Deleveraging

We are currently going through an early-stage bear market cycle called “deleveraging”. To better explain what is happening right now, it is best to start by explaining the creation of money through debt. The modern way of creating money is through the debt system. How we do this is; one person loans money from a bank that is holding that money for another person. This is called fractional reserve banking. To make this short and sweet, we will go through a little example.

Person A deposits $100 in the bank. At this stage, we have $100 in the financial system. That bank then loans out $90 of that $100 to Person B. Person B spends that money. The money spent is person C’s income. Naturally, person C deposits it into another bank. At this stage We have 2 people with the ability to withdraw a total of $190 from the Financial system, thus we create $90 in the process.

When this happens it creates leverage in the system. In the previous example, there was a 1.9X leverage in the system. Naturally, the second bank will loan out the $90 dollars and create even more money, increasing the amount of leverage again. This will go on until there is no more money to loan or the reserve limit is lowered.

Inevitably we reach maximum leverage at dollars cease to be created. During this phase of the cycle, the credit limit of the population is at an upper threshold. All dollars are spent or invested at the end of the day so businesses love the expansion of the money supply. Where things get interesting is when the cycle stops or even reverses. At the top of the money cycle, we get stagnation as businesses look to cut costs or expand into new markets. Eventually, it's not enough to overcome gravity, and business growth slows. This could be it but this huge expansion in the money supply overextends people/investors. Investors and institutions borrowed money to invest. When interest rates are lower than the returns of the investment it's essentially free money. When the cost to carry rises the return on investment decreases and becomes riskier.

Everything is flipped on its head when rates begin rising. Once rates begin moving up and the cost of debt rises investors and institutions are forced to liquidate the riskiest assets that have the least amount of return potential. This is the beginning of the deleveraging cycle.

When Assets are sold and not reinvested it destroys previously created dollars. Going back to our person A example… if Person B were to pay back the entirety of the $90 dollar loan, then the income he received to pay back that loan was a net negative for the person that paid his income. Negative $90 from the payee and the cancelation of $90 in debt. Our new total is back to the original $100.

Selling assets or paying back debt is deflationary in the financial system. A simple way to remember this is, that new debt is inflationary, and paying debt is deflationary. As interest rates rise, even by a little, investors and the general population are forced to pay back larger amounts. Worst case scenario is that the payments just go up from the interest rate going up and no one sells any assets. This is still deflationary because the extra payment amount is coming from income not based on the expansion of the money supply like when interest rates are dropped.

Typically, the deflationary pressure on the dollar pulls the prices of assets down due to the increasing strength of the currency and leads to the further liquidation of assets. As more assets are sold and more dollars are destroyed it propels the deflationary spiral further and fast. Inevitably the cycle needs to be stopped or reversed. The Fed normally starts by dropping interest rates. This can stop the dollar destruction due to interest rates but not always the assumed selling of assets. At this point, we are moving into another leg of the cycle and that is a whole new discussion.

Currently, we are in the process of rising interest rates and deleveraging. There are some secret weapons the Fed has to combat the deflationary pressure has on assets, cough cough “Reverse Repo”, right now those are not in play. As seasoned investors wait for the cycle to reverse or slow down before reinvesting at better values.