Saturday, August 22, 2015

Eye on the credit markets now

In times of equity market tumbles, there can be a follow-on attached credit market squeeze that has a broader and more fundamental impact on both individuals, small companies, and large corporations than does the tsunami of a serious decline in the S&P 500 or any other index.

1997 and 1998 began with the Asian currency crisis that morphed into the Long Term Capital Markets fund bust and the impact of extreme amounts of "trust me" lending by large private banks to Greek shipping magnates and others of dubious ethics. While the equity market was not doing well at all, especially anything related to finance, the resulting credit squeeze that led, for a week or two in the fall of 1998, to a real global credit freeze was terrifying to those who knew what was going on. As always with an event like that, going through it is a time when no one, or almost no one, has any idea what is going to happen next.

Of course, the most recent event of this type is fresh in the minds of most people over 25 who read.  Equities began leaking in late 2007 and through the first half of 2008 before the bottom dropped out completely on equities in the fall of '08, and at the same time the credit markets became almost inaccessible for a few months, culminating in March 2009 for equities.  Both the equity and the credit markets had a long climb back to normalcy.

What leads to this concern now is primarily the significant weakness in many country's currencies in the midst of this global stock market reset.  Currency, in a sense, could be viewed as a commodity. When the value of a currency is in flux there can be a period when determining value is difficult. When China devalued, it set in motion uncertainty that cuts across many countries, and is widespread in emerging markets. Lending, financing, and trading when broad swaths of the currency markets are unstable is difficult at best. Everything cannot be perfectly hedged, and with the shortsighted Dodd Frank bill now significantly limiting the inventories of securities that large U.S. or U.S related banks can hold for their market making activities, the desired hedges may not be easy to put together or even adequately available.  A credit crisis could ensue if markets don't settle down. As we learned painfully in 2008/2009, a credit crisis can lead to recession.

Given the gains of recent years for those that were in the market constantly, the equity decline so far is not especially alarming.  More declines may well come and change that view as most investors will be on the sidelines watching at first.  What would be severely painful is a full fledged credit market meltdown. That is not likely but, with the currency markets behaving the way they are and the usual market makers handcuffed relative to the past, it is not impossible.

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