Author: Arthur Hayes
Original compilation: GaryMa Wu said blockchain
Author: Arthur Hayes
Original compilation: GaryMa Wu said blockchain
US CPI YoY Index
As you can see from the chart above, inflation, as measured by the (flawed and misleading) Consumer Price Index (CPI) series released by the U.S. Bureau of Labor Statistics, peaked at around 9% in mid-2022 and is now on track to A sharp decline towards the crucial 2% level.
There are many who believe that the recent steady downward trend in the CPI can only mean one thing: Powell is ready to put the water back on, as in March 2020. With the U.S. and possibly the world on the brink of recession, those prognosticators would say that Powell is looking at every opportunity to move away from his current quantitative tightening (QT) policy, which will take a huge toll if we enter a recession. Part of the responsibility. With the CPI down, he can now point to the drop and say that his just campaign to kill the beast of inflation has succeeded, and he can now safely turn the spigot back on.
I'm not so sure these predictions are correct, but we'll have more to say later. Now, let's assume the market thinks this is the most likely path forward, so how can we expect Bitcoin to react? To model accurately, we must remember two important things about Bitcoin.
First, Bitcoin and the broader crypto capital market are the only ones that are truly immune to manipulation by central bankers and large global financial institutions. You might ask: "But what about the alleged misconduct of bankrupt companies like 3AC, FTX, Genesis, Celsius, etc.?" That's a fair question, but my answer is that these companies went out of business as crypto market prices adjusted , the market quickly found a much lower liquidation price at which leverage was kicked out of the system. Had the same reckless behavior happened in the TradFi system, the authorities would have tried to delay the reckoning of the market by propping up failing entities (which they have always done), and in the process destroying the very economy they were supposed to protect, But the cryptocurrency space has faced serious challenges and quickly cleaned up poorly run businesses with flawed business models, setting the stage for a swift and healthy rebound.
The second thing to remember about Bitcoin is that because it is a reaction to the profligacy of the world's global fiat currency system, its price is heavily dependent on the future path of the dollar's global liquidity (due to the dollar's role as a global reserve currency). I have written about this concept and my USD Liquidity Index at length in a recent article. To this end, Bitcoin has outperformed the flat USD Liquidity Index over the past two months. In my opinion, this shows that the market believes that the Fed's turn has come.
Gold (yellow), Bitcoin (green), USD Liquidity Index (white), with an index of 100Looking at the price trend of Bitcoin, it is currently pulling up from a low. From here, we can identify a few different potential paths forward based on what is actually driving the rally:
Rally Catalyst Scenario 1:
Bitcoin has only experienced a natural bounce from local lows below $16,000.● If this rally is really just a natural bounce off local lows, I would expect Bitcoin to then find a new platform and move sideways until USD liquidity conditions improve.
Rally Catalyst Scenario 2:
Bitcoin rose as the market ahead of the Fed to resume printing money. If that's the case, I think two things could happen:
● Scenario 2 A: If the Fed does not implement the steering, or several Fed officials are not optimistic about the expectations of the steering after the CPI data is "good", Bitcoin may fall back to the previous low.
● Scenario 2B: If the Fed does implement a policy shift, Bitcoin will continue to perform strongly, and this rally will be the beginning of a long-term bull market.Clearly, we would all like to believe that we are moving towards Scenario 2B. That said, I think we're actually going to be facing some combination of Scenarios 1 and 2A, which makes my itchy "buy" finger a bit hesitant.While I believe the Fed will pivot, I don't think it will happen just because CPI is trending lower.
Powell declared that he was more concerned with the interplay between wage growth (U.S. hourly wages) and core personal consumption expenditures (core PCE) rather than relying on the CPI as a measure of inflation. As an aside, I don't think CPI nor core CPE are good indicators of inflation.
Core PCE is especially hypocritical because it excludes food and energy. Civilians don't riot because the price of a flat-screen TV goes up, they riot because the price of bread goes up 100%. But no matter what I think, the important thing for our forecasting work is that Powell has telegraphed that he intends to base any decision on potential policy shifts not only on CPI but also on how US wage growth compares to core personal consumption expenditures .
