Are We Heading Into a Credit Crunch?

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The short answer: Yes. Definitely. We are already in one now.

The question really is what’s going to happen, why this one is different, and how best to prepare for the future.

How do we know there is a credit crunch?

Well, aside from the stock markets collapsing, the thing to notice is the price of gold. Everyone says you should invest in precious metals to be prepared in times of crisis, because they don’t lose value.

Well, the price of gold has been falling for a couple of days, erasing all the gains it had during the year, and even during the spike over coronavirus fears.

Now, obviously gold isn’t going to become worthless, and an argument can be made for it going back up again. But this drive down in both equities and “safe” assets like gold shows that there is a desperate need for cash.

Everyone is selling everything to cover losses, and to retain what value they have. To make matters worse, amateur financial investors are withdrawing their funds out of fear that the market will go down further.

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Liquidity and Credit

With major banks needing to access cash quickly on behalf of customers, this increases the concern that financial institutions won’t be able to meet their credit obligations.

This is only a short-term phenomenon. Institutions will be able to pay in the future, but people want their cash now. And if they can’t get it now, it destroys the credibility of the financial institution. This means that they won’t be able to pay back in the future, either.

This is why central banks are injecting massive amounts of cash into the system, in order to guarantee that payments are being met. The objective is to avert a credit crisis, where financial institutions go insolvent (on a cash flow basis) because they don’t have enough liquidity to cover their credit obligations.

That’s what’s known as a “Lehman moment”, referring to the collapse of Lehman Brothers on September 15th, 2008, marking the beginning of the sub-prime crisis and subsequent “great recession”.

The mere fact central banks are injecting that much liquidity shows that there is a credit crunch

The question is…

Will it Unfold into a Credit Crisis?

Arguably, there is nothing inherently wrong with the financial system. COVID-19 is not infecting credit.

The question is whether companies who will suffer financially during the economic shutdown in order to prevent the spread of the virus will be unable to meet their credit obligations. And, in turn, whether that will precipitate a domino effect leading to a credit crisis.

Enough credit flexibility from regulators and central banks supplying liquidity, coupled with a relatively quick control of the pandemic leading a return to normal in the services sector, could mean that there is a credit crunch for a couple of weeks and then the market rebounds.

If one of those three pillars fails, then we could see a credit crisis forming, leading to a recession.

At this point, it’s not possible to determine that. And that’s why so many investors and traders are holding on to liquidity, and actually exacerbating the problem.

What Now?

The two things to watch out for are:

  • Debt Defaults
    If companies are unable to meet their debt obligations, it will be the first sign that a financial crisis might be in process. So far, companies have been able to roll over debt as it has come due.
  • The Evolution of Cases in Italy 
    Both China and South Korea have ostensibly controlled the COVID-19 outbreak, with the number of cases peaking and returning to low enough levels they can start relaxing economic measures.Italy was the first country in Europe to start having major cases. So, the question is when (and if) the number of reported cases peaks. That way, we can project when Europe can potentially start relaxing its economic measures.

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