Arthur Hayes’ latest blog post: Bearish on the Fed and bullish on Bitcoin

Compilation|GaryMa Wu said about blockchain

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U.S. market participants are less patient about the journey to building more wealth. In our never-ending search for the next bull market, we often ask ourselves, “Are we there yet?” And in the cryptocurrency market, we often ask ourselves, when will the shitcoins we hold in our wallets ever get close again? November 2021 highs.

Savvy traders are looking for leading indicators that may indicate an approaching bull run, with the goal of determining when to go all-in on the cryptocurrency market. Like a Pavlovian dog, we have been trained by our central bank masters to buy financial assets whenever they cut interest rates or print massive amounts of money to expand their balance sheets. We hang all our attention on every word these scammers say in the hope that they will provide free money that drives returns on risky assets.

Fed balance sheet (white) and Bitcoin (yellow) with initial index value of 100

Amid the Fed’s massive money-printing spree during the pandemic, Bitcoin outperformed the Fed’s balance sheet growth by 129%, confirming that our reflex to invest based on the pronouncements of Fed Chairman Powell, a false prophet, has been quite profitable. .

Since the Fed began raising interest rates in March 2022, a group of macroeconomic analysts have been trying to guess when the Fed will stop. I present to readers a series of reasons why I believe the Fed's rate hike cycle will ultimately lead to some kind of financial disaster that requires them to cut rates and expand their balance sheet.

On March 10 this year, Silicon Valley Bank and Signature Bank experienced serious balance sheet problems under the Federal Reserve's policies. By then Sunday night it was clear that these banks were hopeless and unless the Fed and the U.S. Treasury really wanted to live up to the values of free market capitalism and bankrupt a poorly managed traditional financial company, some form of bailout was Imminent. As expected, the Fed and Treasury intervened and provided a bailout in the form of the Bank Term Funding Program (BTFP). BTFP provides unlimited vitality to the US banking system. Banks can hand over their junk US Treasury bonds to the Federal Reserve and receive new dollars in return. These dollars are then given to depositors, who flee as money market funds (MMFs) offer over 5% interest, while bank deposits earn interest rates close to 0%.

This is the critical moment. I and many others believe the Fed has definitely stopped raising interest rates. The Fed's real top priority is protecting banks and other financial institutions from failure, and the underwater bond rot spreading throughout the financial sector threatens the entire system. It seems the Fed’s only option is to cut interest rates, restore the health of the U.S. banking system, and then watch Bitcoin quickly rise to $70,000.

but it is not the truth. On the contrary, the Federal Reserve has raised interest rates three more times since March.

When your predictions are consistently wrong, it's time to revisit what you believe to be the truth and explore some "what if I continue to be wrong" scenarios. In this case, that means starting to think about whether my portfolio can survive if the Fed continues to raise interest rates.

Last week, I gave a keynote address at the South Korea Blockchain Week conference, where I explored the question of whether Bitcoin could still rise if the Federal Reserve and other major central banks continue to raise interest rates. For those who weren't there, or who think I'm moving too quickly on some concepts, here's a short article exploring the issue.

**if? **

What if America doesn’t decline?

What if inflation doesn't come down?

What if the U.S. financial system doesn’t collapse?

If these hold true, then we can expect the Fed and other major central banks not to cut interest rates but to raise them further.

Past and current actual rate of return

What is the actual rate of return? Real rate of return is a rather vague concept, and definitions vary from person to person. My (slightly simplified) definition is that if I lend money to the government, I should at least get a return that matches the growth rate of nominal gross domestic product (GDP). If I get less than that, the government is profiting at my expense.

Clearly the government wants to raise money at a rate lower than the economic value generated by its debt. The use of financial repression to ensure nominal GDP growth exceeds bond yields has been the policy of all the most successful export-oriented Asian economies since the end of World War II. Since the end of World War II, Japan, South Korea, and others have used this tactic to export their way out of the devastation their countries experienced in the aftermath of World War I. The government must use its banking system to carry out this type of financial repression. Banks were instructed to offer low interest rates to depositors. The government then introduced restrictions to prevent them from moving money out of the system. Banks were then told to lend at low interest rates to large, state-backed or government-linked heavy industry companies.

