Loose threads 26 May 2006

Guambat has been trying to sort out the liquidity quandary, and it now looks like there has indeed been an excess of liquidity which the Bank of Japan has recently started to mop up.

The best insight came from the Carried away post.

Jim Jubak has now pinned the market ructions of the past fortnight on the BoJ deck swabbing:

You can't understand why some asset prices have tumbled and others have stayed rock solid if you don't know what the Bank of Japan has been doing over the last few months.

As good as its word, the Bank of Japan has been taking huge amounts of liquidity out of the global capital markets. In an effort to re-inflate the Japanese economy and end the years of deflation that had kept the country mired in a no-growth swamp, the Bank of Japan had pumped billions into the country's banking system. Now that the economy is finally growing again and now that prices aren't sinking any longer, the Bank of Japan has given two cheers to the return of inflation and has started to remove some of that cash from the financial markets.

In the last two months, the bank has taken almost 16 trillion yen, or about $140 billion, in cash deposits out of the country's banks. The country's money supply has fallen by almost 10%. The Bank of Japan isn't finished pumping out the liquidity that it had pumped in. That should take a few more months. And when it is finished, the Bank of Japan is expected to start raising short-term interest rates.
No more cheap
This sign of the return of economic and financial health to Japan is, however, bad news to the speculators who have used cheap Japanese cash to make big profits by buying everything from Icelandic bonds to Indian stocks. The momentum in many of the world's riskier markets was a result of ever increasing floods of cash -- borrowed at 1% in Japan and multiplied by leverage as speculators turned $1 of capital into $3 or more of borrowed money.

For example, India's Mumbai stock market, up 21% in 2006 and 70% over the last 12 months, has seen an inflow of $10 billion in overseas money. That wouldn't be enough to move a market like the $14 trillion (market cap) New York Stock Exchange, but it's a bigger deal on the $742 billion Mumbai market. Although $10 billion isn't enough to move a market by itself -- that took improving fundamentals in the Indian economy -- it is enough to increase upside momentum once the ball is rolling. (The Indian market's benchmark BSE index plunged 10% Monday before trading was halted for an hour. It ended the day down 4.2%.)

New inflows of cash are needed to keep the momentum going, hot money investors know, and it looks like the supply of money flowing into these markets might diminish. The moves to date by the Bank of Japan aren't enough to radically diminish global liquidity, but they are enough so that the investors who have fed some of the world's riskier markets understand that the trend has turned.

What we've witnessed since May 13 is a global flight out of more leveraged and more speculative investments. Speculators attracted by the momentum of the gold, copper, and silver markets have sold -- and are still selling -- rushing to get out before other speculators could liquidate their positions. Emerging equity markets have sold off for the same reason: India's Bombay Sensex index dropped 6.8% on the same day as the Jakarta market fell. High-yielding bond markets have collapsed as prices dropped, sending yields soaring and currencies skidding. The central bank of Iceland has raised interest rates to 12.25% in an effort to prevent the further fall of the krona as hot money flees the country.

What the Bank of Japan has done is to set off a global re-setting of investors' risk tolerance. With Japanese interest rates so low and Japanese cash so abundant, speculators, traders, and investors have been more and more willing in the last few years to take on risk at increasingly low premiums.

Risk tolerance doesn't get reset in a day. The Bank of Japan is only halfway through removing liquidity from its domestic and global markets. Interest-rate hikes are likely to follow that with the first increases coming in the second half of 2006. At the same time, the European Central Bank is raising interest rates.

All excess liquidity has by no means been removed from the global financial markets. But the speculators know that money is gradually getting more expensive. Rallies can count on less hot money to fuel their last stages. Getting out earlier in rallies starts to seem wiser. Some risks are just not worth taking.

The correction that began on May 13 is part of the process of resetting risk tolerance and recalibrating risk premiums.

Jubak seems pretty sanguine that the markets will not react any worse than they already have, though the ride will be bumpy.

Other folks who actually manage and make bunches of money don't sound quite so sanguine.

BRITAIN’S most successful stockpicker yesterday told investors to brace themselves for months of falling share prices.

Anthony Bolton, who runs £6.5 billion of funds for Fidelity International, suggested that the jitters of the past two weeks could turn into a more prolonged bear phase as shares plunged again.

In a rare public appearance, Mr Bolton said: “I think it could be the end of the bull market. The correction could be months, not days.”

And technical analysts like Carl Swenlin and John Murhpy are expecting a bit of a bounce off oversold conditions, but don't seem to hold out any hopes for a sustained bull run.

Meanwhile, retail cash is bleeding out of the US stock funds, but that may just be the kind of counter-intuitive event that assures a bounce for the pros to sell into.

And how do these market ructions play out in the real world, in the lives of the ordinary folks on the street? Not only does it bankrupt many of them, but it affects the very social fabric of the community:

The stock market crash, which affected more than 3.5 million middle income investors, has delayed the marriages of many people this summer, Asharq Al-Awsat newspaper reported.

Every summer, tens of thousand of Saudis get married but this year, the number is expected to drop by more than 50 percent.

Fahd Al-Harbi, a wedding hall owner, said that many people who had made reservations cancelled them after the crash.

Al-Harbi said that many wedding hall owners would reduce prices to attract customers and that he had reduced his prices by more than 50 percent.

Saleh Al-Muntasheri has postponed his wedding which was scheduled for the summer because of the crash. He said that he had lost SR120,000.

Ahmad Ali is another Saudi who lost money in the crash. He said he had lost SR67,000 which had taken him more than five years to save.

He said he had been forced to cancel his wedding because he could not afford it and that he would not borrow the money.

Many kind thanks to the Kirk Report for the inspiration and material for this post.