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Against the tide: How capital liquidity could leak away

Continuing high levels of capital liquidity rest on flows from securitization and derivatives, and from dollar dominance in international trade. Neither source is immune to a violent adjustment.

Why are global bond yields so low, despite the fact that central banks everywhere are increasing interest rates? Why does the dollar stay stable when the US is running a huge external payments deficit?

I have argued in previous columns that the main reason why global bond yields have not risen in parallel with interest rate increases is because there has been a glut of new sources of liquidity outside traditional monetary aggregates: namely securitized debt and the huge derivatives market. This liquidity has absorbed much of the impact of rising short-term interest rates. Thus the cost of long-term capital has remained low.

It is a key phenomenon of the past decade that the quantity and price of money are no longer controlled by central banks. Central bank-dictated reserve ratios no longer set the credit multiplier. So increases in policy rates have not affected the cost of capital.

The currency accelerator
Source: IMF, WTO, Independent Strategy

This new form of liquidity has sustained financial markets but it also brings increased risk.

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