Coronavirus and credit – a perfect storm


by Alasdair Macleod, GoldMoney:

This article posits that the spread of the coronavirus coincides with the downturn in the global credit cycle, with potentially catastrophic results. At the time of writing, analysts are still trying to get to grips with the virus’s economic impact and they commonly express the hope that after a month or two everything will return to normal. This seems too optimistic.

The credit crisis was already likely to be severe, given the combination of the end of a prolonged expansionary phase of the credit cycle and trade protectionism. These were the conditions that led to the Wall Street crash of 1929-32. Given similar credit cycle and trade dynamics today, the question to be resolved is how an overvaluation of bonds and equities coupled with escalating monetary inflation will play out.

This article sees worrying parallels with the collapse of John Law’s Mississippi scheme exactly 300 years ago. By tying in the purchasing power of his livres to the value of his Mississippi venture, Law ensured they both collapsed together in the space of only six months.

The similarities with our Keynesian experiment are too great to ignore. Could a simultaneous collapse of fiat currencies and financial assets happen again? If so both the money bubble and financial asset bubble could be fully deflated into worthlessness by this year’s end.

The epidemic

“Ring-a-ring o’ roses / A pocket full of posies / A-tishoo! A-tishoo! / We all fall down.”

Some folk attribute this old nursery rhyme to the plague in England of 1665. But it seems singularly appropriate for coronavirus or COVID-19, about which, as yet, we know little. Its origin is, allegedly, a mutation of a virus from a snake, bat or pangolin. Alternatively, one school of thought believes it escaped from a biological warfare laboratory in Hunan. At the time of writing, officially, the ratio of reported deaths to reported recovered is about 23%, which has been declining as time progresses.[i] While the fatality rate is expected by Western analysts to level out at about 3.5-4% of those infected, its spread is probably much more serious than admitted, with the Chinese being accused of playing the crisis down. To be fair, it will have been hard for the authorities to keep up with its rapid spread. Coming during the Chinese New Year holiday when most factories have closed anyway, there is some confusion about the economic impact. Officially, the public holiday ended on 30 January, but nearly all factories were still closed a week later, and their reopening will be gradual at best.

Not only do Chinese factories supply the world with consumer goods, but they are integral to global supply chains. Hyundai in South Korea has already been forced to close all its factories due to lack of Chinese components and other car makers around the world have expressed similar difficulties. For all intents and purposes, China is shut, and therefore its economy is not functioning. And the longer this goes on it is increasingly difficult to see when, if ever, past normality will return.

China’s experience threatens to be repeated elsewhere, in which case the world, with closed factories and people severely restricted in their human interactions, faces the deepest global economic slump since medieval times, when the plague ravished Europe. Ring-a-ring o’ roses indeed. Meanwhile, financial assets stand close to all-time highs. This is undoubtedly due to money and credit being pumped into financial markets at a quickening pace, and while bond yields are suppressed by freely available money, it seems economic actors prefer not to hold bank deposits relative to the risk of holding equities.

Just when this viral epidemic materialised, the financial system was already on life support and at its weakest. The credit cycle is due to turn down, and the dynamics behind it suggest it could be worse than the Lehman crisis, which was broadly contained to financial entities and residential property prices. This time the banks have accumulated worrying levels of junk debt directly and indirectly through collateralised loan obligations. Money markets are badly stretched with liquidity having miraculously disappeared. Central banks are flooding them with new money even before the periodic banking and systemic crisis has occurred. But all this extra central bank money achieves is to drive financial asset values even higher.

It will be a mistake to blame the financial and economic events that follow on the coronavirus, but inevitably this is what those who have relied on a failing monetary system will do. As to the course of the coronavirus epidemic, only time will tell. With financial markets already teetering on the edge of a systemic and economic crisis, the timing of its emergence could pull the trigger on a global financial and economic collapse.

The credit cycle and asset inflation

We should remind ourselves that the credit cycle, which is the manifestation of banking psychology in changes in the availability of credit, is on the turn. There are three distinct classifications of credit demand affected: the non-financial economy, speculators (particularly large hedge funds) and governments.

Commentary by financial pundits almost exclusively concerns the non-financial economy, with monetary policy officially targeting consumer prices and employment. The encouragement of banks to lend is part of it. By creating an artificial boom, banks are further persuaded to increase their lending at suppressed rates, leading to a misallocation of capital resources.  Prices of consumer goods then begin to rise, and interest rates with them, undermining the basis of business calculation. Sensing increased loan risk, the banks begin to restrict the expansion of bank credit, which only increases credit risk even more. Banks begin to panic, withdraw revolving credit facilities and consequently they drive the economy into a slump.

