Fight Club

Research Sep 29, 2022

Are we there yet?

Key Take-aways

·      The one-two combination of a hawkish Powell speech at the Jackson Hole Symposium  and the hotter-than-expected August inflation report were knock-out punches to the crypto bulls.

·      “Higher, for longer” has been the consistent message from the Fed and, as the slump in global asset markets confirms, investors have taken that on-fully on board.

·      Despite the recent mayhem, especially in government bond markets, there is no sign of capitulation from central bankers. All are signalling continued rate hikes.

·      However, there is no escaping the widespread wealth destruction resulting from their actions. In fact, apart from the USD the only thing going up at the moment is the probability of a global recession.

·      Hence, a 2023 Fed pivot is still on the cards, just don’t expect them to acknowledge that any time soon because they are channelling their inner Brad Pitt.

·      When it does come, the turn will be swift, and cryptocurrencies are well placed to benefit.

“Are we there yet?”. The phrase all parents dread hearing on long journeys. It’s also the phrase that has been on many crypto investors lips over recent months, with many wishing the latest crypto-winter would come to an end.

For a few weeks over the summer, when prices stabilized, hopes of a thaw began to emerge amid speculation the Fed would start to rein in the pace of interest rate hikes ahead of an eventual policy pivot in mid-2023. However, the one-two combination delivered in the form of a hawkish Powell speech at the Jackson Hole Symposium and the hotter-than-expected August inflation report were knock-out punches to the bulls. The September 20/21 FOMC meeting only served to reinforce this hawkishness. The 75bp hike may have been line with consensus estimates, but the updated dot-plot forecasts and the language (statement and press conference) suggested the Fed Funds rate would be “higher, for longer”. Certainly, that is what global investors heard judging by the subsequent spike in government bond yields, equity market slump and surging USD.


Follow My Leader

The Fed may be leading the charge when it comes to global monetary policy trends but other central banks are not far behind – see chart below. At their last policy meetings, the ECB, the BoE, and the Riksbank (the world’s oldest central bank) all hiked at the fastest pace so far this cycle.

Central Bank Rate Hikes (Year to-date)

Source: Bloomberg

Moreover, despite the recent mayhem in global asset markets, there is no sign of capitulation as ECB Chief Lagarde made clear earlier this week when she stated that the ECB expects “to raise interest rates further over the next several meetings to dampen demand and guard against the risk of a persistent upward shift in inflation expectations”[1].

Part of the reason why these central banks are following the Fed’s hawkish stance is because their inflation outlooks are being similarly impacted by the jump in food and energy prices, ie, they are all “victims”[2] of the same global trends. There is, however, an additional reason and it is all down to exchange rates.

As noted above, the rise in US interest rates has pushed the USD to 20-year highs. Because exchange rates are relative prices – all currencies can’t be up or down at the same time, there have to be winners and losers - the corollary of USD appreciation is currency depreciation for their trading partners and this generates an additional inflationary impulse. One can think of it as the US exporting its inflation to the rest of the world and the only way to mitigate this effect is for other central banks to follow the Fed’s lead.

Nowhere is this currency impact more acute than the UK. GBP dropped to record lows versus the USD after the new Tory government presented its Growth Plan 2022[3]. It was lauded as “the biggest package of tax cuts in generations” but because it amounted to a sizeable debt-financed fiscal injection (at least on the basis of the details so far released[4]), it went down like the proverbial lead balloon with investors. Gilts slumped along with the currency (2-year yields were up over 100bp in less than two days!)  prompting both the Chancellor[5] and the BoE[6] to release statements seeking to assuage investor concerns. While the BoE governor refrained from announcing an emergency rate hike, of which there was considerable media speculation, he made clear the MPC “will not hesitate to change interest rates by as much as needed to return inflation to the 2% target”.

To reiterate, where the Fed leads the rest must follow[7].


UpOnly

The most shocking aspect of the move up in government bond yields is the speed. For example, on August 1 the 10-year nominal US Treasury yield stood at 2.60%. Fast forward barely more than a handful of weeks and they are closing in on 4%. Other developed bond markets have witnessed similar (or even greater) increases. These are savage moves, as evidenced by the chart below which shows the MOVE index, a measure of bond market volatility. It has risen to levels previously only seen during periods of considerable economic turbulence such as the outbreak of the Covid pandemic or during the depths of the Great Recession.


