The Mysterious Case of Massive Liquidity
“Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.”
— Sherlock Holmes, The Adventure of the Abbey Grange (1904)
Professionals in the markets are more suggestible than a layman might imagine. Try as we might, we can never know the one thing we really want to know—that is, the future. Not knowing, we compare notes with others. Most are brave together at the tops and meek together at the bottoms.
As we finished 2006, the general consensus was that the latter half was spurred by a wave of global liquidity with U.S. and European stock markets gaining double-digit returns, and the emerging markets doing even better. Alongside the liquidity came a remarkable fall in volatility with the CBOE’s VIX index (known as the “fear gauge”) falling to 13-year lows in November and December.
All was rosy as strategists at twelve of the biggest Wall Street firms agreeing that U.S. stocks will rally in 2007. With everybody lining up in the bull camp, however, Davide and I are a little nervous about the market’s complacency—ironically the last year Wall Street strategists were this rosy was in 2001 when the S&P 500 Index dropped 13%.
Assuming that Bernanke has maneuvered us into a “soft-landing” and we are in a “goldilocks” economic environment, what could go wrong?
Based on last year’s actions by Goldman Sachs when they poached Lachlan Edwards, one of Europe’s financial restructuring gurus, the “smart money” is gearing up for a credit crunch—that is, a reversal of the liquidity tide that investors find themselves floating on. History shows that when mass scale restructurings occur, they tend to do so very rapidly like tsunamis—often triggered by an unexpected economic downturn or political shock.
Our main job as money managers is risk management. Looking forward we try to best assess where potential risks may come from. If the concern is about liquidity and the credit markets, then we need to understand how this sanguine market environment came about.
Monetarists such as Milton Friedman, who recently passed away at age 94, believed that “money supply” was the key to the ups and downs in the economy. Further, he thought that the Fed's sole job was to "expand the money supply in a steady manner by 3% per year."
The Greenspan legacy, however, is for the Fed to intervene in the markets strategically during times of financial crisis. He first did so early in his career back in 1987 when the Fed added heavy doses of liquidity to arrest the stock market crash. Then there was the expansion of money supply in the weeks leading up to the end of the 20th century when the so-called Y2K computer bug was expected to disrupt financial systems. Lastly, in response to the 2001 recession Greenspan lowered overnight rates to a 1958 low of 1 percent resulting in record mortgage refinancings that minimized the recession. Intervention, rather than being a brief rescue effort, seems to have become a permanent policy.
Another wave of stimulus came from the 2001 and 2003 “Bush tax cuts.” There are two ways in which tax cuts can stimulate growth—in the near term by generating extra demand, and in the long run by encouraging increased supply, labor or capital. Add to this the 108th and 109th Congress gone-amuck earmark spending as well as the increased military budget to finance two wars (the Iraq war now is estimated to have cost $350bn so far and is still costing $7bn a month), and the combination of monetary and fiscal stimulus in the first half of this decade set the stage for a tidal wave of liquidity.
The overhang of fear resulting from the 2001-2002 bear market also contributed to the current environment as money gravitated from the stock market into “safe assets” such as government and agency bonds. This in turn drove down interest rates on the long end of the yield curve which further lowered borrowing costs, and functioned to help corporations get their balance sheets in order as well as support real estate prices upwards through the 2001 recession.
Effectively, lower interest rates led to a boom in home buying which caused real estate prices to double and triple in some locations. One result was owners taking advantage of their increased home values in the form of mortgage equity loans. The impact was not insignificant on the economy. According to Calculated Risk, GDP as reported for the last six years has appreciably improved as a direct result of home equity withdrawals, a trend that first began in 2001. The process of incurring debt collateralized by an inflated asset is similar to margining a securities brokerage account as stock prices go up, the result is additional liquidity and leverage.
