Author: Arthur Hayes

Original compilation: GaryMa Wu said blockchain

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Everyone who manages money today is drawing deep parallels between how the Fed responded to inflation in the early 1980s and whats happening today. Powell believes he is the Paul Volker of this moment (the Fed chairman credited with ending inflation in the 1970s), so we can expect him to try to take the same approach (boldly raising rates) to get out of the U.S. inflation. He has said this virtually in many interviews since first revealing in late 2021 that the Fed would begin tightening monetary policy by raising interest rates and shrinking its balance sheet.

The problem is that Americas economic and monetary conditions are very different today than they were in 1980. What worked in the past under ideal conditions will not succeed in todays tough, competitive times.

Through this article, I want to show readers why the Fed is doomed to fail, and how the more they try to use Volcker economics to correct the course, the more they push the United States in the opposite direction from their intended goals. . The Fed wants to reduce internal inflation in the United States, however, the more they simultaneously raise interest rates and reduce their balance sheet, the more incentives they provide to wealthy asset holders. The U.S. federal government will demand a change of strategy from the Federal Reserve, and I will quote from a paper written by Dr. Charles Calomis, professor of economics at Columbia University, and published by the Federal Reserve Bank of St. Louis. The Federal Reserve is quietly telling markets it made a mistake and charting a path to redemption. As we know, the path to redemption always requires more financial repression and money printing. Good for Bitcoin!

Control currency quantity or price?

The Federal Reserve currently wants to control the quantity and price of money, but it cannot grasp the sequence.

The Fed controls the quantity of money by changing the size of its balance sheet. The Fed buys and sells U.S. Treasuries (USTs) and U.S. mortgage-backed securities (MBS), which causes its balance sheet to rise and fall. When the balance sheet goes up, they call it quantitative easing (QE); when it goes down, they call it quantitative tightening (QT). The New York Feds Trading Desk manages these open market operations. With trillions of dollars worth of Treasuries and MBS held and traded by the Fed, I believe the U.S. fixed income market is no longer free because there is an entity that can print money at will, unilaterally change banking and financial rules, always traded in the market and fix interest rates at politically convenient locations. Dont fight the Fed unless you want to get burned.

When Volcker became chairman of the Federal Reserve, he proposed what was considered a crazy policy at the time: targeting quantity and letting the price of money (the federal funds rate FFR or short-term interest rate) move in line with market desires. Volcker didnt care if short-term interest rates spiked, as long as money/credit was withdrawn from the financial system. Its important to understand this; in the 1980s, the Fed might raise or lower its policy rate, but it didnt try to force the market to trade at that level. From the Feds perspective, the only thing that has changed is the size of its balance sheet.

Recently, the Fed has wanted to ensure that short-term market interest rates match its policy rate. The Fed achieves this by setting interest rates on its reverse repurchase program (RRP) and its interest on reserve balances (IORB), keeping its policy rate between a lower and upper bound.

Approved participants, such as banks and money market funds (MMFs), are allowed to deposit dollars with the Fed on an overnight basis and receive a reverse repurchase (RRP) rate set by the Fed. This means that retail and institutional savers will not buy dollar-denominated bonds for a yield below this rate. Why take on more credit risk and earn less interest than if you deposited money with the Fed on a risk-free basis?

In order to keep a certain amount of bank reserves on deposit at the Fed, the Fed bribes banks by paying them interest on those balances. Interest on Reserve Balances (IORB) rates are another limiting factor, and banks will not lend to individuals, companies, or the U.S. government at a lower rate than they would risk-free from the Fed.

There is also a view that the Fed must pay interest to RRP and IORB depositors to reduce the flow of money. In total, nearly $5 trillion is held in these facilities; imagine what the level of inflation would be if these funds were actually used to create loans in the real economy. The Federal Reserve created so much money through its quantitative easing (QE) program after the 2008 financial crisis that it paid billions of dollars in monthly interest to keep the money ring-fenced and prevent it from being injected entirely into the monetary system. Whatever the reason, in order to “save” the fiat banking system from destruction time and time again, they have created a bad situation for themselves.

Currently, the Fed sets short-term interest rates and manages the size of its balance sheet. Powell has already disagreed with his idol, Volcker, in one very important way. To effectively manipulate short-term interest rates, the Fed must print money and give it to depositors in the RRP and IORB. The problem with this, however, is that if the Fed believes that in order to curb inflation it must simultaneously raise interest rates and reduce the size of its balance sheet, then this is tantamount to cutting a flesh to cure an elbow.

