If liquidity bubbles (the unintended fallout of quantitative easing) really can deflate, then where is the evidence? Among the many places liquidity appeared to park itself, oil markets sure look like a burst bubble, down 40 per cent in the past year. The same goes for base metals, with copper down 13 per cent.
Precious metals are headed in the same direction. Is the bubble-deflation theory elegant, but far from evident? On the surface, perhaps; but if the time is ripe for bubbles to do as they usually do, then why are they not all bursting at the same time?
Other frothy areas of the market don't look nearly as bumpy. Rates on risky sovereign paper are almost universally low, indicating strong demand. The market for corporate junk bonds is strong. Then there are the lengthening amortizations on mortgages and car loans, rising price-to-earnings ratios in equity markets everywhere, and new funds playing in the insurance world, not to mention the rising interest in instruments geared to unusual weather effects and other natural catastrophes. If activity on the fringe of the market is really unwinding, then why is there still considerable interest in these vehicles?
There are at least three possible explanations. First, the "end" of U.S. quantitative easing this far only means no additions to the mountain of liquidity that was made available. Withdrawal of that liquidity is still a future matter. Any unwind in the marketplace to date is 'taper tantrum' stuff, anticipating the effects of a full scale retreat or repatriation of the excessive liquidity. Since history has never seen the aftermath of a period of quantitative easing, much of current action is creative guesswork. Second, at the same time the Fed is talking withdrawal, the ECB and the Bank of Japan are increasing their activity, muddying the liquidity waters at least over the short term. Third, bubbles that appear to be bursting today in the commodities space may indeed be the combination of revealed supply-demand imbalances in those markets and the threat of lower available liquidity.
So, what's going to stir up the remaining peripheral categories? First, the need for investment funds. Corporations have been "parking" vast sums of cash due to a protracted period of under-investment. With capacity tightening, these funds are being attracted to the rising yields in more traditional activities. This reversal of flows is expected to increase as global growth accelerates over the coming months.
A parallel activity is the withdrawal of liquidity by central banks -- in the form of sopping up the spare cash in the economy and higher interest rates. One of the anticipated effects is an asymmetric availability of funds. Take emerging markets, for example. At the very moment they are set to take off, they could be facing substantial increases in interest rates. To complicate things, new bank regulations are drying up these markets' traditional sources of bank lending. Normally, this happens when the cycle is more mature, but in this case, it seems set to occur at the near end of a growth phase.
If so, this presents an extraordinary opportunity. A capital vacuum ahead of a growth phase seems like a good moment for those who are capital-rich to step in. Capacity-constrained markets, like the U.S., might well divert corporate cash into green- or brownfield investments in emerging markets, especially population-rich ones with spare industrial capacity. It also presents an opportunity for nations with solid banking systems.
If the picture seems a bit bizarre, it's likely because the macro-picture we are walking into is in general bizarre. The capital market shifts we are beginning to observe follow a period of historically unprecedented monetary policy, and there really is no playbook that maps out traceable consequences. As such, the return to growth is likely to be anything but usual, and those engaged in international markets should be as prepared as possible for higher volatility and a few surprises along the way.
The bottom line? Financial markets are likely in for a bumpy ride in the coming years -- what we now see is perhaps a foretaste. Hiding from the ups and downs isn't likely an option. Looking for this period's manifold opportunities could actually be exciting.
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