What means for cryptocurrencies the recent fall in interbank lending
The craze in stock markets called “buy the dips” is going to end. In other words, trying to profit from the temporary downsizing of securities to buy them and make profits on a renewed climb. Problem: the recent rise of stocks was not physiological at all. Even the media mainstream are opening their eyes to the hypothetical end of the aforementioned mania: first a spokesman for Goldman Sachs on the Financial Times, then a manager of a famous hedge fund on Bloomberg. Needless to say that both, not having a coherent theory about the business cycle, speak only of external shocks or lack of volatility as a cause of the recent crash in the stock market, but this is something we will discuss later in this article. Let’s talk before of the importance of these two news. In fact, they come in concomitance with an event that few have given weight, while instead it represents a crucial point in the development of the business cycle.
In fact, there are various tools to understand when the boom is practically at the end and is about to enter the bust phase. In addition to the yield curve, the other important factor to keep an eye on is the interbank lending market. According to the most recent data, in the first few weeks of 2018 interbank loans fell by about $55 billion, a decline of about 80%, reaching a historical low.
The interbank lending entered a long-term decline following the Federal Reserve’s response to the 2008 financial crisis. Since then, Fed’s QE programs have injected trillions of dollars into bank excess reserves and, in addition, the Fed has continued to pay interest on these reserves. Both measures have significantly improved the capital ratios of the banks and have reduced the need to borrow from each other through interbank lending. Nevertheless, the magnitude and timing of the recent decline in interbank lending is anomalous. Why is it important? Because this parameter represents the thermometer of trust that commercial banks place in one another. And now that the various central banks of the world are pulling the monetary handbrake, those sectors more influenced by their actions are worried.
It will be fun now, given Trump’s proposal to make an infrastructure expense of $1.5 trillion. This is the classic Keynesian bias according to which public spending has helped the economy of any country to come out of a period of economic decline. For example, in the United States, infrastructure spending (on transportation) is tens of billions a month (an average of $30 billion for 2017 compared to $25 billion in 2011 and $18 billion in 2004). So, talking about a shortage of expenses in this sector is nothing but criminal. Except then we discover that what have been built is nothing but useless.
So, following this Pharaonic plan and the will of the Fed to pull the monetary handbrake by normalizing its policy, who will buy Uncle Sam’s bonds? The effects of this policy began to be felt in the financial markets. Bond yields have soared and stock prices have crashed over the last weeks.
QEs pushed the demand for Treasury bonds because they introduced liquidity into the accounts of the Primary Dealers. QT does not directly drain money from these PDs, but has the same effect, because it denies the funding they need to buy those bonds. This is the same problem that caused the stock market crash in 2008. As a result, we should not be surprised by stock market action over the last weeks. Nor should we be surprised if we see similar crashes several times this year, or at least until the Fed reverses QT. But this time we are at the zero bound, and with it a small space for maneuvering and gigantic possibilities that the whole thing gets out of hand.
As Zerohedge reminds us, two scenarios are now unraveled along the way: one in which traders consider VIX shares to be poorly structured and sell only those for the time being (awaiting a more consistent tapering by BOJ and ECB); or they sell VIX securities as a whole and start a cascade of sales in other sectors too. Whatever the path, it is only the tip of the iceberg because the underlying problem, never emphasized enough, is that central banks policies triggered a great disconnection. Their huge purchase offer for certain securities has not only allowed for a greater misallocation of economic resources, allowing the financial zombies to stay alive, but has guiltily eroded the pool of real savings.
And in order to maintain their living standards, most people are forced to resort to revolving credit.
The mad expansion of the money supply by the various central banks has not reached the broader economy (only a small part has done so, the rest has remained confined into Wall Street). This means that any inflationary effect of the money escaped from these financial canyons has been controlled in some way by central planners through the tax system. The euphoria, this time, remained confined to the stock and bond sectors. The middle class has had little access to it, especially after the easy credit spree of the Greenspan/Bernanke/Yellen era. This means that while in Main Street a period of deleveraging was partially granted, Wall Street was artificially kept afloat thanks to the generosity of central banks.
Nevertheless, the economic distortions continued. Negative cash flows of corporate pachyderms, financial engineering, bureaucracy and taxation are the four horsemen of the apocalypse who, through the flashing red light of interbank loans, will tear down the illusion on which the economy has believed since 2009.
At that time the Federal Reserve responded in a way that no one had ever imagined: a gigantic credit expansion and the lowest rate of interbank lending ever.
Federal Reserve has thrown thousands of billions of dollars into the financial sector and into the banking system, hoping that the so-called “trickle-down wealth effect” would turn into more spending and jobs across the broader economy. It wanted to stem the fall in house prices and stocks, but in doing so it did nothing but make things worse, fulfilling its unofficial mandate: safeguarding the commercial banking system and government accounts. The answer obviously should not have been an active intervention in the markets, distorting the healthy signals, but a passive monitoring of the situation. Impossible? For those who are ignorant in economic history, surely. In short, Federal Reserve has prevented the whole economy from facing a healthy correction, necessary after the last business cycle induced by its previous loose monetary policies.