Change in U.S. Hourly Earnings minus Change in Core PCE, both in percent year-over-year
As you can see from the chart above, average wages in the US are growing at the same rate as inflation. This means that while goods are getting more expensive, people's ability to buy them is actually growing at a similar rate due to rising wages. Therefore, the increase in people's purchasing power may further promote commodity inflation. In other words, commodity producers may realize that their buyers are now making more money than before and raise prices further to absorb more of buyers' recent wage increases, all without fear of stifling demand for their products. So Powell actually has a case for continuing to raise interest rates (i.e. dampen consumer demand and stop commodity prices from rising further). And he's likely to use it, since he's already said he's looking to ensure that yields across the U.S. Treasury curve are above inflation (yet).
U.S. Treasury Activity Curve
December 2022 core personal consumption expenditures rose 4.7% YoY. As you can see from the above curve, only the 6-month Treasury bill currently yields more than 4.7%. So Powell has a lot of wiggle room to keep raising rates. More importantly, continue to shrink the Fed's balance sheet and further tighten monetary conditions to the level he wants.
The point of these last few charts and some of the remarks is simply to suggest that the falling CPI number is meaningless as it is inconsistent with the actual metric Powell is using to judge whether the Fed is successfully taming inflation. The drop in CPI could mean something, but I don't think it will predict in any meaningful way when the Fed will eventually turn.That said, I do believe that if Powell ignores the CPI data and continues to shrink the Fed's balance sheet via QT, it will cause serious disruption in the credit markets and force them to pivot aggressively.
Since reaching a high of $8.965 trillion on April 13, 2022, the Fed's balance sheet has been reduced by $458 billion as of January 4, 2023. The Fed was supposed to shrink its total balance sheet by $523 billion in 2022, so they've achieved 88% of their goal. Current QT rates suggest that the balance sheet will fall by another $100 billion per month and another $1.2 trillion in fiscal year 2023.
The market reacts asymmetrically when it injects and withdraws funds. As such, I expect the law of unintended consequences to bite the Fed's ass as it continues to withdraw liquidity. I also believe that Powell understands this instinctively because although his QT is very aggressive, at the current rate it will take many years to fully reverse the amount of money printing since the start of the new crown epidemic. From mid-March 2020 to mid-April 2022, the Fed printed $4.653 trillion. Based on a monthly cut of US$100 billion, it will take about four years to fully return to the pre-epidemic level of the Fed's balance sheet.
If the Fed really wants to reverse money growth, it should sell MBS and Treasuries outright, rather than just stop reinvesting in maturing bonds. Powell could have stepped up the pace, but he didn't, suggesting he knows the market can't afford the Fed to dump its assets. But I still think he overestimated the market's ability to deal with the Fed's continued passive involvement. The MBS and Treasuries markets need Fed liquidity, and if QT continues to grow at the same rate, these markets, and all other fixed income markets that derive their valuations and pricing from these benchmarks, will soon be in a world of pain.
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Fed turns to scenario analysis
In my view, two things could prompt the Fed to pivot:
1. Powell believes that the decline in the CPI indicator confirms that the Fed has done enough to pause interest rate hikes at some point in the near future, and may stop QT and cut interest rates if there is a mild recession in 2H23. Monetary policy typically has a lag of 12 to 24 months, so Powell sees CPI trending down and can be confident that based on what has happened over the past year, inflation will continue to return to the Holy Grail of 2% in the near future. As I outlined above, I think this scenario is unlikely as I don't think Powell uses CPI as a measure of inflation, but it's not impossible either.
2. Parts of the U.S. credit market collapse, leading to a financial meltdown involving a broad range of financial assets. In a similar response to March 2020, the Fed held an emergency press conference, halted QT, slashed rates, and restarted QE by buying bonds again.
In Scenario 1, I expect risky asset prices to rise slowly. We're not going back to the 2022 lows, and it's going to be a pleasant environment for fund managers. Just sit back and watch the base effects of the CPI kick in, mechanically lowering the headline numbers. The U.S. economy will find itself in an average position, but nothing terribly bad will happen. Even a mild recession would not be like what we saw during March-April 2020 or during the 2008 global financial crisis. Of the two, it's the preferred one, as it means you can start buying now, before the economy gets better and inflation stays low.
