Are we heading for a global credit crunch?

Is this the year that the global liquidity boom dries up? asks John Stepek. Merrill Lynch certainly thinks so: the US bank has warned that complacent investors are taking far too much risk.

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Is this the year that the global liquidity boom dries up?

Merrill Lynch certainly thinks so. The US bank has warned that complacent investors are ignoring rising interest rates and taking far too much risk, even as a global credit crunch is looming.

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The rate of liquidity growth - the expansion in the amount of money flooding across the globe - has fallen to around 10%, the bank reckons. That's down from a 22% peak at the end of 2005 .

So why is this bad news?

US investment bank Merrill Lynch is worried.

"We think global interest rates are going to rise a lot more than investors are discounting, and this is a worrisome outlook for profits," said Khuram Chaudry, Merrill Lynch's chief European strategist.

Despite a growing number of commentators who are suggesting that central banks have lost their control over monetary policy, Mr Chaudry believes that central banks still have more impact on the global economy than many investors appear to think. "It matters when central banks tighten monetary policy."

Global liquidity growth has fallen from a peak of 22% in 2005, to around 10% now, notes Ambrose Evans-Pritchard in The Daily Telegraph. "Mr Chaudry said the suddenness of the fall matters more than the absolute level, typically serving as a warning signal with a lead time of 12 to 18 months. It slid in a similar fashion in 2000, and before both the 1998 Asia crisis and the US Savings and Loan crisis in the 1980s."

This is all happening at a time when global investors are more exposed to sudden shocks or liquidity drying up than ever before. For example, Tony Tassell in the FT reports that State Street Global Markets reckons that the carry trade (borrowing in a low-yielding currency - mainly yen at the moment - to buy a higher-yielding currency) "is approaching extreme levels."

The carry trade is difficult to measure - people don't fill in a form detailing their intentions when they buy or sell currencies. But State Street has found a pretty good method of working out roughly how much carrying' is going on. They look at where money from institutional investors is going, and where it is coming from. They then relate that to the yields on various currencies.

So basically, when there's a lot of money leaving the low-yield currencies, and lots heading into the high-yield currencies, you can be fairly comfortable with concluding that a big chunk of that is people aiming to profit from the carry trade.

That's the theory. And at the moment, the correlation between fund flows and currency yields is at 61%, its highest since 1999. Investors are borrowing in yen and Swiss francs, and buying up the Brazilian real and the Australian dollar, among others.

But the carry trade is very risky. Others have described it as "picking up nickels in front of a steamroller." As Albert Edwards, Dresdner Kleinwort analyst, points out, the "yen is extremely cyclical, closely tracking shifts in the Japanese economy."

If you've borrowed money in yen to put in Australian dollars, and the yen suddenly strengthens, you could find yourself in a very deep hole, very quickly. So some decent Japanese economic news could cause a sharp rush out of carry trades - particularly if it makes a rise in Japanese interest rates more likely.

Of course, that would mean reversing all those fund flows, so that demand for yen would increase sharply, which would in turn drive the yen higher, making the position of all those carry trades still outstanding even more disastrous.

So what should investors do? Merrill reckons that it's time to invest in cash, large cap stocks with decent dividend yields (they suggest AstraZeneca and Swedens H&M, among others), and - of course - gold.

Subscribers can read more about why gold makes a good investment in hard economic times in our recent cover story: Why you should hang onto your gold.

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Turning to the stock markets

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In London, the FTSE 100 gained 7 points to close at 6,317 as energy stocks rallied on the climbing price of crude, although platinum producer Johnson Matthey was the day's biggest riser. For a full market report, see: London market close

Elsewhere in Europe, the Paris CAC-40 ended the day relatively flat at 5,681, having gained 3 points. In Frankfurt, the DAX-30 closed 11 points lower, at 6,874.

Across the Atlantic, the Dow Jones was boosted by better-than-expected sales from retailer Wal-mart and gained 8 points to end the day at 12,661. The tech-heavy Nasdaq fell 5 points to close at 2,470, whilst the broader S&P 500 ended the day at 1,446, a one-point fall.

The Nikkei climbed 62 points to achieve a close of 17,406 on raised profit forecasts from Toyota and Nikon.

Crude oil was edging closer to the $60 mark this morning, last trading at $59.25. In London, Brent spot was over 1% higher at $57.74.

Spot gold was at $650.20/oz this morning, whilst the price of silver had nudged higher to $13.48.

And in London this morning, oil major BP announced a 22% fall in Q4 profit due to production losses and lower refining margins. The company has also predicted output will be lower in 2007. BP's share price had fallen by as much as 1.9% today.

And our two recommended articles for today...

It's time to make a killing in Japan

- As Japan's recovery gets under way, now is the time for investors to buy into the market, says Merryn Somerset Webb. And there's more to this story than stocks. To find out where the best opportunities in the Japanese market lie, read: It's time to make a killing in Japan

Underground threats to the global economy

- The global economy has been following a pretty normal course of late, says Jeremy Batstone of Charles Stanley - with some exceptions. And it is these small nudges on the economic seismograpth which we should pay attention to. For more on the unusual - and potentially dangerous - combination of low volatility and high risk premiums, see: Underground threats to the global economy