First, lets look at the banking system in isolation to understand why the Feds current policy is counterproductive. When the Fed engages in quantitative easing (QE), it purchases bonds from banks and credits them with reserves (i.e., IORB increases) in reserve accounts they maintain with the Fed. The opposite is true when doing quantitative tightening (QT). If the Fed just did QT, the IORB would steadily decline. This means banks must lend less to the real economy and demand higher interest rates to obtain any loans or investments in securities because they hold billions of dollars in high-yield bonds purchased from the Fed. This is one side.

On the other hand, banks still hold about $3.2 trillion in IORB that they dont need to use, and these funds are parked at the Federal Reserve to earn interest. Every time the Fed raises interest rates, the Fed hands billions of dollars to the same banks every month.

The Fed is constantly adding (QE) and subtracting (QT) reserves to banks as it attempts to control the quantity and price of money. Later Ill show how mathematically futile this is, but I want to first provide some background before presenting some tables.

Quantitative Tightening (QT) does not directly affect ordinary individual and corporate savers; however, by disbursing billions of dollars each month to RRP depositors, the Fed is also affecting these groups. The reason the Fed distributes cash to these people is because they want to control the price of money. This also directly offsets the tightening effect of QT, as the Fed hands out free money to wealthy rentiers (individuals, corporations, and banks). If you have a large sum of cash and you want to do zero financial analysis and take on zero risk, you can deposit with the Fed and get almost a 6% yield. Every time the Fed raises interest rates, I cheer because I know Ill get more free money in my money market fund account.

To summarize how contradictory the Fed is, here are some handy tables.

Looking at these two tables, you would conclude that the Fed is still tightening as a total of $57.47 billion in monthly liquidity is being withdrawn. However, I left out an important source of free money: interest payments on U.S. Treasury bonds. In the next section, I explain how the Feds actions affect the U.S. governments ability to raise funds through the sale of bonds. When that factor is taken into account, Mr. Powells efforts look even more unrealistic.

The era of simply raising interest rates to solve inflation is over

A historical background for Paul Volckers interest rate hikes to end inflation in the 1970s is that the U.S. debt-to-GDP ratio was 30% in 1980 and is now 118%. Such a large debt would have a significant impact on interest rate increases. With a big impact, the U.S. Treasury Department needs to issue more new debt to pay off old debt, fund interest payments on current debt, and cover government spending, ultimately resulting in the Treasury Department having to pay huge interest payments.

CPI Index: Services Component Takes Large Proportion

Why is U.S. economic growth surging while regional banks are faltering and indicators show the small businesses that drive the U.S. economy are in trouble? Thats because the wealthy are spending more on services.

Although according to normal logic, when people receive subsidies, they will buy daily necessities under the guidance of the government, thereby promoting commodity inflation. But the rich already have all these things. When you give money to the rich, they spend more on services and buy more financial assets.

Services account for a large portion of the Consumer Price Index (CPI) basket. The Fed has proposed a super core inflation measure, which basically refers to services.

Powell and his team are focused on sharply lowering this measure of inflation. But how can this inflation go down if every time they do something (raise interest rates) it actually makes the largest consumers of services richer?

asset income differentiation

Before I move on to the future, let’s take a look at some recent developments.

We need to know that even if the Fed is injecting liquidity into the market, it does not mean that all assets will rise.

Using March 8, 2023 as a baseline (the day Silvergate Bank filed for bankruptcy), I looked at the U.S. Regional Bank Index (white), the Russell 2000 Index (green), the Nasdaq 100 Index (yellow), and Bitcoin ( magenta) performance.

Aside from the too-big-to-fail banks, regional banks fared worse, down 24%.

The businesses that employ workers and drive the U.S. economy rely on regional banks to provide credit, but those banks are unable to provide credit while their balance sheets are so damaged. As a result, these businesses will continue to be unable to expand and in many cases will go bankrupt. Thats what the Russell 2000 Index, which is primarily composed of smaller companies, tells us. The index has barely risen over the past quarter.

Tech giants do not rely heavily on banks, and they have benefited from the recent AI craze. If the U.S. banking system isnt healthy, tech companies dont care. People with spare capital are willing to chase high-tech stocks again and again. Thats why the Nasdaq 100 is up 24% since the banking crisis.

