The world is scrambling and it makes me bullish (Macro Update: Sep-2022)

Hi there, I decided to share publicly a monthly update I normally write for a private group of friends (mostly TradeFi people with high-level interest in crypto). Let me know if you find it interesting, it will encourage me to share more. Thanks :)

Credit: Kipper Williams cartoon on Mark Carney’s ‘forward guidance’. Illustration: Kipper Williams

Monthly Performance Summary:

• USD Liquidity Index: down -11.4%
• S&P: down -9.3%
• Nasdaq: down -10.5%
• BTC: down -3.1%
• Broader crypto market (total crypto market cap excluding BTC and stablecoins): down -6.5%

This has been another eventful month, both on the crypto side and on the macro side.

On the crypto side, this was a big month for Ethereum with the successful execution of The Merge (big month from a tech point of view; not so much from a short-term price action point of view where it was more a “buy the rumour, sell the news” type of event, ETH is down -14.5%). The Merge corresponds to the transition from a proof-of-work to a proof-of-stake consensus mechanism, the various Ethereum teams across the world had been working on that for years and it is probably the most important upgrade to date in the history of Ethereum. The execution of this upgrade was like “changing the engine of an airplane mid-flight”, yet the transition has been flow-less and is nothing short of an engineering wonder. It has a few important implications:

• Greener: It entirely removes the energy-incentive proof-of-work mining process from the Ethereum ecosystem, effectively reducing energy consumption to secure the Ethereum network by ~99.95%. Before The Merge, Ethereum miners were consuming around 60–80 TWh per year to secure the network, this is equivalent to the annual energy consumption of medium-size country like Austria or the Philippines. Thanks to The Merge, the world global energy consumption dropped by ~0.25% overnight.
• Faster: It opens the door for sharding, a scaling solution that should enable Ethereum to process up to 100,000 transactions per seconds vs. ~13 currently while reducing massively the cost per transaction. Scalability and transaction cost have been a major bottleneck for adoption, particularly for non-financial applications and for smaller users. Note that this is just a milestone on the roadmap, it will probably take another 1–2 years of development before sharding goes live.
• Stronger: The Merge significantly improve Ethereum monetary policy, making the asset deflationary if the network activity is high enough. Before the upgrade, ~13,500 new ETH were minted and distributed to miners every day as a reward for securing the network (corresponding to ~4.3% annual inflation), in addition to the transaction fees contain within each block. A proof-of-stake system does not require so much inflationary rewards to be secured, as a result new ETH issuance has been reduced by 90% post Merge, bringing down the annual base inflation to ~0.4%. In addition, following a previous upgrade from last year (called EIP-1559), a share of the transaction fees is burnt every block, effectively creating a permanent deflationary pressure on the total Ethereum supply. If the network activity is high enough, the amount of ETH fees burnt become greater than the issuance of new ETH and Ethereum become net deflationary. Since the Merge went live on September 15th, the annualised net inflation rate has been 0.18%, so over 50% of the issuance has been offset, and this is in the middle of a bear market, if/when activity level comes back to last year levels, it will be net deflationary by a wide margin.
• Really stronger: The transition to proof-of-stake also makes the chain more secured: with proof-of-work a potential attacker only puts at risk temporary mining power (i.e. electricity cost for a short period), whereas with proof-of-stake he is also risking his entire stake. In other words, proof-of-stake makes it extremely more expensive to try to attack the network.
• Better: Ethereum investors can participate in securing the network by staking their ETH and in exchange get rewarded with a share of the new ETH issuance + transaction fees. Following The Merge, base staking yield have slightly improved to ~5% (up ~1%), and savvy validators can get higher yield by also participating in MEV (very interesting topic, but I am not gonna get into that rabbit hole today). This number is not set in stone, it depends on the amount of ETH that is staked and the network activity.

So, to sum-up, ETH is now an ESG friendly asset, with an almost fixed supply (potentially even decreasing), that currently yield ~5%. All those factors are improving ETH fundamentals and could make it the new favourite for institutional adoption (vs. Bitcoin). For info, Fidelity is building in-house capability for ETH custody and staking; BlackRock announced they will be working with Kraken and Coinbase to provide that offering; Nasdaq also announced they this month that they will be launching institutional custody services for Bitcoin, pretty sure they will also launch ETH staking. Once you can offer crypto custody and staking, you can easily add access to the application layer and flood DeFi with fresh institutional capital. So, fundamentals are strong, but then there is macro…

And on the macro front, things look seriously depressed. The war in Ukraine intensifies; Putin mobilising civilians and making nuclear threats; energy crisis in Europe is destabilising the entire block; massive price rises and strong dollar are putting a large part of population and small businesses in precarious situation in energy/commodities/USD dependant nations in Europe, the UK and many other regions across the globe; China is dealing with slowing growth and the implosion of its property market while keeping a part of its population strictly locked down with their extreme zero-covid policy. Yeah, a lot of things are really looking bad in our world and it’s depressing, people are more and more polarised, civil unrest are on the rise and maybe that’s the only way out of a broken system that is reaching the end of its cycle, as it has been the case throughout history (Ray Dalio explains it well).

