BitMEX Founder: Using History as a Guide, Why It's Foolish to Short the Entire Crypto Market
Author: Arthur Hayes, founder of BitMEX
For those with a Bloomberg terminal, run the FARBAST Index. This is an index of the Fed's balance sheet in millions of dollars and is updated weekly. I've been clichéd about this, but the number and its trajectory is the only thing that matters. If you believe that the Fed's balance sheet will grow exponentially from today's levels, short-term volatility in the cryptocurrency market becomes irrelevant.
To be clear, two things are critical to my overall bullishness on macro crypto market cap.
The US government will begin implementing a nominal GDP target, funded by the Federal Reserve's purchases of T-bills, notes and bonds. As a result, the Fed's balance sheet would be larger than it is today.
Decentralized finance (DeFi) will actively decentralize many of the rent-seeking activities performed by centralized financial services institutions. Savings due to cheaper fees and greater inclusiveness will flow to end users and token holders.
The high growth of point 1 drives the acceleration of point 2.
Self-perpetuation and growth are two universal constants when evaluating the potential behavior of an organism or a civilization as a collection of humans. Most modern societies have an underlying assumption of infinite growth. See how we price our shares.
The value of a stock is the discounted flow of all future cash flows. Ultimate value assumes that the company continues to exist and grow forever. This is obviously empirically wrong, but we plug it into our fantasy model anyway. So my overarching assumption is that growth is preferred and assumed. The problem is cost. There are many ways to achieve growth, and one of the most effective at the national level is to use borrowing to achieve GDP targets.
To fully understand why I am so confident that the Fed's balance sheet could be 10x higher in the short term, I will compare how the US dealt with the aftermath of WWII with how it dealt with the aftermath of COVID-19. The political and economic conundrum is always, "How does a country survive a devastating crisis?"
I spend a lot of time talking about U.S. monetary policy, not the fundamental advantages of a decentralized monetary and financial system over the parasitic centralized systems that currently dominate. We live in a dollar world. Anyone who has read Satoshi Nakamoto's white paper understands that the 2008 financial crisis and the reaction of all the major central banks was one of the reasons Satoshi believed that something better could be created. Thus, appreciation and confidence in the Fed, the world's most important financial institution, will make any speculators shrug off a 30% to 50% drop on the day, knowing that the tsunami of money printing in less than a decade will make The combined market capitalization of cryptocurrencies has reached unimaginable levels.
Before we go back to 1939, take a look at this. Net federal spending was 31% of GDP in 2020 as the US enacted a massive fiscal stimulus to fight COVID. As measured by 2020 global GDP, this makes the U.S. government as a stand-alone entity the third-largest economy -- behind the U.S. private sector and China. The great thing about any large central government is that they collect a lot of statistics. You can't manage what you can't measure. Thus, the abundance of statistics during and after World War II allowed access to anyone with an internet connection.
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1 What happened after World War II
To pay for WWII expenditures, the U.S. government borrowed money. To lower the cost of funds, the Fed buys bonds in sufficient quantities to fix the price of money. The long tail is fixed at no more than 2.5%.
As a result, the Fed's balance sheet grew 11-fold from 1939 to 1946.
At its peak, the U.S. debt-to-GDP ratio was 110%; in order to inflate the debt incurred to win the war, the Fed continued to fix the price of the Treasury curve until the Monetary Agreement of 1951, when the Fed regained its independence from the Treasury .
Unfortunately, commoners were prohibited from owning gold privately, so they suffered from severe negative interest rates and high inflation. They have nowhere to invest but government bonds and stocks.
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2 What happened after COVID
In 2020, the war with COVID led to the largest decline in US GDP since World War II.
In response, the Republican-led U.S. government spent the most money in U.S. history.
The Fed, while not explicitly pricing the Treasury curve, bought 55% of all Treasury bonds issued in 2020. This led to a 76% increase in its balance sheet in 2020.
At the end of 2020, the US debt-to-GDP ratio reached an all-time high of 130%.
