The Ephemeral Nature Of The Liquidity Myth

As I have often stressed, "ample liquidity" is just a polite, less anxiety-inducing term for "high debt." But liquidity also has another, more qualitative component. It is the willingness of market participants to borrow and "play" in large amounts, to place bets in big sums and thus create the environment where large transactions can be accomplished with little price volatility.

So, what I term "operative market liquidity" is a combination of the ability to easily and cheaply tap into debt capital and the willingness to do so. When both are present (as they are today) assets markets move higher regardless of fundamentals, geopolitical tensions or sunspots. Credit "ability" is influenced by monetary and credit policy and changes relatively slowly. "Willingness" is an ephemeral psychological condition that is heavily influenced by confidence, itself created by momentum; it can change in seconds.

As I said, both are needed to sustain bull markets - though not necessarily in equal amounts. For example, monetary policy may become more restrictive, but sentiment may be so overwhelming as to keep the game going until an adjustment comes, frequently in violent fashion. A perfect example is the 1999-2000 period in the US when the Fed was tightening, but the dotcom madness went on blithely. The Fed's higher rates were dismissed as "pushing on a string"; in the brave new world of venture capital finance, borrowing costs were deemed unimportant. Reality soon caught up. (Interestingly, there is a parallel today: high Fed interest rates are supposedly less important than ever before because credit derivatives caused spreads to narrow dramatically, keeping effective interest rates low.)

So, where are we now in the ability-willingness balance?

Unquestionably, "ability" is slowly being squeezed as US, EU and Chinese interest rates rise. The ECB just raised rates another 25 bp yesterday, bringing euro rates to 4.00%. Japan is still very loose and this largesse has shifted an enormous amount of borrowing to the yen (plus the Swiss franc, to a smaller extent). Increasingly, market leverage is dependent on BOJ's interest rate policy: one basket for an awful lot of global eggs, in my opinion. [For historical perspective, the yen-carry is analogous to the broker call money situation in the late 1920's, when even non-financial corporations invested their spare operating cash via this market because rates were higher and money could be "called" back with a day's notice, i.e. the money was "safe". This liquidity literally disappeared within minutes in October 1929.]

"Willingness" to borrow is still strong, as can be seen from record debt-financed M&A activity, NYSE margin outstanding and the bullish performance of equity markets. There are some cracks appearing, like the bursting of the real estate bubble which removed significant mortgage loan demand, but they are not big enough to induce speculator concern - so far.

In summary, Operative Market Liquidity is now more dependent on speculators' willingness to borrow, despite rising interest rates. The balance is tilting uncomfortably towards the more ephemeral, psychological side of the "ability-willingness" scale. There is a visible dis-equilibrium between the two (partly ameliorated by the cheap yen) that may be corrected suddenly and aggressively.

At one point, the liquidity that we are told is so abundant will simply evaporate. After all, it is now based mostly on evanescent sentiment, the ephemeral feeling that borrowed money can be applied to a range of assets. Liquidity has thus become a self-serving, self-perpetuating meta-reality: in other words, a myth.