Is this finally a logical explanation for the equity rally?
Of course, while excess liquidity may be a key driver for asset booms, it does not come without associated dangers. As the MS analysts note, among the greatest is inflation, especially in a scenario of sovereign default:
Finally, we believe that sovereign risk in the major economies is really inflation risk, as the prospect of a default would prompt governments to instruct central banks to print money to pay back debt. Investors should be compensated for such risks by inflation markets.
Some charts to prove their point on QE and record excess liquidity:
Regarding the risk of sovereign default itself, Morgan Stanley note the accompanying rise in nominal bond yields has been almost entirely due to a rise in breakeven inflation rates, rather than real yields. As they explain:
This makes sense as the risk of a sovereign default for countries such as the US, where government debt is denominated in the domestic currency, is virtually zero. If needed, the central bank will simply be instructed to print more money to service the debt. Thus, sovereign risk in these cases is really inflation risk, and should be reflected in rising breakeven inflation rates.
Which goes some way to explaining Wednesday’s treasury yield spike.