Forced Deleveraging

Two seemingly unrelated processes are currently coming together to produce what may end up as a perfect financial storm. On the one hand, China is continuing to push local interest rates higher, and on the other hand, there's what looks like insurrection in the US markets.

What the two processes have in common is that they forces speculators to deleverage. In China, the mechanism is immediately clear. Higher interest rates makes it more expensive to borrow money, and highly leveraged bets will therefore have to be reduced. However, the wreckage caused by the rag tag army of day traders in the US has the same effect. Margin calls forces people to abandon their leveraged bets. Only those playing with their own money, without leverage, are able to weather the sudden gusts of long and short squeezes. Those with margin are forced to abandon their positions, often at the worst possible time.

Forced deleveraging reduces in turn the money supply, making currencies even more scarce. People become more reluctant to lend, and those in debt become desperate with a crash in financial assets as the inevitable endpoint.

The only alternative to a financial crash is a coordinated debasement of all currencies. However, central banks cannot go that way on their own. Every central bank has to be on board with such a plan, or people will catch on to what's going on and rush for the exit. Without China on their side, other countries cannot very well debase their currencies. Buying the Yuan is just too much of an obvious exit. But even with China on board, the debasement option seems increasingly unlikely to work due to the loop hole that this creates for day traders to game the system.

Deleveraging appears to be where we're heading. Interest rates are going to go up, and anything depending on leverage for its current price level will return to its true level, probably overshooting fair value due to momentum. Those with ready cash can in that event pick up true bargains. Even better than cash will be gold and silver since the prices of these metals are kept low through rehypothecation, a type of leverage used to suppress prices.

Sovereign

By Heritage Auctions for image, Mary Gillick for coin - Newman Numismatic Portal, Public Domain, Link