Beware of the effects of global liquidity

Excess global liquidity sounds like a complicated idea, but in fact means the ultra-easy monetary policy pursued by world banks. Some central banks are attempting to tighten money supply, but the response is uncoordinated.

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.

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