Asset markets around the world have been propelled higher over the past few years on the back of surging global liquidity. However, with central banks around the world now hiking interest rates and reversing the stimulative monetary policies of the recent past, this run may be coming to an end.
Or maybe not.
On 21 February, the Bank of Japan decided to raise its overnight lending rate by 25 basis points to 0.5 percent. It was the second in a series of rates hikes expected from the BoJ that would take interest rates in Japan away from zero and undermine the infamous yen carry trade that is said to pump liquidity into global markets.
Except that things did not quite turn out that way. Japanese bond yields fell instead, as did the yen, which fell to an all-time low against the euro after the BoJ decision. The carry trade carries on.
In fact, Morgan Stanley's Stephen Jen thinks that the fixation on central banks as the source of excess global liquidity is wrong. In a note on Friday, he wrote:
In contrast to the popular view that central banks’ irresponsibly easy monetary policy has led to the bloated asset prices in the world, I believe that the more important source of global liquidity is the (curiously) low capex/capital stock in the world. Until the global economy’s capex accelerates to absorb much of the savings, real long bond yields in the world should remain low and risky assets should be supported.
This type of ‘real’ liquidity will only be withdrawn when the global economy becomes capex-led. By then, risky assets could come under some modest pressures. I say ‘modest’ because a capex-led global economy will be a low-inflation, high-growth economy, much like we have seen in China in the past few years. This should provide some support for risky assets.
The main reasons for the low capital expenditure, in Jen's view, include the uncertainty over the US economic recovery as well as political risks attached to expansion in emerging economies, where investment rates have "collapsed".
Based on this view, Jen wrote that "risky assets will be surprisingly resilient to monetary tightening", and that the BoJ "could raise the policy rate to 1.00% and that would not undermine risky assets in the world".
Having said that, Jen acknowledged that "monetary policy still matters", but "as long as central banks don’t push policy rates deep into restrictive territory, and as long as the world does not fully absorb its own savings, global financial conditions will remain stimulative".
Jen as good as calls this view a "new paradigm", which should set off alarm bells among those who tend to think that new paradigms are thought up by those who wish to peddle ideas that are not supported by historical evidence.
Except that in this case, I think Jen is on to something. Certainly, global liquidity does not seem to have been much affected by global central bank tightening, if recent price trends in asset markets, especially stock markets, are anything to go by.
Jen's main claim to fame in recent years has been his view that the US dollar will not crash despite its large and growing current account deficit. That view has turned out to be correct, so he clearly knows something about global capital flows.
Or perhaps it is premature to pass judgement. After all, many people remember the words of the famous economist Irving Fisher -- "Stock prices have reached what looks like a permanently high plateau" -- uttered just before the stock market crash of 1929.
Indeed, the accompanying charts suggest that monetary policy does matter.
From 2001 to 2003, the Federal Reserve and the European Central Bank eased monetary policy quite aggressively and global 10-year government bond yields fell apparently in response. After a lag, inflation rates and stock markets bottomed, then turned up, in accordance with conventional economic theory.
Central banks then reversed course, the Federal Reserve starting interest rate hikes in 2004, the ECB in 2005, and the BoJ in 2006. The response in 10-year yields has been mild, but they are generally in a rising trend, and indeed, inflation rates appear to have peaked, which would indicate that monetary policy does have traction.
However, stock markets seem to be blithely ignoring the actions of central banks; they continue to rise. So apparently other drivers are at work. Perhaps Jen is right: low global investment rates are keeping excess savings high enough to feed asset markets even as central banks attempt to drain liquidity.
Or perhaps it just means that there is a correction in stocks coming.
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