Arthur Hayes: Where will the encrypted world go in the "economic wrestling"?
Author: Arthur Hayes
Compilation of the original text: Deep Tide TechFlow
Author: Arthur Hayes
Compilation of the original text: Deep Tide TechFlow
Last week, I caught up with my favorite volatility fund manager, David Dredge, and a few of his colleagues, and our conversation started with how Japan's financial markets are booming. Back then, ordinary people and businesses had a lot of cash, and rising inflation was pulling them out of low-yielding or even non-yielding bank deposits and into stocks and real estate.
We then turned to the current state of the cryptocurrency market and Dave asked me, "What the heck is the SEC going after Coinbase and Binance?"
I replied that this was just another example of the fiat financial system trying to limit capital leaving the casino. There is a lot of debt to pay, and the system needs as much exit liquidity as possible. He nodded in agreement. Dave likes to refer to the fragile fiat financial system as the Sharpe world. (Note: The name comes from Sharpe's Sharpe ratio, which most risk managers consider a standard measure of how "risky" a portfolio is - however in reality, this is completely bogus as it looks at probabilistic possibilities, rather than the actual outcome of investment decisions.)
Then I added that I don't think the U.S. attitude toward cryptocurrencies really matters because capital is fungible.
Finally, we talked about the impending devaluation of the Chinese Yuan (CNY). The thread that kicks off this topic is our general skepticism about the current upward trend in Singapore's residential market. Chinese capital doesn't care how much tax is levied on property purchases because the renminbi is overvalued and the Singapore dollar is undervalued. So even though they have to pay 60% tax to the Singapore government, Chinese capital sees property in Singapore as a cheap bank account where they can store their wealth safely.
David went on to argue that Beijing will eventually devalue the CNY against the Japanese Yen (JPY) because Japan is China's true global export competitor. Since the Bank of Japan (BOJ) continued its currency printing campaign (known as Yield Curve Control (YCC)) while all other major central banks were raising interest rates and reducing their balance sheets, the Japanese Yen has been depreciating against the US Dollar and Chinese Yuan at a very fast pace. quick. The People's Bank of China (PBOC) and the government have been relatively restrained in printing money since COVID - which is why the CNY is so "strong" against the USD and JPY.
We touched briefly on the fact that as the global economy slows, China's exports are starting to slow. The government will soon need to start generating growth to appease the common people, which means that the PBOC will need to adjust its monetary policy, devaluing the yuan against the yen and the dollar. A weaker yuan would help boost Chinese exports at the expense of their Japanese rivals.
As I was getting ready to go home, a little idea popped up. The current market reminds me of the summer of 2015. Beginning with the implosion of Mt. Gox in early 2014, the bear market has been brutal. Volatility and volume plummeted; sideways price action was tiresome. The price of Bitcoin has been hovering around $200. But in August 2015, the PBOC suddenly sparked China's interest in Bitcoin by devaluing the dollar. From August to November 2015, the price of bitcoin tripled, with Chinese traders propelling the market higher. I think something similar could happen in 2023.
Since 2021, when major Chinese exchanges stopped operating in mainland China, the inflow of Chinese retail investors into the crypto capital market has collapsed. The most influential and profitable retail investors have moved from China to the United States.
Starting 2020, the United States Government (USG) did something unexpected when deciding how to distribute stimulus money. Rather than just handing free money to the wealthy holding financial assets, USG directly distributes money to everyone — rich and poor. For the mass affluent (I'll discuss this demographic group in more detail later in this post, but for now, let's just call them $100,000-$200,000 a year households), many people don't really need government assistance because they have not lost their jobs (because they are white collar workers who can work remotely).
They took this free money, went straight to the financial markets, and had a great time. Stocks, cryptocurrencies, NFTs, and more have all been pushed higher by retail investors in the US. As usual, some of these people made enough money to buy a Lamborghini, but the vast majority bought at the top of the market, and then by the time Fed Chairman Powell starts raising rates in March 2022, the decision has been made After that fell fate.