One of Bitcoin’s value propositions is that it is the antidote to a broken, corrupt and parasitic fiat currency banking system. Therefore, as the banking system collapses, Bitcoin’s value proposition becomes even stronger. Therefore, as the denominator of fiat currencies grows, Bitcoin also increases in terms of its value to fiat currencies. Heres why Bitcoin is up 18% since March.

In trouble

Inflation is always a top concern for any population. If people can work hard and buy more with less, they actually dont care about the personal characteristics of those in power. But when gasoline or beef prices are high, politicians who have to run for re-election run into trouble. Good politicians know that if there is inflation, they must get it under control.

The Fed will continue this ridiculous strategy of trying to control the quantity and price of money because politics demand it. Powell cant stop until politicians give him the signal to fix everything. With the 2024 US election looming, the Federal Reserve is more paralyzed than ever. Powell does not want to change Fed policy between now and next November for fear of being accused of supporting a certain political party.

But the math doesnt hold. Something has to change. Take a look at the chart below - depositors continue to withdraw funds from banks with low deposit rates and deposit them into MMFs, essentially depositing funds with the Fed. If this continues, small U.S. banks will continue to go bankrupt one after another, which will be a direct impact of the Feds policies.

In addition, the US Treasury is increasing the amount of bonds it issues as tax revenues fall and the fiscal deficit soars. As money prices rise (provided by the Fed) and debt issuance increases, interest payments will get bigger and bigger. There must be a way to solve this puzzle...

The best thing about being in charge right now is that while they may be intellectually dishonest, they wont lie to you. Fortunately, they will also tell you what they are going to do in the future. You just need to listen.

fiscal leadership

For those who want to understand how the Federal Reserve and the U.S. Treasury Department do both mathematically and politically well, theres a great read: the most important paper published by the St. Louis Federal Reserve earlier this year. They have a research institute that allows well-known economists to publish papers. These papers influence Fed policy. If you are serious about investing, you must read this paper in its entirety. I will only excerpt some of them.

Dr. Calomiris has explained in detail what fiscal dominance is and what it actually means, I would like to give readers a brief summary:

● Fiscal dominance, whereby the accumulation of government debt and deficits may have the effect of increasing inflation, an effect that dominates the central banks intention to keep inflation low.

● Fiscal dominance occurs when the central bank must set policy, not to maintain stable prices, but to ensure that the federal government can raise funds in the debt market, at which point the governments bond auctions may fail as the market reacts to new bond issuance The interest rates required were so high that the government withdrew from the auction, opting instead to print money as an alternative.

● Since governments require debt yields below nominal GDP growth and/or inflation, investors have no interest in purchasing this debt. This is the definition of a negative real yield.

● In order to find a fool to buy this debt, the central bank needs to require commercial banks to deposit large amounts of reserves with it. These reserves do not pay interest and can only be used to purchase government bonds. (So ​​the fool here is the commercial bank)

● As commercial banks profitability declines, they are unable to attract deposits for lending because they are allowed to offer deposit rates that are well below nominal GDP growth and/or inflation.

● Since depositors cannot earn real returns on bank or government bonds, they turn to financial instruments outside the banking system (such as cryptocurrencies). In many cases, commercial banks themselves are actively involved in moving funds to different jurisdictions and/or asset classes in order to obtain fees from their clients. This is called financial disintermediation.

● An unanswered question is whether commercial banks have enough political power to protect their customers and enable this financial disintermediation to occur.

So why go to all this trouble instead of just telling the Fed to cut interest rates? Because, in the words of Dr. Kalomiris, it’s a “stealth” tax that most Americans won’t notice or understand. Its politically more convenient to keep interest rates higher when inflation is still destroying the American middle class, rather than publicly instructing the Fed to start cutting rates and stimulating markets again, or worse, cutting government spending.

Dr. Kalomiriss paper presents a very solid solution to the problem of the Fed and the U.S. Treasury, namely that weakening the banks is the best policy option if one moves towards fiscal dominance.

Then, the Federal Reserve may require that most of the deposits in the reserve be kept as reserves, cancel the payment of interest on reserves, terminate the payment of RRP balances, etc. Government agencies should not offer higher yields than long-term Treasury bonds. Given that the entire purpose of this move is to keep long-term Treasury yields below inflation and nominal GDP growth, this will no longer entice investors to park their money in money market funds (MMFs) and/or buy US Treasuries. As a result, the current fat yields that cash earns will disappear.