Because of inflated home valuations the use of exotic mortgage products such as ARMs, I/Os, etc. increased from very limited usage to approximately 50 percent of the mortgages used to finance homes in California. The seriousness of the potential fallout is not lost on the Federal Reserve Board and the Office of Thrift Supervision who recently came out with warnings regarding "payment shock," essentially “margin calls,” associated with sharp upward adjustments of a loan's interest rate after initial low-rate discount periods on exotic mortgage products. Such payment shocks are expected to increase substantially in 2007 and 2008.
In addition, the Center for Responsible Lending just published a report suggesting that 2.2m American households could lose their homes and as much as $164bn due to foreclosures in the ‘subprime’ mortgage market. To put this report into historical perspective, at the peak of the credit boom in the 1930s, home mortgage loans were offered without the usual documentation, a practice that in the last few years has again become enormously popular through so-called “stated income,” “low-doc” or “no-doc” loans. Stated income loans, originally conceived to improve access to prime credit for self-employed people with irregular income, has spread like a virus down through the lending industry, where it is a virtual invitation to fraud.
Credit fraud is a liquidity multiplier. The link between fraud and liquidity is documented by several white papers in relation to international banking. A paper written by Dr. Wimboh Stantoso, Senior Researcher at the Directorate of Banking Research and Regulation Bank Indonesia, points out that the 1998 Pacific Rim currency crisis resulted in the Indonesian government revoking permits on 16 private national banks whose “sources of problems for those banks were mainly illiquidity and insolvency as a result of credit defaults, fraud and liquidity mismatches.” Another paper by Jean-Claude Berthelemy on “Financial Reforms and Financial Development in Arab Countries” writes about non performing loan (NPLs) and “cases of fraud and liquidity problems faced by the banking sector” in regards to bad debt with a delay of servicing over one year.
The topic of NPLs brings us overseas to the shores of China. China is dealing with a mountain of bad loans—how much is the question. In May 2006 Ernst & Young reported that NPL exposure for China was estimated at US$911bn, but subsequently withdrew the report. According to the China Banking Regulatory Commission, as of the end of the third quarter of 2006, the total number of NPLs in China’s commercial banks was approximately US$160bn. However, this amount does not include NPLs that are presently held by foreign investors such as hedge funds that have been on a buying binge in Chinese distressed debt. Based on the 1999 transfers that investors have resolved, the implication is that E&Y’s NPL estimate is not miscalculated. The main inference, however, is that these NPLs represent a significant liquidity multiplier and risk.
China’s economy, in the meantime, is on track to grow by more than 10 percent for the third year in a row. In November 2006 China reported that its foreign currency reserves, the world’s largest, had exceeded $1,000bn for the first time. China has effectively outsourced its monetary policy to the U.S. resulting in talk of pressure from the incoming Democratic Congress in the form of “currency manipulation anti-subsidy laws” to persuade China’s government to revalue its currency. Even Fed Chairman Bernanke stepped into the fray with his remarks branding China’s undervalued currency an “effective subsidy” for exporters that was distorting trade. At the same time, China’s monetary policy committee complained that the main responsibility for this imbalance lies with the U.S. Treasury printing too much money. The upshot is that a fundamental change in reserve allocation/diversification away from the dollar is taking place and not just with China.
The subject of dollar imbalances brings us to the so-called Japan carry-trade. With the Bank of Japan keeping rates pegged to a measly 0.25 percent, this bubble has been ballooning in which people borrow cheaply in yen and then invest in higher-yielding assets abroad. The economic effect is again similar to leveraging your brokerage account with margin, except that this is taking place on a global scale with hedge funds leading the way. Concern is that a sudden flowback of yen, such as what happened in 1998 when the yen went from Y140 to the dollar to Y110 in just two days, could trigger financial chaos as far abroad as Iceland and India. Even the U.S. is not immune as some market participants blame the limited unwinding of the carry-trade that occurred in April 2006 as initiating the sharp decline in the stock market in May 2006.
