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.  Continued...