Markets throughout the world cratered yesterday and today. The US, Asia, Europe, bonds, stocks, and precious metals especially got whacked. Wall Street pundits and opinion makers all blamed Bernanke’s dog and pony show yesterday. However, Bernankephobia is probably not the real reason for the massive wave of liquidation.
This panicky selling has all the earmarks of a margin driven liquidation. The world’s second largest economy, China, has been undergoing a massive liquidity crunch in recent days as the central bank there maintains a tight monetary policy that has drained reserves from the system this year. The Chinese central bank, the People’s Bank of China (PBOC), has kept things tight in an attempt to bring the shadow banking system there to rein in and to cool massive speculative bubbles. Of major media outlets only the New York Times has recognized the impact of the China credit crunch on the markets today, but even it blames the selloff on “concern” about it, rather than actual forced selling because of it.
With the PBOC unwilling to ease the crunch, players in that system with assets abroad will raise cash to meet margin by selling whatever assets they can, wherever they can, particularly the world’s most liquid markets- US stocks and Treasuries. To the extent that they hold assets in those markets, they sell. This selling is significant enough at the margin to send asset prices crashing around the world, which triggers more margin calls in other assets, gold in particular, as well as in leveraged positions in US Treasuries and Treasury futures.
This selling is in spite of the Bank of Japan and the Fed pumping massive amounts of cash into world markets. Just this week the Fed added $85 billion to the accounts of the Primary Dealers. The Bank of Japan continues to add billions each week as well. However, some players are simultaneously deleveraging, repaying LTRO loans from the ECB. That was probably the proximate cause of the initial selling in US Treasuries and other instruments earlier this year which may have set in motion a chain reaction that led straight to China, the most leveraged, bubblized system.
According to Reuters, the PBOC injected a net of just 28 billion yuan ($4.57 billion) into their banking system this week. It has drained 198 billion yuan so far this year after injecting 1.438 trillion yuan in 2012. 1.4 trillion may sound like a lot, but it was on a base of over 29 trillion, so it was an increase of “only” 5%, which pales in comparison to the 35% the Fed is adding to its asset base this year.
The PBOC’s draining actions along with the ECB allowing its balance sheet to shrink are counteracting the efforts of the Fed and BoJ to expand liquidity. While the Chinese financial system is mostly closed to the rest of the world, many of the players there transact business and do trades around the world. Whereas the Fed, ECB, BoJ, and Bank of England all pump (or drain) liquidity to the same world cash pool, some big Chinese players are playing in that pool and are siphoning liquidity. At the same time many players are deleveraging and draining liquidity from the pool to repay the ECB’s loans. Its balance sheet is shrinking at a breakneck pace. These actions and tight Chinese monetary policy are counteracting the liquidity pumping operations of the Fed and BoJ and are contributing to the instability we see today.
On Thursday the PBOC refused to provide liquidity to China’s stricken markets. Panicked institutional traders were forced to sell whatever they could. We saw the results of that around the world. Some media reports today indicated that the PBOC had relented and provided targeted liquidity. If that is the beginning of a loosening of policy there to provide enough credit to end the forced selling of assets around the world, then the markets should find their footing and reverse. That’s a big if. It’s something we need to watch.
Meanwhile, most of the rest of the big players around the world remain flush with cash thanks to the Fed and BoJ. That could be sufficient for the markets to mount a comeback, but the test will be for key support levels to hold in the US. If they don’t this could be the beginning of the endgame.
I’ve been watching the Fed’s operations every day along with its weekly balance sheet and the commercial banking system balance sheet ever since it started publishing them in 2002. As the famous financial philosopher L. Berra wisely said, “You can observe a lot by watching.” I invite you to watch along with me, and observe a lot.
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