In Scenario 2, risky asset prices plummet. Bonds, stocks, and every cryptocurrency under the sun will be blackened as the glue of the dollar-based global financial system dissolves. Imagine the US 10-year treasury yield quickly doubling from 3.5% to 7%, the S&P 500 falling below 3,000, the Nasdaq 100 falling below 8,000, and Bitcoin trading at 15,000 or less trade. Like a deer caught in headlights, I expected Sir Powell to mount his horse and lead an army of money printing to the rescue. This is less than ideal, as it means that everyone buying risky assets now will face a significant downturn in performance. 2023 could be as bad as 2022 before the Fed turns.
My guess is scenario 2.
Why is gold rising?
Gold (yellow), Bitcoin (green), USD Liquidity Index (white), with an index of 100
The most plausible rebuttal to my underlying assumption for Scenario 2 is that gold also rises along with Bitcoin. Gold, a more liquid and trustworthy anti-fragile asset, serves a similar purpose in that it is also a hedge against the fiat currency system. So at first glance, you might reasonably surmise that gold's recent gains are further evidence of the market's belief that the Fed will adjust policy in the near future. That's a reasonable inference, but I suspect gold is up for another reason entirely. Therefore, it is important not to confuse the rise of gold and bitcoin as joint confirmation that the Fed is about to turn. let me explain.
Gold is sovereign money because, at the end of the day, nation-states can always settle trade in goods and energy in gold. This is why every central bank has a certain amount of gold on its balance sheet.
Since each central bank holds a certain amount of gold, when a country's currency must be devalued to remain globally competitive, central banks always resort to devaluing gold. As a recent example, the United States devalued the dollar against gold in 1933 and 1971. That's why I have a large allocation of physical gold and gold miners in my portfolio. It is always better to invest alongside the central bank than against it.
I (and many others) have written extensively about how the de-dollarization of the world will accelerate in the coming years following several recent key geopolitical events such as the U.S. freezing of Russian "assets" held in the Western financial system article. I predict that sooner or later the world's producers of cheap labor and natural resources will realize that if they piss off the American states they could face the same fate as Russia, and that there is no point in hoarding wealth in US Treasuries. This makes gold the most obvious and attractive investment destination.
The data supports the view that governments are turning to the time-honored sovereign reserve currency, gold, to store wealth. The chart below goes back 10 years and depicts net gold purchases by central banks. As you can see, we hit an all-time high in the third quarter of 2022.
Net gold purchases by central banks (metric tons)
This excellent chart from Gavekal Research clearly shows that gold is a better store of energy than US Treasuries.
In my view, these data suggest that gold prices are rising more because of real physical demand than because the world's central banks think the Fed will turn. Of course, at least some of this is due to expectations that the Federal Reserve's monetary policy may ease in the near future, but I don't think those expectations are the driving force behind it.
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What if I'm wrong and Scenario 1 happens with a good economy and low inflation?
This means that I have missed the bounce off the bottom and Bitcoin is unlikely to turn back as it is relentlessly marching towards new all-time highs. If true, the rate hike could come in two phases. In the first phase, savvy speculators will be ahead of the actual shift in Fed policy. At this stage, Bitcoin can easily trade to $30,000-$40,000, as the price is currently heavily depressed by post-FTX bearish sentiment. The next phase will take us to $69K or more, but it will only start after a lot of dollars are injected into the crypto capital market. Such an injection would require at least a pause in rate hikes and QT.
If I'm wrong, I'd happily miss the initial chance to bounce off the bottom. I'm already long, so I benefit anyway. However, my USD holdings in the form of T-bills would suddenly underperform and I would need to reallocate those funds into Bitcoin to maximize my return on investment. Before I give up on the bonds I bought at 5% yields though, I want to have a high level of confidence that the bull market is back. 5% is clearly below inflation, but it's better than a 20% drop because I mistimed the market and bought risky assets too early in the next cycle.
Since the Fed has yet to signal a turn, I can wait. I think the first is capital preservation, and the second is growth. I'd rather buy a market that has bounced 100%+ off its lows after the Fed signaled a turn than buying a market that bounced 100%+ off its lows because the turn didn't happen, then crashed due to poor macro fundamentals Suffering from 50%+ pullbacks.
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