Thursday, June 7, 2007

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.


  1. Hi Hellasious,

    I found it extremely difficult to understand the mechanisms behind the C-T, specifically the Yen-based one.

    The principle is OK. The profitability is obvious.

    But I am clearly failing to understand the practicalities. Who is handling the risk and is this risk paid the way it should be?

    I have the feeling that a significant part of the risk is unduly handled by the BoJ aka Japan itself? Am I wrong?


  2. The risk is being assumed by those who borrow yen, sell it in the spot FX market for dollars, euros, or whichever other currency they prefer, and proceed to buy stocks, bonds, real estate, etc. denominated in the currency of their choice.

    Japan does not assume any direct risk; however, if the carry positions are reversed suddenly, the yen may appreciate very fast, endangering Japanese exports.

    In my opinion, the higher return available right now is too small compared with the yen FX risk.


  3. Let's say I borrow Yen at .5% and buy USD. I deposit the USD in risk-free T-bill and earn 5%. To hedge my risk, I want enter into a forward currency contract that allows me to sell my Yen and buy USD in one year. If I could find a counter party that would allow me to convert my USD to Yen at todays rates I have risk free return of 4.5%. In other words, a free lunch.

    It's obvious then that any counter-party I could find is going to give me less Yen for each USD in a year than I could get today. In other words, the futures market would predict that a currency would depreciate at the difference between the risk free rate of the two currencies.

    In practice, lower yielding currencies tend to depreciate against higher yielding currencies. This is the basis of the carry trade. Economists call this the "forward premium puzzle."

    There are a lot of scholarly papers that attempt to explain the forward premium puzzle.

    One explanation is that countries with lower yielding currencies tend to have populations with a lower marginal propensity to consume. Meaning they tend to spend less and save more. Buying a lower yielding currency (a reverse carry-trade) then becomes a hedge against your populations reckless ways.