BitMEX founder: Inflation has become the new normal in the world, I am cautiously bullish on Bitcoin

Source: Bitmex

By Arthur Hayes, Co-founder of BitMEX

Compiled by: Odaily Planet Daily/Moni

From a macro-humanist perspective, war is always destructive and consumes a lot of energy.

War is an act of consuming energy to destroy the gains of human civilization, which transforms the potential energy of the sun and the earth into food, shelter, and recreation. While one side "wins" and achieves some resource-driven goal by defeating the enemy, humanity loses.

In this article, we will interpret the crypto capital market, but we must view humanity as a whole, and money and assets are for the benefit of everyone, not just a specific imaginary structure. Every life and structure requires energy to support and build, which means that the more we waste, the more negative impact it has on humanity as a whole.

Now, perhaps our biggest waste is money, and the most obvious impact of this is inflation. We must be prepared to protect the value of our financial assets.

The truth behind

Monetary policy is the loosest it's ever been, and there have been some frightening clashes between countries recently. I know that every central bank is trying to deal with inflation and promising to fix it, but almost every central bank is still printing money.

We have looked at some charts comparing policy rates to official inflation indicators and found that the "official" inflation indicators are not, in fact, fully representative of the prices faced by ordinary citizens. I believe that these statistics are processed and embellished, and in fact, consumer price inflation has deteriorated significantly, even the official data is a mess.

US Fed Funds – US CPI = US real interest rate (currently negative 7%)

Eurozone deposit rate – Eurozone CPI = Eurozone real interest rate (currently -5%)

UK Bank Rate – UK CPI = UK Real Interest Rate (currently -5%)

The three charts above show [policy interest rates - official consumer price inflation index]. As you can see, real interest rates have become very negative since the outbreak of the COVID-19 pandemic. Imagine that you have 1 dollar in your wallet now, or 1 euro, or 1 pound, and next year, the value of these fiat currencies suddenly drops by 5% to 7%.

If workers’ wages also increased by the same amount, there would be no problem. However, for most salaried or hourly workers, their wages have not increased as the value of the currency in their physical or digital wallets has depreciated.

As you can tell, people are unhappy that their wages have not kept pace with the rise in food, energy and transportation prices. What politicians are doing is letting their "independent" central banks control inflation. There is no dispute that central banks must raise their policy rates; there is dispute as to how much they should raise them and how quickly they should do so.

If the Fed raises interest rates six times this year, the entire financial world will certainly present a doomsday scenario. In fact, the U.S. federal funds futures market has already predicted the results of the rate hike, assuming that the Fed will raise interest rates by 0.25 percentage points each time, which will eventually push the so-called "policy rate" up to 1.5%.

We know that the current CPI inflation rate in the United States has soared to more than 7%. In this case, even if the inflation rate is halved to 3.5% by the end of 2022, the real interest rate of the US dollar will still be negative 2%.

The above figure is the term structure of Eurodollar futures . To find the yield on US dollar deposits held outside the United States, use 100 and subtract the futures price. For example, if the Eurodollar futures price is 98.00, the yield is 2%.

I actually have a lot to say about the importance of the Eurodollar market, but it all boils down to one thing: it is the most important interest rate market in the world and is deeply influenced by the Federal Reserve's policies.

If we look at the trend curve, we will find that Eurodollar futures will reach a peak of nearly 2.5% in September next year. This is because the market expects the Federal Reserve to raise short-term interest rates, so these futures trends reflect the three-month US dollar deposit rate. It can be said that 2.5% is not enough to fight the current inflation level, and this does not take into account the medium-sized and large-scale war factors that will affect global energy use in the next year.

Despite the orders of American politicians to “fix inflation,” the final execution effect is not ideal. Why is this? Because the policy interest rate level that may lead to financial crises has become lower and lower with each economic recession.

The above chart is a chart of the lower bound of the federal funds rate since 1990. We found that every major global financial crisis was caused by the accumulation of leverage and debt in some areas of the financial market. Once the Fed raises interest rates, the bubble will be punctured because blind financing will make speculators pay higher costs.

After the first Gulf War with Iraq, the Fed ended the era of low interest rates and raised interest rates by about 5% to 6% in late 1994. However, this led to the Mexican Peso Crisis, which was finally ended by the intervention of the US Treasury and a slight reduction in interest rates by the Fed.