That is a brief summary of the classic credit cycle, but it bears little relation to that of today. Instead of bank credit being predominantly deployed for production, it is increasingly taken up by financial intermediaries lending to consumers. Furthermore, consumers have reduced their deferred consumption in the form of savings, which in former times were integral to the workings of the credit cycle. And despite central bank propaganda about being primarily interested in the non-financial economy, this sector has become progressively demoted relative to the funding needs for financial speculation in order to maintain asset values and sustain government borrowing.

Today, in the US, UK and many other developed economies, with the exception of pension and insurance funds, savings as an economic force have virtually disappeared. The majority of consumers are now living pay-day to pay-day and continually in debt with respect to their current spending. Predominantly at the expense of ordinary people, wealth and real income have been increasingly transferred from productive individuals to governments, the banks and their favoured borrowers through monetary debasement. The effects of monetary debasement have been concealed by statistical method, leaving consumers considerably worse off than slavish followers of government statistics are generally aware.

Every credit cycle impoverishes consumers even more, as their earnings and diminishing savings are continually eroded by ever accelerating monetary debasement. Having tamed the statistics, governments such as the US, the UK and some members of the EU now think they can abandon all fiscal probity. They think they can finance budget deficits, public investment projects and even sustainable energy projects with only limited consequences for the currency’s purchasing power, all by inflationary means. It is, of course, all delusion, consistent with end of cycle psychology.

The reality is government spending is out of control. The net present values of future welfare commitments are materialising in the form of current liabilities. Governments are funded by the expansion of their central banks’ balance sheets. The only thing keeping this illusion going is the activities of speculating hedge funds leading directly and indirectly to continually rising financial asset values.

But there is a crunch coming. It appears to have started to arrive last September, when the US repo market suddenly seized when the overnight rate spiked up to ten per cent. Such are the accelerating demands of government funding that they cannot be accommodated as well as the interest arbitrage activities of the speculators active in repos and foreign exchange (fx) swaps.

The speculators, particularly the big relative value hedge funds, turned bullish on the dollar in April 2018, three months after President Trump took office. It was clear, to the speculators at least, that his proposed tax cuts would stimulate the economy, drive up government borrowing rates, and therefore foreign demand for dollars to invest in US debt at a time when euro and yen interest rates were trapped under the zero bound. That point is marked by the up-arrow in Figure 1 below, when a clear breakout in the dollar’s Trade-Weighted Index took place.

Photo 1 XAU NOW 32

The dollar’s trade-weighted index is heavily weighted in favour of the euro. Since the ECB had pegged its interest rates below the zero bound, it gave rise to an immensely profitable trade. A speculator could borrow euros at close to zero interest rates to buy US Treasury bills and even coupon-paying bonds for a yield pick up of over 1.5% in April 2018, rising to 2.39% for T-Bills a year later as the Fed tried to reduce its balance sheet. Much of this trade is conducted through fx swaps, which lock in interest rate differentials for as long as a year (sometimes more) and whose 10% deposit for the forward leg allows a speculator to gear the trade up ten times. The basic mechanism is shown in the schematic illustration below (courtesy of The Bank for International Settlements).

Photo 2 XAU now

Putting counterparty risk aside, this is seen by hedge funds as a riskless trade, with the leg at maturity fixed at the outset. Therefore, it operates much like a repo. But it should be noted that when the trade is unwound, changes in the value of the collateral and the exchange rate have to be absorbed directly or indirectly by the swap provider.

Rising bond yields and a fall in the dollar exchange rate will have significant consequences for swap availability. Meanwhile, according to The Bank for International Settlements, FX forwards and swaps outstanding grew from $53.9 trillion to $59.4 trillion in the first half of 2019, the vast majority involving dollars. Given the increasing popularity of this trade it is likely to have grown further into the year-end. It is now straining the resources of the banking system to lend dollars as part of swap arrangements at the same time as the primary dealer subsidiaries of the G-SIBs have to hold increasing quantities of inventory of US Treasury bills and bonds.

We must also consider the currency effect. Because the trade requires the FX swap counterparty directly or indirectly to short euros or yen for dollars and to invest them in T-bills and short maturity US Treasuries, the effect has been to depress the euro and the yen while increasing demand for dollars. So much so, that the trade imbalances that favour the euro and yen and strongly disfavour the dollar have not been uppermost in currency pricing. Normal trade related supply and demand has been swamped by speculative demand for the dollar.

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