In essence, the Fed will end trying to control the price of money and focus on the quantity of money. The quantity of money can be changed by adjusting bank reserve requirements and/or the size of the Feds balance sheet. Short-term interest rates will be slashed, probably to zero. This helped return regional banks to profitability, as they could now attract deposits and earn profitable interest rate spreads. It also makes financial assets outside of big tech companies attractive again. As the stock market generally rises, capital gains taxes rise, helping to fill government coffers.

Why is weakening banks the best policy option?

First, reserve requirements are a regulatory decision dictated by financial regulators, in contrast to new taxes enacted by legislation (where the legislature could be blocked). It can be implemented quickly, assuming that regulators, who can be influenced by the pressure of fiscal policy, have the power to change policy. In the case of the U.S., the decision on whether to require reserves to maintain reserves on deposits and whether to pay interest is up to the Feds board of directors.

The Fed is not accountable to the public as an elected representative. It can do whatever it wants without voter approval. Democracy is great, but sometimes dictatorships are faster and stronger.

Second, because many people are unfamiliar with the concept of an inflation tax (especially in societies that have not experienced high inflation), they have no idea that they are actually paying it, which makes it very popular among politicians.

financial disintermediation

Financial disintermediation is the flow of cash out of the banking system for paltry yields and into alternatives. Bankers have come up with all sorts of novel ways to offer their clients higher yields, as long as the fees are decent. Sometimes regulators are not happy with this innovation.

Fiscal dominance occurred during the U.S. Vietnam War. To keep interest rates stable in the face of high inflation, U.S. regulators have imposed caps on deposit rates for banks. In response, U.S. banks established branches outside, mostly in, London, outside the control of U.S. banking regulators, that were free to offer market rates to depositors. Thus, the Eurodollar market was born, and it and its related fixed income derivatives became the most traded financial market in the world.

Interestingly, often the struggle to control something often leads to the creation of a larger, harder-to-control monster. To this day, the Fed and the U.S. Treasury hardly fully understand all the nuances of the Eurodollar market that U.S. banks have been forced to create to protect their profitability. Something similar can happen in the world of encryption.

The heads of these large traditional financial intermediaries, such as banks, brokerage firms, and asset managers, are some of the smartest people on the planet. Their entire job is to anticipate political and economic trends in advance and adapt their business models to survive and thrive in the future. Jamie Dimon, for example, has for years highlighted the unsustainability of the US governments debt load and fiscal spending habits. He and his ilk knew a reckoning was coming, the result of which would be that the profitability of their financial institutions would be sacrificed to fund the government. So they have to create something new in todays monetary environment that is similar to the euro market of the 1960s and 1970s. I believe cryptocurrencies are part of the answer.

The ongoing crackdown on cryptocurrencies in the U.S. and the West has largely targeted operators in non-traditional financial circles, making it difficult for them to do business. Ponder this: Winklevii (Two Tall, Handsome, Harvard Educated, Tech Billionaire Men) - Why They Cant Get Bitcoin ETF Approved in the US, But It Seems Larry Fink of Larry Fink of Old Blackstone But will things go smoothly? In fact, the cryptocurrency itself was never the problem - the problem was who owns it.

Is it clear now why banks and asset managers are suddenly enthusiastic about cryptocurrencies, just after the collapse of their competitors? They know that the government is about to attack their deposit base (i.e. the aforementioned weakening of the banks), and they need to ensure that the only available antidote to inflation, cryptocurrencies, are under their control. Traditional finance (TradFi) banks and asset managers will offer cryptocurrency exchange-traded funds (ETFs) or similar types of managed products, exchanging clients’ fiat currencies for cryptocurrency derivatives. Fund managers can charge extremely high fees because they are the only players that allow investors to easily convert fiat currencies into cryptocurrencies for financial returns. If cryptocurrencies have a greater impact on the monetary system than the euro market over the next few decades, traditional finance can recoup losses due to unfavorable banking regulation by being the crypto gateway to its multi-trillion dollar deposit base .

The only problem is that traditional finance is already creating such a negative image of cryptocurrencies that politicians actually believe it. Now, traditional finance needs to change the narrative to ensure that financial regulators give them the space to control capital flows, as the federal government needs to do when it imposes this implicit inflationary tax on bank depositors.