MOVE Bond Volatility

Source: Yahoo Finance

A major reason why the move higher in government bond yields has been so aggressive is that although real yields have risen break-even inflation (a market-based proxy for inflation expectations reflecting the difference between the yields on nominal bonds and inflation-protected bonds) has not moved by much. Compare this episode with the spike in yields that occurred during the Great Recession. Back then break-even inflation plummeted. As bad as that period was, the slump in break-even inflation not only contained the rise in the nominal bond yields, but it sent a strong signal to the Fed that deflationary pressures were building providing them with scope to loosen monetary policy, which helped cap and eventually reverse the move up in real yields. No such luck this time around.



US Bond Yields – Real Yields Vs. Break-even

Source: FRED Database

The consequence of this surge in yields is holders of developed market government bonds have seen their value drop by more than 12% over the past 12 months[8], wiping out eight years cumulative returns (investment grade bond performance has been even worse at -22%, or 10 years worth of cumulative performance destroyed). That is quite a shock for investors to digest, especially as government bonds are supposed to be the highest quality asset within a “well-diversified” portfolio. Certainly, it has been a shock to the UK pension industry.


Financial Instability

Just two days after the UK Treasury and the BoE made their aforementioned statements the BoE surprised markets by announcing it “will carry out temporary purchases of long-dated UK government bonds from 28 September. The purpose of these purchases will be to restore orderly market conditions. The purchases will be carried out on whatever scale is necessary to effect this outcome.”[9]

The BoE added the qualifier that these purchases will be “strictly time limited” and made clear that the decision was made by the FPC (financial policy committee), which is tasked with ensuring financial stability[10], and not the MPC (monetary policy committee), which sets monetary policy. As such, the BoE is trying to differentiate this intervention with its earlier QE programmes. However, one must question the merits of a central bank raising short-term interest rates in order to bring inflation down while injecting liquidity at the long-end of the government bond curve. It is hardly a credibility enhancing move[11]. It is also the slippery slope to Japanese-style yield curve control (YCC) as I tweeted at the time of the announcement[12].

Some have taken the BoE’s surprise intervention in the gilt market as a sign that maybe the Fed will start to waiver in its commitment to continue raising interest rates, in line with the narrative that the Fed will continue tightening until “something breaks”. The problem with this argument is that their mandate is domestic focused. It takes overseas developments into consideration when setting monetary policy but only to the extent that it changes the domestic situation and, for now at least, there is no sign of financial contagion or dysfunction in US financial markets, something Treasury Secretary Yellen remarked on recently[13].  


Texan Hedges

That said, while asset markets may not be dysfunctional (gilts aside obviously), they can hardly be described as healthy. Just like bonds, developed equity markets are also down heavily, with many stock indices around bear market territory (defined as 20% off the highs). Well-diversified portfolios comprised of stocks and bonds are supposed to insulate investors from the vagaries of the business cycle but they have turned into wealth-destroying Texan hedges[14].

A portfolio comprising of stocks and bonds is supposed to be diversified because it assumes negative correlation between bonds and equities[15]. Most of the time this assumption holds. However, when inflation significantly overshoots the central bank’s target and their credibility as guardians of price stability is called into question, as has happened over recent quarters, the correlation flips to positive.

This is because one of the key lessons central banks learned from the 1970’s is that, if lost, it is extremely costly in terms of economic underperformance to regain their credibility. Maintaining it is very important to them and the only way to do this is to increase their tolerance for short-term economic pain and adopt a laser-like focus on inflation. Unfortunately, in the process it means government bonds no longer act as a return-generating insurance policy for equity portfolios.


A Sea Of Red

If that wasn’t bad enough, now for the kicker. Government interest rates are the benchmark upon which all other interest rate products are priced. The most important of these is the mortgage rate, given housing is one of the most widely-held assets by households. As per the tweet below, on the back of the jump in Treasury yields, 30-year mortgage rates in the US have rise to around 7%.  The Case-Shiller house price index posted it’s first monthly decline in over a decade in July (latest available data), suggesting the US housing market was already showing signs of buckling with mortgage rates 100bp lower than were they are today. Straw, camel, back anyone?

Source: Twitter

2022 has turned into a sea of red. The negative wealth effect from falling equity and bond prices, particularly if reinforced by a correction in house prices (see chart below), would be substantial and toxic for US economic growth. In my view, the US economy will, if not already, soon be in recession. Moreover, because other central banks are having to follow the Fed’s lead (for reasons already mentioned) and their asset markets are also performing poorly, the US will not be alone. Predicting a global downturn at this stage does not appear to be too bold a call.

