The needle that popped the balloon of excitement

It has been a nightmare since last Friday for investors who have taken considerably leveraged financial risks with the help of a liquidity glut and cheap money. It started because the steam for investment peaked at a point when markets had the lowest volatility of all time. Things came crashing down when the stock market collapsed in one day.

“Now what? Does this represent a shift in mindset?” These are the questions being asked. No one is able to say anything because it is too foggy to see what lies ahead.

The balloon of excitement had been popped because as investors had put in money thinking “nothing is happening anyway,” they had taken risk after risk. This is the point when the “moral hazard” began; while financial markets were breaking an all-time record, there was an expectation that “central banks would not raise interest rates due to the stock market collapse.” But that does not seem to be the situation.

The United States stock market has recovered a bit from the sudden crash. But not many think there is a high chance of returning “to the good old days.”

It seems to be of consolation that this crash is limited to the stock market and is not “contagious.” But those who are cautious have reservations that it might not be that way. It is apparent that those who share these reservations are not few, as there was a sharp rise in the dollar index and a fall in the price of gold. That is also why in Turkey, the U.S. dollar/Turkish Lira exchange rate has gone above 3.80.

After the market crash, the first thing that came to mind for the ones who were most affected was, “No way, the Federal Reserve System [Fed] will not raise interest rates because it is concerned with financial stability.” This is what I call the “moral hazard;” thinking that “institutions will not allow us to go bankrupt.” But news shattering such hopes came from New York Fed president William Dudley. “My outlook has not changed because the stock market is a little bit lower than it was a few days ago. It is still up sharply from where it was a year ago,” Dudley said. Those were quite significant words.

The value of financial engineering products linked to volatility indexes such as VIX is close to $8 billion, with it being known that stock quotes valued at $3.8 billion fell below $500 million. Those funds lost 85 percent of their assets. Most of those funds are automatically liquidated when the loss exceeds 80 percent. That means they are closed.

There is concern over the unknown risks and losses resulting from this collapse. Although it is not on the same scale, the stock market crash coincides with the 10th anniversary of the Lehman crisis.

The stones have shifted from their place 

The demand for the dollar has grown as people have increasingly turned to cash. Fear of credit and leverage transactions seem to be a nightmare for all players.

It is obvious that “the stones have shifted from their place.” Everything is expensive, especially for those who have a lot of debt, such as taking out a new loan or paying off a dollar debt in another currency.

Nothing will be same for developing countries after this current wave. Not only globally, but households, companies and financial market players in Turkey have learned a lot over the past 10 years.

When we adopted the free floating exchange rate regime between 2002 and 2007, we learned that exchange rates would go up but would eventually come down again in the medium term. “Exchange rates will go up but then they will come down,” was embedded in minds at the time. What made us realize this was the continuous inflow of capital. As long as capital kept coming in, the exchange rate would come down from its previous highs. What made this possible was the fact that there was a greater inflow of capital than we needed.

We received the first sign in 2011 but we only learned that the currency rates had started to change after 2013. This time around, the prevailing thought was that “exchange rates will fall but then they will rise again.” Especially Turkish companies who had accumulated a foreign currency debt between 2010 and 2018 learned that very well. Some households and companies saved around $50 billion in banks over five years. The key: there was less capital flowing, companies had more debt and households were buying foreign currencies. The floating exchange rate regime had been in place for 17 years in Turkey. Everyone has learned something except for politicians, who still appear to be living in the period between 2002 and 2007.