WASHINGTON – JANUARY 22: The Federal Reserve building is seen January 22, 2008 in Washington, DC. … [+] The Fed cut its benchmark interest rate by three-quarters of a percentage point after two days of tumult in international markets due to fear of a recession in the United States. (Photo by Chip Somodevilla/Getty Images)
Mar 15, 2020. It was the best of times, it was the worst of times.
Amidst the brewing of a worldwide pandemic and global financial crisis, the Federal Reserve called an emergency meeting where it announced a rate cut to zero and launched a massive $700 billion quantitative easing (QE) program. Since then, we’ve witnessed an unprecedented expansion in the Fed’s balance sheet and appreciation in financial asset prices. Trillions of dollars of liquidity were injected into the economy to prevent a global slowdown that could have rivaled the 2008 global financial crisis.
The Fed has bought $4 trillion of bonds in the past 18 months
The results of this liquidity injection are unsurprising – as Howard Marks recently said, we’re in an “Everything Bubble”. Approximately 25% of all global government debt is negative yielding. Equity markets are breaking all time highs on a daily basis, with over $600 billion flowing into global equity funds as of August 2021 (equating to $4B/ day). There were over 100 SPAC IPOs in March 2021 alone. Global PE dry powder hit an all-time high of $1.9 trillion in January of 2021. VC funds deployed almost $160 billion in just the third quarter of 2021, with private market valuations soaring across the board. The overall crypto market cap topped $3 trillion, with Bitcoin up over 800% in the past 15 months.
“QE Infinity turned your savings account into your checking account, the bond market into your … [+] savings account, the equity market into the bond market, the venture market into the equity market, and the crypto market into the new venture market.”
Inflation Is Coming
Over the past year and a half, we’ve seen one of the greatest creations of wealth in human history, catalyzed by trillions of dollars of monetary and fiscal stimulus across the globe. But with great wealth creation, comes great price appreciation. And price appreciation, aka inflation, is exactly what we’re starting to see from U.S economic data. Just last week, U.S inflation hit a 31-year high with consumer prices jumping over 6% from a year ago.
The big question on everyone’s minds is whether the uptick in inflation that we’re seeing is “transitory”, as the Fed claims it is, or more permanent that would eventually force the Fed to tighten monetary policy (a process known as “tapering”).
The thesis for transitory inflation is simple – COVID induced supply chain shortages, combined with pent up consumer demand for services have temporarily inflated prices. As the global economy restarts, these effects should prove to be ephemeral. To top it off, technology, automation, and globalization should have deflationary effects in the medium-term.
On the other hand, some argue that we are headed for a significant period of higher inflation due to a demand shock induced by the Fed’s accommodative monetary policy. An estimated $2 trillion was added to consumer balance sheets in 2020, and this wealth effect could translate to a more permanent increase in consumer demand that will outstrip supply and production capabilities.
“The issue is that demand has exploded, creating an imbalance of a magnitude that we haven’t seen … [+] since the 1970s.”
How Will the Fed React?
At a very high level, the Fed has two broad mandates:
- Ensuring the economy is growing, leading to full employment
- Keeping inflation under control
The Fed is hence always playing a balancing act – cutting interest rates to stimulate the economy when unemployment is too high and hiking rates to combat inflation when the economy is overheated. When done effectively, this stabilizes the economy and reduces volatility in financial markets across debt cycles. When done ineffectively, this leads to stagflation – low economic growth in times of high inflation, where the effects of monetary policy tools are highly limited.
“The Federal Reserve…is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.” – Fed Chairman William McChesney Martin, Jr., October 1955.
As inflation has been ticking up over the past few months, the Fed has been forced to react. In its most recent meeting, the Fed announced a plan to reduce the monthly pace of asset purchases (which is currently at $120 billion/ month) by $15 billion a month starting in November and to end the program entirely by the middle of next year.
The big question now becomes when will the Fed begin to hike interest rates? While the market is pricing in two hikes by the end of 2022, Fed officials are currently much less aggressive in their expectations. In essence, the market is signaling to the Fed that inflation concerns are serious. As this narrative continues and more inflation data trickles in, the Fed will likely come under increasing pressure to hike rates sooner than intended.
Each blue dot represents an FOMC participant’s estimate for the fed funds rate at the end of 2022.
Bitcoin’s Correlation to Macro
The implications of the broader macro environment and inflation concerns on Bitcoin are two-fold. On one hand, Bitcoin is an inflation hedge, so more inflation makes it more valuable. On the other hand, higher inflation implies higher interest rates. This would lead to risk assets, including Bitcoin, selling off.
Empirical data is not helpful in resolving this dilemma. While Bitcoin has generally appreciated alongside rising inflation expectations, its longer-term historical relationships with inflation and gold have been relatively weak.
Historically, no clear correlation trends to validation the “inflation hedge” thesis
Bitcoin price has been tracking US 10 year yields over the past year. If this trend continues, that would be supportive of the “inflation hedge” thesis, and we would see Bitcoin appreciate as the Fed hikes rates to combat inflation.
Over the past year, Bitcoin price has been moving in line with 10yr rates
However, over the past couple of years, we’ve increasingly seen Bitcoin trade in line with other risk assets such as equities. As larger asset managers and institutional investors allocate more capital towards the crypto ecosystem, this is a trend we can expect to continue going forward. Given this relationship, a tightening in monetary policy in response to rising inflation would be bearish for Bitcoin and all risk assets more broadly.
Bitcoin’s 30-day rolling correlation with the S&P 500
So where does this leave us? In short, although the Fed may say otherwise, the market is pricing in sustained inflation and aggressive Fed rate hikes by the end of next year. If this does happen, it will be interesting to see how Bitcoin reacts. While the “inflation hedge” thesis should be supportive of Bitcoin prices, its increasing correlation with risk assets could cause significant downward price pressure as the tightening of monetary policy causes valuations to collapse across the board.
The ultimate goal of Bitcoin was to create a decentralized currency, shielded from the monetary policy of any central bank. However as crypto markets integrate with traditional financial markets, and more institutional capital flows into digital assets, that goal increasingly becomes a myth. How the next year plays out will be crucial in determining the narrative for Bitcoin – is it truly a store of value or is it now a risky asset?