However, a few years later, when interest rates rose to nearly 6%, the Asian financial crisis broke out. As the cost of US dollar funds increased, the "Four Asian Tigers" requested economic assistance from the International Monetary Fund and the World Bank.

We all know what happened to the tech industry in 2000. The charts clearly show that the Fed cut rates slightly after the Asian financial crisis and has since raised them again. The rise in the cost of capital ended the hopes and dreams of a tech utopia, and an unexpected stock market crash followed.

Then, in 2001, the 9/11 terrorist attacks occurred in the United States, and the Federal Reserve began to cut interest rates and began to speculate on real estate. However, after the interest rate soared by 5%, the US real estate market finally began to bubble in 2006. It was not until 2008 that the outbreak of the US subprime mortgage crisis affected the entire global financial system and triggered a global financial tsunami!

Then, after 7 years of 0 interest rates, the Fed raised interest rates again to just above 2% until late 2018/early 2019. The increase in interest rates was followed by a general recession in late 2019, which, combined with the global coronavirus outbreak, led to the largest contraction in economic activity ever recorded.

6%, then 5%, then 2% - almost every decade, financial markets go lower at nominal rates. Given the explosion in global systemic debt and leverage after the coronavirus pandemic due to low or negative rates and the need to generate yield, I think even 2% nominal interest rates in U.S. dollars are unsustainable in global financial markets.

Looking at the chart above, it is clear that at a 2% policy rate, interest rates are still negative. Unless workers start getting bigger pay raises, they will still suffer from inflation month after month. So, let's talk about -

Inflation narrative

Every asset class has an evolving narrative, but a key metric for judging an asset’s value is whether it is a good hedge against inflation. Many people instinctively believe that as a scarce asset, Bitcoin and other cryptocurrencies should be a good inflation hedge.

This idea may have been correct for many years, but recently Bitcoin's performance seems to be more "risk-on" rather than "safe-haven", and it seems that when the market goes down, Bitcoin has not become an appreciating asset as expected.

Frankly speaking, the reason why Bitcoin prices have risen sharply is largely because the COVID-19 epidemic has caused many central banks to start printing a lot of money. In other words, Bitcoin needs to "digest" this sharp rise in a short period of time. Once liquidity begins to tighten, Bitcoin's performance may not be as good as you expected.

But let’s put aside the issue of negative interest rates and look at how past macroeconomics has affected Bitcoin performance. In March 2020, the price of Bitcoin was around $4,500, but by November 2021, the price of Bitcoin had soared to nearly $70,000. Then, central banks changed their attitudes—they began to take the right measures to curb inflation, the market quickly responded, and the crypto bull market stagnated.

The above chart shows the trend comparison between Bitcoin (yellow line) and US 2-year Treasury bonds (white line) since September 2021. In my opinion, the reason why the Bitcoin bull market has stagnated is because of the tightening of global liquidity.

In anticipation of future increases in nominal interest rates from many central banks (such as the Federal Reserve), markets began to reprice fiat currency credit, resulting in an 8x increase in the yield on the US 2-year Treasury bond - while on the other hand, Bitcoin prices moved sideways and began to move slightly lower.

At this point, gold finally began to slowly come out of the trough. As the US dollar interest rate continued to be in the negative area, gold began to rise towards $2,000. In addition, despite the increase in the short-term nominal interest rate of the US dollar, the price of gold continued to rise because the real interest rate of the US dollar was still negative.

Eventually, as fiat currencies depreciate, gold’s value-preserving properties kick in and it regains investor attention. I expect Bitcoin will eventually experience a similar narrative as gold, and investors will rediscover the value of Bitcoin.

However, the most important thing for investors is to remain patient and tame your itchy fingers and not click the buy button at random, so that you can re-enter or reallocate financial market assets when the right time comes.

If the current situation in Eastern Europe expands further and turns into a medium- or large-scale global conflict, what might happen? Let's first analyze the current market environment:

1. Due to environmental concerns, many countries have decided to reduce investment in hydrocarbon production and exploration, which has led to societies replacing cheap hydrocarbons with relatively expensive wind and solar energy (measured in terms of the energy each produces versus the energy investment each requires).

