Liquidity tide could be about to turn

Liquidity is often seem as the key driver of todays markets. And its loss the biggest risk to their continued strength. But what us behind this liquidity, and is there a danger it could evaporate?

When asked what is driving markets today, most strategists point to liquidity: too much money chasing too few assets. The empirical evidence is compelling as virtually all markets have risen – be they equities, property, gold or oil – an indication that there is a common factor lifting all boats.

Going on from this, strategists then naturally highlight a loss of liquidity as the biggest risk to financial markets. Any loss of liquidity would result in a significant setback for risk assets. So are we at a turning point in the liquidity cycle, or can we expect more of the same, with risk trades outperforming?

Before describing our views, we would note that one difficulty with this area is that no one has pinned down the appropriate measure of liquidity for financial markets. What follows is our preferred approach, which we believe captures important elements of the drivers of liquidity today.

We see the main driver of liquidity as the low level of interest rates in the major economies combined with a growing appetite for risk. The latter is important as low interest rates alone cannot drive markets. Low rates can be a sign of weakness, as Japan demonstrated during the 1990s, a period when cautious investors kept their money in cash.

However, once investors regain confidence in the outlook for activity, their expected rate of return rises well above that on cash, and so they set out along the risk curve. The result is the outperformance of risky assets and a compression in bond spreads.

From this perspective, a simple way of gauging the incentive to take risk is to compare the level of cash rates with nominal GDP growth. The latter can be seen as a proxy for the return available from investing in real assets, with the gap between this and cash being the incentive to take risk.

Having moved together for much of the 1990s, interest rates fell well below nominal GDP growth for the G7 economies in 2001 as central banks eased monetary policy (see chart below, top).

On our calculations, G7 rates bottomed out in 2003 and the tightening of global monetary policy began with America’s Federal Reserve raising rates in 2004. Some 15 rate moves later, and with the European Central Bank and Bank of Canada now also tightening, G7 rates are at their highest level for five years. However, while this has caused fears of a major liquidity squeeze, the recovery in global growth has meant that the gap between cash and nominal GDP remains substantial, indicating an ongoing incentive to keep moving money into the markets.

Going forward, the gap is likely to narrow further – so putting pressure on liquidity – but only slowly. In our view, the Fed is close to being done. One, or possibly two, more moves and rates will go on hold. Further tightening will come from the ECB and the Bank of Japan, but fear of derailing the recovery in their economies means that they will move cautiously. As long as growth remains steady and the world economy avoids a significant downturn, this suggests that the liquidity squeeze will be mild.

But while a sudden loss of liquidity will probably not be the trigger that brings the bull market to a halt, drilling down a little further reveals that there are important shifts under way in global capital flows that will impact markets.

For some time, Asian central banks have been one of the main providers of liquidity to the US Treasury bond market. The desire to prevent their currencies appreciating against the dollar has led to the accumulation of massive foreign exchange reserves, which are mostly held in the US Treasury market and are widely believed to have depressed bond yields.

More recently, the rate of accumulation of reserves by Asian central banks has slowed, probably reflecting a growing recognition that such intervention is ultimately futile (see chart left). China continues to intervene significantly, but pressure from American politicians for a greater revaluation of the remnimbi means that we may be in the end-game for intervention. We believe that a slower rate of foreign exchange intervention has been a factor behind the rise in America and global bond yields since September and the unwinding of the “Greenspan conundrum”, where long yields had failed to respond to rising short rates.

As Asian central bank liquidity weakens, another source of liquidity remains robust. The strong and sustained upturn in profits, combined with a cautious approach to capital spending, means that the corporate sector continues to run a significant cash surplus. Initially this was used to improve balance sheets, but today it is supporting increased merger and acquisitions activity and higher payments to shareholders through dividends and buybacks.

The point is that the source of liquidity is changing: it is moving away from flows into the American bond market and towards equity markets. The shareholder is now the main beneficiary of liquidity flows.