Because on the other side of Asia, a silent currency war between China and Japan over export competitiveness will push the world's second-largest economy to issue massive amounts of credit. This credit issuance - that is, money printing - will eventually devalue the renminbi and prompt China's mass affluent to move their capital elsewhere. Given the sheer size of China's affluent class, when their money wants to "monetize", all hard asset prices will be pushed up.
In this post, I'm going to cover a lot. I'll start by discussing the world of Sharpe and then discuss why the US goes to great lengths to convince its citizens that their money is "safest" with US financial institutions. Then, I will discuss the fungibility of capital, even if it is difficult or impossible for wealthy retail investors in the United States to enter the crypto capital market, the wealthy in the United States can still easily exit the fiat currency system and buy hard crypto assets. This will ultimately lead me -- and hopefully you -- to conclude that all this worry about what's going on in "land of the free" is internal friction. I will then discuss the currency war brewing between China and Japan, and how this will bring some Chinese capital into cryptocurrencies through the Hong Kong financial market.
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01 Sharpe world
David is one of the best and brightest derivatives traders I have ever met. Every time we talk, I learn something new about market structure. Most of his time in banking has been spent in the Asia Pacific region. In our last meeting, we exchanged stories about our favorite bars in Jakarta. He lived there in the late 1980s, and I frequented it in the 2010s.
He was closely connected with the economic institutions of East and West. US Treasury Secretary Janet Yellen was one of his university professors. He also serves on several central bank advisory committees. Every time we meet, he talks about how to make it clear to the "adults in the room" that they're seeing risk all wrong. As I mentioned before, he called it Sharpe World.
"How do humans manage the risk of dying?" Dave asked rhetorically.
"You don't do things that are sure to kill you -- even if the chances of death are small each time -- and that prolongs your lifespan."
I think of many simple things humans do to prolong life:
do not smoke;
not drinking and driving;
wear a motorcycle/bicycle helmet;
Wear your seat belt.
If you follow these simple rules consistently, you can completely eliminate avoidable causes of death and (likely) extend your life. But humans do not deliberately evaluate each of their actions, moment by moment, for the possibility of death. For example, the average cyclist doesn't look at his helmet and say like a financial practitioner:
"This thing is annoying, and if I don't wear it today, the odds of an accident and I die are 3-sigma events (<1%), very low odds." Turns out that day ended up being a 3-sigma event day , you can't ask God to give you another life because you're adhering to a +/- 2-sigma lognormal probability decision criterion and thus taking the appropriate risk...you die.
However, in Sharpe World, financial institutions always bet on the probability of death and engage in high-risk activities. The main reason they do this is because they know that when they die on average every 5 to 7 years, the US central bank and the government will step in to save them. This system always saves the inhabitants of Sharpe World by printing money and devaluing the public's wealth.
Governments and financial institutions love Sharpe World because it's a place where super smart academics at "elite universities" make the rules telling them what to do and how to behave. Everyone plays by the rules, so when things blow up, no one can say they did something unethical. So the public should not feel unfair when they have to pay the price to bail out yet another financial institution (e.g. Credit Suisse) that has failed due to regulation.
The whole point of the monetary confidence game is to masquerade unproven economic theory as a law of nature in order to keep investors buying and holding government bonds for a long time. If I, as a government, can persuade my citizens to delay consumption and invest their savings in me over the long term, then I am a successful, credible state actor. On the other hand, if investors are only willing to lend money to the government short-term (if they choose to), then the country cannot be trusted and unpopular measures must be taken (such as high taxes).
The Sharpe World indoctrination by world-class financiers begins early in their youth. If you've taken any college-level finance courses, you've already learned about the efficient frontier and how certain magic assets—government bonds—can boost returns and lower a portfolio's overall volatility. Therefore, all portfolio managers need only add leverage to long-term government bonds and forget about the rate of return.
With the 40-year bull market in US and developed market bond yields, everyone thought they were geniuses. Someone like Ray Dalio just needs to be long on bonds to become a billionaire. Whenever the market is volatile, they apply more leverage, knowing that the authorities will print money to suppress any form of true price discovery.
