There are only two places for liquidity to go: either somewhere useful or straight down the drain...
This is precisely the problem for a world awash in US Dollars. The Dollars drive everything up indiscriminately, and threaten to wash it all away. There are too many Dollars and not enough containers (investment products) to contain them. Thus, you get liquidity driven bull markets, where cash pours into an asset and drives the price up artificially. When it leaves, the asset value collapses, often irrespective of the fundamental value of the asset.
If it sounds ludicrous that's because it is. Too much liquidity renders traditional balance sheet valuation useless as a tool for picking investments. But that doesn't mean you should give up identifying frauds and bad risks when you see them.
For example, we find it remarkable that investors continue to buy US Treasury notes and bonds. But when we asked our friend Steve Belmont why anyone would buy the Dollar-denominated assets of a debt-crazy country, he gave us something to think about.
"Bonds and notes have shown a remarkable ability to trade independently of Fed Funds," Steve replied. "The reasons probably vary but are most likely to include a globe awash in petroDollars and Asian Dollar reserves. Where else is this money going to go without converting it into another currency – something neither the Chinese nor the oil producers can do without crushing the value of the Dollar reserves they already own? Can you say Catch 22?"
"Catch 22! Great book. Joseph Heller, fine writer! But what about gold," we reply?
Steve anticipates us...
"Gold? That's only a partial alternative; it buys some diversification but not a whole lot. Despite the desires of the hard money crowd, the world will probably never go back to a gold standard. It simply cannot afford to without a financial dislocation of monumental proportion."
"Ahh..." we reply. "So in a gold-backed financial system, credit can't exceed the gold that backs it. No wonder the financiers and money-changers don't like gold. "Financial dislocation" means the end of many of the derivatives and credit products, the selling of which has paid many a six-figure salary in the world of money-shufflers.
"But what about oil?" we go on. "Surely there is enough liquidity in the oil market for it to act as a reserve currency, or reserve commodity. And with oil's strategic importance, doesn't it make more sense to own oil instead of Dollars? Burn a barrel of each and you'll get a lot more energy from the oil."
"Oil? There has been talk of China converting some of its Dollars into oil reserves. But how much is actually available. How do you handle this conversion without roiling the market and pricing the desired asset out of reach?"
"If not oil then...what about the Euro? C'mon Steve, work with me. Something's gotta keep this whole financial jalopy flying down the highway to the future of endless, riskless, effortless prosperity..."
"The Euro? Some of that is happening now, but you could make the argument that the Euro has just as many potential problems as the Dollar. A lot of smart people don't expect the currency itself to survive the next decade. What it has going for it now is the fact that it is not the Dollar – not much else."
"Okay. So if the world's financial system can't operate, as it is, on anything but Dollars, that means things will basically stay the same, or be radically different. So why are all these people buying bonds? Do they really think it's the safest play in a dangerous global capital market?"
"The upshot is bonds have become the default repository of US Dollars held abroad. Whether or not this is prudent remains to be seem. I do not expect a reduction in the Fed Funds rates will change this much. Two years ago Fed Funds stood just above 1.5% and bonds were yields roughly the same as today. It happened before so why couldn't it happen again?"
"Hmmn. With the housing market crashing, retail spending in America already weak, and oil back over $62, I can see the Fed wanting to ease again. It seems suicidal to me, and highly inflationary. But since when has that bothered a central bank...?"
"A lot of folks expect a steepening of the yield curve, when it occurs, to happen on the long end of the curve so they short bonds," says Steve. "I believe there is a good possibility it will actually take place on the short end – just as the inversion did. Thus, the logic behind buying EuroDollars instead of shorting bonds... That's not to say I won't consider shorting bonds in the future, but for now I'll stick with the EuroDollars."
"So you think the US yield curve will steepen, but it will steepen because the Fed cuts rates on the short-end, creating even more official liquidity and given debtors a break in 2007. Hmmn. But won't this make it more difficult and expensive for the U.S. to finance its huge deficits with short-term bonds? And won't it ignite more inflation? And won't it...Steve...hey Steve? Are you there...?"
Lots of questions. In the meantime, we note that gold may not replace the Dollar as the currency of international trade and capital. In fact, there may be nothing to replace the Dollar. Then you get what's called a liquidity black hole.
The money simply disappears where it came from, down the drain, leaving a big empty hole.