• Excessive. The world is literally awash with liquidity. According to our calculations, global money supply has risen much more rapidly than the corresponding nominal GDP over the last ten years. The ratio increased by a stunning 25%!
  • Origin. Roughly one third of this liquidity overhang stems from the eurozone with a still rising trend. But Japan and China also made a substantial contribution. In contrast, excess liquidity in the US declined during the last Fed tightening cycle. Recently, however, US money supply growth has also accelerated again, leaving most borrowers with sufficient liquidity.
  • ECB. Against this backdrop of rapid money and credit growth and the still favorable EMU growth prospects, the ECB will hike its key rate further. We expect the next move this coming Thursday. And whether the final hike will really come in the summer at a refi rate of 4% is becoming increasingly uncertain.
  • Reduction. The Bank of Japan would also be well advised to continue to raise its key interest rate steadily and communicate its intentions to the market in order to gradually reduce global excess liquidity. At the same time, China should revalue its currency further. This way, an abrupt end to the liquidity boom could be avoided – despite considerable risks from carry trades and Hedge Funds.

Further topics:

  • Weekly Comment: The correction we've all been waiting for.
  • Germany: A sustained labor market recovery.
  • Swiss National Bank dials up its rhetoric.
  • Data outlook: Bank of England to tighten again; EMU service managers to remain confident; only below-average US non-farm payrolls.
  • Market outlook: Yields to rise again, caution advised for carry trades.

THE CORRECTION WE'VE ALL BEEN WAITING FOR

Volatility has returned to the markets with a vengeance this week: the VIX has taken one of its highest jumps in percentage terms, credit spreads have widened quickly and brutally, equity markets have dropped, most risky and high-yielding assets have suffered, and the traditional funding currencies for carry trades, JPY and CHF, have suddenly strengthened.

It was not a bloodbath – in fact, the correction has not been as bad as the one we witnessed last May (yet). But it is probably not over.

What triggered the sell-off? Nothing concrete, really.

Ex post the finger has been pointed against a selected number of suspects, but each has a convincing alibi, in our view. It all started with a 9% drop in China’s stock market, seemingly due to concerns that the government would soon enact draconian measures to cool down the economy. This is unconvincing: no specific announcement had been made, and the government has given no hint that it would consider triggering a sharp slowdown in growth.

Greenspan had mentioned the word recession, and durable goods orders dropped more than expected.

But Greenspan’s speech was far more balanced than the initial news headlines seemed to suggest, and the durable goods figures by themselves were certainly not enough to justify a sudden drastic revision of the US growth outlook. Finally, investors reportedly worried that developments in the sub-prime mortgage market might give the coup de grace to the US housing market, undermine consumption, and possibly trigger a massive deleveraging and a credit crunch. But again, investors had been pondering the situation in the sub-prime mortgage markets for some time, and there was no news nor any sign that deterioration in sub-prime mortgages was spilling over to the rest of the mortgage markets.

We believe the correction has been driven by a sudden loss of confidence rather than by a reassessment of the fundamental outlook. Heavy positioning and a widespread and growing feeling that valuations were stretched across the board had made markets increasingly nervous. The conviction that a correction was inevitable and would indeed be healthy created the ideal conditions for a significant sell-off.

There is no doubt that the focus in this latest sell-off is on growth, unlike last May when the focus was on inflation risks. The market has suddenly priced in a 50% chance of Fed rate cut by June. But if the trigger had really been a spike in worries over the US growth outlook due to the weak durable goods figures, we would have expected a much stronger relief rally in response to yesterday’s surprisingly strong ISM figure, with the main index returning comfortably into expansionary territory. This, in our mind, confirms that what we are seeing is a crisis of confidence, which focuses on growth as the most likely weak link in goldilocks’ necklace. Had the ISM surprised on the downside, we believe the market’s reaction would have been much stronger, exacerbating the sell-off.

WHAT NEXT?

We do not see anything at this stage that would lead us to fundamentally reassess our growth picture. It probably helps that on US growth we were somewhat more bearish than consensus to begin with, and we remain confident in our call that the US economy is experiencing a soft landing and will settle at sub-par but still healthy growth for a few more quarters. Here our view is shared by the Fed: Chairman Bernanke stepped in to reassure markets Wednesday, arguing that the latest data did not change the benign assessment of the economic outlook he had presented to Congress just two weeks earlier, and that the deterioration in sub-prime mortgages, while serious, showed no signs of infecting the main mortgage market. We would also stress that weakness in US growth is at this stage compensated by the robust dynamics in the eurozone (confirming the decoupling story we have been highlighting for some time), the very cautious and growthsupporting stance of the Bank of Japan, and the seemingly unstoppable momentum of emerging markets giants like China and India.

We therefore do not believe that we are seeing the beginning of a structural and durable re-pricing of risk. The pricing of risk depends to a large extent on liquidity and fundamentals. Liquidity remains abundant (cf. Research Notes by Andreas Rees and Roger Kubarych), and, as we argued above, the underlying picture on fundamentals for the global economy has not changed. We therefore believe that fundamentals will reassert themselves, and that the sell-off will eventually be unwound.

Having said that, we do not believe the correction is over yet, and we expect high volatility and nervous sell-offs to continue over the next few weeks, until the price adjustment will allow investors to regain confidence in the valuations. The focus will remain on US growth, and the market will remain more sensitive to negative than to positive surprises.

A word of caution: we cannot entirely rule out the risk that the sell-off turns into a self-feeding crisis of larger proportions. This could happen if widening credit spreads started triggering deleveraging on a wide scale, accompanied by a string of failures in hedge funds and other financial institutions. We have been pointing out for some time that the credit market is probably the weakest link in the chain.

We strongly believe, however, that this full-fledged crisis scenario is highly unlikely. Our call is that the correction will still play out over the next couple of weeks, but healthy fundamentals will eventually reassert themselves. If we are right, the main challenge is identifying the right time to jump back in.