Another liquidity multiplier is all the petrodollars that have been created with oil prices rising from the $20-$30 range to $78 dollars as of August 2006. Last year will be remembered in the Middle East for Iraq’s tragic slide into sectarian conflict and Israel’s miscalculated? war in Lebanon. Less noticed, though no less dramatic, has been the oil-fuelled economic boom in the Gulf and a surge in financial liquidity that has been transforming the face of the region. Oil wealth translates into political advantage on the world stage as petrodollars are deployed and recycled in the local region and abroad. The key question is whether oil producers can turn this boon into a lasting opportunity and create more robust economies that can sustain themselves through periods of low oil prices. Referring once again to reserve diversification, Russia and Opec have reduced their exposure to the dollar and shifted oil income into euros, yen and sterling.
But more interestingly has been the proliferation in the issuance of “sukuk” or “Islamic bonds.” Usury in Islam is prohibited, but banks today are adopting methods to get around this by combining Islamically permissible contracts to produce what is effectively interest-bearing loans. The effective result is not only the leveraging of petrodollars, but the evolution of an Islamic monetary system similar to modern Western banking system which had historically evolved from the practices of European goldsmiths in the 17th century. Back then, the receipts issued and backed by deposits of gold coins on deposit for safekeeping with goldsmiths transformed these merchants into money-lenders who manufactured “bank money” on such receipts, giving rise to the concept of money supply.
Money supply creation is no longer something constrained to banks, but now something that is easily produced between two parties through derivatives trading. When Greenspan took over the Federal Reserve Bank much attention was focused on gauges of money supply defined as M-1, M-2 and M-3. Disregarding the debate on the importance money supply as a reliable measure and indicator of future inflation, a new type of money supply which I've coined “M-0” has increased explosively alongside the growth of derivatives since the early 1990s. "M-0" is the “notional” valuation associated with a derivatives contract; that is, for example, the difference between the $250,000 nominal face value of an S&P futures contract and the $25,000 actual cash required to trade the instrument. The definition of financial leverage is liquidity magnified. Derivatives, while very effective as a risk diversifier, also has had the effect of leveraging asset values throughout the economic system.
And round and round it goes—the examples of liquidity expanding throughout our global monetary system are nearly endless. Many would argue this is all good and point to how robust the world economic landscape has been in the last few years as globablization has spread. And on an encouraging note, the World Bank recently hypothesized in a report that if growth around the world continues at about its current pace, by 2030 the number of middle-class people living in developing nations will triple to 1.2 billion.
However, the problem with liquidity is that it is like an addictive drug—initially it produces euphoria which then disappears with increasing tolerance. Once an economy is hooked it needs more and more in order to sustain itself and withdrawal can be difficult.
Key to the creation of liquidity is credit. “Credit” is a financial term with a moral lineage. Its first meaning is “debt.” John Locke once wrote “Credit is nothing but the expectation of money, within some limited time.” To credit is to believe, and to lend money it is necessary to trust someone. Yet, financial history is rife with periods when prolonged prosperity wore down the skepticism of creditors only to result in eras of economic hardships.
The riddle is whether the central banks have succeeded in breaking the cycle, not the inflationary cycle which in fact it has enthusiastically subsidized, but the deflationary cycle. Has the sheer bulk of global liquidity forestalled the kind of contraction that paralyzed business activity in the depression and demoralized speculative activity for a generation after that?
I started out this piece by asking what could go wrong…
Sudden economic downturns are typically instigated by event risks from unexpected places. Looking at the tea leaves we’ve identified several areas of concern:
The price of oil this past week has dropped to $55. A further implosion in the price of oil would undermine a major source of revenue for countries who produce this commodity. The recent windfall has allowed such nations to build foreign reserves and improve the quality of their debt resulting in lower interest rates and helping drive an infrastructure investment binge. This could unwind if investors begin to pull money from emerging equity and debt markets resulting in an increase in interest rates. In this scenario, the combination of reduced oil revenue and higher interest rates would cause infrastructure projects to grind to a halt triggering a global recession.