Ludwig von Mises was the first to propose a coherent theory of how central banks are the cause the business cycle. His reasoning began with a simple question: “What pushes a large group of entrepreneurs to commit the same mistakes at the same time?” In fact, they rely on interest rates to choose those sustainable investment projects to pursue, how many people to hire, what kind of capital goods they need, etc. Without external interference, the interest rate plays a fundamental role between borrowers and lenders as it reflects the interactions of the various market players, who allocate savings based on their own time preferences.
For example, if market players start to save more and are ready to lend some of their savings to potential borrowers, the interest rate goes down. The supply of resources saved (land, building materials, equipment, etc.) is transferred into the hands of borrowers who will use them to expand their businesses, buy houses, start a new business, etc. This type of action will only be undertaken if borrowers expect to earn enough money to repay what they have borrowed (plus interest) and gain some profits. The interest rate, therefore, not only carries out a balancing act, but also coordinates production within the economic environment so that we can judge which business projects are worth pursuing and which are not.
This process of more efficient allocation of resources saved, based on reliable and accurate informations, turns into chaos when central banks interfere; for example, when the Fed artificially expands credit, lowers interest rates and makes it appear that there is a greater amount of resources saved. Entrepreneurs take the new funds to hire new workers and buy new tools, machines and other capital goods. At the same time, consumers also take advantage of it and buy houses, cars and other consumer goods. Everything seems great: employment rises, incomes go up, companies see their inventories empty, stock prices fly to new highs. Even amateur investors are successful, because their income is increasing and it is difficult to make bad choices when everything goes well.
Is this therefore the road to perpetual prosperity? Unfortunately no. New pieces of paper created from thin air will not increase our production capacity; nor new loans or credit cards. Beyond appearances and what is seen, production capacity is destroyed and resources are wasted by a misallocation of capital goods. At a certain point entrepreneurs find out that they have been induced to pursue riskier projects, whose completion requires more time due to false informations from the credit markets. As a result, easy credit masks the availability of real capital. There seemed to be all the materials to build a house, and instead the calculations were wrong, as suggested by Mises with his example of the mason. The prices of capital goods, by virtue of their scarcity, begin to rise dramatically and all those unproductive projects are abandoned. This also means that all the workers employed in these projects will have to find a new job.
When central banks pull the monetary handbrake, the crisis emerges: market players begin to reconsider how they have allocated capital in light of new expectations on interest rates and the profitability of their current projects. This phase of the business cycle, even if it is marked by the rise of unemployment, the fall of stock prices and widespread bankruptcies, it is actually a healthy process and one must allow it to take its own course. Supporting stock prices and ignoring the fundamental problems of the economy is not the solution, it is a palliative; we can not solve a business cycle by causing another one.
These are the reasons that have transformed the economic environment in a barrel of financial gunpowder. This is because, given the current interconnection of all global financial institutions, the failure of a reality in the US can mean the failure of one in Europe. Liabilities of one are the assets of another. Think of one of the biggest financial zombies in Europe: Deutsche Bank.
Although central bank interference has allowed the current system to gain some time, the distortions have made most of the risk and portfolio management activities unproductive. Deutsche Bank’s fixed-income assets recorded revenues of €554 million in the last quarter, a 29% decline from the fourth quarter of 2016. For the year as a whole, revenues from fixed income were €4.38 billion, 14% less than in 2016. There is no money to be made, it is not worth the time, the effort and now also the budget resources are very limited. In short, now that central banks are preparing to pull the monetary handbrake, we realize that there are unproductive investments that are not worth pursuing.
But the German bank is not the only financial zombie in circulation. The Italian commercial banking sector is a big bubble ready to pop, especially when the ECB will end its QE program and it will be realized that the secondary market of government bonds has been torn apart by manipulation of central planners. As the chart below shows, in recent years almost all types of large investors have become net sellers of BTPs. Stated differently, for over a year the only marginal buyer of Italian bonds has been the ECB (dark blue).
And guess who was one of the biggest sellers at the ECB? Nothing but Italian banks. In fact, Italian banks reduced their positions in sovereign debt securities by €12.6 billion in December, and by €40 billion in the fourth quarter of last year. Since the start of the European QE, around €100 billion in Italian bonds have changed ownership: from Italian banks to the European Central Bank.
On the one hand this is good news as it suggests that Europe is flaking from within. In 2011–2013, uninterrupted purchases of sovereign debt by local banks, which were too afraid of investing in other assets, were one of the reasons why the ECB launched the QE: skyrocketing the prices of European government bonds and support the balance sheets of European banks. The downside is that while European banks sell sovereign bonds, they have moved the proceeds to other, much more risky assets; assets whose value will drop when the ECB finally pulls the handbrake.
Keep an eye on Italian banks and their holdings of BTPs: once the reduction is reversed and the banks begin to buy back, it is safe to assume that next Draghi’s QE will not be so far.
Meanwhile cryptocurrencies, especially Bitcoin and Bitcoin Cash, are gaining more and more traction in the markets, lately as an indicator of sentiment among other things. Along with gold, they are assuming the role of financial hedging.