Deposit interest rate < corporate loan interest rate < nominal GDP growth rate

The result was that these industrial companies, which required large capital expenditures, received cheap financing to quickly build modern manufacturing bases. The government then uses these manufacturing bases to accumulate sovereign wealth, which is reinvested in U.S. Treasuries and other dollar-denominated financial assets. It is said that these funds can be used in times of financial difficulty. Ordinary people can get high-paying, blue-collar manufacturing jobs that are guaranteed for life. Compared to their previous lives as agricultural farmers, when their living standards were very difficult, they now work for large companies with full benefits and work eight hours a day. This is a major improvement for them.

Real yield = government bond yield - nominal GDP growth

This financial suppression strategy only works if money cannot leave the banking system. This is why South Korea and others have closed capital accounts. Or in the case of Japan, it is almost impossible for the government to get foreign financial companies to advertise or accept Japanese depositors, and as a result, ordinary Japanese investors are stuck working with Japanese banks with negative real returns. However, in the current digital age, this strategy has become more difficult to execute, especially given the rise of alternative, decentralized financial systems like Bitcoin. When real returns are negative for a long time, depositors can now get out before the door closes (or at least they think they can).

Let's look at U.S. real yields starting in 2022 and going through now.

U.S. two-year Treasury yield minus U.S. nominal GDP growth

I use the 2-year Treasury note yield as a proxy for government bond rates because this is the most popular and liquid instrument for tracking short-term rates. As you can see, when the Fed begins raising interest rates in March 2022, real interest rates are indeed negative. Although the Federal Reserve has raised interest rates at an unprecedented pace, real interest rates are now only weakly positive. If you replace the 2-year yield with a 10-year or 30-year yield, the real interest rate is still negative. That's why it's foolish to buy long-term bonds with your own money. Institutions still do this because financial responsibility ceases to exist when you are a trustee who plays on behalf of others and earns fat management fees because of average intelligence and ability.

As I consider the chart above, my next question is: "What can we expect real earnings to look like going forward?" The Atlanta Fed has released a "GDPNow" forecast, which is a forecast of real GDP growth for the current quarter. Instant estimates. As of September 8, the Fed predicted that third-quarter growth would be incredibly huge, at 5.7%. To arrive at the nominal growth rate, I added another 3.7%, which I calculated by looking at the average difference between nominal and real growth over the past six quarters.

GDP now grew by 5.7% in real terms + GDP deflator grew by 3.7% = Nominal GDP grew by 9.4% in the third quarter

Forecasted real yield in the third quarter = 2-year U.S. Treasury bond yield of 5% - nominal GDP growth of 9.4% in the third quarter = real yield of -4.4%

What exactly is going on! Conventional economics says that when the Fed raises interest rates, growth will slow in economies with very high credit sensitivity. Common sense tells us that in this case, nominal GDP growth should fall and real interest rates should rise. but it is not the truth.

Let's take a look at why.

No money, no sweetness

The government makes money through taxes and then spends it on various things. If spending is greater than tax revenue, then they will issue debt to fund the deficit.

The main export of the United States is finance. As a result, the government earns significant capital gains tax revenue from the stock and bond markets.

The 2020-2021 pandemic bull market generated a huge amount of tax revenue from the wealthy. However, starting in early 2022, the Federal Reserve began to raise interest rates. Higher interest rates have had a rapid impact on financial asset markets. This is a major reason why good-guy scammers like Sam Bankman-Fried and crypto entrepreneurs like Su Zhu and Kyle Davies fell.

Here are the returns for the S&P 500 (yellow), Nasdaq 100 (white), Russell 2000 (green) and the Bloomberg U.S. Aggregate Total Return Bond Index (magenta) from the start of 2022 to now, ending in 100-based chart.

