What's Triggering the Liquidity Boom?

by: James Picerno

As signals in the bond market go, Thursday's was fairly lucid. When translating bondspeak to street language, the trading in the 10-year Treasury on Thursday might be interpreted thus: Ahhhhhhhhhhh!

As the chart below shows, the 10-year yield jumped more than a little, closing at roughly 5.1%. This is the first time the benchmark Treasury has been swimming in those statistical waters since last July.

10-yr T-Note Chart

What caused the revaluation in the price of money? In broad terms, it's clear that risk is being repriced. What's triggered this repricing? Liquidity invariably turns up as a suspect. Mr. Liquidity is innocent till proven guilty, of course. But for the moment, he's been arrested and awaits arraignment.

Meantime, the court of public opinion will survey the evidence until a formal decision arrives. Exhibit A is the supply of liquidity in the global economy. But most standards, it's in amply supply, and then some. But for every action there's a reaction, which may or may not arrive in a timely fashion. Eventually, however, liquidity will have an impact and the debate about what comes next will be done.

In fact, we've already witnessed some of the impact in recent years in the form of price inflation across the spectrum of asset classes. Bull markets, in other words, have reigned supreme.

The Federal Reserve has, of course, been a co-conspirator in the liquidity boom. In fact, the central bank continues to keep M2 money supply bubbling to the tune of more than 6%, based on a year-over-year basis using weekly data. Through May 28, money supply increased by 6.4% over the past year. In contrast, the rate of growth in the summer of '06 was comfortably under 5%.

There are other measures of liquidity, and perhaps more relevant ones. But, no matter which gauge you employ, the result is the same: the world is awash in capital. We know where the cash has gone, now the question is where is it going in the coming weeks, months and years. Indeed, finding capital a home that offers an expected return that will beat the risk-free rate available is looking more challenging by the day. No doubt there's still opportunity left. But comparing that opportunity against the sea of cash-laden investors looking for financial salvation, frustration looks set to rise a notch or two.