Friday, February 23, 2007

About Liquidity and Risk

All financial and asset markets depend on fresh money coming in to push them higher, i.e. ever increasing "liquidity". This has certainly been the case during the past few years, as the Fed cut rates to avoid a deflationary spiral in 2001-02 and the ECB and BOJ already had very low rates. After the US and the EU started raising rates, the global speculators' fraternity turned to the yen, the Swiss franc and the Chinese won, which kept on providing tanker-fulls of liquidity through a variety of carry trades and/or low inflation. Debt levels soared everywhere (that's what liquidity actually is, more debt).

But there are clear signs that the excess is now coming to an end. Consider:
  1. After the housing bubble burst and the sub-prime loan debacle, US lending practices are finally tightening. Short term rates are already pretty high.
  2. The ECB has been raising rates gradually and shows no sign of stopping any time soon.
  3. The BOE already has high rates and has shown it is not shy about raising them more, even unexpectedly, if need be.
  4. The BOJ has finally started raising rates as well, though most still think it is a reluctant "tightener". In my experience, when central banks start moving rates up (or down) they do not pause until...they stop.
  5. The Swiss National Bank has just announced it will start raising rates, too.
  6. The People's Bank of China has raised banks' reserve requirements to 10%, the fifth time it has done so in eight months.
Are speculators listening? Certainly not.

Stock markets are zooming from New York to Frankfurt to Tokyo and all points in between. Indexes in the US, Brazil, Mexico, China, all over Europe, Turkey...are all making new highs. But this a hyper-global event: markets are going vertical also in Iceland, Mauritius, Kenya, Namibia, Botswana, Ghana - even Zimbabwe, the very model of a failed economy (how very, very sad).

The reason is this: the global financial system is now ruled by hedge and private equity funds, plus an enormous array of structured finance products for retail consumption, instead of the traditional institutional and individual investors. Those funds are by design short-term, risk- loving speculators who are compensated as a percentage of gains but, very crucially, do not share in the losses. Such an arrangement constantly raises the risk exposure and leverage of the funds, as they seek to maintain high returns. This strategy was very profitable when their assets were relatively small, but now that they have taken over entire markets excess returns are mathematically impossible to achieve, despite ever more risk and leverage. The speculators are essentially trapped in their own momentum-play strategy, a merry-go-round that spins faster and faster as the riders grip the poles tighter and tighter, fearing lower returns if they let go.

The results have been:
  1. A massive collapse of risk premiums. This sounds benign, until you see it from the other direction: the assumption of more and more risk.
  2. A similar collapse in volatility. Some see it as apathy, but they are wrong: instead, everyone is looking over his shoulder, anxious to jump off the spinning Nickelodeon, but not wanting to be first off the gilded horsey (or Golden Piggy, given the Chinese New Year).
So what can happen to the Merry-Go-Rounders?

If you expect the riders to get off on their own you are new at this. Such situations always end thus: the operator finally slams on the brakes to protect his precious machine and the riders are thrown off violently, careening and crashing onto the hard pavement, some expiring on the spot, others breaking every bone they own.

I do have one more observation, related to my previous post (The Paulsen Put). If riders believe the operator is not going to stop the ride soon, or that he will do it nice and slow, then they believe in the Paulsen Put.

If, and this is the absolute worst scenario, the operator himself thinks "what the heck, let them have fun forever, they pay me by the turn" then we might as well be prepared to order a new carousel because the old one will soon be thimble-sticks.

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