As you can see, no one has made money since the beginning of 2022. As a result, capital gains tax revenue fell sharply. The Congressional Budget Office estimates that in 2021, realized capital gains will be about 9% of GDP. Those taxes declined rapidly as the Fed moved to combat inflation.

“A crunch of data from the Internal Revenue Service (IRS) shows a significant increase in realized gains in 2021, reaching 8.7% of GDP according to CBO estimates, the highest level in more than 40 years.”

Also, remember that the top priority for any politician is re-election. The older generation of "baby boomers" has been promising relatively free health care, while the general American public likes to consume energy at levels far higher per person than the rest of the world. Given these two facts, it's safe to assume that politicians who campaign on cutting health care spending and/or defense budgets will not be re-elected. Instead, governments will continue to increase spending in both areas as populations age and the world becomes more multipolar. If spending increases and revenue falls, the deficit must rise. Since GDP is only a snapshot of economic activity, when the government spends money, it by definition increases GDP - regardless of whether the spending is actually productive.

U.S. government deficit as a percentage of nominal GDP

Rising deficits must be financed by selling more bonds. By the end of the year, the U.S. Treasury must sell an additional $1.85 trillion in bonds to pay off old debt and cover the budget deficit. Additionally, in addition to having to issue these bonds, the Fed is raising interest rates, which further increases the amount of interest the U.S. Treasury must pay.

As of the end of the second quarter, the U.S. Treasury was spending $1 trillion annually on interest payments to debt holders. Given that most wealth is concentrated among the top 10% of households (meaning these households hold the majority of government debt), the U.S. Treasury effectively distributes benefits in the form of interest payments to the wealthy.

What did nobles buy when they had accumulated enough money to pay for the most important parts of life (housing and food)? They will pay for services. Approximately 77% of the U.S. economy is services-related. To summarize: when interest rates rise, the government pays more interest to the rich, the rich consume more services through the interest income, and GDP grows further.

Praising each other in the circle

Let’s put it all together and walk through it step by step to see how raising rates by the Fed increases nominal GDP, thereby producing more Fed monetary tightening.

The Fed must raise interest rates to combat inflation.

I will never get tired of this photo. Powell looks like a fool while Biden points his pen at him, instructing the Fed to deal with inflation.

**Financial asset prices fall, and then taxes also fall. **

With the exception of a few standout tech stocks like Nvidia, most companies that make physical products have struggled due to rising credit costs and declining credit availability, which in turn has driven their stock prices lower. Bonds, the world's largest asset market, were on track to post a second straight year of losses on a total return basis. The government's capital gains tax revenue fell sharply while broader equity and bond markets remained below 2021 highs.

**At the same time that tax revenue fell, government spending increased and the deficit also increased, leading to a higher deficit. The more government spending, the bigger the deficit becomes. If more spending = higher deficits, and more spending also = higher nominal GDP growth, then logically higher deficits = higher nominal GDP growth. **

**Due to high interest rates, the U.S. Treasury must issue more bonds at higher interest rates. **

Wealthy savers haven't had this much interest income in more than two decades.

**The rich will use their interest income to consume more services, which further drives nominal GDP growth. **

Approximately 77% of US GDP consists of services.

Inflation becomes stubborn as nominal GDP growth > government bond yields.

Higher bond yields have not curbed U.S. government spending because the U.S. government has a net benefit from the situation. When the government finances itself at a lower rate than the growth in debt would produce, the debt-to-GDP ratio actually falls. This is exactly the same policy adopted by the U.S. government after World War II to repay the country's huge war debt.

**The Fed must raise interest rates to combat inflation. **

As GDP growth continues to outpace bond yields, inflation will rise from current "depressed" levels and remain elevated. As long as inflation remains well above the Fed's 2% target, they must continue to raise rates.

Fatal Weakness

Mr. Powell can keep raising rates as long as markets are willing to accept rates below nominal GDP growth. But Mr. Satoshi Nakamoto gave the world an alternative financial system that included a fixed-supply currency and a decentralized, nearly instant payments network called Bitcoin. Banks face unprecedented competition. (Of course, you used to be able to take money out of the bank and buy gold, but it was impractical to use heavy gold in everyday life.)

