Some notes on the source of global imbalances

 

 

Everybody speaks of excess liquidity in the financial markets, which as we know as led to an unprecedented boom in asset prices. Where does liquidity come from? If it comes from the US and Europe, then the period of excess liquidity will soon be over due to current policies. But if it comes from Asia, as we suspect, the bubble may get a lot worse – again due to current policies.

 

The first theory says that the Federal Reserve, and to a lesser extent the ECB, supplied the financial markets with excess liquidities by cutting short-term policy interest rates to 1% in the case of the Fed, and 2% in the case of the ECB. Long rates fell to below 4%, so our capital markets were swamped with cheap money for several years. Under this theory, this domestically generated cheap money is the driver of global imbalances (because it encourages excess consumption in the west). As policy rates, and long rates, are rising back towards levels that are more consistent with long-term inflation targets of around 2% in most advanced western economies, one would expect the party to come to an end at some point. There are a lot of worried people in the structured credit field who believe that we will see liquidity dry up at some stage this year, as the Fed Funds rate remains stubbornly at 5.25%, and as short-term rates continue to rise in Europe as well. As higher interest rates take their effect with a short time delay, that would suggest some trouble ahead in the autumn perhaps.

 

The second theory is more disturbing and more comforting at the same time – depending on how you look at it. This theory says that excess liquidity is driven by imbalances originating in Asia. We recently heard, for example, a senior European official express alarm about persistently low interest rates in Japan, which was driving a lot of hot Japanese money into Europe. Asian exchange rates are undervalued, but more importantly Asian interest rates are too low. The built-up of Asian foreign exchange reserves in excess of anything needed to preserve economic stability is a huge source of market liquidity.

 

These are two conflicting theories. We are not able to settle this issue at this stage.  Perhaps there is a combination of the two factors at work. Our own hunch, not more, is that the second theory is more pronounced, which means that liquidity will not suddenly dry up as a result of high US and European interest rates. In fact, euro area und UK short-term rates may edge up a little, but not a lot, and US rates have probably peaked. So we are not going to see an interest shock in any of our economies, and we do not believe that the lagged effect of previous rate increases is going to be dramatic (except for some regional turmoil, but that is another story).

 

The good news about the scenario is that there will probably be no correction in the near term. The bad news is that there will be no correction in the near term. It means that global imbalances continue to persist and strengthen, it means that China’s reserves will grow at maddening rates, it means that Japan will provide the world economy with further cheap liquidity, and all this means that the show will go on for a while, will get more extreme, before it bangs. Another Asia crisis will loom, very different this time, but still one with great systemic implications for the financial system. The structured credit market will grow and grow, and then implode.

 

US and European interest rates are in our view not the most important control variables in this scenario – which is yet another sign of the impact of financial globalisation. We remain deeply sceptical about current asset price valuations in the long-run. We think the spreads in credit markets are the result of a collective failure to price in risk correctly, but we have no way of telling when the long run arrives. Globalisation has not only change the game, but also our time horizons. The pessimists may be right, but they may not live long enough to see the day.

 

 

Eurointelligence ECB Watch

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