The real inflation problem
A prerequisite for a bull market to start is a pause in interest rate hikes by the Federal Reserve and central banks, and keeping the size of their balance sheets unchanged. Under the current rate hike cycle, the CPI has corrected, but the income of ordinary American workers is also decreasing. Since this is a midterm election year in the United States, this will become a bigger and bigger issue as November rolls in and what the ruling Democratic Party will need to do to correct.
As voters pay more and more for less and less money, inflation becomes extremely important to them. Those red bars in the picture above mean that whichever party comes to power will face the problems of the moment.
The Fed has done such a good job of driving down asset prices that the U.S. 10-year Treasury note has posted its worst 2022 return so far since 1788. However, people are more concerned about the price of energy and food. By destroying demand through a negative wealth effect, it can substantially slow the rise in energy and food prices. The theory argues that the wealthy consume far more of these resources than the common man. Thus, raising interest rates can force the wealthy to spend less, dampening inflation in energy and food prices in the process.
In a recent speech, Governor Waller put it this way:
I support another 50 basis points of policy tightening in a few meetings. In particular, I won’t put a 50 basis point hike on the table until I see inflation come down close to our 2% target. And, by the end of the year, I support keeping the policy rate above neutral so that it reduces demand for products and labor more in line with supply, thereby helping to control inflation.
The above might work if the world is not in a world war. Today, however, the United States and NATO are openly supplying Ukraine with sophisticated weapons so that its armed forces can engage Russia directly. While there is no direct kinetic confrontation between the West and Russia, the West has gone to war with Russia economically through various sanctions.
Russia and Ukraine jointly produce vast amounts of energy and food, and the longer this conflict drags on, the less the rest of the world will have access to these critical resources. And what’s really scary is that even when the war is over, complex systems don’t restore previous outputs in a linear fashion. As a result of current disruptions, we could lose significant amounts of global agricultural and energy output within a few decades. To make matters worse, Russia and Ukraine provide a large portion of the world’s fertilizers, and without these exports, agricultural production in other countries would likely plummet as well. And if Russia has to shut down oil and gas wells for lack of a buyer who can logistically receive them, it will take decades to restore current daily production.
The contingent will continue to seek to reduce demand for energy and food, but prices for both will continue to rise unless full trade with Russia and Ukraine resumes. If trade cannot be resumed, the United States has to resort to another common solution to the problem.
That is to provide energy and food subsidies that will keep these necessities at affordable prices. Subsidies come in many forms. Windfall taxes on private companies that “gouging” prices, price controls on various items, and direct government checks (aka food stamps) are all potential forms of subsidies.
But either way, the government needs to generate more cash, that is, by issuing more government bonds to widen the fiscal deficit. But who will buy these bonds?
In a wartime economy, the central bank loses its independence and merges with the Treasury. This happened after World War II, and it will happen again now. The central bank will press the button and immediately begin buying all debt issued by the Treasury at politically appropriate rates.
The externalities of this policy are accelerated global inflation and famine. The worst affected will be countries in the Global South, which do not have the capacity to print money to solve their macroeconomic problems. The US issues the global reserve currency, has the strongest military, so it will be fine and it will get all it needs at the expense of everyone else. EU countries will be in a similar position, as the euro is the second-largest currency used in trade. Europeans are experts at subsidies that distort demand and ensure domestic entities receive preferential treatment compared to the rest of the world. But if the world’s richest citizens don’t curb their consumption as global output shrinks, everyone else will starve to death.
My bet is that the Fed will tighten the currency harder in the third quarter, even if the S&P 500 and Nasdaq 100 are below 3,000 and 10,000, respectively. Because they have to keep energy and food prices down, not just risk assets. But if energy and food inflation are not meaningfully adjusted by then, politicians will have to offer subsidies to appease agitated voters.
These subsidies will be paid for by printed money provided by the Fed, at which point we will renew the bull market in risk assets. If the words of the all-knowing hedge fund expert Felix Zulauf are to be believed, a major financial market crash will follow, as fiat currencies crumble themselves under the weight of the biggest money-printing machine in human history.
But with that comes the recovery of the bubble, which may only be a few quarters away. Now, we have to ask ourselves: Has the cryptocurrency bear market bottomed out?
Since cryptocurrencies are the last free market in the world and will soon be included in the recovery risk ranks, it is reasonable to think that the recent collapse of UST and LUNA will break the bottom of the market.
I want to connect the two theories.
1. In terms of fee-adjusted performance, most tech VCs are instruments of beta that are expensive to the overall market. So as inflation overwhelms bellwethers like Netflix as users choose to eat rather than pay for the privilege of watching more mediocre Netflix originals, some of the world’s most successful tech companies like Facebook have seen flat or even subscriber growth negative, the general funding and IPO environment deteriorated rapidly in the first quarter of 2022. Add to that rising nominal interest rates, and you can imagine the pain of those Patagonia-clad, khaki-clad brothers in Silicon Valley, Beijing’s Zhongguancun and Mayfair.
2. The theory below comes from one of the smartest cryptocurrency traders I know, I haven’t thoroughly tested his theory, but logically it makes sense. He speculates that the event that burst the UST bubble stemmed from over-the-counter transactions by VCs who needed to cash out their LUNA positions with minimal market impact.
