The investment climate continues to be characterized by high liquidity and low volatility, and there is little reason to expect a significant change in those conditions over the next several months.
That means current investment strategies — which favor pursuing returns over safety — are likely to persist, even after the late-February lurch in equity markets. The pendulum that swings between fear and greed should remain closer to the latter.
Many central banks have raised interest rates over the past nine months. Several key central banks, including the European Central Bank (ECB), the Bank of Japan (BOJ), the Bank of England (BOE), the Swiss National Bank (SNB), the Reserve Bank of New Zealand (RBNZ), and Norway’s central bank (Norgesbank) are all expected to raise rates again in the coming months. The central banks of Brazil and Indonesia stand out as notable exceptions.
However, the price of money is only one dimension of monetary policy; the other is quantity. And there are few signs that liquidity has been dampened. Money supply, as measured by M3, for example, is expanding significantly faster in the Eurozone now than it was when the ECB first began raising interest rates in December 2005. Broad money supply in the UK and the U.S. appear to be expanding faster than nominal GDP. Chinese and Indian money supply is also expanding rapidly.
Japan is the chief exception, but it is noteworthy that despite the sluggish growth in the country’s monetary base since its current account balances were normalized last year, bank lending remains positive.
Critics of this liquidity explanation point to the circular reasoning often surrounding it, or its elusive definition. Yet, the power of the thesis lies in its broad explanatory ability. It explains both the persistent yen weakness and the Swiss franc’s underperformance, and it also helps explain the persistent strength of high-yielding currencies, such as the New Zealand dollar (NZD), despite its large current account deficit, and the Brazilian real (BRL), despite daily intervention by the Brazilian central bank.
The liquidity hypothesis helps explain numerous other market developments outside the forex arena:
• A long and ustained bull market in global equities.
• Relatively low yields despite mature business cycles.
• Tight credit-quality spreads, including corporate and high-yield bonds over Treasuries.
• The ongoing appeal of emerging-market assets.
• Sustained low volatility across asset classes.
• A continued boom in mergers and acquisitions (M&A).
This conceptualization of liquidity also includes financial engineering. Various instruments, such as asset-backed securities, allow companies to extend the credit cycle independent from the central bank. Similarly, and especially in the U.S., the development of new mortgage products, such as those that allow buyers to pay interest on no principal, or the popularity of adjustable-rate mortgages, effectively extends the credit cycle for many households.
The high liquidity also sheds light on why prevailing prices do not seem to be accounting for risk properly according to the models of economists and policymakers. As whitewater rafters know, ample water hides the rocks and makes a calmer surface. So too, is the case with liquidity in the capital markets.
While the improvement of macroeconomic fundamentals in numerous emerging markets is undeniable, it is likely this improvement might account for a little more than half of the convergence in interest rates and a smaller portion of the increased correlation between emerging market indices, such as Brazil’s Bovespa and the U.S. S&P 500.
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