Another area of concern is geopolitical risk where mismanagement of monetary and fiscal policies spreads to other markets. For example, the Asian financial crisis of 1997-98 began in Thailand with the devaluation of the baht. Recently Thailand’s newly minted military government stumbled badly by imposing capital controls. Such controls demonstrate a poor grasp of such action’s consequences. In a world where China, Japan, Taiwan, South Korea, Russia and Singapore control two-thirds of the world’s reserves, we find ourselves exposed to these nation’s monetary or fiscal policies. Who knows where its starts: a miscalculation by China’s central bank in its efforts to manage excess liquidity could trigger a global recession, or the Bank for International Settlement’s Basle II standards forcing new hedge fund investment rules in Japan may trigger widespread redemptions there and an unwinding of the carry trade.
A third concern is that the U.S. economy will in fact grow as expected, but the markets come to realize that growth rate is in fact not so great. Analysts close to the Fed believe most policymakers now see U.S. potential growth as being between 2.5-3 percent, a decline from the 3-3.25 percent range commonly cited a few years ago. Many private sector analysts interpret a decline in productivity growth as likely to put upward pressure on inflation and interest rates. Given that the U.S. stock market is “fairly valued” at earnings ratios based on record productivity levels, if corporate earnings cool off the stock market could begin to melt down. Add to this an economy fueled by leveraged loans and looser lending standards, S&P warns that a sudden change in appetite from investors could force banks to absorb large leverage loans on to their own balance sheets. This in turn could cause a re-pricing of credit risk resulting in higher interest rates causing the economy to spiral downward.
Then again, perhaps given the enormous attention to the riddle of liquidity in the financial press, this is all but a tempest in a teapot—economists can’t seem to agree whether there’s too much or too little. As so eloquently said by Sherlock Holmes, “My dear Watson, there we come into those realms of conjecture where the most logical mind may be at fault.”
- Mack Frankfurter, Managing Director
— Sherlock Holmes, The Adventure of the Abbey Grange (1904)
Professionals in the markets are more suggestible than a layman might imagine. Try as we might, we can never know the one thing we really want to know—that is, the future. Not knowing, we compare notes with others. Most are brave together at the tops and meek together at the bottoms.
As we finished 2006, the general consensus was that the latter half was spurred by a wave of global liquidity with U.S. and European stock markets gaining double-digit returns, and the emerging markets doing even better. Alongside the liquidity came a remarkable fall in volatility with the CBOE’s VIX index (known as the “fear gauge”) falling to 13-year lows in November and December.
All was rosy as strategists at twelve of the biggest Wall Street firms agreeing that U.S. stocks will rally in 2007. With everybody lining up in the bull camp, however, Davide and I are a little nervous about the market’s complacency—ironically the last year Wall Street strategists were this rosy was in 2001 when the S&P 500 Index dropped 13%.
Assuming that Bernanke has maneuvered us into a “soft-landing” and we are in a “goldilocks” economic environment, what could go wrong?
Based on last year’s actions by Goldman Sachs when they poached Lachlan Edwards, one of Europe’s financial restructuring gurus, the “smart money” is gearing up for a credit crunch—that is, a reversal of the liquidity tide that investors find themselves floating on. History shows that when mass scale restructurings occur, they tend to do so very rapidly like tsunamis—often triggered by an unexpected economic downturn or political shock.
Our main job as money managers is risk management. Looking forward we try to best assess where potential risks may come from. If the concern is about liquidity and the credit markets, then we need to understand how this sanguine market environment came about.
Monetarists such as Milton Friedman, who recently passed away at age 94, believed that “money supply” was the key to the ups and downs in the economy. Further, he thought that the Fed's sole job was to "expand the money supply in a steady manner by 3% per year."