For now, the FED continue to tighten (FED funds rate is now at 3–3.25% and QT running at full speed at $95bn per month) to try to kill demand and get inflation under control, and the US can still afford to do that for now because their economic situation is stronger than on the other side of the Atlantic: debt level is very high, but not as bad as in most large countries in Europe, and unemployment rate is rising but still only at 3.7% (Euro Area is almost double that). Again, at the latest FOMC meeting, Powell has made it clear that getting the US inflation under control is the number 1 priority and that they were willing to hurt the economy/employment to achieve that.

There is one major issue however: the tightening is accelerating the scrambling of the house of cards that is our global debt-based fiat monetary system. For that reason, I am not buying into the multi-year market depression that some very smart macro investors I follow have been outlining. My base case remains that financial markets will eventually, once again, decorrelate from the real economy and start trending up again (while the real economy and asset poor people will probably suffer for several years). Let me explain my reasoning.

Let’s take the example of Europe (credit to the great Arthur Hayes for inspiring this analysis): As of Q2–22, the Euro area outstanding government debt is €12.0trn (95.6% of GDP), the latest reported government deficit (2021) is €626bn, assuming the deficit number remain constant, this means that European Governments are missing €626bn in revenue just to finance their expenditures for the year, which means the debt load will have to increase by 5.2% in a year to €12.6trn. In addition, out of the €12.0trn of outstanding debt, €1.9trn is due to be repaid within 1 year, so it will also need to be refinanced, which bring the total of new debt to €2.5trn. At the end of 2021, the 10-Year Eurozone Central Government Bond yield was 0.28% (almost free money; also, I am looking at the euro zone in aggregate, but there is quite a wide delta country by country, which makes things worst), but at the end of Aug-22 it is at 3.02% and we know that the ECB is likely gonna do at least another 75bps hike, so let’s take 3.80% rate for the new debt, so that’s an extra €94bn of interest payment that will be added to our €626bn deficit for next year, bringing it to €720bn. Now, because of the economic downturn, governments revenue next year (i.e. mostly tax collection) will very likely be lower, and realistically, governments expenses will likely increase, so the actual deficit will probably be meaningfully higher than €720bn. This, together with the debt arriving at maturity, will again need to be financed with new, more expensive, debt, which will further increase the deficit for the following year, etc. I think you got the picture. Also, important to note that Euro area hasn’t had a single year of surplus in the last 10 years (possibly even in its entire existence, but the data I am looking at only goes 10 years back), and interest rates were super low for most of the period, so it is very unlikely that this trend will ever reverse, particularly in a rising rate environment. So, imagine, if the EU was a company with a debt load almost equal to its revenue (and that’s taking GDP as a proxy for revenue which is the common way to measure the debt of a country, but it would be more accurate to compare it to the actual governments revenue, in that case we are closer to 1.9x debt/revenue) and with this kind of structurally negative cashflow profile, would you invest into it or lend it money?… me neither. And because most investors think the same, there are not many buyers queuing to buy newly issued EU government bonds. Due to regulation, there are some forced buyers among commercial banks, but the largest buyer (of last resort) is by far the ECB itself, and to give you a sense, the ECB used to own less than 2% of the Euro area government debt back in 2016, but it now owns 40.8%!

So, to sum-up, we have governments with ever-increasing deficits that can only be refinance with new debt, and a debt load that will be increasing exponentially in an environment where interest rates are positive, and no organic demand to buy this new debt. There are only two possible outcomes: 1) governments start to default on their debt and obligations (public worker salaries, healthcare, pension, defence, etc.), or 2) the ECB restart QE (probably with a different name, “YCC”) and buy the new governments bonds with freshly printed money, which will end up pumping asset prices. There is also a solution 2b that is the US print the money instead/in addition via the Exchange Stabilization Fund which I mentioned last month. Solution 1) would force a faster reset of the monetary system, but it would be brutal and would likely cause a lot of chaos, so I would bet on option 2), kicking the can down the road one more time, keeping the Ponzi alive, that’s the easy political choice. The situation is very similar in the UK and probably in most countries that run a structural deficit, so basically everyone in Europe except Norway (big outlier because they have petrol and gas), Denmark, Luxembourg, and by a small margin Sweden and Switzerland. There is a theme here: either natural resource rich countries, or small country that are easier to manage/adapt, which reminds me an interesting Credit Suisse research report I read years ago, and which is also why I am a big believer that, in many cases, “decentralisation > centralisation” which is one of the core value upon which the crypto space is built.

