MARKET MOVER - BNP PARIBAS - Investment Services India

ond market attracted huge swathes of global
currency reserves, providing a stable inflow of capital
into the US for most of the past decade. Despite
these inflows, the USD remained weak because the
US provided cheap USD liquidity globally via its
powerful banking system. Hence, the funding
position of the USD is key to explaining its reverse
relationship with risk appetite. This relationship,
which is likely to persist, constitutes the reason why
we expect the USD to stay weak for the remainder of
this year. Nonetheless, we see a period of USD
strength again next year when we expect slower
global growth in combination with a potential EMU
bond crisis to hit investor confidence once again. The
USD’s position as a funding currency underlines its
status as a safe haven play at times of financial
market stress.
What drives risk appetite?
The assessment of risk appetite requires analysing
liquidity in the context of economic circumstances.
Within stable economic conditions (inflation not
deviating substantially from the 2% target and real
growth operating around the growth potential of
economies), the relationship between liquidity and
risk appetite is linear. The more liquidity there is in
the market, the better for risk appetite. Liquidity can
come from various sources: central bank liquidity
(narrow money supply); the private sector taking out
loans from banks (credit multiplier); and foreign
liquidity, which itself can be divided into income from
abroad via trade or investment-related flows. At
present, central bank liquidity is the focus, while the
other factors of liquidity generation can be ignored.
This applies especially to the credit multiplier, which
will have to remain slow in the context of deleveraging.
For the next quarter, we see central bank
liquidity continuing to support risk appetite. Also
supportive are:
• Japan intervening on the FX markets, leaving
added reserves unsterilised in the system;
• Other Asian central banks limiting the pace of
currency appreciation causing currency reserve
growth gaining momentum again;
• The Fed interest rate statement released this
week, which was dovish – supporting our projection
that it will increase funding into the system in
November;
• The ECB continuing to allocate unlimited repos;
and
• The likelihood that the BoE will soon rejoin the
club of liquidity-adding central banks.
Chart 2: US Cash Position Relative to Total
Assets (measured by total equity market cap)
Still High
Source: Reuters EcoWin Pro
Chart 3: Dow Jones versus Changes in Global
Currency Reserves
35
30
25
20
15
10
5
0
Apr-05 Apr-07 Apr-09
Y/Y %Change Global Reserves
Source: Reuters EcoWin Pro
14000
13000
12000
11000
10000
9000
8000
7000
DOW Monthly Close (rhs)
While this liquidity creation will support asset prices
in the short term, the longer-term implications are
less clear. There have been very few cases where
the success or failure of quantitative easing can be
evaluated. BoJ President Shirokawa points out that
quantitative easing may be able to stabilise
expectations via rising asset prices, but that
supportive effects on the economy should not be
overestimated. This assessment is probably correct
given that the elasticity of the economy to changes in
interest rates or rate expectations is low when rates
are near zero. Once the asset price boosting effect
has worked into higher prices for shares and other
risky assets, markets will look for new direction. This
direction will come from the assessment of the
economy. Despite our bullish risk and equity market
outlook for the next quarter, we maintain that the
long-term outlook for equity markets does not look
promising should Western economies not pick up
momentum next year. In fact, we see global growth
slowing from 5% in Q2 2010 to 3.7% in Q2 2011.
Currency markets will trade accordingly. While high
Hans Redeker 23 September 2010
Market Mover, Non-Objective Research Section
45
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