Google search trends – Housing Worries[16]

Source: Google

Having said that central banks’ economic pain thresholds have increased in order to defend their credibility, they are not infinite. At some point, a tipping point will come and they will be forced to change tack. The issue is when. Judged by their comments, it is still come considerable way off (beyond 2023). I’m not convinced that is the case. Let me explain why.

Under The Radar

Something that appears to have gone under the radar of most investors is the pull-back in commodity prices. Since the early June high they have fallen 30%. As can be seen in the chart below, the ebbing and flowing of commodity prices are strongly correlated with the direction of headline US CPI inflation, particularly after large moves. The implication is that US CPI inflation will decelerate markedly over the coming months. As mentioned above, this disinflationary trend is not being reflected in US break-even inflation rates in any meaningful sense, yet. Sure, some CPI components are sticker and this will moderate the disinflationary trend in core inflation, but if, as seems highly plausible, headline inflation is at or potentially even below the 2% target and the economy is contracting due to consumers retrenching following a severe wealth hit, it is hard to envisage the Fed hiking as per the latest dot-plot. Ditto for the rest of the world.

Commodity Price Inflation vs. US CPI Inflation

Source: Yahoo Finance and Fred Database‌‌

Fight Club

So a 2023 Fed pivot is still on the cards? Yes, it is but don’t expect the Fed to acknowledge that any time soon. One of the major lessons central banks learned during the Great Recession was the power of communication. When they were hard up against the zero bound, the Fed sought to inject additional stimulus by influencing market expectations via verbal intervention, aka forward guidance. It worked and they are trying the same thing again, only this time in reverse. Their desire to stop inflation becoming entrenched means they are incentivized to continue to talk tough notwithstanding financial market weakness and the rising prospect of a recession. As I noted in a recent tweet, signalling a pivot well in advance doesn’t suit their purpose at this juncture – see below.

Twitter Ryan Shea

A policy pivot is, in some sense, like fight club.

Certainly, it is a risky strategy as the global economy is a large, complex, multidimensional system where unintended consequences lurk at every turn, as the BoE recently found out. The Fed is fully cognisant of these risks, but in the battle to bring down inflation they have to talk tough. Barring a accident with the plumbing of the financial system (“something breaks”), when inflation goes “limp”, they will pivot, just don’t expect them to signal the change too far in advance. When it comes, it will be fast; they will spin on a dime.

Faith No More (In Fiat)

I appreciate that is a lot of macro to digest, especially when the focus of these pieces is crypto but the simple fact is markets – and crypto is no exception – are influenced by different forces at different times and right now macro is dominant because fiat asset markets are under considerable pressure. So what are the implications of all this for cryptocurrency prices?

As discussed, central banks are on a rate hiking mission as penitence for last year’s inflation mea culpa and to ensure inflation expectations do not become embedded in the economy (the dreaded second round effects Lagarde alluded to). This process has been hazardous to one’s financial health especially because there have been so few places for investors to hide with bonds and equities having both tumbled in value and house prices look set to be the next shoe to drop. Cryptocurrency prices have been similarly negatively impacted. In fact, apart from the USD the only thing going up at the moment is the probability of a global recession.

One has to wonder though what the longer-run impact of such widespread wealth destruction will be. Will it prompt people to question whether the fiat money system really is delivering for them given the deep losses and high price volatility in tradfi asset markets? The latter has been one of the long-standing criticisms of cryptocurrencies, but in times such as these they start to look like an “oasis of calm”. (NB: When GBP hit its record low versus the USD trading volumes versus Bitcoin exploded[17]).

Moreover, when the Fed pivot does come cryptocurrencies are likely to be one of the greatest beneficiaries. The reason: government debt.

By raising interest rates to bring inflation under control central banks are increasing governments’ debt service costs. At the world level, government debt-to-GDP ratios are around 100% of nominal GDP, meaning every percentage point increase in government bond yields adds almost a full percentage point to budget deficits. This is not a small number. Add in government fiscal injections to protect households from the rise in energy prices (utility bill handouts etc) and a recession, the result is government debt ratios are only going one way – up.

