The days of the 'Great Sedation' appear to be numbered. Since 2011, stock prices have been pushed to record highs while volatility was at a record low. Stock market prices steadily increased, without any serious corrections. Up to last Monday at least, when a new 'Black Friday' hit the market. Stock prices crashed; China’s losses being the worst. Volatility went through the roof globally. What is going to happen next? And what will that mean for you?
Volatility is one of my favorite topics. Due to the monetary policy set by central banks, we now live in a world which is 'seemingly stable.' Rarely has the volatility on security markets ever been this low.
However, low volatility has a downside: at some point in time it will lead to an eruption of extremely high volatility.
We seem to have reached that point. Last week, volatility has gone through the roof on nearly every exchange.
Will There Be Another Black Monday in 2015?
Suddenly, everyone spoke of a new Black Monday. Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed, and the Dow Jones Industrial Average fell with more than 22%.
Last week’s Monday, the Shanghai stock exchange suffered a drop of 8.5%. Panic ensued when the U.S. market opened later; the Dow Jones needed only mere seconds to drop with more than 1000 points. That day, it closed with a loss of 588 points (about 3.6%), the lowest point in the past one year and a half.
In other words, if you had invested in the Dow Jones for the past 18 months, you would now have made a loss. How many investors are aware of this?
You Have Been Warned
Luckily, our readers were warned. In February, I mocked the Dutch newspaper Algemeen Dagblad for telling us that “In the short term, nobody expects a disaster similar to 2008, when stock exchanges collapsed worldwide.”
However, this argument contains a fallacy. Obviously, no one was able to foresee the 2008 drama. The very idea behind a market crash already implies that a majority of the market participants will not foresee it, otherwise stock prices would already have been adjusted correspondingly.
But the nevertheless overall small price correction of past Monday does not mean there’s an investment opportunity on the market right now. The price increases of past Thursday clearly demonstrated that the 'Great Sedation' has met its end. Yesterday, the Dow Jones saw its third largest price increase ever recorded on a single day.
The events of last week’s Monday marks the beginning of a period in which increasing volatility and uncertainty is the norm. And that means that we’ll sometimes see strong price increases, but mostly we’ll see sharp declines.
What Happened During the 1997 Asian Crisis
A description of the 1997 Asian Crisis deserves a book rather than a paragraph in an article. But there is one major and currently relevant point that we have to take away from it.
The Asian crisis started in Thailand. The Thai baht was fixed (pegged) to the dollar. The Bath was suffering, while the dollar rapidly strengthened. In order to save the 'peg,' the Thai central bank sold $20 billion dollars. Soon, they had to give in; they needed to abandon the peg. In the weeks thereafter, the bath depreciated by more than 20% relative to the dollar. And Thailand wasn’t the only country suffering; other Asian countries were also forced to let their currencies 'float,' meaning that their exchange rates would fluctuate freely.
This had major implications: capital fled out of Asia, corporate profits declined strongly, and debts denominated in dollars became unpayable. As money and capital continued to flee from Asia, a lot of currencies were seriously harmed. As a result, the world economy suffered as a result of the Asian crisis. Russia was the first victim; the Russians had payment difficulties and were forced to default. Brazil, Japan, and other countries also suffered severely from the Asian crisis.
The Second Asian Crisis: What is About to Happen
The essence of the problem is that many countries still have a full or partial peg with the dollar. It works as follows:
- In order to prevent an appreciation of their local currency, they must buy dollar-denominated assets on the market. The foreign currency reserves increase.
- In order to prevent a depreciation of their local currency, they must sell dollar reserves (thereby decreasing their reserves).
Some countries use a 'hard' peg (a single price target, or desired parity), while other countries use a 'soft' peg, meaning they allow their peg to fluctuate around their target (with a minimum and maximum price).
There’s a clear limit to what can be done with the second mechanism (selling dollar reserves). When the foreign currency reserves are (almost) depleted, the central bank has no other option than to give up. They can no longer 'protect' their currency.
Russia provides a recent example; the Russian central bank was forced to abandon its peg with the dollar, after which the ruble’s exchange rate crashed. But only after selling billions of their foreign currency reserves in order to stop a further devaluation of the ruble. The end result was a loss of 300 billion dollars’ worth of Russian foreign exchange reserves.
The Strong Dollar Is a Big Problem
Last week, China faced a similar problem. However, China’s currency reserves are ten times larger than Russia’s selling spree. Figuratively speaking, the Russian reserves are spare change compared to China’s.
We have seen it coming for a while: the dollar is strengthening, and many foreign currencies — especially of countries producing commodities — are under pressure. After years of capital flowing into the countries, the trend has been reversed.
This problem will worsen as the dollar strengthens further.
China Sold $100 Billion in Treasuries in Two Weeks!
Due to the increasing tension on the foreign exchange market, China was forced to sell some of its dollar-denominated assets. In barely two weeks, they have sold a $100 billion worth of assets.
Now that commodity prices are declining, and the U.S. central bank is expected to hike its interest rates, the currencies of other upcoming countries are under pressure. China won’t be the only country to have to liquidate its dollar reserves.
In short, a selling spree in the (U.S.) bond market is a realistic scenario. And given the current state of affairs, a 'Black Monday' in the global bond market, next to the stock market, is increasingly likely to happen.
The events of last Monday provide a glimpse into the future. Not only in the stock market, but also certainly in the bond market.
Apart from the strong likelihood that there will be a stock market crash akin to the proportions of a real 'Black Monday,' it is probably even more likely that there will be a 'Black Monday' in the bond market.