It has been quite a while since we had the great market sell off in January of this year. But I would like to point something out about this sell-off that I found strange. It’s as if all the asset classes fell in unison. Let us look at the most liquid asset classes:
Equity markets post Jan 2018:
Bond markets post Jan 2018:
Commodities markets post Jan 2018:
Cryptocurrency markets post Jan 2018:
Thus, all of the markets had major price corrections. Why?
Because no one can afford to pay for any of these assets, atleast, not as much as they could just a month before.
Because people had gotten their hands on lots of money for cheap!
How can anyone get money for cheap?
They can get money from the banks when the lending rate is low.
When is the lending rate low?
When the banks can procure money from the government (you know that thing called ‘fed hikes’ that the Fed does? Or if you are from India, it’s the RBI that does something called ‘hikes’)
The way the world works is that money is created, indirectly by the governments (How money is created is a completely different ball game and I will go through that in another article), when they set a fixed rate at which the banks can lend at. If the rate is low, more customers are willing to avail loans, and the banks go, ‘Hey, I can lend money to customers real cheap.’ Customers will just LOOOVE the cheap loans! They then go and lend it to companies / institutions / people / students / home buyers.
They also exclaim, “We should preferably bundle up the returns from the interest paid by the home buyers into securities, get them rated AAA and sell them to the highest bidder! Ahem, I meant lend it and make money off the interest rate difference (Spread).”
Now, one side effect of letting everyone have a lot of money, is that there is more liquidity in the system. As a result of which, more people start buying things they don’t need, with money they don’t have, to impress people they don’t like. And it is a bidding war that happens, because everyone can now pay more for that shitty refrigerator, and the seller knows he can find someone willing to do just that. The seller marks up his prices and as a result everything gets pricier, and that is inflation.
What happened in January?
Now governments worry about inflation, they don’t like it. If prices of things go up too fast, the common people start to notice. And they don’t like things getting dearer. In January, macro-economic data emanating from America indicated that inflation was slowly edging higher. Till then, although there had been rate hikes in between, there were no fears of inflation. But now, wall street felt that rate hikes were around the corner. The govt. controls inflation by these rate hikes. And by making money costlier they discourage weaker entities from borrowing and banks from lending money to other parties. As a result, all the parties realize that money is drying up. The other parties, i.e. the weaker entities, which were not doing well to begin with, and whose performance was being masked by easy money cheaply available from different banks/institutions close down (So far they were being able to pay interest because it was low, with interest rates rising, especially in cases of floating rate loans (loans where the prices change with the fed rates), interest servicing becomes difficult if your business was not doing exceptionally well in the first place. This is nature’s game, rather Wall Street’s game of survival of the fittest. Poetic justice befalls those banks/financial institutions (FIs) which did not lend to intrinsically good companies i.e. didn’t do a proper check/due diligence.
We need to understand that the parties that invest in these markets, such as commodity trading companies (Trafigura), stock trading companies (various hedge funds) even cryptocurrency traders often borrow from the banks to make money in the market.
The previous year had been huge for the market, with several asset classes reaching record highs. If you go through the above charts, you will easily be able to see the rally in almost all of these asset classes. Now with the forecast of inflation rising, the investor community realized that in future raising debt would be quite expensive.
This has 2 main effects:
1. People get cautious with whatever money they have now so they stop investing
2. People tend to remove their money from risky and speculative investments
Institutional investors start to withdraw their money from risky assets. These assets can be that cement factory being built in Nigeria, that hospital being built in India or that speculative asset that ‘in theory’ has no value, i.e. cryptocurrency.
So now that we have rationalized the sudden decline in the crypto markets, let’s talk about resurgence. One has to understand that the valuations for even the equity and commodity markets were hot during the period just before the decline. Although we have die-hard fans of crypto who can sooner chew off an arm and a leg than admit that, that there was general euphoria and exuberance in the market, I will still have to point out that exuberance it was.
I will discuss this issue in my next post. The point at the end of the day is to figure out when the macro data will start to show that inflation is slowing down, or when the general people feel (rather, the head of the fed feels) that the rates are going down.
To do this we need to analyze many things, from where and how money comes from to who are the key players in the game. I will go through this in my next blog.