Credit Crisis or Currency Crisis? The Difference is Massive

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Today’s Daily Reckoning is an excerpt from a recent report I wrote for Crisis & Opportunity subscribers. Everyone is on the lookout for another 2008-like event. The fear from the GFC is still apparent.

But history never repeats, and the market never does what you expect it to. So if you want to survive an uncertain future, learn to keep an open mind about what the market can do.

Here’s why…

When you hear the term ‘next crisis’, what is it that comes to mind?

If you’re like most people, you think the ‘next crisis’ means a re-run of 2008 — only bigger. That is, a massive global credit crunch, plunging asset prices, and general market mayhem.

Such a scenario is certainly a possibility. But I consider it a low probability risk. Let me explain why…

The term ‘credit crisis’ is much bandied about. But what does it actually mean?

A credit crisis unfolds when people lose confidence in riskier assets like stocks and rush into cash en masse.

But in ‘normal times’ there isn’t much cash around. Banks only hold a small amount of cash as reserves. So when a panic hits, they ‘run out’ of cash.

This is why stock prices plunge in a credit crunch. People dump their shares at any price to move to the safety of cash, which is limited in supply.

So, in 2008, when investors realised that their high yielding ‘cash-like’ mortgage bonds weren’t like cash at all, they panicked, dumped the bonds, and moved into actual cash.

Of course, the highly leveraged banks didn’t have enough ‘real’ cash to satisfy demand, so they dumped their mortgage bonds, and other assets, to get their hands on what little cash was floating around the system.

This is the definition of a credit crunch. An event happens and credit values get ‘crunched’. This damages bank balance sheets and restricts their ability to lend; that is, create more credit.

This is what happened in late 2008. But central banks quickly moved to stem the damage. They started buying mortgage bonds and Treasury bonds in exchange for cash. That is, they satisfied the massive demand for cash by increasing the supply of it.

This eventually stabilised the crisis. The problem was that the central banks never pulled back their support. They kept buying assets, which soon resulted in too much cash sloshing around the system.

The point to understand is that there remains a huge amount of cash in the system! This makes a genuine credit crisis difficult, if not impossible, to play out. Why? Because when people panic and sell to move into cash, there is plenty of cash already there waiting.

You would need to see a collapse of a major financial institution — and the massive shock to confidence that brings — to get really worried about another major credit crisis. And, as I said, I think the probability of that is low.

Of course, share prices can, and very well may, continue to fall. If the global economy continues to slow, earnings will decline and the market will adjust valuations lower.

The point is that falling share prices don’t necessarily signal a coming credit crisis.

But that doesn’t mean a ‘crisis’ isn’t on the cards. Negative interest rates are not healthy for capitalism to function well.

What type of crisis though? What if, instead of a credit crisis — like everyone expects — we end up with a currency crisis?

What does a currency crisis look like?

In short, it has the opposite effect of a credit crisis. That is, in a credit crisis, the value of cash increases relative to stocks. But in a currency crisis the value of stocks increases relative to cash.

That’s because, in the lead up to a currency crisis, global central banks pump so much cash into the system that the supply overwhelms demand.

They’ve already been doing this for years, of course. But what makes you think they won’t continue to do so, or up the ante to even more absurd levels if conditions warrant it?

That’s why I think the prospect of another major credit crisis is slim, and that you shouldn’t let this fear stop you from buying into good opportunities as they present themselves.

Further economic deterioration will result in ever greater attempts at money printing and currency devaluation. At some point in the future, that could result in a wholesale flight out of cash and currencies, and into assets.

That is, stocks could eventually go much higher than what you think is possible…not because things are good, but because it will reflect a world in the throes of a currency crisis.

The rising gold price is perhaps an early indicator of this trend. If the market views gold as a currency, what better currency to own than one that central banks cannot devalue?

I want to stress that a ‘currency crisis’ is not a near term prediction. Depending on central bank actions, this could take a while to play out. But it is important to be flexible in how you think about the future.

Don’t lock yourself into a certain way of thinking. The popular line of thinking right now is to be on the lookout for another 2008-type event. But markets NEVER do what you expect. Something unexpected always pops up.

Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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