Cycle of liquidity keeps turning

The exorbitant levels of clients’ margin accounts among US brokers and last year’s astronomical inflows into high-yield bond funds are the direct result of the excess of money and liquidity that politicians decided to inject into the system after the 2008-09 crisis.

The proliferation of these signs of excess pushed the US Federal Reserve a year ago to become more realistic – that is, to communicate its intention to remove its extreme monetary policy.

The Fed has acted on its word by reducing its quantitative easing programme (QE). It will continue this process even if the economy does not take off as expected. The cycle of liquidity of the US dollar has also definitely entered a deceleration phase as risk management becomes critical to the Fed chair, Janet Yellen.

In China, state reflation and subsidies to non-performing economic sectors, as well as the quasi-endemic excesses of cheap credit for many years, have produced perverse effects. Indexes of speculation in property are obvious, along with the explosion of the carry trade of domestic institutions taking advantage of the strength and the low volatility of the yuan.

The People’s Bank of China has finally decided to control and regulate all financing channels – that is, to curb shadow banking. As a result, growth is slowing in parallel with the gradual normalisation of interest rates, which feeds political and social tensions. The bankruptcies, of reasonable size, will multiply and will further be tolerated by China’s leaders. Market forces, and sometimes ruthless capitalistic rules, now infiltrate deep into the country’s economic and financial framework.

The incredible wave of liquidity that large countries have synchronously dumped is beginning to gradually change in nature. Some are reassured by the fact that Japan is now accelerating its QE and that the European Central Bank will shyly follow through in the summer. But the transmission channels of euro and yen flows are very different from those of the dollar. Similarly, a weak dollar (courtesy of QE) normally fuels rising prices of raw materials, while a weak yen mainly creates deflationary pressures in the country or area directly competing for exports.

Granted, liquidity is not homogeneous, and its currency source also spells very different impacts on assets. The most recent large dispersion in performance between sectors and countries such as the US and Japan in the first quarter reflects these mutations. Liquidity injections, meanwhile, will remain tame in the future.

The ECB chief, Mario Draghi, has brilliantly managed to seduce and convince investors of his determination and ability of potential action. His style, his voluntarism and his creativity have done wonders to reduce the cost of credit in the euro area, assuage Berlin and deliver and perform almost nothing in terms of extreme politics. The return of Greece to the markets with its issuance of €3 billion is a case in point.

But the day of reckoning is approaching, with markets continuing to push the euro up. The process of European banks’ stress test and the subsequent recapitalisation that will take place this fall are tying the ECB’s hands for now.

We anticipate a regime change in currencies – that is, upcoming turbulences linked to desynchronised liquidity cycles. European sovereign bonds could also experience profit-taking as soon as the ECB’s QE approaches, especially if the euro were to weaken quickly. It seems like the risks of a policy error are clearly increasing.

Philippe Schindler is the chief investment officer at Blue Lakes Advisors, a Swiss company that advises financial institutions in Europe and the Middle East

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