Robert Lucas' 1990 paper, "Why Doesn't Capital Flow from Rich to Poor Countries?" examined the modern characteristic of global capital flowing uphill. This backwash recycling of global liquidity has been nicknamed The Lucas Paradox. Benoit Coeure' of the ECB addressed some of the problems with global liquidity and risk appetite in a speech yesterday. A few key takeaways:
1. Abundant liquidity facilitated spread compression and Euro member state yields converged at low levels. These spreads "did not reflect the differences in macroeconomic fundamentals. In other words, abundant liquidity undermined market discipline....an important pillar of macroeconomic and fiscal discipline." (emphasis mine)
2. There is a strong link between the liquidity cycle and the availability of safe assets.
The internal metrics are showing signs the Paradoxical flow of capital is normalizing. More importantly, the record volume of US supply is losing the key foundation to being viewed as "in shortage.," economic downturn and crisis. T-Bill auctions are 4.5 times over subscribed near zero. The Treasury should "snap" fill a larger portion of the demand. The Primary Dealer community has become an incrementally more significant source of support for longer term supply. Federal Reserve transparency, distorted as term promises, is promulgating a concentration of risk outlined in #2 above in the PD space. (MF Global the worst example) That serious, yet attenuated, negotiations in the EZ only emerged after markets weighed in should not be taken lightly. As central bank balance sheets explode around the globe, the US (and owners of US government debt) should keep these observations in mind.
Special thanks to Danny Noonen at Capital Edge NY for Treasury Supply metrics.