But now, after the fastest rise in inflation and short-term interest rates in decades, there appears to be no reason for investors to hold long-term government bonds. And you, the reader, are part of this story. Your retirement plan is managed by a public or private pension fund filled with residents of Sharpe World. Fund managers are required by law to invest the bulk of your savings in long-term government bonds because...well, because the government says so. These are the same government bonds that get hit hard when inflation rises, but the financial institutions at Sharpe World obey the rules and direct their clients' capital to the slaughterhouse because rules are rules! In Sharpe World, no one buys long-term government bonds with their own money.
Dave harps on this question over and over in his monthly newsletter. His argument is that investors should forego holding government bonds to reduce volatility and increase returns, because at low interest rates, these vehicles no longer work like magic. Instead, investors should hold equities, gold, cryptocurrencies and long volatility tail hedges.
"Engage and protect," he said. “My fund provides protection by holding derivatives, and you as an investor should only buy a basket of stocks to participate in the rise.”
This chart clearly shows that owning a basket of U.S. Treasuries (UST) has lost money in both nominal and real terms over the past decade.
The red line in the chart above represents the performance of the most common 60/40 portfolio recommended by the standard - with 60% invested in stocks and 40% allocated to bonds by investing in the Bloomberg US Total Return Index. The blue line is a portfolio that maintains the standard 60% equity allocation, but allocates the remaining 40% of its assets to bonds, puts 62.5% of that into equities, and leverages the other 37.5% with the LongVol proxy (thus 75% risk exposure). As you can see, this blue portfolio without any bond allocation has outperformed the standard 60/40 portfolio over the past decade.
This raises an important question: why do your fund managers still hold long-dated government bonds? The answer is that the entire US fiat financial system is structured so that it is mandatory for your pension fund managers to hold government bonds, or at least strongly encouraged to do so. If they don't follow this, they risk losing their jobs, something no citizen of Sharpe World wants to see. Being the puppet of mediocrity in Sharpe World, making millions of dollars a year by constantly cheating customers while playing by the rules is pretty cool.
The reality is that there aren't enough convincing arguments in the world for investors to stick with this losing bet. So the U.S. government has to coerce investors into doing things—often by simply putting up barriers to keep capital from flowing out of the system. Things are a bit trickier for the US because if it implements capital controls that explicitly target cryptocurrencies or any other assets outside the system, the dollar will stop being the global reserve currency. However, it seems the U.S. has realized that if you make it painful and expensive enough for people to acquire crypto, most of the mass affluent class and below will give up — and their short attention span will force them back to their Instagrams and TikTok subscriptions.
The US is very keen to support Sharpe World as it is the biggest beneficiary of Sharpe World's existence. American universities are brainwashing centers for the citizens of Sharpe World. These people proliferate across the globe to ensure everyone abides by the global financial system that continues to put the dollar, long-term treasuries, and major currencies (JP Morgan, Goldman Sachs, Citibank, etc.) on its pedestals. Considering the US stopped making stuff decades ago and decided to export financial engineering, it makes sense for the US to keep making sure everyone plays by the rules of Sharpe World. When the existing order is threatened, the entire system will unite and take the necessary steps to ensure that capital never leaves.
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02 Alternative Capital
The US population only accounts for about 4% of the world's population. That's a very small share, but relative to the rest of the world, those 4% are pretty rich. That's why, as investors, we care about what this small demographic group does with their money.
However, this wealth is not evenly distributed among the American masses - it is highly concentrated at the top. 70% of the wealth in the United States is in the hands of 10% of Americans.
In fact, most people in the United States are poor and therefore irrelevant to global capital markets. You might counter that the casinos make a lot of money off the poor. My answer is that while the ground floor of the casino is filled with gamblers eager for easy money, the real profits — and what drives quarterly revenue growth — are made upstairs by the whales in their private rooms. You can't build Las Vegas, Macau, Monaco, etc. casinos by playing "dogs" playing five-point slot machines.
Leaving the richest 10% aside, let's focus on the next rung on America's economic ladder: the rich. As I mentioned before, I define this range to include all households with an annual income between $100,000 and $200,000, which is about 25% of the country.
