The wisdom of a Russian grandmother: today’s financial bubbles are trouble

Last February I wrote about an elderly Russian “Znakhar”, which in English would be a person who is a blend of a seer, witch and healer. I run across her in my Moscow neighborhood from time to time and we mostly limit our chats to polite hellos, as metaphysics is not something I hold in high regard. Last year however, she paused and approached me.

“You are that foreigner, no?” I nodded smilingly. “Be ready for very big changes to begin as we approach the middle of this coming March. It is just as well you now live here with us in Russia, you would not want to live elsewhere for a long time to come”.

Curious, I asked what makes her believe that the world outside of Russia will stress out, and why tell me. Not answering directly, she went on to say, “Better you get rid of your “valyuta” (US$/Euros) and turn them into rubles or better still, gold St. George coins. Very big changes are now destined to happen and much will turn upside down, so be ready”. I thanked her for her pithy global commentary and bid her a good day as she shuffled off into the nearby church.

This incident got me thinking a year ago, first why she chose to speak with me and not simply nodded a hello as usual. Secondly, why she chose to deliver her somewhat disturbing opinion to me, “that foreigner”. Since equity and commodity markets are areas where from time to time I am engaged, the first thing that came to mind then was market bubbles… could this uneducated old lady now be analyzing the economic rhythms of the western world, and making her prognosis to me? Furthermore, what elements could be gathering steam now that might prove to be so calamitous? Then thinking… I must be nuts to even dwell on her ramblings.

Since then I have run into her in the local farmers market or simply walking near my home. Today I stopped and chatted since a year had passed since she laid her initial “foreigner” prognosis on me. I asked her “do you still think the world is going to hell in a handbasket?”

She simply looked me in the eye and answered “Most assuredly. The ways of this world are not like a train schedule, nor should you expect them to be. There is no doubt that last winter when we spoke, the changes have begun, and they have been gathering strength. One morning we shall wake up, no doubt surprised that so much has happened and we did not notice the process until it has passed us and we eat its dust”. I thanked her for the wise words and proceeded on my way to the Metro station and my office.

One thing I acknowledge the “Znakhar” does well is that she puts me in a mood to reflect. Undoubtedly we now live in a time when a number of “unquestioned” components of the economic and geopolitical world are under intense re-evaluation; politicians, fake vs. real, the dollar, Euro, central banks, Federal Reserve, QE, ZIRP’s, NIRP’s, Crypto’s, and historically unprecedented debt of all types. Unquestionably a nervous time, and in many ways engendering a Stockholm-like syndrome of denial…. shall we go on as before, what can really happen?

Well, just last week we witnessed rather sudden and sharp global market spasms starting in the US, which may be a prelude to what is likely to repeat. We see interest rates largely rising throughout the world whereas the business culture has grown used to ‘cheap money’ as this past decade’s new normal. Much has been built up on the back of cheap funds and the prospect of paying double or more to settle credits taken is a dismal undertaking. Looking back at rates these past 10+ years, today the downtrend line(s) have been broken, suggesting long-term trend changes.

What has changed in market perception? Following the money is usually a good place to start. One item that sticks out is the interbank lending among US and western banks. Towards the end of 2017 interbank lending sharply dropped. In fact, it dropped to pre-1974 recession levels of approximately $12.7 billion. Since 2008/09 the amount of interbank lending has steadily decreased with the strong possibility that the players were acutely aware of their own, hence their counter-party’s remarkably weak balance sheets.

Whatever the case, the reasons for interbank lending to collapse has two likely reasons, either there is no longer a need for credit, or there is an absence of trust in the interbank lending world. It would seem to me that a lack of trust is the more probable. Remember, the bedrock of fiat currencies is trust.

A further factor to consider is velocity of money. If the markets believe inflation therefore rates are going higher it generates fear or as we used to say “the anxiety quotient”. Fear that financial instruments will be worth less because they are “discounted” against interest rates. There is also the very real anxiety of losses due to bankruptcies whether by an issuer or counterparty. Higher rates also means no more easy ability to refinance or to “roll over” debt”.

It is worth keeping in mind that all fiat currencies are debt based, so the fear factor will be seen expressed not only in the sale of bonds but the underlying currency, be it the US Dollar, Euro, Yen or similar. The velocity of these currencies will turn markedly higher as market participants finally “spend” them to get free of the denominated equities or debt instruments trap.

The markets have changed, and if last week was any indication of things to come it may be only the appetizer. I think most would agree that 2017 and the first month of 2018 were abnormal for equities. Stocks as an asset class were never meant to go straight up without even a smidge of a pullback. That is exactly what happened for an entire year.

What has been the case in the past decade is that the central banks have openly played an unprecedented interventionist role in supporting the commercial markets, some even call this the CB’s ‘Plunge Protection Team’. In the real world, in open markets, when a sell off is in process no investor has the gall, or deep enough pockets to flood markets with buy orders except the central banks, which they quietly did just one week ago. I even heard the term ‘QP’ for Quantitative Propping, no doubt the stepsister of ‘QE’.

Never in history has so much money been magically created in so short a time. The money exists and the corresponding debts are in place which seem to indicate a fertile field for inflation. In simpler financial times when money was linked to gold, we could expect at some point in these current circumstances a massive deflation.

Today however, when gold has been replaced by debt and fiat currencies, the result will again be a deflation but of a different sort. The deflation will be in currencies and credit versus gold. To those holding currencies and debt, it will feel like acute hyperinflation. Assets that derived their value from investors borrowing to purchase will deflate against gold; while quite probably still inflate against struggling fiat currencies.

In closing, I tip my hat to the “Znakhar” if for no other reason than the fact that she got me thinking on the truly interesting times we are living in, and wondering when the much touted inflection point may arrive. She may have the “crystal ball”, but I can do one better by trudging to my local Sberbank (savings bank) branch here and place a ruble order for a gold St. George coin or two, maybe that will help.

Paul Goncharoff is an American business executive working in Russia.