Considerable risk of a correction in asset markets

Rising markets bring about more liquidity (leverage). When markets reverse liquidity dries up rapidly. Moreover, nobody will knock on your door and let you know that liquidity is about to diminish!

If liquidity suddenly or gently evaporates the most vulnerable markets will be today's most popular themes: industrial commodities (nickel, tin, zinc etc), brokerage and exchange shares, and extended and popular emerging stock markets (India, China, Mexico).

But not all is bad! Tighter international liquidity will temporary support the US dollar. The dollar started to rally at the same time bond yields began to move up in early December 2006 and could benefit in 2007 from a repatriation of funds invested overseas.

Dollar rally short-term

This does, however, not change my long term negative stance about the US dollar. Equally tighter global liquidity could benefit Japanese asset prices on a relative basis.

In 2006, the Japanese stock market was one of the world's worst performing asset classes suffering both from a weak Yen and declining stock prices. Tighter liquidity coming from declining speculative asset classes could end the Yen carry trade and lead to Japanese asset prices out-performing their foreign counterparts.

A contrary play would now be to purchase smaller market capitalization stocks in Japan (i.e. the NYSE listed Japan Smaller Capitalization Fund - JOF).

And although one of my favorite asset classes remain precious metals (gold, silver and platinum) some near term weakness should not be surprising.

Oil producers and bond prices

In the US, the decline in home prices has brought about some illiquidity in the household sector and internationally, the decline in oil prices has brought some diminishing liquidity among oil producers, which may account for the stagnant growth of Foreign Official Dollar Reserves.

I am aware that some observers will argue that less liquidity at the hands of oil producers is offset by more liquidity for consumers around the world and specifically in the US, because a decline in oil prices has a similar impact as a tax cut.

But that is precisely the point. Oil producers tend to have a high saving rate as the oil revenues flow to the state or state controlled companies - this particularly in OPEC countries, where, when oil prices increase, international monetary reserves increase rapidly.

Conversely, when oil prices decline, the oil producers' reserve growth slows down or their reserves even decline while the US consumer immediately spends the windfall from lower energy prices.

Therefore, while economically beneficial for the US consumer, lower oil prices can lead to less international liquidity, which means less purchases - or even outright sales - of US treasury securities by oil producers.