The important thing about this class is that when COVID hit, they were likely to continue doing their old jobs from home. So when the lockdown came, they didn't need to use government handouts to stay afloat. They basically have extra income to spend or invest in whatever they want.
It's this class that's fueled the surge in sign-ups with online brokerages like Robinhood. This class has experimented with cryptocurrency transactions for the first time in 2020 and 2021.
Both times the personal savings rate in the US has soared was due to government stimulus checks. Most of the money is spent between 2020 and 2021, which is why you're seeing savings amounts reverting to the long-term average.
This class drove the market up during the COVID cryptocurrency boom. However, this class is actually not that wealthy. They may have some savings, but financial intermediaries that specialize in catering to the wealthy will not open accounts for this class. This wealthy class is entirely in the realm of retail investors, so it is difficult to easily enter the cryptocurrency market. Coinbase, Kraken, Gemini, Crypto.com, Binance.us, and Robinhood are some of the major platforms these retail investors have been forced to turn to.
During the last bull market, these exchanges and fintech companies were highly regarded for serving the wealthy class - they have a lot of disposable income to invest, thanks to US government assistance. However, without the services of these retail-focused fintech firms, the affluent would not be able to easily access the global cryptocurrency market.
Let’s do some brainstorming and imagine that due to regulatory changes in the US, these fintech companies suddenly have to delist most of the tokens they trade, and/or stop offering cryptocurrency trading services altogether (Crypto.com recently An example for the US market). This, then, would completely exclude wealthy Americans, eliminating a seemingly large pool of capital, which sounds bad but doesn't really matter.
This class first forayed into cryptocurrencies because of government aid. However, the level of apparent and deeply inflationary money printing by COVID is so high that I don't believe monetary authorities will resort to this behavior again in the near future. Instead, the Federal Reserve and the U.S. Treasury will hand out money for free by paying the rich interest on government bonds and central bank deposit facilities. This is usually how they move financial markets.
These are the people who use the most bank accounts in the world. Even if they are Americans, they can trade any and all financial assets globally - which means that if this wealthy group starts to believe that Bitcoin and cryptocurrencies do well in an inflationary environment, then they can easily move from exclusively to Rich people buy from dealers who sell cryptocurrencies. I'm talking about companies like Cumberland, NYDig, and the over-the-counter desks of US-registered cryptocurrency exchanges Coinbase and Kraken.
My point is that despite a lot of anxiety in the cryptocurrency market, it really doesn't matter at all whether most of the wealthy class and below can own or trade Bitcoin or some altcoin. They ran out of money and the government stopped sending checks. Even if Robinhood still allows them to trade a coin, they don't have the capital to buy it. The rich, on the other hand, are richer in capital and are all over the world - thanks to the many intermediaries that serve America's rich and will faithfully do whatever is asked of them, as long as they get handsome commissions.
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03 The real trade war
China and Japan hold more U.S. Treasuries than any other country. This is because they all use the same economic model:
Weakening the ability of collective labor organizations.
Undervaluing the national currency allows labor's productivity gains to flow to industrialists and the state in the form of offshore dollar income.
An undervalued currency keeps goods cheap so developed countries can continue to outsource the manufacture of goods to them.
This is the simple economic model of "Asia". The current competition among major Asian exporters is mainly on price, which is largely determined by the value of each country's currency. Therefore, China and Japan are more concerned about the CNYJPY cross rate than their currency's cross rate with the US dollar.
So which country is the most price competitive right now?
I indexed the USD/CNY and USD/JPY rates to 100 from January 1, 2009 to June 12, 2023. As you can see, relative to that period, the Yen has depreciated about 50% more than the CNY - but perhaps most notably, the spread between the two has increased since the onset of COVID. greatly expanded.
Below I've added CNYKRW (China vs South Korea, white) and CNYEUR (China vs basically Germany, yellow) to complement the competitive landscape of global export powerhouses.
Using this simple measure, China is 3% cheaper than South Korea, but 25% more expensive than Germany.