Banks and financial regulators could easily find common ground by restricting physical redemptions of any cryptocurrency financial product offered. This means that those holding any of these products will never be able to redeem and receive physical cryptocurrency. They can only exchange and receive dollars, which are immediately put back into the banking system.

The deeper question is whether we can maintain Satoshis values ​​at a time when trillions of dollars of financial products are likely to be flooded within the traditional financial system. Larry Fink doesnt care about decentralization. What impact will asset management companies like Blackstone, Vanguard, Fidelity and others have on Bitcoin improvement proposals? For example, proposals to improve privacy or resist censorship? These large asset managers will be eager to offer ETFs tracking an index of publicly listed cryptocurrency mining companies. Soon, miners will discover that these large asset managers will control large voting rights in their stocks and influence management decisions. I wish we could remain true to our Founder, but the devil is waiting, offering temptations that many cannot resist.

Trading plan related

The question now is how do I adjust my portfolio, sit tight, and wait for fiscal dominance to push the policy prescription Dr. Carlo Miris describes into effect.

Cash is a good bet right now because, broadly speaking, only tech giants and cryptocurrencies beat it in terms of financial returns. I have to make ends meet, and unfortunately, holding tech stocks or most cryptocurrencies generates basically no income for me. Tech stocks don’t pay dividends, and there are no risk-free Bitcoin bonds to invest in. Earning almost 6% on my fiat back-up is great because I can cover living expenses without having to sell or borrow my crypto. Therefore, I will continue to hold my current portfolio, which includes fiat and cryptocurrencies.

I dont know when the US Treasury market will crash and force the Fed to act. Given the political demands that the Fed continue to raise interest rates and reduce its balance sheet, it is reasonable to assume that long-term interest rates will continue to rise. The 10-year U.S. Treasury yield recently topped 4%, putting yields at local highs. This is why risky assets such as cryptocurrencies have been hit. The market sees higher long-term interest rates as a threat to indefinite assets such as stocks and cryptocurrencies.

In his recent notes, Felix predicted an upcoming severe market correction for various assets, including cryptocurrencies. His point of view is still worthy of attention. I must be able to earn an income and be able to deal with the market volatility of cryptocurrencies. My portfolio is set up for just that.

I believe I have the right forecast going forward because the Fed has said bank reserve balances must grow and predictably the banking industry is not happy about this. The rise in long-term U.S. Treasury yields is a symptom of a deep-seated corruption in the market structure. China, oil exporters, Japan, the Fed, etc. are no longer buying US Treasuries for various reasons. With the usual buyers on strike, who is going to buy the trillions of dollars of debt the US Treasury will have to sell in the coming months at low yields? The market is heading towards the scenario predicted by Dr. Carlo Miris, which could end up with a failed auction that forces the Fed and Treasury to act.

The market has yet to appreciate that the sooner the Fed loses control of the Treasury market, the sooner it will resume rate cuts and quantitative easing. This was demonstrated earlier this year when the Federal Reserve abandoned monetary tightening by expanding its balance sheet by tens of billions of dollars over a few trading days in order to rescue the banking system from bank defaults across the region. A dysfunctional U.S. Treasury market is good for risky assets with limited supply, like Bitcoin. But thats not how investors have traditionally been trained to think about the relationship between fiat risk-free yield bonds and fiat currency risky assets. We have to go downhill to go up. Im not trying to fight the market, just sit back and accept this liquidity grant.

I also think that at some point, more investors will do the math and realize that the Fed and U.S. Treasury combined are doling out billions of dollars each month to wealthy savers. That money has to go somewhere, and some of it will go to tech stocks and cryptocurrencies. Although the mainstream financial media may sound disastrous on issues related to the sharp decline in cryptocurrency prices, there is a lot of cash that needs to be invested in a limited supply of financial assets such as cryptocurrencies. While some believe that the Bitcoin price will drop below $20K again, I tend to think we will be hovering around $25K early in Q3. Whether cryptocurrencies can weather this storm will directly correlate to the amount of interest income for new interest earners.

I will not fear the weakness of this cryptocurrency, I will embrace it. Since Im not using leverage in this portion of the portfolio, I dont mind a big drop in price. Using an algorithmic strategy, I will patiently buy several altcoins that I believe will do well when the bull market returns.

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