When Democrats came to power, like Republicans, they quickly enacted trillions of dollars in spending bills and promised to do more.
The US is now a twin deficit country; it spends more than it taxes (fiscal deficit) and imports more than it exports (negative capital account).
U.S. politicians of both parties have bluntly stated that the government must aggressively expand fiscal spending to correct past mistakes and ensure that workers are protected post-COVID.
Foreigners won't wait to see their $7 trillion worth of U.S. Treasuries shrink sharply, and are net buyers of 8% of Treasuries issued in 2020, compared to 42% of all Treasuries issued between 2002 and 2019 .
The only politically acceptable option is to pay for aggressive fiscal spending through money printing by the Federal Reserve.
Thankfully, by 2021, we have crypto capital markets, which is not the goal of some government agency or central bank.
While not all of the tens of trillions of dollars created by the Fed will flow into cryptocurrencies, some of them will — and because crypto is unencumbered, it can rise to levels that allow holders to maintain purchasing power in the face of monetary inflation.
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3 War = Inflation
War is a terrible thing. It's even worse when you, as a taxpayer, have to pay directly. This is why the government would rather adopt a hidden inflation tax than aggressively raise taxes to pay for the war. People can get a little too pacifist, leading to objections to using their tax dollars.
While certain taxes were raised to pay for America's involvement in WWII, like all governments before and since, they chose to borrow money to pay for the war. I will be quoting heavily from a February 2020 working paper by the Federal Bank of New York titled "Managing the 1940s Treasury Yield Curve" (the following italics are from this paper).
After Pearl Harbor in 1941, when the U.S. decided to officially enter the war, they had to figure out how to pay for the enormous costs of fighting. Remember - the government spends, and the Treasury pays for it by selling bonds. As always, you want to pay as little interest as possible when you borrow money. The Treasury politely asks the Fed to create excess bank reserves for the sole purpose of backing its bond issuance.
Before the war:
The FOMC (Federal Open Market Committee) is not trying to manage the level of reserves or the level of interest rates. Open market operations are limited to maintaining an "orderly market" in Treasuries, and typically involve maturity transformations rather than outright purchases or sales.
But then, the Treasury Department asked the Fed to help them set the price of their currency, because the general public did not accept such low interest rates to help the US government fund the war effort:
The ⅜ percent bill rate doesn't have the same broad support. Before the first major wartime financing—a $900 million 2.5% 25-year bond in May 1942—Treasury officials asked the FOMC to commit to maintaining adequate excess reserves. They hope to be able to rely on the pressure of excess reserves to boost demand for bonds.
footnote:
Governing Council Chair Marriner Eccles noted months ago that "if current funding patterns continue largely, ... it will be necessary to create significant excess reserves to keep banks under pressure to buy government securities." Federal Open Market Committee Proceedings, March 2, 1942, p. 4.
The translation means: the Ministry of Finance wants to borrow money at a very cheap price. You are dragging us, the Fed, screaming for a policy where we have to buy unlimited amounts of bonds to keep prices fixed at what you, the Treasury, want. The result is that our balance sheet will explode.
From 1939 to 1946, the Fed's SOMA account balance inflated more than tenfold as it performed its patriotic duty of fixing money prices at the behest of the Treasury Department. On top of that, the interest rate on long-term bonds is fixed at 2.5%.
This chart clearly shows that the public does not want to borrow money from the US government at artificially low prices. Unfortunately, as early as the 1930's, President Roosevelt banned private ownership of gold. This millennia-old traditional inflation hedge is not available.
I roughly define the real interest rate as the long-term bond rate minus the year-over-year growth rate of nominal GDP. Any government can stimulate economic activity by printing money. If it pays a lower interest rate than the GDP growth it creates through debt financing, it gains, while holders of its public debt lose. The Asian Tigers owe each of their "economic miracles" after World War II to their financial suppression of savers and the diversion of cheap financing to heavy industry. This is the reason why China was able to grow rapidly from 1980 to the present. The hard part is getting yourself out of the benefit boost of the national debt.