It makes perfect sense for the yen to depreciate so much against the yuan, as the Bank of Japan continues to print more money in an attempt to keep Japanese government bond yields at a certain level. This is known as yield curve control (YCC). Post-COVID, China has not engaged in such a large-scale money printing or credit extension to artificially fix bond yields at a certain level. Therefore, a 46% depreciation of the yen against the yuan since 2009 is entirely reasonable.
Chinese goods are more expensive than Japanese goods. This has had an impact on export volumes, which is confirmed by recent data.
The main impact of COVID's lockdown measures begins in summer 2022 - we can see from the chart above that exports collapse at that time. Then, overnight, China ditched its zero-zero policy and reopened its economy. Exports surged again as people returned to work. This bust-to-boom trajectory masks a general weakness in global consumers and a decline in the price competitiveness of Chinese goods.
This graph tells a similar story to exports.
China is now fully open, and there should be no aftermath of the 2022 lockdown. However, exports are now falling year-on-year. This is not a good thing. And, while all of these things were happening, the yen was depreciating badly against the yuan. If the global market is shrinking, China needs to be more competitive with its main export rivals to maintain steady growth and appease its populace. China's number one competitor is Japan (remember, they have the same economic model). The yuan must depreciate against the yen to help boost China's economic growth.
The biggest reason why the Chinese government needs to achieve economic growth is that they are facing a huge unemployment problem. Specifically, the urban youth unemployment rate exceeds 20%. There are not enough jobs for high school and college graduates.
For those who don't know, graduating from a university in China is a big deal because getting into a university is hard. High school students take the so-called gaokao. If your score is not high enough, you won't be able to go to college. There is no such thing as a professional rapper in China. Therefore, from elementary school onwards, children and parents devote all their energy to this test. In a country with such a large population, how do you assess who to hire or not to hire? HR relies on things like test scores and college attendance.
Parents who have spent all their energy and money over the past 40 years guiding their children through the education system have been rewarded. College graduates find jobs that pay more than factory jobs, move their families to cities, obtain hukou, and leapfrog class.
But now, even if all kinds of boring studies spoil your child's childhood, what awaits you is that you still can't find a job after graduating from college. China has a large number of highly educated and bored young people. For stability, this is simply the worst nightmare. The authorities must also realize that jobs must be created to get young people back to work.
When it gets stuck, China adopts policies that support exports and infrastructure projects to boost growth and employment. The supply-side economic measures that got China to where it is today could be repeated, even if it means adding more unhelpful debt to an already large debt pile. This requires a weaker yuan.
To devalue the currency, the PBOC will encourage credit growth in "good" areas of the economy. There will be higher interest rates on loans in semiconductors, artificial intelligence, clean energy, real estate, and more. Banks will be instructed to lend a certain amount of renminbi to these sectors. It doesn't matter whether these businesses actually need capital.
As credit expands, the currency will be allowed to depreciate. The People's Bank of China may conduct a shock devaluation, and then gradually guide the yuan down, gradually weakening the exchange rate of the yuan against the yen.
With both PPI and CPI in negative territory, the PBOC can ease policy without worrying about triggering inflation.
Since some high-quality businesses don't need this capital, they will "leak" into financial assets (like the stimulus checks for the wealthy in the US). Companies are supposed to make parts, but end up getting loans and using them to speculate in the financial asset market. Most importantly for this article, wealthy Chinese who see a trend will probably start moving capital out of China.
In the past, the PBOC may have worried about capital outflows, but Chinese holdings of financial assets in Western fiat currencies have become liabilities rather than assets. This is because the West has changed from an ally to an enemy. Who knows what will happen in Western political circles with regard to Chinese capital. It is entirely possible that we will wake up one day and some Chinese assets will be frozen because certain actions do not favor Western politics.
As you can see, China has a "problem" of about $3 trillion.
A better policy would be to allow the rich to buy hard assets like cryptocurrencies and ensure they are stored in China by trustees they own or control. I have predicted and continue to believe that Hong Kong will be the conduit through which Chinese capital will be allowed to hold crypto financial assets.
