Explanation: why are the markets falling? – News

Falling interest rates have led many savers to invest in stocks, real estate and cryptos, leading to price spikes in these asset classes



By Vivek Kaul

Published: Sat, May 14, 2022, 11:18 AM

High inflation put an end to the global stock market party.

The Dow Jones Industrial Average, the leading US stock index, has fallen more than 8% in the past month. It closed at 31,730.3 points on May 12. The Nasdaq Composite, another widely followed index in the United States, has fallen about 17% in the past month.

Cryptos are also going through a tough time. Bitcoin, the most followed crypto, has fallen over 26% in the past month. As of this writing, this bitcoin is priced around $30,000. The price of Terra Luna, another crypto, has dropped 100% in recent days. Almost all crypto exchanges have suspended trading.

Gold has also fallen on hard times, with the price of the yellow metal dropping 8% to around $1,819 an ounce in the past month.

Why is this happening then? Inflation in the rich world has reached decade highs. Retail price inflation in the United States was 8.2% in April and 8.6% in March. This type of inflation was last seen in the early 1980s, more than four decades ago.

In the United Kingdom, retail price inflation stood at 6.2% in March, the highest level since February 1992, when it stood at 6.3%. In the euro zone, retail price inflation stood at 7.4% in March, the highest level since January 1997, when this figure was first calculated. The euro zone is the monetary union of 19 countries that are part of the European Union and have adopted the euro as their main currency.

There are three reasons for this inflation. First, in the aftermath of the Covid pandemic, central banks across the rich world printed trillions of units of their currencies. This was done to lower interest rates to encourage individuals and businesses to borrow and spend more. The idea was also to help tax-strapped governments borrow at low interest rates. Some of this money was also given directly to citizens improving their spending capacity.

Second, global supply chains have collapsed with the spread of the Covid pandemic. What hasn’t helped is China’s zero-tolerance policy, which has led to the closure of many factories and broken supply chains in a highly globalized world.

This led to an environment where people in the rich world sought to spend money and at the same time the supply of goods was negatively affected due to the breakdown of supply chains. This drove up the price of goods.

Third, Russia’s attack on Ukraine has made matters worse. Among other things, Russia is one of the main exporters of oil, coal, fertilizers, nickel and wheat. This supply has been impacted and prices have increased further. In fact, it has led to food inflation in large parts of the world.

In this environment, in order to control the inflation that disproportionately affects the poor, the central banks of the rich world began to raise short-term interest rates. Earlier this month, the US Federal Reserve raised a short-term policy rate by fifty basis points. It plans to continue raising rates throughout this year.

Along with this, the Fed also plans to gradually withdraw all the money it has printed and injected into the financial system in order to drive down long-term interest rates. The US central bank plans to withdraw up to around $1 trillion from the financial system over the next year, starting June 1. The Bank of England and the European Central Bank should follow the Federal Reserve. The likelihood of this happening has started to drive up interest rates all over the world. Higher interest rates will dampen consumer demand. A drop in consumer demand will ensure that price increases will eventually slow to comfortable levels.

This essentially means that the era of easy money that began in late 2008 when Lehman Brothers, Wall Street’s fourth-largest investment bank failed, may finally be coming to an end.

The central banks of the rich world had to print a lot of money after 2008 in order to save the big financial institutions and also to lower interest rates. A similar thing happened in early 2020 once the Covid pandemic started spreading and led to physical lockdowns. With the lockdowns in place, economic activity collapsed. The world was witnessing an economic depression. To avoid this, central banks printed money and lowered interest rates.

Falling interest rates have led many savers to invest in stocks, real estate, and cryptos, leading to price spikes in these asset classes. Now that interest rates are rising and central banks are making it clear that the era of easy money is coming to an end, money is flowing out of stocks and cryptos. There are more sellers than buyers and prices have fallen rapidly.

This is what experienced market men like to call a dash for money. Cash, once again, was seen as the only safe asset in circulation. Money is flowing out of other asset classes, including gold, which is otherwise considered a safe asset class, especially in times when everything else is collapsing. Real estate remains.

The real estate market never evolves as quickly as other markets. Nevertheless, with the probable end of the era of easy money, real estate speculation will gradually slow down and the bubble will eventually burst. Interest rates on 30-year mortgages in the United States have risen rapidly, from around 3% at the start of the year to around 5.3% today.

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Of course, the risk of letting interest rates rise quickly and dampening consumer demand is that the central banks of rich countries will end up causing an economic recession. It will be interesting to see how central banks react to this eventuality. If the odds of an economic recession increase, will they keep interest rates higher to control inflation or print money and lower interest rates further? That’s the trade-off they may have to make.

Vivek Kaul is the author of Bad Money.