In recent weeks, analysts from Morgan Stanley have grown fond of saying that the excess liquidity' argument is flawed and that carry trades' have not been a key source of global liquidity as broadly assumed. For those of our readers not comfortable with terms such as excess liquidity and carry trade,allow us to quickly summarise: Excess liquidity is used to describe the ultra-easy monetary policy (i.e. very low interest rates) pursued by the world's central banks since the bursting of the equity bubble in 2000. The fact that the collapse of global stock markets coincided with a global deflationary scare in 2001-02 only made central banks throughout the world even more eager to lower the price of money.
Low interest rates have raised investors' appetite for risk, as access to credit has been cheap and readily available. If one can borrow at less than 2% (as is currently possible in yen) and invest in emerging market bonds yielding 7%, we say that the trade has a positive carry of 5%. The bigger the carry is, the bigger the incentive is to put on carry trades like the one described.
It follows from this that low borrowing rates have created an environment which encourages risk taking and the use of gearing. Consequently, the almost universal rise in asset prices since the spring of 2003 can be explained by this phenomenon, or so the argument goes.
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Now, what Morgan Stanley is saying is that there is in fact little evidence of any excess money being printed by the world's principal central banks, hence the excess liquidity argument is flawed, they say.Apart from some very apparent weaknesses in their argumentation (they complete ignore, for example, that the carry trade has become a global business, i.e. borrowers are happy to borrow in one currency only to invest in a different currency), it reminds us of the weather forecast which states that we won't see any rain today. Yet, when you look out, it is pouring down. The meteorologist in charge of the forecast forgot to look out. He looked at his computer models instead.
When we look out of our window, we see plenty of evidence of excess liquidity at work. We see it in investors' portfolios. We see it in the behaviour of certain asset classes. We don't believe the close link between the performance of high yielding emerging market bonds and the yen exchange rate is any coincidence. The circumstantial evidence is indeed very strong.
On the other hand, there is no question that the aggressive hiking of rates in the U.S. over the past couple of years has caused a dramatic slowdown of the growth in global U.S. dollar liquidity. And, as we pointed out in the first article of this month's Absolute Return Letter, the ECB seems determined to slow down the growth of the European monetary growth.
However, in a world which is becoming increasingly globalised, the central bankers of the U.S. and Euroland must be painfully aware that, as long as other central banks are prepared to provide an ample supply of cheap money, their efforts to cool down the economy and/or asset prices may be jeopardised.
In this context it is worth noticing that Japan is not the only "culprit". Money is very cheap in Switzerland as well, and it is our experience that European investors are far more comfortable borrowing in Swiss francs than in yen. In our experience, a very high proportion of continental European private investors have borrowings in Swiss francs. So much for Morgan Stanley's assertions.
All this leads us to conclude that, so long as the central bank clampdown on cheap money is not coordinated, the carry trade will continue in some shape or form. Only after large numbers of investors are hurt financially (and it will mostdefinitely happen it is only a question of when), will the appetite for risk cool down meaningfully. This puts our bullish view on yen at risk, at least in the short term. If investors continue to borrow happily in yen, it will put a lid on the yen's ability to rise from currently depressed levels. However,the longer the carry trade runs for, the more borrowings are accumulated in low cost currencies such as yen and Swiss francs. We probably do not need to remind you that, all other things being equal, when the appetite for these trades wanes, exchange rates are capable of moving faster than you can liquidate your borrowings.
Niels C. Jensen, chief executive partner at Absolute Return Partners LLP. To contact Niels email: njensen@arpllp.com
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