As a result, people have to pay more for everything because, as humans, we need energy to survive in our current social structure. One could argue that the cost of hydrocarbons does not fully reflect their negative environmental externalities - but when a family has to pay 50% more to heat their home during a severe winter, all the problems start to surface.

2. Over the past 50 years, countries around the world have printed the largest amount of money in human history. On the other hand, the aging population problem in all major economies is getting worse, which means that the ability to repay debts will become lower and lower.

In order to keep the game going, central banks must continue to print money so that they can use new money to pay off old debts. Take the United States as an example. The US government will not voluntarily allow its currency to default, so it will not hesitate even if there is widespread inflation.

3. After the COVID-19 pandemic, inflation rates in many countries have risen and labor has become more scarce. In today's "post-epidemic era", global costs are rising because there are fewer and fewer workers left on the production line, so they will demand higher wages and benefits. Robots are not ready yet, so companies still need workers.

4. As the central bank of the world's most developed economy, the Federal Reserve needs to significantly raise interest rates to make the real interest rate positive. However, the nominal interest rate level of the US dollar is at a historical low. Once the nominal interest rate level is at a historical low, some financial and real economies may face the risk of collapse.

Back to the monetary issue, what will central bankers do when politicians who demand that the Fed control inflation wave their swords? I think there are three possibilities:

Scenario 1: Curbing inflation

To properly control inflation, the central bank would have to achieve at least a 0% real interest rate on the dollar, which would mean a policy rate of over 6% – something that seems unlikely given the current state of financial markets, but is the minimum necessary rate level to curb inflation and correct all the imbalances of the past 50 years.

It is important to note that a large part of the current sharp rise in energy prices (oil prices) is not monetary, and central banks may be unable to do anything about it, so they may raise interest rates, raise interest rates, and raise interest rates again, and energy prices will never fall. Then once the global economy collapses, per capita energy demand will fall sharply because we have significantly reduced our consumption patterns - that is, energy prices may suddenly collapse.

If the US dollar interest rate rises to 5% or 6%, it may cause some damage to the global economy, but compared with the global financial crisis in 2008, the economic impact of the rate hike is really small. Of course, economic turmoil will eliminate some companies, but it will eventually push humanity onto a more sustainable growth track.

However, this rebalancing is destabilizing. If real interest rates level off and then rise sharply enough to overwhelm the world economy and ultimately cause energy use to fall, nothing but volatility hedging (such as investing in cryptocurrencies) can save you.

But I think that's unlikely to happen.

Scenario 2: Misleading the market

For much of 2022, it could be easy for us to be misled by the markets.

In much of the financial media, you'll see central bankers appear and tell politicians that they are serious about fighting inflation. Bankers are raising policy rates to the 1% to 2% range - because the futures markets tell them to, that's all.

But even if you do that, the real interest rate on the dollar is still negative, which is very important in times of war or near war. Why? Because governments need to spend money to fight wars or prepare for wars, and they need to pay for wars.

By keeping real interest rates negative while ensuring that nominal government bond rates are below nominal GDP growth, the US government can afford to finance itself and reduce its debt/GDP ratio. The implementation of negative real interest rates is actually a surreptitious transfer of wealth from savers by the US government. Although this level of nominal policy interest rates will lead to an economic recession, it will not significantly change the social structure, and the US government can still afford to finance the war.

The problem here, however, is that the Fed cannot control energy costs, which are likely to continue to become more expensive. Moreover, since the Fed's monetary policy remains loose on government spending, the US government will continue to crowd out private companies in terms of energy use, which means that energy costs will continue to rise, and ultimately, the lack of anti-inflationary convictions could lead to social unrest.

USD interest rates are relevant to our portfolio, but first, be patient.

If the Federal Reserve and other central banks raise interest rates, asset prices will be pushed down, and the first to escape the "carnage" will be Bitcoin and cryptocurrencies, because the crypto market is the only freely tradable market that all humans with an internet connection can participate in.

Therefore, compared with other TradFi markets, the crypto market will fall first and then rise. Please remember that our analysis is based on the situation that real interest rates will remain negative. Once the sustained negative real interest rates erode the purchasing power of fiat currencies, scarce assets will undoubtedly benefit from it.

