LIQUIDITY ANALYSIS. NOT ALL RATE RISES ARE CREATED EQUAL
[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +9.4%]

Mid-way through the recent bond market sell-off, I discussed the meaning of rising yields with Macro Man. He elegantly summed up my position with the sentence: "Not all rate rises are created equal". My point was that interest rates can change for a variety of reasons. As the great Horace W. Brock taught us almost 20 years ago, long-term interest rates change whenever new information alters the behavior of those who demand and/or supply loanable resources in the credit market (*). When discussing the valuation of risky assets, this simple insight can be very useful.

If interest rates increase because participants get new —and very bullish— information about the state of the global economy, the impact on risky assets is not necessarily negative. Demand for credit increases at every level of the interest rate as firms rush to borrow funds to take advantage of the expected increase in profitability. Now, interest rates can go up for seemingly "bad" reasons as well: reduced foreign capital inflows, rising inflation expectations and budget deficits, etc. (a bearish proposition in terms of risky assets).

In my discussion with Macro Man, I argued that spreads can go a long way in telling us why interest rates change. Narrowing CDS and high-yield bond spreads, plus decreasing inflation expectations usually tell a bullish story. In the event, this is largely what happened: the stock market took off despite higher interest rates. Poring over my spreadsheets again this morning, my impressions are more mixed. Year-on-year, spreads still tell a distinctly bullish story. In the short term, however, it would be nice if inflation expectations spreads would again decline towards the 2.30%/2.35% range.

(*) Horace W. Brock. "Determinants of interest rates", Euromoney, 1988. The Financial Times's Tony Jackson, for expample, seems to take it for granted that bond yields went up because of reduced foreign capital flows. There is an element of truth in that: our Global Dollar Liquidity measure shows declines for two weeks in a row. But spreads were painting a rosier picture.