Liquidity wave lifts markets, but beware drought

By Herbert Lash

NEW YORK (Reuters) - Capital markets are awash in money, lifting all manner of assets to records this year and brightening prospects for 2007, but key money managers fret that an errant move by a key central bank could crash that party.

Whether sparked by Japan bumping interest rates too fast or an offshoot of the slowing U.S. housing market, the wrong move at the wrong time could sop up liquidity and sow havoc, they told this week's Reuters Investment Outlook 2007 Summit in New York.

"I'm worried it might disappear," said money manager Reiner Triltsch of U.S. Trust. "We have this liquidity sloshing around and it's the reason why markets have been going up."

The European Central Bank has raised interest rates six times in the past year to 3.5 percent, which Triltsch said was draining liquidity "at the margin." ECB policymakers said on Thursday the bank stands ready to raise rates again if needed to stem inflationary pressures.

"The question is a policy error on the wrong side could cause that (liquidity) to disappear, and not just disappear, but disappear quickly," Triltsch said.

An untimely Japanese move to raise rates could rattle markets by unraveling the carry trade in which investors borrow in a low-yielding currency -- such as the yen -- to buy higher-yielding assets in other currencies, analysts have said. Pull the plug on the easy money, and it will quickly dry up liquidity elsewhere.

Another source of liquidity has been global merger and acquisitions, which reached an all-time high of $3.37 trillion in 2006, surpassing a previous record in 2000, research firm Dealogic said in November. Low interest rates, stock market gains and liberal credit have driven the boom this year.

The wave of liquidity has distorted markets, especially the money private equity is throwing at takeover targets, said Peter Siris of hedge fund Guerrilla Capital Management. Firms are raising money cheaply and paying prices fund managers never would, which is causing investors to take the money they made on a takeover and invest in other stocks, driving up prices.

"They (private equity) are all way overpaying, because they have got to spend the money. They are like an American consumer. One of the laws here is that money cannot stay in the wallet. Running a private equity fund, you've got it spend it," Siris said.

The enormous amount of money in global markets is puzzling, said Margaret Patel of Pioneer Investments. Global capital flows and new financial products such as credit default swaps have distorted traditional measures of liquidity, she said.

How the surge in money plays out is unclear, but markets have trended higher and will continue to do so, Patel said.

"There's nothing like success to make you want to take more risk. This is a year where risk takers did very well. It's going to go on for a while. Like a lot of financial trends they last longer and go higher or lower than we thought," she said.

Many commodity prices, led by gold, copper and oil, and stock indexes have hit all-time highs this year. The benchmark Dow Jones Industrial Average .DJI and the MSCI World Index .MSCIWD that measures the stock markets of 23 developed countries hit news highs on Thursday.

Thomas Metzold, who manages a portfolio of muni bonds at Eaton Vance Corp. CEV.A, said liquidity was tremendous, and like any capital market, "It's great until it's not anymore."

But, that's the worry, Metzold said. Investors have become complacent as long rallies in commodities and stocks have created the false sense markets have no downside, he said.

"I can't believe I haven't seen a cartoon that shows a tombstone with the name 'Risk -- Rest In Peace' because risk is dead. People don't believe they can lose money anymore," Metzold said.