Due to the openness of the blockchain, early VCs who sell a large number of LUNA positions will be easily discovered. The protocol allows holders of LUNA to exchange 1 USD of LUNA for 1 UST at the current market price of LUNA/UST. This LUNA will be burned and an equal amount of UST will be created, with no market impact on the wider LUNA value. Using over-the-counter (OTC) transactions, VCs exchange large amounts of UST for other stablecoins such as USDT, USDC, or even USD without affecting the market. The end result was a massive increase in the supply of UST, which ultimately impacted the de-pegging of its price.
This liquidity is nearly $5 billion. The onset of the UST collapse occurs when the peg’s curve breaks slightly. This is because the supply of UST is too large relative to other stable currencies like USDT and USDC. Once the peg starts to break slightly and confidence in a quick recovery diminishes, the negative convexity of algorithmic stablecoin design takes over and creates an unstoppable downward force.
Putting these two events together, the inflation-driven VC balance sheet contraction and the bursting of the Luna bubble, my theory is that the broader risk aversion environment prompted them to cash out their LUNA at the same time. The global risk aversion movement was initiated by the Fed. Therefore, the collapse of TerraUSD is an indirect result of global central banks tightening liquidity. So I believe this event has brought pain that will happen anyway in a few months as the Fed and others continue to tighten liquidity conditions.
For the record, I’m not blaming the Fed for the collapse of the UST. Its collapse is doomed, understandable to anyone who has read the white paper or studied algorithmic stablecoins. My point is that the Fed provides the catalyst for what will eventually happen. Thankfully, since there was no government bailout for cryptocurrencies, we quickly found the true liquidation price and can now slowly recover and move on to our goal.
I firmly believe that cryptocurrencies lead the wider market. Data backs this up as correlations between Bitcoin, Ethereum and the Nasdaq 100 decoupled during the recent cryptocurrency market crash. Below, let’s revisit the correlation charts to see how they all turned sharply lower.
Below are 10-, 30- and 90-day rolling correlation charts between Bitcoin and the previous month’s Nasdaq-100 futures contract, in order of precedence.
Below is a 10-day, 30-day and 90-day rolling correlation chart of Ether and the previous month’s Nasdaq 100 futures contract, in order.
As you can see, cryptocurrencies have decoupled from the broader risk asset space during this latest selloff. This is good on a macro level, but there are other cryptocurrency market indicators pointing to a local low as well.
Let’s just focus on Bitcoin and Ethereum as they are my crypto benchmark assets. Both cryptocurrencies are in a big cycle bull market. I mean, bitcoin and ether prices are rising at the bottom of every bear market.
Here is a chart from glassnode that helped me conceptualize the three major Bitcoin price cycles. The biggest drop was a local bottom compared to the previous cycle’s all-time high (ATH). Below is a table representing the levels of the three main cycles.
Ethereum has gone through two cycles. The first cycle started when ether was freely traded for the first time after the ICO was issued, and the second cycle started after the ICO boom subsided in 2017 and 2018 and ether bottomed out.
Don’t take these as exact science, we can roughly come up with a range that corresponds to what we think is the bottom. For Bitcoin, $25,000 to $27,000. For ether, that’s $1,700 to $1,800. (His prediction in May: $20,000 for Bitcoin, $1,300 for Ether)
If I had a natural language processor scraping all the articles about cryptocurrencies in the mainstream financial media, I could plot a language sentiment indicator. Even without a robust model, a cursory search of highly clicked articles published by Bloomberg, the Financial Times, the Wall Street Journal, and others can reveal how painful the markets are for cryptocurrency traders around the world.
My bottom checklist:
1. Bitcoin/Ethereum movements are less and less correlated with the Nasdaq 100.
2. The current price level is very close to the all-time high of the previous cycle.
3. The mainstream financial media gloated about how stupid and greedy those who invested in cryptocurrencies for short-lived wealth were.
A typical feature of bottoms is when the most committed bulls are forced to sell assets, and LFG is one such role. Spitting out 80,000 BTC makes me more convinced that the $25,000-27,000 region is the bottom of the cycle.
Politics must align with the macroeconomic environment, and while the bottom has come (I hope so), that doesn’t mean prices will automatically resume their rapid rise.
The market will stage an impressive bear market rally, allowing traders who have lost a lot of money to take advantage of the rebound. Now, many traders are sitting on a 50% to 90% drop and they are reluctant to exit at the bottom price. Therefore, any rebound will usher in selling pressure, and only if all of this selling pressure is absorbed can the bull market be ushered in.
In a previous article, I made an argument that I think ETH can hit $10,000 by the end of the year. Given the recent carnage, many readers wonder if I still believe in this goal. In short, have confidence in price, but not in timing.
My political theory is based on the assumption that the core tenets of inflation that American voters care about are energy and food, not risky assets. So while the rate hike has sent risk assets down quite a bit, voters won’t be happy.
Will the Fed hide anything about its shift, and those who wait for the signal will receive the signal. For those patient traders with time spans spanning several years, the wait is worth the wait. Good luck to those who trade on the short-term.