As we have seen, anyone saving through the banking system or holding US Treasuries has been hollowed out by deeply negative interest rates so that the US can withstand war. There's really not much you can do - either bank your savings or buy bonds. The stock market is still recovering from the Great Recession. From 1939 to 1951, the Dow Jones Industrial Average fell 4.6%. There is no way out of the financial repression inflicted on savers.
This monetary inflation does filter down to actual goods and services. From 1939 to 1951, the CPI index nearly doubled.
I hate stock-to-flow ratio (STFU), but it's popular, so I take STFU and use it in my analysis. The graph illustrates how the US balance sheet was sacrificed to go to war.
Even after hostilities ended, the Fed continued to fix money prices. America emerged with its physical infrastructure intact and rebuilt Europe. GDP growth soared. But interest rates don't. The result was a deleveraging of the government's balance sheet.
The Federal Reserve finally regained its independence in 1951. They performed their patriotic duty and were then allowed to pursue an independent monetary policy.
The stalemate continued until mid-February 1951, when Snyder was hospitalized and left Assistant Secretary of State William McChesney Martin to negotiate the so-called Treasury-Federal Reserve Agreement. On the evening of Saturday, March 3, 1951, Treasury and Federal Reserve officials announced that they had "reached complete agreement on debt management and monetary policy to further their common goal of ensuring the successful financing of the government's needs, And at the same time, minimize the monetization of public debt.” 51 Alan Meltzer (2003, p. 712) concluded that the agreement “ends a decade of inflexible interest rates” and is “a major achievement for the country.”
I really like this quote:
Alan Meltzer (2003, p. 712) concluded that the agreement "ends a decade of unchanged interest rates" and is "a major achievement for the country".
Translation: We keep currency prices artificially low to help governments pay for wars using hidden inflation taxes.
Fortunately, the US has the innate physical and natural capital to pursue such a blatantly inflationary monetary policy without any social unrest. That's because the US has a very strong domestic manufacturing base that feeds itself and has the industrial goods domestically needed to produce real goods. Most countries that pursued war-payments-like policies were plunged into social chaos as the expansion of the money supply led to severe inflation of real goods and services. That's because most countries don't get the bounty of nature.
Britain had just paid off its World War II debt to the United States in 2006. It took them almost 6 years to fully pay for the war. It took the United States just five years—from 1946 to 1951—to inflate significantly to remove the cost of the war. That's the beauty of being the world's reserve currency.
The key lessons to remember as we transition to the present are as follows:
Going to war is expensive and the government would rather tax it indirectly through inflation than directly through wage and capital taxes.
Central bank independence is an illusion. When the domestic agenda calls for central banks to print money to lower government borrowing costs, central banks will always obey orders. In order to deleverage the government's balance sheet, the government must be able to borrow at a cost below the nominal GDP growth created by the debt expansion.
The valve is the central bank's balance sheet because it has to grow as much as needed to absorb government debt that the public refuses to buy at the government's artificially low interest rates.
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4 COVID-19 Forever War
Officially, 600,000 Americans have died from COVID-19 in roughly the past two years.
And about 400,000 Americans died during World War II. All human life is precious, but to a politician elected domestically, those who die within the sharp line are the most important.
COVID-19 is already more devastating than World War II in terms of loss of life. This is further evidence that epidemics cause more suffering and carnage to humans than wars. That's why policy in response to a pandemic can easily outweigh war.
Modern cities demonstrate the impact of infectious disease. Piped water, sewer systems, and building codes all changed dramatically or were newly introduced in the 19th and 20th centuries to combat the various infectious diseases that flourished when humans lived in close quarters.
US GDP fell in 2020 by the most since World War II, while budget deficits to fight COVID set post-World War II records. In the name of COVID, anything is possible right now, not least because the outbreak of the pandemic has accelerated trends that were already happening.
a paid game
Let's first analyze how the US government will pay for the huge fiscal spending enacted in 2020.
