Manas Chakravarty: Too many dollars

In spite of the Fed raising interest rates, global liquidity is higher today

Earlier this week, after the US Federal Reserve raised its Fed Funds rate by 25 basis points to 2.25 per cent, equity markets around the world celebrated.

The Sensex soared to an all-time peak, the S&P 500 and the Nasdaq rose to three-year highs, European shares moved up to their highest level in 29 months and the Australian share market tested record closing highs.

This wasn't supposed to happen. Rising interest rates are expected to negatively impact stocks, and we've been assured time and again that the lowering of interest rates in this country has been an important factor in boosting valuations.

But conversely, when interest rates are rising, nobody's talking of lower valuations. And how can they, with stock indices in countries as far apart as India, Brazil, Mexico, Chile and Indonesia hitting record highs?

Forget the fundamentals

As a matter of fact, if we look at equity market indices in early May (before the US Fed commenced its tightening) and compare them with current levels, we'll find that most markets have moved up since May, including both the developed and the emerging markets.

The World MSCI index rose by 7.3 per cent between May 5 and December 8. The MSCI Emerging Markets Free Index did even better, moving up by 14.5 per cent over the same period.

And all this happened while Alan Greenspan tightened the US Fed funds rate from 1 per cent to 2.25 per cent. Clearly, the 1.25 percentage point hike in rates hasn't deterred markets from going up.

It's nice to think of the Indian market moving up because our "fundamentals" are strong. But take a look at some of the other countries that have seen huge rises in their stock markets, and that warm feeling about our fundamentals oozes away.

As on December 8, the Indonesian market was up 41.5 per cent this year, compared to 7.2 per cent for the Indian market. Indonesia's third quarter GDP growth was 5 per cent, and industrial production was a negative 2.3 per cent in August.

Colombia, a country torn by drug wars, has seen its market rise by 74.7 per cent this year, on a GDP growth of 2.4 per cent in the third quarter.

And China, whose GDP growth was 9.1 per cent in Q3, has seen its market fall by 11.3 per cent this year. Look at some of the emerging markets that have risen the most, and the fundamentals don't seem to be driving this rally.

What's even stranger is that despite the rise in short-term rates, bond prices in many countries are higher and bond yields lower than what they were in May.

The JP Morgan Emerging Markets Bond Index went up 14.6 per cent between May 5 and December 8. Even the Citigroup World Government Bond Index has risen by 11.3 per cent in that period.

At the level of individual countries, 10-year bond yields in the US, UK, Japan, Australia, and the Euro area are all lower than what they were in early May, although short-term rates have hardened in some countries. Surely bond prices should have been hit and bond yields increased after the Fed increased rates?

Why the rally?

The most common explanation for the markets rising after a Fed Funds hike is that the rate increases have been small, and people do not expect the Fed to do anything to prick the bubble.

That's why the Fed funds rate, at 2.25 per cent, is still way below the US consumer price inflation of 3.2 per cent. Inflation in producer prices is even higher, at 4.4 per cent, and even the 10-year Treasury note offers a negative real yield.

That makes it extremely attractive for hedge funds to borrow at negative real interest rates and use that money to boost asset prices across the world.

As the recent sharp volatility in crude oil, gold and copper prices has shown, hedge funds, estimated to manage around $1 trillion in assets, are a potent force across markets.

These short-term investors have so far boosted markets by crowding into them, but they can just as easily break markets when they rush for the exits. The sharp and sudden rise in oil prices and the recent equally spectacular fall are an indication of what hedge funds can do.

The falling dollar has been cited as another reason for the flow of money to emerging markets, explaining the out-performance of these markets compared to the developed ones.

According to figures from EmergingPortfolio.com, global and international equity funds had received around $67 billion of net investor contributions by the end of November this year, compared to only $11.5 billion flowing into US equity funds.

Asia ex-Japan funds have received $3.8 billion of net inflows. But it's important to note that even the US markets have been recording new highs.

Liquidity

The reason why both the stock and the bond markets have been rising, of course, is liquidity. One simple measure of liquidity lies in the figures for growth in broad money.

The data are pretty revealing. It shows that year-on-year broad money growth in the US was 4.8 per cent in October, well above August's 4.4 per cent.

Similarly, broad money growth in the Euro area was 5.8 per cent in October, again well above August's 5.5 per cent. Japan, the UK and Canada all have higher rates of broad money growth now than in August.

Moreover, growth has slowed in most economies. In the US, Q2 GDP growth was 4.8 per cent, which decelerated to 4 per cent in Q3. In Britain, Q2 growth was higher than Q3's. In the Euro area, too, growth slowed in the third quarter.

Likewise in Japan, GDP growth in Q3 at 2.6 per cent was much lower than Q2's 4.2 per cent. While the growth in broad money has led to higher liquidity, slower GDP growth would mean that the extra money could go into pushing up asset prices. That's precisely what has happened.

Yet another measure of global liquidity is the rise in foreign exchange reserves of central banks. Between July-August and October-November this year, the forex reserves of a sample of 25 large emerging economies went up from $1.7 trillion to $ 3.1 trillion, an increase of $1.4 trillion in three months.

Part of the rise is due to the decrease in the value of the dollar, but a large chunk represents dollar buying by central banks, which, if unsterilised, translates into liquidity released into local money markets.

In short, a combination of factors "" high money supply growth in the US and other developed countries, a slowing down of growth, a depreciating dollar, and negative real interest rates in the US have all combined to boost the current global rally.

What's more, at the moment the signs all seem to indicate that all these positive factors will continue, and liquidity flows show no signs of abating.

Nevertheless, so far as the Indian market is concerned, it could be helpful to bear in mind that the last rally petered out when local mutual funds started buying. FIIs will book profits as soon as they get someone to sell to.