If the market demands Treasury bonds yielding at least 9.4%, equal to forecasted nominal GDP growth, then the tables will be turned. The Fed must then either ban banks from allowing funds to be transferred to digital fintech companies that offer physical cryptocurrencies, or it must restart quantitative easing (aka printing money) and buy bonds to ensure that their returns are lower than nominal GDP growth. I will continue to remind you that buying ETFs does not take your money out of the traditional financial system. The only way out is to buy Bitcoin and withdraw it to your own wallet, where you will hold the private keys.

It is reasonable to assume that when there is a financial escape hatch like Bitcoin, the market will tire of handing over profits to the government. But for the remainder of this analysis, I will assume that the Fed will be able to continue on its path of raising interest rates without too much money fleeing the U.S. banking system.

Changing financial climate

We are taught to believe that when interest rates rise, the prices of risky financial assets such as Bitcoin, stocks, and gold should fall. However, as the government continues its spending spree and drives up GDP, the real return one would earn on what appears to be valuable government bonds of around 5% may actually be closer to -4% - which means the risk The asset remains a very attractive option for investors.

Investors' search for positive returns in real yields gave rise to the Bitcoin bull market, which officially began on the fateful weekend of March 10, 2022. Since then, the price of Bitcoin has increased by nearly 29%. Although the price has tested $30,000 multiple times and failed to break above, Bitcoin is still trading at its pre-bank subsidy level of $20,000.

The market is quietly telling us that if the Fed continues to raise interest rates, real interest rates will become more negative and will remain that way for the foreseeable future. If that wasn’t the case, shouldn’t Bitcoin be hovering around $16,000? The reason we don't get to $70,000 is because everyone is focused on the nominal federal base rate rather than the real rate compared to America's staggeringly high nominal GDP growth. However, this information is slowly being spread through various mainstream media government propaganda mouthpieces such as the Washington Post:

Furman said: "It's really shocking to see this in an economy with low unemployment. Nothing like this has ever happened. A good, strong economy with no new emergency spending - but with such a huge deficit Big. It's so big in one year that you think there must be some weird weird thing going on."

As it becomes increasingly clear that owning bonds is a fool's game, even at short-term nominal interest rates of 5.5%, fringe capital will begin to seek out hard-core financial assets. Certain assets such as Bitcoin, Big Tech/AI stocks, productive farmland, etc. will continue to rise and make most financial analysis experts (who are actually just trustees of average intelligence and ability) able to Getting a fat management fee for using other people's money) is confusing. They don’t understand why Bitcoin is holding up because what they see is a manipulated market controlled by the Fed buying assets like Treasury Inflation-Protected Securities (TIPS) yields – which (seem to be) positive and rising.

Putting aside the faulty analysis we are sure to read in the mainstream financial news, **I believe I have proven that Bitcoin can survive even if the Fed has to keep raising interest rates. This is reassuring to me, because while I still believe the base case is that the Fed is forced to cut rates to near zero and restart the QE money printing press, even if I'm wrong, I still believe cryptocurrencies can rise significantly. **

The reason there is such a positive convex relationship between Bitcoin and Fed policy is that the debt-to-GDP ratio is so high that the traditional economic relationship has broken down. This is similar to when the temperature of water is raised to 100 degrees Celsius, it will remain in a liquid state until it suddenly boils and turns into a gas. In extreme cases, things become nonlinear—sometimes binary.

The U.S. and global economies are in such an extreme state. Central banks and governments are trying to use the economic theories of yesteryear to respond to today's new conditions; at the same time, a global debt-to-GDP ratio of 360% is creating inverse conditions that require a rethinking of correlations between assets.

Yes, it is possible to teach an old dog new tricks, but only if the dog is willing to learn. The scoundrels we tolerate who rule in our name have no such desire to learn. Therefore, Master Satoshi will punish them with powerful Bitcoins.