The Greenspan legacy, however, is for the Fed to intervene in the markets strategically during times of financial crisis. He first did so early in his career back in 1987 when the Fed added heavy doses of liquidity to arrest the stock market crash. Then there was the expansion of money supply in the weeks leading up to the end of the 20th century when the so-called Y2K computer bug was expected to disrupt financial systems. Lastly, in response to the 2001 recession Greenspan lowered overnight rates to a 1958 low of 1 percent resulting in record mortgage refinancings that minimized the recession. Intervention, rather than being a brief rescue effort, seems to have become a permanent policy.
Another wave of stimulus came from the 2001 and 2003 “Bush tax cuts.” There are two ways in which tax cuts can stimulate growth—in the near term by generating extra demand, and in the long run by encouraging increased supply, labor or capital. Add to this the 108th and 109th Congress gone-amuck earmark spending as well as the increased military budget to finance two wars (the Iraq war now is estimated to have cost $350bn so far and is still costing $7bn a month), and the combination of monetary and fiscal stimulus in the first half of this decade set the stage for a tidal wave of liquidity.
The overhang of fear resulting from the 2001-2002 bear market also contributed to the current environment as money gravitated from the stock market into “safe assets” such as government and agency bonds. This in turn drove down interest rates on the long end of the yield curve which further lowered borrowing costs, and functioned to help corporations get their balance sheets in order as well as support real estate prices upwards through the 2001 recession.
Effectively, lower interest rates led to a boom in home buying which caused real estate prices to double and triple in some locations. One result was owners taking advantage of their increased home values in the form of mortgage equity loans. The impact was not insignificant on the economy. According to Calculated Risk, GDP as reported for the last six years has appreciably improved as a direct result of home equity withdrawals, a trend that first began in 2001. The process of incurring debt collateralized by an inflated asset is similar to margining a securities brokerage account as stock prices go up, the result is additional liquidity and leverage.
Because of inflated home valuations the use of exotic mortgage products such as ARMs, I/Os, etc. increased from very limited usage to approximately 50 percent of the mortgages used to finance homes in California. The seriousness of the potential fallout is not lost on the Federal Reserve Board and the Office of Thrift Supervision who recently came out with warnings regarding "payment shock," essentially “margin calls,” associated with sharp upward adjustments of a loan's interest rate after initial low-rate discount periods on exotic mortgage products. Such payment shocks are expected to increase substantially in 2007 and 2008.
In addition, the Center for Responsible Lending just published a report suggesting that 2.2m American households could lose their homes and as much as $164bn due to foreclosures in the ‘subprime’ mortgage market. To put this report into historical perspective, at the peak of the credit boom in the 1930s, home mortgage loans were offered without the usual documentation, a practice that in the last few years has again become enormously popular through so-called “stated income,” “low-doc” or “no-doc” loans. Stated income loans, originally conceived to improve access to prime credit for self-employed people with irregular income, has spread like a virus down through the lending industry, where it is a virtual invitation to fraud.
Credit fraud is a liquidity multiplier. The link between fraud and liquidity is documented by several white papers in relation to international banking. A paper written by Dr. Wimboh Stantoso, Senior Researcher at the Directorate of Banking Research and Regulation Bank Indonesia, points out that the 1998 Pacific Rim currency crisis resulted in the Indonesian government revoking permits on 16 private national banks whose “sources of problems for those banks were mainly illiquidity and insolvency as a result of credit defaults, fraud and liquidity mismatches.” Another paper by Jean-Claude Berthelemy on “Financial Reforms and Financial Development in Arab Countries” writes about non performing loan (NPLs) and “cases of fraud and liquidity problems faced by the banking sector” in regards to bad debt with a delay of servicing over one year.