When I talk about financial assets, I mean ownership of financial returns on underlying crypto tokens or currencies, possibly through funds or derivatives — because China doesn’t want its citizens to hold real assets that can provide non-state Technology that supports economic freedom. In this way, Chinese investors dumped liabilities on the country's balance sheet and replaced them with Bitcoin and other cryptocurrencies. In doing so, the Chinese state would have a stronger financial balance overall.
Here's the flow I imagine:
Hong Kong allows various asset managers to offer cryptocurrency-backed exchange-traded funds (ETFs). Let's take Bitcoin ETF as an example.
Wealthy Chinese investors somehow convert their yuan into Hong Kong dollars. It couldn't be hard - otherwise Hong Kong's real estate market wouldn't be so buoyant.
Chinese investors then buy one of the bitcoin ETFs listed on the Hong Kong stock exchange.
ETF managers buy physical bitcoins from global markets and hold them with local Hong Kong-licensed custodians.
Chinese investors now own ETFs, which are derivatives of Bitcoin, but not physical Bitcoin. Investors can only participate in the price performance of Bitcoin, not hold the token itself.
This solves many problems in China:
It provides an outlet for hard assets for wealthy Chinese who want to escape the continued depreciation of the renminbi. Rich people feel smart and happy because their capital is "protected".
The end point of this exit is an institution that must abide by any rules set by Hong Kong regulators, effectively meaning that the physical bitcoin is under the control of the Chinese government. This is the same as holding Bitcoin in any US-listed ETF or trust, which is ultimately controlled by the US government. Same purpose.
This is a great result for our cryptocurrency holders. Through Hong Kong’s financial pipeline, the return of Chinese cryptocurrency traders will reignite the market, while America’s affluent are effectively left out. Every national action between the US and China pushes the other to do more of the same.
The simple act of China weakening its currency and allowing its loyal comrades to buy bitcoin derivatives has reduced the amount of western fiat currency assets the country holds. The more reluctant China is to use its export earnings to buy US Treasuries or hold dollar assets in any form, the harder the US must work to ensure that its citizens' capital cannot leave the Sharpe World because the buyer of long-term debt - China - is not buying.
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04 Trading Strategies
As confusion continues over what, if any, U.S. regulators want in the crypto industry, U.S. businesses are set to stop offering or severely scale back many cryptocurrency trading services. Many small coins will no longer be listed, and many U.S. financial intermediaries will dump indiscriminately on the open market small coins that are causing headaches for their compliance departments.
Bad mood + forced selling = falling price
People abandon me to pick it up, and the value of some sold coins must be zero. For example, why do things like L2 need tokens? This is something to be dubious about...but there are actually some tokens that are building the technology needed for an AI economy.
Because timing is very important, and I cannot predict when some of the large US-facing crypto trading firms will stop servicing the US and/or dump their crypto holdings, I have to buy in batches and without leverage.
This past weekend was a perfect example. Someone has to sell crypto quickly and in large quantities, and doesn't care about the market impact. Great - I bought tokens there at a fantastic price. But prices could drop another 20 percent next weekend. My point is that I must have absolute conviction in the value of products and services in order to continue buying in the face of serious losses.
Many crypto Twitter warriors might retort, "ARTHUR, the market is going sideways or down, but you're continuing to fantasize about a bull market."
This is a fair criticism. However, if my timing is wrong (which almost certainly happens), I slow down my scheduled bets and use no leverage. I am confident in my macro outlook and things are moving as I expect, albeit at a slower pace. For those short-term time traders, I agree with you that my analysis is useless because you have been plagued by false breakouts and corrections.
At some point, the sell-off will stop and we'll be facing sideways trading. The boring price action will continue until something stimulates the speculative spirit of cryptocurrency traders. I raised a possibility - a sudden devaluation of the renminbi against the yen. I'll be watching the yuan/yen exchange rate and China's export data. The less China grows, the more credit is extended. Then the currency will weaken, capital will be allowed to "flee" into suitable vehicles, and finally, the crypto capital markets will get the spark to start the fall rally hopefully.