Because of its status as the issuer of the global reserve currency, the US is uniquely positioned with regard to its financing options. Most trade is denominated in U.S. dollars, so goods from net exporting countries are denominated in U.S. dollars. Countries with excess production must buy dollar-denominated financial assets unless they want to drive up the value of their currency by selling dollars and buying their own currency. The US must have an open capital account to fulfill its role as issuer of the global reserve currency. Most countries do not want foreigners to buy any type of financial asset, especially domestic property. This is why major economic powers like China and Japan refuse to assume the role of reserve currency issuer. They are very comfortable with closed or semi-closed capital markets.
Traditionally, countries with excess production recycle their export earnings into U.S. Treasuries due to their liquidity and perceived risk-free nature. The US Treasury Department publishes Treasury International Capital (TIC) data monthly. It aggregates details of who owns which types of U.S. dollar financial assets.
From 2002 to 2019, foreigners bought 42% of net U.S. Treasury debt issuance.
The Fed bought 13%. On the margin, foreign purchases help the U.S. government finance its budget deficit at reasonable rates.
That all changed in 2020. COVID has destroyed global trade and exposed ineffectiveness and underinvestment in global public health. Governments around the world are scrambling to figure out how to pay for shutting down economies to stem the spread of the virus, ensuring supplies of personal protective equipment and vaccines, and upgrading public health systems. They need all the money they can beg, borrow or print.
Unfortunately, most countries cannot expand government spending as generously as the United States. If countries increase fiscal spending by printing money, it is likely to destroy their currencies and lead to higher commodity prices (with ensuing social unrest). If the common people do not get their bread, then you are not safe.
The "America First" slogan comes in different flavors, but both Democrats and Republicans advocate it. Policies to help working people, such as home-grown manufacturing, infrastructure spending and import tariffs, are widely seen as the right thing to do for the first time in 50 years. Unfortunately, these policies are inflationary.
I did a quick estimate of the interest rate exposure to foreign holders of U.S. Treasuries. SIFMA provides a table that breaks down U.S. Treasury issuance by maturity. I look at the current composition of outstanding national debt and use these ratios to calculate an estimated portfolio for foreign holders. Then I use functions on Bloomberg to calculate the modified duration for each note or bond. Treasury bills have maturities ranging from 2 to 10 years. This also includes floating rate notes. Treasuries are anything over 10 years, which is 20 and 30 year bonds and TIPS.
I calculated the weighted average term for foreign holders to be 17.08 years.
Dollar Value of One Basis Point (DV01) = USD Face Value * Duration * 0.0001
DV01 = $6.461 trillion * 17.08 * 0.0001 = $12.08 billion
That number may not mean much, but it's a huge interest rate risk. If interest rates rise by 1%, or 100 basis points, I loosely estimate that foreigners will lose $1.208 trillion to the market. Given a nominal size of $6.461 trillion as of March 2021, a 100 basis point rise in interest rates would result in a loss of almost 20%. Can I get negative convexity! ! !
Remember, if you're long-term bonds, you're short-term interest rates. Rising interest rates are bad news for bondholders.
If you were a large foreign holder of US Treasuries, and the government told you it preferred inflationary policies to support its domestic middle class, you would opt out. That's why in 2020 when the US government rained money, foreigners went on strike and only bought 8.39% of the outstanding Treasury bonds. Who made this difference?
The answer is simple. What happened in 1939 when the Treasury Department needed a sucker for those expensive bonds? They called the "independent" central banks and told them to fucking step up. In 2020, the Treasury doesn't even have to ask - the Fed buys 55% of all Treasuries outstanding. That's why the Fed's balance sheet grew 76% in 2020.
Don't forget foreign bondholders. Later, when we discuss the U.S. government's policy choices over the next decade, we will return to the dilemmas they face.
There are a few technical details that help the Fed sustain the narrative that it's not just running the money printing press to pay the government's bills:
The Fed has yet to set a clear target for government bond yields. It appears they prefer an orderly, non-volatile rise in yields to some level we don't yet know. Because they haven't set a target, they can say with a straight face that they are not participating in yield curve control (YCC). This is important because remember what President Eccles said earlier - if the Fed is doing YCC, their balance sheet will expand to whatever level is necessary to keep yields at or below target level. As the balance sheet expands, so does the money supply, which creates an environment for inflation.
