Saturday, May 30, 2009
The Global Liquidity Cycle Revisited
May 29, 2009 By Joachim Fels & Manoj Pradhan London Reality check: One of our key macro themes for 2009 has been the emergence of a new global liquidity cycle powered by massive monetary stimulus, which should help to support asset markets, end the recession and prevent lasting deflation (see "A New Global Liquidity Cycle", The Global Monetary Analyst, January 14, 2009). A little more than four months later, it is time to review the evidence that has accumulated since then and discuss whether the theme is likely to have staying power for 2H09. In short, our conclusion is - yes, it is. Excess liquidity surges to a new record-high... Back in January, the available data indicated that the new liquidity cycle was only in its infancy. Our favourite metric for excess liquidity - the ratio of money supply M1 to nominal GDP (a.k.a. the ‘Marshallian K') - had only started to tick up slightly for the G5 advanced economies (the US, euro area, Japan, Canada and UK) and was still declining for the BRICs aggregate. Now, our updated metrics, which include data up to March 2009, confirm that a powerful liquidity cycle is underway, with excess liquidity surging to a new record-high both in the advanced and the emerging economies. Thus, the jump in excess liquidity over the past two quarters has more than fully reversed the preceding decline in excess liquidity, which had foreshadowed the credit crisis. ...and further increases are likely in the coming quarters: The surge in excess liquidity reflects both rapid M1 growth in response to monetary easing, and the outsized declines in GDP in most economies over the past couple of quarters (recall that the growth rate of excess liquidity equals the growth rate of M1 minus the growth rate of nominal GDP). Looking ahead, further growth in excess liquidity appears likely, though probably at a slower pace. We expect M1 growth to remain strong or even accelerate further, reflecting the active quantitative easing in the US, UK, Japan and euro area that is underway and still has further to go. At the same time, we expect global GDP to bottom out soon, so that the real economy will start to ‘absorb' some of the additional money that central banks are printing. Yet, further growth in excess liquidity appears likely in the foreseeable future as central banks are far from done with quantitative easing, and we deem a V-shaped economic recovery to be unlikely. Asset markets supported: We have argued repeatedly over the years that the ups and downs in excess liquidity have been key drivers of past asset booms and busts. The bond market rally of the early 1990s was led by a build-up of excess liquidity and gave way to a bear market for bonds in 1994 as excess liquidity evaporated. The equity bull market of the late 1990s was also accompanied by a build-up of excess liquidity, culminating in the dotcom bubble which burst early this decade as excess liquidity turned down. The mother of all credit and housing bubbles was also fuelled by the surge in excess liquidity that started in 2002, just as the downturn in excess liquidity in the G5 from 2006 onwards and in the BRICs from mid-2007 foreshadowed the crisis of 2007/08. This time around, it doesn't seem to be any different. Risky assets such as equities, credit and commodities have rallied over the past few months as excess liquidity has surged. The ‘wall of money' has dominated the (justified) concerns about the outlook for corporate earnings and the implications of deleveraging in the financial sector and the private household sector. Whether the rally in risky assets can continue remains to be seen - our European and US equity strategists are cautious and our EM equity strategist Jonathan Garner has become less bullish recently. In any case, our analysis suggests that there is plenty of liquidity around - and more coming - to support asset prices. Global bottoming is near: Also, our view expressed in January that the massive liquidity injections by central banks would find traction and help to end the recession in the course of this year appears to be on track. Most economic indicators suggest that the global economy will bottom out soon, though we continue to think that any recovery during 2H09 will be rather anaemic. While the bank lending channel remains impaired, easy monetary policy has been affecting the global economy through several other channels, including asset markets, inflation expectations and cross-border money flows into countries pegging to the dollar, such as China (for more detail on these channels, see "Money Talks", The Global Monetary Analyst, May 6, 2009). Deflation fears dispelled: Finally, decisive monetary action has in fact helped to dispel the fears of lasting deflation that were so widespread around the turn of the year. Market-based measures of inflation expectations have increased significantly from very low levels back to more normal levels over the past several months. In our view, however, inflation expectations still look too low and could move substantially higher once markets start to focus more on the potential implications of the monetisation of government debt that is currently underway. Sure, hyperinflation is a tail event, but one that cannot be dismissed lightly against the backdrop of massive central banks' balance sheet expansion and rapidly rising public sector debt (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009). Sovereign risk = inflation risk: Indeed, there are some signs that, over the past week or so, investors have started to worry about inflation risks. While the headlines have been dominated by concerns about sovereign risk and potential sovereign downgrades, we find it interesting that the accompanying rise in nominal bond yields has been almost entirely due to a rise in breakeven inflation rates, rather than real yields. This makes sense as the risk of a sovereign default for countries such as the US, where government debt is denominated in the domestic currency, is virtually zero. If needed, the central bank will simply be instructed to print more money to service the debt. Thus, sovereign risk in these cases is really inflation risk, and should be reflected in rising breakeven inflation rates. Bottom line: Reviewing the evidence to date, we conclude that the new global liquidity cycle, which started late last year, is alive and kicking. Excess liquidity has surged, asset markets have rallied, the global economy looks set to bottom out, fears of lasting deflation have been dispelled, and inflation risks are on the rise. With quantitative easing still in full swing and the economic recovery in 2H09 expected to be rather anaemic, we believe that there is no early end in sight for this liquidity cycle.