Pretty simple

Morgan Stanley's Serhan Cevik, left to his own devices and thinking big picture while the senior strategists are on vacation, comes up with a polite one paragraph worth reading in "the Limits of Engineering" on the MS-GEF page. Wonder what Dick Berner and the amenable gang will say when they get back!

Middle East/North Africa
Limits of Engineering
August 16, 2007

By Serhan Cevik | London

...The abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon.Central banks’ coordinated attempt to flood money markets with cash may ease the immediate pain, but would not really address systemic threats. This is why we need to dig deeper and identify underlying fragilities in the global financial system. It seems that the ‘original sin’ was the extreme monetary easing campaign that ended up lowering the average short-term interest rate in the world from 4.8% in 2000 to 1.6% in 2003. Of course, with real interest rates declining from 4.3% to 0.8% over this period, it was not surprising to witness the emergence of a global liquidity wave and greater appetite of risk-taking among investors. However, the abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon and kept expanding even as central banks tightened the policy stance to 3.7% last year and 4.4% of late. In other words, despite higher (real) interest rates bringing an end to the expansion of monetary liquidity, financial market liquidity increased (with occasional moments of pause) and fuelled the search for higher returns in riskier assets. But what is (or possibly was) behind the disconnection between monetary and market liquidity? We think that a couple of factors have made the most significant contribution to the pool of global liquidity. First, the recycling of current account surpluses has helped to de-link financial conditions from the behaviour of short-term interest rates. Second, financial innovation and the rise of new investors have become far more important in determining market liquidity. As one would have expected, these new financial trends depressed volatility and set the stage for greater risk-taking through highly leveraged derivative-based instruments. However, this type of liquidity is partly a function of confidence and thereby vulnerable to sudden changes in sentiment (see The Curse of Alpha, November 16, 2006). Hence, while structural factors are likely to keep the ‘excess savings’ channel intact, the ‘high-tech market liquidity’ channel is fragile and can quickly disappear when an unexpected shock occurs...