Fed liabilities are not legal tender. Simply put, the Fed doesn't just print money and spend it directly from their accounts. Instead, they played a small game around the major dealers. The Treasury held a Treasury auction, large dealers bid on the bonds, and the Fed immediately bought the bonds from the dealers at a small markup. Everyone wins. The U.S. government has their backs, the banks are paid to take zero risk, and the Fed can claim they don't fund the government directly.
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5 Taper Tantrum
Monetary inflation is only a problem when it manifests itself in politically unacceptable ways. The prices that politicians care most about are the price of labor (wages), but also the price of food and energy.
When COVID-19 hit, the US government shut down the economy and sent checks to everyone who suffered - 1, 2, buckle up my shoes, 3, 4 get out the door and invest in Robinhood with your stimulus check. When you add up all the various government checks, the minimum wage in most states is now $15 to $20 an hour, whereas pre-COVID, many states had a legal minimum wage of less than $10.
Businesses now complain that government largesse prevents them from hiring enough workers. Stimulus checks absolutely prevent businesses from hiring workers at the old low wages, but the solution is to pay more. After 50 years of losing out to capital, labor will accept nothing but continued real wage growth. Elections are coming up in 2022, red or blue, if you don't hand out the goodies, someone else will run on a made in America, pro-union, high-wage platform and beat pro-business candidates who would rather prioritize capital returns. The zeitgeist has changed.
The fact that memes on social media are making fun of the ridiculous prices America pays for lumber tells you that inflation is here, and more importantly, people know it's here.
With rising wages and raw material prices, the Fed needs to slow down and speak up, the Fed needs to slow down and raise rates, or at least slow down the growth of its balance sheet.
It didn't help that the April consumer price index (CPI) was the highest in decades. The CPI is a government-calculated index that measures inflation in the real economy. If the Fed cares about fighting inflation, all signs are there - now they need to change course.
Meanwhile, the White House is struggling to secure a key Senate vote to approve the next trillion-dollar infrastructure deal that comes with tax increases. It appears that the urgency of the COVID pandemic has subsided enough for partisan politics to reemerge.
For the Fed's balance sheet to continue to grow, two things need to happen:
The US government needs to continue spending heavily.
The Fed needs to buy most of the bonds it issues in order to keep interest rates at levels the U.S. government can afford.
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6 The risk of a decline in the Fed's balance sheet
foreign holder
Remember those holders of foreign government bonds who decided to cut their purchases of new issuance by 80%? What can they do with their dollars?
The US GDP economic forecast for 2021 compiled by Bloomberg is 6.50%. If achieved, it would be the fastest growth since the early 1980s.
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Source: World Bank
China, Germany and Japan will earn dollars producing gadgets for American consumers, who will spend their checks. Japan and China are also the No. 1 and No. 2 holders of U.S. Treasuries, respectively. They earn the most dollars and therefore hold the most US Treasuries.
In order to maintain their stock of treasuries, they need to purchase a diverse set of dollar assets that are not significantly devalued by inflationary government policies. Tech stocks, beneficiaries of the U.S. stock market, especially post-COVID behavior, blew the door in 2020. Instead of buying bonds, foreigners got smart and got into the stock market in large numbers.
In 2020, foreigners bought $2.454 trillion worth of stoneks (an intentional misspelling of “stocks,” a meme often used in a humorous or satirical way, especially to comment on financial losses). That's about 57% of all U.S. Treasury debt issuance. Based on January-March 2021 data and straight-line extrapolation, foreigners are expected to buy an additional $3.224 trillion worth of stoneks in 2021.
Instead of recycling their export earnings into U.S. Treasuries, foreigners bought stocks -- helped by low interest rates and an expanding Fed balance sheet. Foreigners still hold $7.07 trillion worth of national debt.
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7 The "Almighty" U.S. Government
Every regime implicitly or explicitly promises something to its citizens in exchange for their support. The architects of modern America were Presidents Roosevelt and LBJ.