So, we have Europeans/UK governments that cannot afford to raise interest rates (via their central banks proxies), but that are forced to do it anyway. They are forced because: 1) they need to show they are doing something to curb inflation (‘Whatever It Takes’) which is the #1 concern of most voters at the moment, and 2) if they don’t, as long as the US is hiking, market forces will continue to devalue the EUR/GBP versus the dollar by playing the carry trade (e.g. borrow EUR at 1.5% >> sell EUR for USD (demand for EUR drop relative to USD, so USD get stronger/EUR get weaker) and invest USD in a US Treasury Note at 4% >> pocket the difference (net of optional FX hedging cost)). Given energy, commodities and most of the international trade is priced in USD, a weakening currency vs. the dollar is really bad for those import-dependent countries which are already struggling with their energy cost. This currency devaluation started to happen since the beginning of the year following the FED aggressive rate hikes, which triggered a big drop in European currencies vs. the dollar and eventually forced both the ECB and BoE to raise rates too.

So, the idea is that central banks on both side of the Atlantic will continue to raise rates and do QT till something breaks, then they will have to reverse course. The FED can afford to tighten stronger and for longer, and things will likely start breaking in Europe first, but eventually the FED will have to ease too, or the US will likely bankrupt their Western allies. There are many things that could “break” (in no specific order, and not mutually exclusive):

• Sovereign debt crisis: Governments not finding willing buyers to finance their deficits, forcing central banks to print and buy government bonds (that’s the ultimate breaking point, but unlikely the first thing to break. This would happen on a country-by-country basis, with Southern Europe economies being the more at risk… Italy is the elephant in the room. This could eventually lead to the collapse of the Euro)
• Surge in corporate defaults: Higher interest charges combined with higher energy and raw material costs making a material part of the business sector insolvent, which would have cascading effects in the broader economy
• Surge in households defaults: Higher interest charges (any mortgages due for refinancing my UK-based friends?) combined with higher energy, goods and services costs + unemployment making a material part of the household sector insolvent (note: loosening monetary policies could make supply-driven price increases worst, but if the economy start to crumble too much, central banks will surely aim to lower rates to try to release the pressure on businesses and households, and/or will come up with some support packages which will have to be finance is freshly printed money)
• Banking crisis: the increasing number of defaults could lead to the collapse of some over exposed banks, and likely some form of bailout financed via freshly printed money. It was no sign of that when I started writing this update, but things went crazy over the weekend with Credit Suisse and Deutsche Bank rumoured to be on the brink of bankruptcy.
• Pension funds failure: this has started last week already, in the UK, forcing the BoE to restart QE in emergency to buy some government bonds at a premium to market price in order to avoid the collapse of some pensions funds that were getting margin calls because they borrowed or entered derivative positions against bonds collateral, and when interest rate increase, bond price fall (that’s finance 101, but it seems like pension funds manager forgot that after a decade and a half of ultra-low interest rates). Pension funds collapse would have terrible consequences for a lot of vulnerable people: Imagine your 85-year-old grandma that was relying on her pension income to finish her days, unless she has accumulated enough wealth to have a buffer till her expected death, or you are making enough to afford to cover her costs, she will be forced to go back to the workforce to survive. Unlikely that any government will let that happen.

So far, the BoE intervention has been a “targeted” QE/YCC measure in response to a specific event, but it will certainly do more whenever it will be needed again. This could become a playbook that the ECB will follow as things start breaking in Europe and governments needs emergency funding (e.g. to bailout financial institutions or finance subsidies).

The question is, will the US join the printing party too? My bet is probably, eventually. The FED can afford to tighten stronger and for longer, but if they keep increasing rates and reduce money supply while the Western allies can’t afford to follow, they might end up bankrupting them. A possible way out of the current energy crisis in Europe would be for the EU to soften the relationship with Putin, let him annexe some more of Ukraine and call it a day, then restore commercial relationships and resume buying Russian gas. But it seems the US doesn’t want a quick end to their proxy war against Russia, so monetary support (e.g. via the ESF and/or by lowering interest rate to make the carry trade less attractive and support the EUR and the GBP) seems more likely.