The topic of NPLs brings us overseas to the shores of China. China is dealing with a mountain of bad loans—how much is the question. In May 2006 Ernst & Young reported that NPL exposure for China was estimated at US$911bn, but subsequently withdrew the report. According to the China Banking Regulatory Commission, as of the end of the third quarter of 2006, the total number of NPLs in China’s commercial banks was approximately US$160bn. However, this amount does not include NPLs that are presently held by foreign investors such as hedge funds that have been on a buying binge in Chinese distressed debt. Based on the 1999 transfers that investors have resolved, the implication is that E&Y’s NPL estimate is not miscalculated. The main inference, however, is that these NPLs represent a significant liquidity multiplier and risk.
China’s economy, in the meantime, is on track to grow by more than 10 percent for the third year in a row. In November 2006 China reported that its foreign currency reserves, the world’s largest, had exceeded $1,000bn for the first time. China has effectively outsourced its monetary policy to the U.S. resulting in talk of pressure from the incoming Democratic Congress in the form of “currency manipulation anti-subsidy laws” to persuade China’s government to revalue its currency. Even Fed Chairman Bernanke stepped into the fray with his remarks branding China’s undervalued currency an “effective subsidy” for exporters that was distorting trade. At the same time, China’s monetary policy committee complained that the main responsibility for this imbalance lies with the U.S. Treasury printing too much money. The upshot is that a fundamental change in reserve allocation/diversification away from the dollar is taking place and not just with China.
The subject of dollar imbalances brings us to the so-called Japan carry-trade. With the Bank of Japan keeping rates pegged to a measly 0.25 percent, this bubble has been ballooning in which people borrow cheaply in yen and then invest in higher-yielding assets abroad. The economic effect is again similar to leveraging your brokerage account with margin, except that this is taking place on a global scale with hedge funds leading the way. Concern is that a sudden flowback of yen, such as what happened in 1998 when the yen went from Y140 to the dollar to Y110 in just two days, could trigger financial chaos as far abroad as Iceland and India. Even the U.S. is not immune as some market participants blame the limited unwinding of the carry-trade that occurred in April 2006 as initiating the sharp decline in the stock market in May 2006.
Another liquidity multiplier is all the petrodollars that have been created with oil prices rising from the $20-$30 range to $78 dollars as of August 2006. Last year will be remembered in the Middle East for Iraq’s tragic slide into sectarian conflict and Israel’s miscalculated? war in Lebanon. Less noticed, though no less dramatic, has been the oil-fuelled economic boom in the Gulf and a surge in financial liquidity that has been transforming the face of the region. Oil wealth translates into political advantage on the world stage as petrodollars are deployed and recycled in the local region and abroad. The key question is whether oil producers can turn this boon into a lasting opportunity and create more robust economies that can sustain themselves through periods of low oil prices. Referring once again to reserve diversification, Russia and Opec have reduced their exposure to the dollar and shifted oil income into euros, yen and sterling.
But more interestingly has been the proliferation in the issuance of “sukuk” or “Islamic bonds.” Usury in Islam is prohibited, but banks today are adopting methods to get around this by combining Islamically permissible contracts to produce what is effectively interest-bearing loans. The effective result is not only the leveraging of petrodollars, but the evolution of an Islamic monetary system similar to modern Western banking system which had historically evolved from the practices of European goldsmiths in the 17th century. Back then, the receipts issued and backed by deposits of gold coins on deposit for safekeeping with goldsmiths transformed these merchants into money-lenders who manufactured “bank money” on such receipts, giving rise to the concept of money supply.
Money supply creation is no longer something constrained to banks, but now something that is easily produced between two parties through derivatives trading. When Greenspan took over the Federal Reserve Bank much attention was focused on gauges of money supply defined as M-1, M-2 and M-3. Disregarding the debate on the importance money supply as a reliable measure and indicator of future inflation, a new type of money supply which I've coined “M-0” has increased explosively alongside the growth of derivatives since the early 1990s. "M-0" is the “notional” valuation associated with a derivatives contract; that is, for example, the difference between the $250,000 nominal face value of an S&P futures contract and the $25,000 actual cash required to trade the instrument. The definition of financial leverage is liquidity magnified. Derivatives, while very effective as a risk diversifier, also has had the effect of leveraging asset values throughout the economic system.