If people start saving, it won't spend. The major big bills that modern governments are trying to eliminate/pay directly are mostly related to healthcare. While health care in the United States is not completely free, the United States does provide free or heavily subsidized medical care to the young, old, and poor. For politicians, the most important group is aging workers. The baby boomers are the largest and wealthiest group in the United States. The old rich control the vote. So if you're a politician, you have to support what they care about. And the old rich care about health care.
As they grow into productive adults, baby boomers have access to affordable/nearly free health care. In addition, they receive a dignified pension paid by the Social Security Administration.
In return, they spend most of their earnings on pursuing the American Dream. A mansion full of gadgets, a pantry full of cheap processed food, a two-car garage with a pickup truck and an SUV full of cheap gas. This is how the US consumer accounts for 60% to 70% of annual GDP.
The U.S. government spending programs for Medicare, Medicaid, and Social Security are collectively known as entitlements. People think they are entitled to government-paid health care and pensions. Any politician who tries to reform these "stuff" will get rejected at the ballot box.
U.S. defense spending is almost never reduced because being the world's policeman is expensive. Especially when the goal is to ensure that cheap energy commodities produced in socially unstable regions are being shipped to the United States every day.
The problem with entitlement and defense spending is that they are real, not monetary goods. No matter how hard the Fed tries, it can't print more nurses, hospitals or aircraft carriers. As the population gets sicker and ages, the already expensive healthcare system will transform into yet another expensive area.
Check this out – the population age 65 and over increased by 7.74% from 2010 to 2019, according to the US Census Bureau. During the same period, Medicare and Social Security costs increased by 48.52%. For every 1% increase in older people, their spending on the government increases by 6%. Over the next ten years, approximately 42 million people aged 55-64 will become 65 and older. Assuming no deaths, between now and 2030, 13% of the population will actively seek government support. If current trends hold, healthcare and retirement spending will need to increase by another 78%.
Understanding the scale of health care, retirement, and defense spending is the goal of this work, and the next question is how the U.S. government will pay for the increased costs of programs that are critical to its contract with the people. Given the massive fiscal spending that has taken place, many believe that the US government will now resort to aggressively raising capital taxes to pay for the rising spending.
This chart shows annual tax revenue as a percentage of total Medicare, Medicaid, Social Security, and defense spending. The conclusion is that taxes barely cover 100% of costs now, compared to 200% 20 years ago. Over the past 20 years, the presidency has been held 60 percent of the time by Republicans and 40 percent by Democrats. Regardless of which party is in power, spending has grown faster than income.
From 2000 to 2020, the cost of these projects increased by 207%, while taxes increased by 83%. If we extrapolate this trend for another decade, tax revenues will only account for 90%. The government still has about 30% to 40% of extra budget items to pay for beyond entitlements and defense spending. This assumes that productivity and economic activity will not be affected by higher tax rates. It is a false assumption in itself that humans produce the same or more output when they get less and less from their efforts.
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8 No choice but up
Slowing down the pace of growth of the Fed's balance sheet is the same thing as raising interest rates. If the Fed doesn't raise rates, interest rates will increase significantly because foreigners won't be recycling their trade dollar earnings into the US Treasury market.
No politically important stakeholder could benefit from higher interest rates.
The portfolios of domestic and foreign bondholders suffer market losses.
Equity holders suffer as higher discount rates applied to future dividend streams mean valuations are squeezed. Economic dogma holds that if the stock market goes up, the real economy must do better. So if the stock market falls, the real economy does worse. Key takeaway: Don't let the S&P drop.
The U.S. government must borrow more and more each year to provide health care, pensions and defense equipment that will become increasingly expensive as the population ages and the world order becomes more multipolar. Raising tax rates is neither popular nor sufficient in extreme cases to generate the needed revenue. The U.S. government needs the Fed to play its part and ensure interest rates remain low while pumping debt into the economy to achieve above-trend growth.