If the FED were to start lowering rates and expanding its balance sheet again, that would have the most impact on assets prices, but they don’t even have to. Global financial markets are connected, doesn’t mater where QE is happening, it will end up in USD, reserve assets (gold/commodities, Bitcoin for some), and “risk-on” assets (equity and crypto). This is Brent Johnson’s Dollar Milkshake Theory that we start to see happening in real time. I am not gonna expand on that because this update is already way too long, but I highly recommend his Real Vision interview from early 2019, it aged extremely well.

What is the end game? We keep debasing our fiat moneys to repay existing debt + interest + deficit with new debt. Every time we kick the can down the road, the total debt load increase to more unsustainable levels. More money chasing the same amount of goods, services and assets means prices in fiat term increase. Investors/people don’t want to store their wealth in a currency that keep being devaluated, so they buy assets with a fixed (or not so aggressively expanding) supply (e.g. equity, real estate, gold/commodities, and certain cryptos). Eventually, the debt spiral unwinds and the credit system collapses to zero and must be replace by some form of new system.

If you ask me, decentralised cryptos are our best shot for this new system and the best hedge against a potential collapse (but of course, I have a dog in this fight!). While Bitcoin is well position as highly secured, non-dilutive digital store of value, and Ethereum as a credibly neutral smart contract platform to run all sort of applications, it doesn’t have to be a one-size-fit-all. There is plenty of space to experiment with various economic and incentive designs, and let people/market participants decided what work for them. All major central banks have also been working on their own CBDCs (Central Bank Digital Currencies) and it is likely that they will try to push for that as a replacement in case of a collapse of the existing system. By the way, an outright collapse is unlikely, it will probably play out over several years with the two systems running in parallel. While not yet finalised, CBDCs will likely remove at least two critical features of decentralised cryptocurrencies: censorship resistance (meaning central banks could decide to freeze or confiscate your assets for whatever reason) and trustlessness (meaning you have to trust the central bank to do the right thing with the monetary policy instead of trusting opensource immutable code; for example, a central bank could decide to double the money supply overnight to finance the bailout of a bank, and the value of your assets will be divided by two; or it could dilute you progressively by issuing at wish newly minted tokens to certain subgroups, as it is the case with the current fiat system); optionally, they could also deprive users of any form of privacy. Depending on how CBDCs are implemented, this could lead to a very dystopian future, but if we remain free of choice and CBDCs are fairly competing with decentralised cryptos, that would be a huge boost for general adoption.

One concerning issue is that some regulators are going more and more aggressively after crypto. SEC chairman Gary Gensler (former Goldman Sachs partner) has been a vigorously opponent since the beginning of his mandate, which is quite ironic as he was teaching blockchain at MIT. But new this month is the CFTC attacking a DAO in a case that, if it makes jurisprudence, could be very damaging for the industry. The silver lining is that we see politicians from both side of the aisle challenging regulators and defending crypto (this hearing of Gensler in front of the Congress has some interesting exchanges, e.g. at 41:20 questions from senator Toomey).

I expect we will see crypto becoming more and more of a political battle with increasing polarisation. But the battle won’t be on the horizontal “Left-Right” axis, but on the vertical axis “Authoritarian/Centralised-Libertarian/Decentralised”.

As discussion about failing banks and pension funds start to take a central stage in mainstream media, and people trust in the centralised institutions supposed to safeguard their buying-power and their assets gets lower, cryptos are in a good spot to benefit. After all, Bitcoin was launched in 2009 after the global financial crisis, as an alternative to a failing banking system, and creator Satoshi Nakamoto symbolically included this headline in the genesis block “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”. It feels very much appropriate in the current climate.

So, that was a lot of text to say that my base case is still the same since the beginning of the year: eventually central banks will be forced to ease again, and risk-on assets will start trending up again. Timing is uncertain, it seems like the FED has still some margin to go on, but Europe/the UK are already showing sign of distress. I think markets are likely to go further down as things start to break before actions are taken by central banks and market participants feel safe again. I think once things reverse, they will likely reverse fast, particularly in crypto. So, I am not trying to time the market, but I keep some stablecoin reserves to further average down if we get another big leg down.

Of course, this is not financial advice, and I got no crystal ball, I could be completely wrong. This is just me sharing my latest macro thoughts, hope you enjoyed it!