As I pointed out in a research note published back in February looking at the impact of Fed tightening on crypto markets[18] the fiscal position of the US, indeed most developed economies, was already looking precarious. To wit,

“If the Fed were to raise the nominal interest rate to 3%, equating to a real or inflation-adjusted rate of 1%, which is certainly not an extreme reading by any means, then to stabilise the debt-to-GDP ratio at 120% the primary fiscal balance must improve by a full percentage point every year for an entire decade. To reduce the debt-to-GDP ratio to 100% in 10 years time, a level that would still be considered elevated by historic standards, the fiscal consolidation requirement increases to 1.4 percentage points of GDP. Fiscal consolidation on this scale would be highly unusual...

… Monetary policy cannot succeed on its own. This is something I think a lot of people fail to appreciate. (In terms of cryptocurrency implications, the Fed going it alone is bearish in the short-term, but longer-term because of the implied rise in the debt-to-GDP ratio, it is bullish as it keeps alive the fiat failure possibility).”

Nothing that has happened subsequently changes this conclusion – if anything it is has been reinforced.

Are We There Yet?

Possibly not. We don’t know how cryptocurrencies perform in a global recession because they haven’t been in existence long enough (the 2020 Covid pandemic recession doesn’t count as it was more akin to pushing the pause button). The cycle low for crypto prices may still be ahead of us, but I sense we are getting close and that’s coming from someone who has been quite pessimistic on cryptocurrencies throughout the year. Moreover, when the turn does arrive it will be fast because, for the reasons outlined above, the Fed is channelling their inner Brad Pitt. Better get ready.

Until next time.

Ryan Shea, Crypto economist




Footnotes


[1]    So-called second round effects  - see: https://www.bloomberg.com/news/articles/2022-09-26/lagarde-says-ecb-rates-to-be-lifted-at-next-several-meetings?srnd=economics-vp

[2]    Inverted commas implies a hint of irony. Having dismissed inflation as transitory last year they are all culpable of being too sanguine.

[3]    See: https://www.gov.uk/government/topical-events/the-growth-plan

[4]    More details will be forthcoming on November 24, but if a week is a long time in politics, two months is an absolute eternity in financial markets.

[5]    See: https://www.gov.uk/government/news/update-on-growth-plan-implementation

[6]    See: https://www.bankofengland.co.uk/news/2022/september/statement-from-the-governor-of-the-boe

[7]    Japan is the exception but that’s because it has a yield curve control policy, where it caps both short and long-term interest rates. It has maintained this policy despite it resulting in the JPY dropping sharply (which prompted them to intervene in the FX for the first time since 1998 a nonsensical policy choice). That the BoJ’s actions help the government service its 230% debt-to-GDP ratio is surely coincidence!

[8]    Yields are the reciprocal of bond prices - see: https://www.spglobal.com/spdji/en/indices/fixed-income/sp-global-developed-sovereign-bond-index/#overview

[9]    See: https://www.bankofengland.co.uk/news/2022/september/bank-of-england-announces-gilt-market-operation

[10]  According to a news story on Bloomberg, the BoE action was triggered by concerns that UK pension funds were facing substantial margin calls which could have resulted in a death-spiral in the gilt market - see: https://www.bloomberg.com/news/articles/2022-09-28/boe-to-carry-out-purchases-of-long-dated-uk-bonds-to-calm-market?srnd=premium-canada

[11]  As I will explain later in the note credibility is a key issue for central banks. However, financial stability tops even that. If needs must, they will always act.

[12]  You can follow me twitter under the handle @CryptoeconRyan. It would be much appreciated.

[13]  See: https://www.bloomberg.com/news/articles/2022-09-27/yellen-says-markets-functioning-well-conditions-not-disorderly

[14]  See: https://en.wikipedia.org/wiki/Texas_hedge

[15]  I have been long-standing critic of the negative bond/equity correlation assumption. From a note I wrote back in 2015: “If government bonds no longer provide the portfolio diversification benefits they once did then asset allocators will either have to find alternative equity market hedges or accept more volatility in future performance and greater drawdowns. Unfortunately, there are very few beta sources that offer negative covariance to equity returns.” – see: https://www.linkedin.com/pulse/great-asset-allocation-problem-ryan-shea/

[16]  See: https://trends.google.com/trends/explore?date=all&geo=US&q=real%20estate%20crash

[17]  See: https://twitter.com/MatthewKimmell/status/1574778992384696320

[18]  See: https://blog.trakx.io/fed-fears/

Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io