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9 try
All those good words and charts are great, but the Fed still wants to believe it has a choice. So they would try to slow down the pace of their bond purchases — with potentially disastrous effects. In 2013, the acting chairman of the Federal Reserve surprised the market by talking about possible future tapering of bond purchases. Stokes and Bond got their hands on it, and Bernanke quickly nailed the plan. Bond purchases will proceed as scheduled.
Whenever the Fed tries to get out of the QE 4 EVA, the market says NYET (nothing). The stakes are even higher this time around because it is the stated policy of the US government that we are at war with COVID and will therefore spend everything we can. Similar to the period from 1939 to 1951, the Fed would be implicitly or explicitly required to buy bonds to engineer a Treasury yield curve below annual economic growth.
Now there are two problems - the Fed is considering reducing the amount of monthly bond purchases, and the elected officials in the US government have not passed any new large-scale spending bills. If the Federal Reserve and the U.S. government don’t cooperate to spend more money, the cryptocurrency market will kick off what will happen to the stock and bond markets.
I fully expect the carnage across asset classes to continue into early fall. The Fed will hold two policy meetings in June and July. Watch out if they start talking seriously about scaling back balance sheet growth.
Democrats need to find a way to pass their infrastructure bill. Who knows what compromises they'll make to qualify, but we need more stimulus checks. The expanded $3,600 child credit check for 2021 is a good step toward maintaining Washington's stewardship and continued investment.
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How tall is 10?
The point of this article is to argue that the only politically acceptable course of action to fight COVID and avoid fueling social unrest is to pay the nominal GDP target with borrowed money. To keep borrowing costs below the level of growth achieved, the Fed will expand its balance sheet to whatever is necessary.
Nominal GDP growth targeting policy works - the only problem is preventing runaway wage and commodity inflation. But sometimes, this is a politically acceptable outcome. During and after the war, governments always accepted this kind of hyperinflation because it was the only thing they could afford for the effort.
The trick is to spend the money on efforts whose real economic value exceeds the interest on the issued debt. From the late 1970s to today, China has pursued this strategy with great success. Michael Pettis argues that the true cost of debt outstripped economic growth sometime after 2008. China has amassed the largest stock of debt in human history because it has an enthusiastic policy of nominal GDP targeting and it does not issue a global reserve currency. If the US also goes all out, there is no limit to how much debt the Fed can hoard.
I cannot predict with certainty how much the Fed's balance sheet will grow. All I know is that if such a policy is to be implemented, the only way is to print money. The question for us traders and investors is which financial assets we can own that are growing at least as fast as the Fed's balance sheet.
The United States has already started this process. Assuming a 2% US 10-year Treasury yield and 6.5% GDP growth by the end of 2021, which is what the Fed and "respected" economists currently estimate. That's a real yield of minus 4%.
you have a bad job
Water, water, everywhere,
All boards are scaled down;
Water, water, everywhere,
Not a drop of water to drink.
——The Rime of the Ancient Mariner
This is one of my favorite verses, and it's perfect for the current state of mobility. Liquidity has increased significantly thanks to the Fed's monthly bond purchases; however, the water we actually need can only come from the massive spending bills passed by the US government and Treasury, which require the issuance of more notes, notes, and bonds.
Unfortunately, this article is already too long, so I can't dig into how exactly the QE transmission channel works. But essentially, when the Fed buys Treasuries from too-big-to-fail banks, it credits bank reserves held by the Fed.
Due to capital adequacy rules, banks must hold additional capital against these reserves.
However, if they hold U.S. Treasuries, they need to hold less, or none at all.
When the Fed conducts open market operations and buys U.S. Treasuries from banks, it takes a high-quality collateral and replaces it with poor-quality collateral. Banks then need to come up with funds to back these reserves. This essentially hinders the banks' ability to extend more credit, as they need to tie up capital to back the large and growing reserves they hold at the Fed.
The Fed is very interested in this issue, so they do reverse repos. That means the Fed swaps reserves for U.S. Treasuries. On the one hand, the Fed increases liquidity by buying Treasuries from banks, and on the other hand, it reduces liquidity by swapping them back to banks.
