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Show Me The Liquidity!


What? Me worry?

The second topic discussed at the Morgan Stanley Macro-Vision conference dealt with the ever declining indicators of volatility. The VXO looks to be the only indicator lower than Boo's spirits. As with the Bond Bubble piece, I will outline the conclusions drawn by those who participated in the conference, and add my thoughts and questions.

The Morgan crowd set out two principal reasons for the waning volatility:

The Complacency Theory: Worries over inflation, debt loads, deficits, international imbalances, bond bubbles, etc. etc., belong to Chicken Little. As Andy Xie noted, investors overwhelmingly believe that policymakers (and here I would narrow that down to Elmer) are firmly in control of all macro problems and will navigate them to an orderly unwinding. The fact that the Fed has been able for now to "print" (writer's embellishment) its way out of the collapse of the 2000 bubble has spread the "Greenspan put" to the entire financial world. Therefore, the macro risk premium can be safely removed from prices.

If the above scenario is in fact true, we are witnessing the development of a new paradigm, one where free-market risks have been neatly stripped off and handed to regulators for disposal like a bunch of toxic waste. The "heads investors win, tails the government bails you out" set-up has gone from representing the ultimate form of moral hazard to being the "smart" way of running the world's finances. In this case, low volatility premiums should no longer be interpreted as a sign of complacency but rather as the re-pricing of financial instruments based upon a structurally risk-free world. In other words, this time truly is different.

Personally I am going to pass on the Kool-Aid. If the above model held any water, was it a mere coincidence that it came about shortly after the implosion of the biggest financial bubble in the history of the world? While the facts might be a bit different, wasn't John Law's Mississippi scheme in essence the same thing?

The Consensus Theory: A corollary to the (misguided) faith put in the powers of the policymakers, is the growing mass of trading based on the seal-tight consensus around the rosy future of the financial markets. This attitude is more sinister than the plain-vanilla complacency described above because it leads large - and typically highly leveraged - investors to lean altogether on the same side of the trade boat. These bets typically manifest themselves in "carry trades" where one asset class is sold short to finance the purchase of a different asset class. The massive wave of money flowing in the same direction crunches the affected market's volatility, which in turn allows for larger and larger leverage. No one really knows how long the coiling of this type of spring can go on, but as Prof. Succo has often stated, once this structure snaps the exit door is usually too tight for everyone to get out in one piece. Ironically, the latter danger is readily recognized and just as quickly dismissed based upon . . . yeap you guessed it: the Greenspan Put.

This house of "greenbacks" of course can only last as long as Elmer keeps printing dollars (liquidity) to make good on the "put", and/or someone decides that there are so many greenbacks around that they are not really worth the paper they are printed on. The latter depends as much on mass psychology as it does on macro-economic models. As to the former, Andy Xie suggests that as the Fed Fund rate approaches the inflation rate, it may mark a level where the outflow of liquidity might spark an unwinding of the carry-trades.
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