap of with $50 trillion of idle
assets will implode like a doomsday machine.
An US dollar exchange rate is a measure of
the relative value of a foreign currency against
the dollar, not the intrinsic value of the dollar.
When the euro rises against the dollar, it is
possible that both currencies have fallen in
purchasing power, but the euro has merely fallen
less than the dollar. This is what drives the
liquidity boom that has been decoupled from the
real economy.
Henry C K Liu is
chairman of a New York-based private investment
group. His website is at www.henryckliu.com.
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