The net effect is therefore that overall liquidity conditions in fixed income markets remain unchanged in extreme cases.
The number of people using the facility at the New York Fed surged to record highs recently as the market ran out of Treasury collateral. The Treasury/U.S. government needs to spend more to borrow more. Because if the Fed insists on buying $120 billion a month, about 70% of which is US Treasuries, there is not enough collateral for the banking system to operate with short-term interest rates above 0%. There are a variety of structural and legal reasons why the short end of the Treasury curve cannot go negative without seriously disrupting the way US money markets operate. In 2008, the Fed switched to high-speed money-printing mode. Yet every Fed governor lamented that they could only do so much. If the US government does not spend more money thereby creating more treasury collateral, their quantitative easing measures are ineffective. Quantitative easing would simply shift the balance sheets of banks and other financial institutions from holding assets in Treasuries to ones holding riskier corporate debt and stocks. That doesn't mean banks will risk lending to the real economy. It won't be putting stimulus checks into the hands of GameStop warriors. Essentially, it does not correct for the underperformance of labor relative to capital since the 1970s.
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11 Cryptocurrencies as release valves
When a measure becomes a target, it ceases to be a good measure. - Marilyn Strassen
Financial markets are a collection of various measures designed to tell us about different aspects of the real economy. However, these measures mean nothing when the central bank turns them into targets. They then only tell us the extent to which central banks will buy or sell assets to achieve the desired politically acceptable outcome.
Thankfully, unlike those of the 1940s and 1950s, we have cryptocurrencies. Even if their domestic government forbids them to own gold, only the very rich really have the ability to express themselves financially. Others just ate their humble pie and complained while their savings were emptied to pay for the world's second total war.
Here are the various measures and how they have become goals:
Government Bonds - Almost every central bank in the world distorts its domestic bond markets with aggressive buying programs. So government bond yields can only tell us how much central banks are willing to expand their balance sheets - it doesn't tell us the true and proper cost of money
Stocks – Almost every central bank in the world is active in their respective domestic stock markets. The Fed hasn't yet, but as long as the S&P 500 keeps falling, they will find a way to support the stock market. Central bankers and most politicians think their credit is a reflection of the stock market, which somehow means the real economy is healthy.
But if you can target stocks at any level by printing money to buy the necessary amount of stocks, stock market performance will say nothing about the actual health of the domestic public corporate sector.
Housing – Almost every central bank in the world is active in their domestic housing finance markets. The market for mortgage-backed assets in the U.S. is developing unusually, but the central bank and federal government set stamp duties, mortgage rates and other affordability measures to encourage or discourage home buying. This is not a good measure because there are too many idiosyncratic policies that distort house prices and imputed owner-occupied rents that represent the material.
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12 cryptocurrencies
Here’s a chart of Bitcoin and Ethereum indexing with the Fed’s balance sheet in the post-COVID world. Starting January 1, 2020, the data index is 100. Even with the recent vicious sell-off, both have performed exceptionally well in terms of purchasing power growth.
Bitcoin and Ethereum outperformed the Fed's balance sheet by 2.3x and 15x, respectively.
No organization with a printing press has a target price for any cryptocurrency. Quite the contrary, they believe that cryptocurrencies simply represent the madness of the Internet crowd. This is perfect because if/when the issuer of the global reserve currency resorts to a nominal GDP target funded by its own printing press, cryptocurrencies can serve as the only effective smoke alarm for monetary inflation.
If you agree with me after all this writing, then you feel that the fluctuations in the total market capitalization of cryptocurrencies are irrelevant.
As the Fed’s balance sheet grows, the cryptocurrency market capitalization will grow with it. The relative performance of tokens in the crypto market depends on narrative, technology and adoption.
Now that I've laid out my global macro thesis why shorting the entire crypto market is stupid, I can return to an in-depth analysis of the micro market structure of cryptocurrencies and how DeFi will make most financial institutions currently only open to those who refuse to use digital payments. People are useful.
This article was also published on the BitMEX blog and is available here.