And round and round it goes—the examples of liquidity expanding throughout our global monetary system are nearly endless. Many would argue this is all good and point to how robust the world economic landscape has been in the last few years as globablization has spread. And on an encouraging note, the World Bank recently hypothesized in a report that if growth around the world continues at about its current pace, by 2030 the number of middle-class people living in developing nations will triple to 1.2 billion.
However, the problem with liquidity is that it is like an addictive drug—initially it produces euphoria which then disappears with increasing tolerance. Once an economy is hooked it needs more and more in order to sustain itself and withdrawal can be difficult.
Key to the creation of liquidity is credit. “Credit” is a financial term with a moral lineage. Its first meaning is “debt.” John Locke once wrote “Credit is nothing but the expectation of money, within some limited time.” To credit is to believe, and to lend money it is necessary to trust someone. Yet, financial history is rife with periods when prolonged prosperity wore down the skepticism of creditors only to result in eras of economic hardships.
The riddle is whether the central banks have succeeded in breaking the cycle, not the inflationary cycle which in fact it has enthusiastically subsidized, but the deflationary cycle. Has the sheer bulk of global liquidity forestalled the kind of contraction that paralyzed business activity in the depression and demoralized speculative activity for a generation after that?
I started out this piece by asking what could go wrong…
Sudden economic downturns are typically instigated by event risks from unexpected places. Looking at the tea leaves we’ve identified several areas of concern:
The price of oil this past week has dropped to $55. A further implosion in the price of oil would undermine a major source of revenue for countries who produce this commodity. The recent windfall has allowed such nations to build foreign reserves and improve the quality of their debt resulting in lower interest rates and helping drive an infrastructure investment binge. This could unwind if investors begin to pull money from emerging equity and debt markets resulting in an increase in interest rates. In this scenario, the combination of reduced oil revenue and higher interest rates would cause infrastructure projects to grind to a halt triggering a global recession.
Another area of concern is geopolitical risk where mismanagement of monetary and fiscal policies spreads to other markets. For example, the Asian financial crisis of 1997-98 began in Thailand with the devaluation of the baht. Recently Thailand’s newly minted military government stumbled badly by imposing capital controls. Such controls demonstrate a poor grasp of such action’s consequences. In a world where China, Japan, Taiwan, South Korea, Russia and Singapore control two-thirds of the world’s reserves, we find ourselves exposed to these nation’s monetary or fiscal policies. Who knows where its starts: a miscalculation by China’s central bank in its efforts to manage excess liquidity could trigger a global recession, or the Bank for International Settlement’s Basle II standards forcing new hedge fund investment rules in Japan may trigger widespread redemptions there and an unwinding of the carry trade.
A third concern is that the U.S. economy will in fact grow as expected, but the markets come to realize that growth rate is in fact not so great. Analysts close to the Fed believe most policymakers now see U.S. potential growth as being between 2.5-3 percent, a decline from the 3-3.25 percent range commonly cited a few years ago. Many private sector analysts interpret a decline in productivity growth as likely to put upward pressure on inflation and interest rates. Given that the U.S. stock market is “fairly valued” at earnings ratios based on record productivity levels, if corporate earnings cool off the stock market could begin to melt down. Add to this an economy fueled by leveraged loans and looser lending standards, S&P warns that a sudden change in appetite from investors could force banks to absorb large leverage loans on to their own balance sheets. This in turn could cause a re-pricing of credit risk resulting in higher interest rates causing the economy to spiral downward.
Then again, perhaps given the enormous attention to the riddle of liquidity in the financial press, this is all but a tempest in a teapot—economists can’t seem to agree whether there’s too much or too little. As so eloquently said by Sherlock Holmes, “My dear Watson, there we come into those realms of conjecture where the most logical mind may be at fault.”
- Mack Frankfurter, Managing Director
posted by Cervino Capital Management LLC at 1/09/2007
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