The US government does not want to restructure society by raising interest rates to actually suppress consumer demand and government spending. After all, once the election is over, the political pressure to fight inflation will disappear.

Once again, patience is a must for crypto traders.

If you are already in the benchmark crypto assets (my benchmark crypto assets are Bitcoin and Ethereum), please do not sell them randomly, do not short them. At this time, you can open a bottle of wine, or read a book (don't watch Douyin), and calm down. If you are a dedicated trader who buys and sells cryptocurrencies every day, then remember that market declines may be short-lived compared to the narrative of inflation-proof assets, so don't be greedy - get in, get out, and look at the long term.

(Note: This article was written at the end of last week, when it seemed that the Russia-Ukraine conflict would be short-lived and the Western response was muted. However, the war continues and the West seems ready to endure the economic pain to decouple from Russia. It is important to note, however, that Russia is a major supplier of food and energy, and the loss of these supplies to global markets would lead to high inflation.

Furthermore, if the West does decouple from Russia, there is no way to really know exactly what the consequences will be. You never know where the problems on the balance sheets of financial institutions are until you see market fluctuations. Therefore, it is reasonable to assume that once the West and Russia decouple, some large financial institutions will get into financial difficulties, which may turn into a global financial crisis.

However, the political reaction in the West to Russia provides an opportunity for global central banks to abandon their commitment to fighting inflation. I am not sure they can really do this, so I am cautiously bullish on Bitcoin. I am trying to invest in some call options on Bitcoin and Ethereum.

Fed Funds futures suggest that the market believes the Fed will raise rates by 0.25% in March. However, keep an eye on the views and comments of the big investment banks and the Wall Street Journal, the mouthpiece of the Fed. The Fed's attitude may change, and depending on the market and global geopolitical issues, they may believe that continuing with a 0% interest rate should be fine.

To be clear, rising oil prices are still going to happen, and I am not ready to invest in more cryptocurrencies. In the face of changing market conditions, buying any asset must be done with great caution. If the Fed deviates from market expectations and raises interest rates by 0.25% to 0.50% in mid-March, financial leverage could cause cryptocurrencies to fall again.)

Scenario 3: The US dollar printing press is turned on at an accelerated pace

A fierce global conflict would completely change the rules of the game, and perhaps the dollar printing press would start to accelerate.

Price controls, rationing, and inflation will become the new normal for nations, as only in this way can all available resources be given to the military. Gold, Bitcoin, and other cryptocurrencies will be hoarded more and more, and this is where Gresham's Law comes into play.

( Note from Planet: Gresham's Law is an economic law, also known as the law that bad money drives out good money. It means that in the case of a dual currency system, when two currencies are in circulation at the same time, if one of them depreciates and its actual value is relatively lower than the value of the other currency, the "good money" with an actual value higher than the legal value will be generally collected, gradually disappear from the market, and eventually be driven out of circulation. The "bad money" with an actual value lower than the legal value will flood the market.)

In this case, it will become more difficult to enter the gold and crypto markets, as some capital control policies will emerge, leaving many ordinary citizens unable to protect their assets and eventually having to be "washed away" by inflation.

In reality, most financial assets denominated in fiat currencies will be worth less and less, perhaps becoming as worthless as toilet paper. Yes, in nominal terms your stock portfolio may go up, but the price of milk, butter, eggs, sugar, etc. will go up faster than your free stock index fund.

I really don't want this to happen. But unfortunately, the history of mankind is a history of conflict.

If you think a bad situation is likely to occur, you should plan ahead and prepare for it.

That is, you can take out some of your idle financial assets and buy globally recognized store of value assets, such as real estate and stocks, gold, Bitcoin and some other cryptocurrencies.

Maybe at some point in the future, when global conflict ends, hopefully your assets won’t lose value. No one is immune to the effects of war, and all you can do is protect your assets – if you don’t believe me, watch Downton Abbey again.

Summarize

Today, everyone has a smartphone in their pocket, a mass communication tool for sharing knowledge instantly. Yet, while we can all be idealistic and hope that the spread of information will change humanity’s propensity to wage war, we must be prepared to protect our wealth from the scourge of inflation.

Of course, this doesn’t mean that we should ignore short-term price movements, but overall, we can take a long-term view and grasp the timing of buying and selling assets.