‘LOW RATES, THE MARKET AND WHAT’S NEXT ,’ from Fidelity Investments.

In Uncategorized on December 8, 2009 at 17:49

Key Takeaways

While economic conditions and market fundamentals have rebounded significantly in 2009, abundant global liquidity has also contributed markedly to driving up asset prices.

The eventual move to withdraw liquidity from today’s extraordinary levels may introduce a higher degree of volatility into asset markets than experienced during the recent rally.

For the most part, however, accommodative monetary policies and easy money conditions are still in place and remain supportive of asset price appreciation.

Broad-based rally a historical rarity

Most asset classes have appreciated significantly in 2009, making it a highly unusual year of widespread good fortune. While investors have embraced riskier investments around the world, such as stocks, high yield corporate bonds and real estate in Asia, other relatively safer markets, such as U.S. municipal bonds and U.S. government-guaranteed mortgage-backed securities, also have seen healthy appreciation. Gold prices have continued to hit new record highs, in part driven by investor concerns about ballooning government debt levels. This occurred even as yields on long-term U.S. Treasury bonds remained near record lows and certain short-term Treasury bill yields actually turned negative in mid-November, suggesting some investors were willing to essentially pay the deficit-strapped government to hold their money.1

What tide has come ashore in 2009 to lift all these different boats, each with varying risk profiles and performance characteristics? One answer is abundant global liquidity. In other words, there appears to be enough money sloshing around global financial markets that seemingly every investment point-of-view is supported by a pool of capital. To be clear, liquidity is only one reason asset prices have recovered dramatically in 2009, with plenty of fundamental factors underpinning the gains. For example, perhaps the most important drivers of the broad rally in asset prices are the stunning turnaround in the global economy and the improvement in credit market conditions following the late-2008 crisis. In addition, the widespread and devastating sell-off in 2008 left asset prices in many categories at depressed prices, allowing plenty of room for a rebound once economic and financial conditions stabilized. However, the support from strong liquidity conditions has undoubtedly contributed to the rally, making an investigation into future liquidity trends important.

Sources of liquidity and how it helps

Quite simply, a high level of liquidity implies there is a lot of money or capital to be invested. Low interest rates and ample liquidity have traditionally been supportive factors for asset prices because they both support economic activity by encouraging lending activity and providing the means for investors to make purchases. While there is no single measure of global liquidity, cheap borrowing rates are typically one tangible measure of ample liquidity. Today, policy rates set by global central bankers have never been lower. The U.S. Federal Reserve (Fed) has received the biggest headlines with its near-zero interest-rate policy, but the low-rate phenomenon exists worldwide. The median (average) policy interest rate of the G-20 countries—the group of the most influential developed and emerging economies in the world—stands at an unprecedented 2%, roughly half as low as its previous record nadir and down from more than 5% in mid-2008 (see Exhibit 1).

The near-universal move by central bankers to slash interest rates was of course the response to the global financial and economic crisis that engulfed the world in late 2008. However, one by-product of this effort was to provide the fuel for “carry trades” that allow investors to borrow cheaply in low-yielding countries and purchase assets in higher-yielding ones. For instance, borrowing in dollars at record low rates to purchase Brazilian bonds at higher rates can earn hefty returns, particularly if the Brazilian currency rises in the process. Thus, extraordinarily easy money policies in some countries (such as the U.S.) may be contributing to massive asset price appreciation in others—particularly emerging-market countries that on average have seen their stock markets double from their March 2009 lows.2

Extremely low policy rates are just one source of global liquidity. Some central banks are still employing quantitative easing measures, such as outright bond purchases, with the Fed and Bank of England having more than doubled the amount of credit they’ve provided to their financial systems during the past year.3 Some developing countries, particularly China, have allowed their foreign exchange reserves to surge to all-time highs, providing more monetary fuel to purchase U.S. Treasury bonds and other assets.4

Some of this money is being deployed into real economic activity via bank loans and other means. Due partly to prodding from the government, China more than doubled bank lending activity in 2009, leading to money supply growth of nearly 30% (see Exhibit 2).5 Money growth in several other developing countries also has reached high levels.6 In the United States, however, much of the extra liquidity in the system has remained parked in bank reserves and has yet to enter the money supply, leading to money growth of only about 5% so far in 2009.

For investors, the question is whether this large amount of liquidity is excessive. The global recovery, particularly in most of the developed world, including the United States, Europe and Japan, remains extremely fragile. Cheap borrowing may be a necessary ingredient toward repairing financial systems and helping heal real economies, but on the other hand it may also run the risk of pushing up asset prices too quickly and creating new problems down the road.

Looking for signs of liquidity retrenchment

If ample global liquidity has provided support to 2009 asset markets, it is natural for investors to try to ascertain whether and when a reversal of current liquidity conditions may remove this support. The outlook, for now, appears to be that global monetary tightening is somewhere on the horizon, but is not yet imminent.

As the world’s most important central bank, the Fed set the tone for the continuation of accommodative monetary policy with its November 4 statement, saying that conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” However, given the fact that money supply growth abroad has been extremely rapid, it is also important to gauge the monetary stance of authorities around the world.

In general, monetary authorities have traditionally raised interest rates and siphoned off liquidity for three main reasons: to counteract an increasing threat of inflation; to keep pace with an improving rate of economic growth; or to influence the value of the local currency. The global interest rate picture is thus more complex due to the variety of differences among the strength of economies, inflationary pressures and exchange rate policies.

For instance, in the United States, deflation remains a credible threat, but in fast-growing India inflation has accelerated to 12% and has already pushed the Indian central bank to signal the start of its exit strategy. 7,8 In the United States, unemployment has continued to rise above 10% and threatens the magnitude of economic recovery, but in Australia unemployment remains below 6%.9 Europe and Japan expect sluggish recoveries, but rebounds in South Korea and other developing Asian economies may push central bankers in these areas to a faster pace of tightening. China has kept its rates low and its currency pegged to the dollar during the past year, allowing its currency to weaken against most others. Russia, however, has lowered its interest rates at least in part in an effort to keep its currency from appreciating too rapidly.

Although Australia was the first G-20 country to tighten rates (in October) and other smaller economies, such as Israel, also have raised rates, the list of countries recently lowering rates still remains longer (Russia, Turkey, Hungary, and Iceland). In sum, the average policy rate for the G-20 economies remains at an all-time low and monetary policy looks likely to remain relatively accommodative of asset prices in the near term.

Investment implications

An eventual shift in the current trend of global policy to one that attempts to rein in liquidity from today’s unprecedented levels would likely dampen what has been a major tailwind for the asset markets. Whether it becomes a headwind will depend on the pace and magnitude of the global tightening response, as well as the simultaneous strength of the global economic recovery. Because broad-based changes in the trajectory of money policy have the potential to create uncertainty, investors may do well to expect such a change to inject more volatility into the global financial markets than has been experienced during the 2009 rally. Remaining attentive to monetary trends—not just here in the United States but also abroad—may provide clues of when this volatility may rise. For now, however, global liquidity conditions remain supportive of asset prices.


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