The danger of currency overvaluation

03/09/2020 in finance, macroeconomics, japan using tags 2020, macroeconomics, economic death spiral

What happens during a stock market sell-off like the one we are experiencing today, when equity valuations have past the peak? Most importantly, what is currently happening to the bond market, which is in my opinion, much more important that the stock market.

Sadly the world may be entering a time where it will transition towards negative growth for the next few years. The drop in interest rates is effectively “pricing in” the future of little to no growth here in the US, and I am noticing this in the bond markets of different places. With the economic attacks to the US shale industry by OPEC+, it could spell the end of an export driven economy unless there is a coordinated bail-out of sorts.

The market may also be pricing in the deflationary effects of nCoV-2019. As there is more information available about the illness and producer/consumer reactions to the illness, market participants are capturing the total damage to the world economy. My fear around this is if we’re already in a situation where we’re not sure what the values of things are anymore. The market behaves very weirdly in this situation as even the investment banks will have trouble buying/selling or holding onto their assets. Rather they will fly to safety by buying 10-year treasury notes, or negative yielding Japanese bonds and the German bund.

As market selloffs occur, really this is just buying more and more US dollars. When you sell shares, you are buying dollars. That drives the price of each dollar up slightly, while dropping the value of all shares slightly. Couple this with the fact that price action is dead, and everything is bundled in ETFs, well, you get a disaster wating to happen.

As hedge funds take cover and are forced to sell off their assets to provide liquidty (as big players get margin called), this results in massive selloffs where the price of the thing they’re selling drops severely. ETFs are bundled securities, when those are sold off, all stocks go down. When someone else buys them in bulk, everything appears green even though there is no “news”. Options only delay the spiral into oblivion, giving hedge funds time to exit when they sell off all while knowing this is the maximum valuation they’ll ever reach in the long term. Insurance companies will collapse as they always do in these situations as volatility gets increasingly more difficult to price. Cash on reserve could be depleted, causing a massive shock in the stock market when the real forced selloffs occur. I don’t think that shock has happened yet, but when it does, we can see a 50% drop in everything as the financial WMDs are deployed. The real loser is you and your 401k, of course which should have been in treasuries in December.

This is a turning point in the global economy. Many speculative billionaires will go back to becoming millionaires, save a few who were smart enough to cover their positions with put options on Febuary. Everyone living paycheck to paycheck will only have higher prices to contend with. This is what right wing environmentalists (Ted Kazynski types, not the latte drinking Apple users at Starbucks) have been waiting for for 40+ years. These aren’t the types that cruise around in their Hydrogen power yachts or those who are saving the environment by driving a Tesla to work.

This event (not the disease) could be the catalyst to solve the “climate change crisis”. If there is any indication of what may happen in the future, look no further to the Nikkei 225, which never got back up to its peak valuation. It is getting more and more difficult to predict the future, but I imagine a future like Japan, where no one is able to build or preserve wealth. Taxes will keep increasing to curb real growth.

My theory: Expect the Federal reserve to purchase ETFs and/or float the possibility of negative interest rates. It’s also just as likely that they will engage in QE4 in a last ditch effort, but the Fed could also say “we have no tools left”. And of course, we will always find scapegoats to blame.

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