Why is liquidity rotating, not disappearing?
by Andy Xie/ Morgan Stanley
When an asset bubble deflates, the liquidity just vanishes. Liquidity is demand-driven. It depends on price, i.e., interest rates determined by central banks, and risk appetite. When the momentum in an asset bubble reverses, the risk appetite tends to decline and liquidity recedes. We saw this phenomenon in 2000 when the tech bubble burst and in 1997 when the Southeast Asian property bubble burst.
Globalization of finance could be the difference. A bubble is like a casino. If a casino has one game, gamblers leave when they have lost enough money. But, when a casino has many games, after losing money in one game, gamblers tend to move to a different game. Today’s financial markets put up so many games that speculators can stick around long enough that they eventually come back to the same game again. This is why some markets get second or third winds, I believe.
In addition to more games, there are more players. The growth of hedge funds, proprietary trading at banks and private banking has increased the number of active traders by multiple times compared to that in the previous bubbles. The safety in numbers is working in this context.
The proliferation of gambling options and players may also explain the breakdowns of some historical relationships. The most important one is the breakdown between commodity prices and the dollar. Commodity prices usually go down when the dollar is strong, because hard commodities are priced in dollars and a strong dollar tends to depress commodity demand. The dollar has been appreciating for one year. The CRB index has kept rising.
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