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Cheap money: a recipe for bubbles?

2009 has turned out to be an excellent year for investors, partly reversing the steep losses of 2008. Champagne may be called for, but its delightful bubbles are not the only ones being contemplated by investors. After all, we are in the aftermath of a crisis, a point in the cycle which in the past has often served as the birth place of financial bubbles. The combination of extremely low interest rates, ample liquidity and limited demand for money by the real economy, can easily cause overinvestment in certain financial assets. This is why liquidity driven markets have a tendency to ignore poor economic news, a fact nicely phrased in the saying “bull markets climb a wall of worry”.

Recently, several renowned economists have warned that new bubbles may be in the making. The most obvious one is in Asian real estate. Real estate prices in countries like China, Hong Kong and Singapore are soaring, a fact which is easily explained by the combination of high economic growth, a strong increase in money supply and interest rates which are artificially low because of linkages with the US currency.

In the developed world, new bubbles are much less likely to emerge than in Asia or Latin America. After all, the availability of low interest rates alone is simply not a sufficient condition for bubble blowing. A bubble also needs to be fuelled by an excessively strong growth in money supply. As it happens, the growth in broad money supply indicators in the US and Europe (M2 and M3) is very modest, much lower than in the 2003 to 2007 period, when the housing bubble was created. Although central banks still create huge amounts of money, this supply does not fully reach the real economy (lending growth is still modest) and gets stuck in the broader banking system, where it is probably parked in government bonds and other low risk assets.

Apart from the developments mentioned above, we should mention another phenomenon which may create bubbles: the “carry trade”. This trade is executed by hedge funds and other financial players, which borrow money in a liquid, low yielding currency and invest that money in risky, higher yielding assets. Before the crisis, the funding currency of choice was the Japanese yen, now it is the US dollar. Since Bernanke has pledged to keep US rates at near zero for some time to come and since the US is not likely to object to a weak dollar in the near term, investors are happy to borrow in US dollars and invest in high yielding currencies, commodities and equities. This may help to create bubbles in any of those asset classes.

So what can investors learn from all of this? Bubbles create temporary investment opportunities, but timing is of the essence. In the US or Europe, bubbles are not likely to develop anytime soon, in spite of the ultra low interest rates. Elsewhere, we cannot yet identify fully blown bubbles, but we can see a few candidate bubbles. Asian real estate, commodities (including gold) and commodity related equities and currencies are good examples. The US dollar is a kind of bubble in reverse, as it has been further weakened by the carry trade and is clearly undervalued (fair value against the Euro is about 1.20). Therefore, the US currency could perversely prove an excellent safe haven if and when financial markets correct and the players of the carry trade are forced to buy back dollars.