DAR Crypto Weekly — 3/27/20

The Fed Wants Inflation

Market Overview

Digital asset prices were up on the week with total industry market cap up 7.1% to $182.9B. Large-cap relative winners on the week were XRP (XRP +4.1%), Bitcoin SV (BSV 2.0%) and Bitcoin (BTC +1.4%). Laggards in the large-cap category were Ethereum (ETH -4.5%), Litecoin (LTC -3.8%), and Bitcoin Cash (BCH -3.1%). Other noteworthy positive movers across the industry were Augur (REP +18.0%), Monero (XMR +17.4%), and Synthetix (SNX +15.3%). Other notable laggards on the week included Steem (STEEM -30.2%), Hadera Hashgraph (HBAR -20.6%), and Storj (STORJ -19.9%).

The Case for Inflation

It’s been a wild 5 weeks in financial markets. We’ve detailed this in the past but since 1928, broad measures of the US stock market, like the S&P 500 Index, have never fallen so much in such a short amount of time. This has been directly the result of the spread of COVID-19 throughout the US and the rest of the world resulting in a grounding halt in economic activity. Major investment banks have estimated a 14% — 30% hit to US GDP as a result of the health crisis, but it’s still anyone’s guess as to how long the crisis lasts.

The Fed Springs into Action

Confronted with this unknown void, various financial indicators have gone haywire, from a plunge in global stock markets to the widening of credit spreads to widespread fears of deflation. With that as a backdrop, the Fed has sprung to life in numerous ways. A high-level overview of their actions include:

• reduced Fed Funds rates to 0% — 0.25%
• increased purchases of US Treasuries and agency Mortgage-Backed Securities (MBS)
• expanded overnight and term repurchase agreements
• expanded dollar swap lines with other central banks
• encouraged depository institutions to access the discount window
• reduced capital requirements
• expanded the size of existing lending facilities and added new ones
• expanded the types of collateral it accepts from institutions
• expanded the types and number of institutions from which it accepts credit

This isn’t even a full accounting of all the Fed’s actions, which can be found here. Make no mistake — the Federal Reserve has been much swifter and more decisive on supporting actions compared to the 2008 Global Financial Crisis (GFC).

Why is the Fed doing this?

It’s important to understand why the Fed is so heavily engaged. After all, this wasn’t a banking crisis or asset bubble — our economy and more importantly society is engaged in a health crisis. Unfortunately, the health crisis has created a secondary crisis, one that is economic in nature, with the abrupt halt in many facets of the economy. With such a sudden halt in consumer and business spending, major wrinkles have appeared across many sectors including large and small businesses. This has created further ripples in the banking sector and the financial plumbing of the economy.

Central bankers seemingly have learned a thing or two since the last crisis. There’s wide acceptance in economic circles that the recovery post-GFC took too long to develop partially because the Fed didn’t do enough to stimulate the economy in the 2008–2009-time frame. We’re going to look at some important economic indicators, describe the Fed’s intended actions, and the implications it has for various assets, including Bitcoin, and inflation. We will argue that an important goal of the Fed today is to increase inflation expectations and push down real interest rates.

Nominal Interest Rates go to 0%

Most of the talk with the Fed and interest rates are related to Fed Funds rates, short term interest rates that banks lend each other excess reserves on an overnight basis. The Fed has pinned this rate, through open market purchases (and sales), at 0% — 0.25%. Because these are influenced by market activity, they can’t be decreed or explicitly set, just targeted. Unfortunately, conventional thinking says there’s not much room to move beyond 0%, also known as the Zero Lower Bound (ZLB) at the short end. However, the Fed can target the shape of the yield curve through quantitative easing (QE), the purchase of US Treasuries (USTs), across all maturities, which it is doing currently. By lowering nominal interest rates on the short and long end, it can make the nominal cost of borrowing lower for a variety of financial institutions as well as other instruments the trade as a spread to USTs (most other financial products).

ZIRP and the ZLB

As we mentioned, conventional wisdom says that a Zero Interest Rate Policy (ZIRP) naturally hits a wall at the ZLB. However, we know from experience that in times of fear, like we’re in now, investors are more concerned with a return of capital rather than return on capital and therefore even nominal rates can go negative reference the $19T of negative nominally yielding debt last August. Investors were so scared of losing their money, they’d pay someone to hold it for them. It’s important to note there are second and third players here that is probably more important than nominal rates — real rates and inflation. As we’ve mentioned previously, we think that real rates the key to focus on. As can be seen in the following chart, nominal rates have cratered recently as safe-haven seeking investors look to US Treasuries and the Fed ups its QE efforts (UST purchases across all durations). The same can’t be said for real rates, though, which is a problem.

The Problem with Real Rates

The reason higher real rates are a problem is because these are the hurdle rates with which to judge investment return — they exclude the impact of money. Said another way, real rates measure purchasing power and increasing purchasing power is the objective of investment. By pushing down real rates, that induces spending, encourages investment and borrowing, redistributes wealth from risk-averse savers to those with higher propensities to spend. Unfortunately, the Fed doesn’t set real rates. It can only influence real rates by targeting nominal rates and setting inflation expectations, the delta between real and nominal rates. While those inflation expectations have been consistently set from the Fed around 2% (with the inability to achieve it), during the recent market crash inflation expectations dropped significantly.

Inflation Expectations Collapse

The following two charts show common measures of inflation expectations — 5-year breakevens and 5 year, 5 year forward inflation expectations. These two charts measure expected inflation between now and 5 years in the future, and between 5 years in the future and 10 years in the future.

As is shown, both measures of inflation expectations have cratered. This is a direct response to the economic crisis where the most immediate market worry is a deflationary spiral — lower prices, lower wages, and decreased demand leading to lower prices, lower wages, and decreased demand, etc. This can be a particularly difficult economic situation to deal with and is often seen as a more challenging economic situation than inflation.

Spreads Blow Out

Compounding the financial woes over the past few weeks has been the widening of credit spreads. Most rate-based products (fixed income) trade on a spread to US Treasuries — their interest rate is priced at the nominal US Treasury rate plus a spread based on credit risk. The lower the credit quality, the higher the spread. The following chart shows interest rate spreads for high-quality (AAA) and low-quality corporate bond issuers (High Yield) — both have exploded recently.

A similar trend can be shown for all sorts of fixed income instruments. Unfortunately, for companies that rely on short term funding needs, this type of market action can be dangerous even for the highest quality companies, US agencies, and municipalities. AAA corporate credit spreads have widened to their largest spread ever, for example. Through the Fed’s various lending conduits or through direct purchases of these assets, the Fed can lower these spreads, bringing down the cost of borrowing or rolling debt.

Summary of Events

To summarize the Fed’s playbook as we see it, it’s to:

• Lower nominal rates
• Increase inflation expectations
• Lower real rates
• Collapse spreads

What does this mean for asset returns? For explicitly supported assets like MBS, the Fed will be directly purchasing them. For other assets, there will be implicit support. The overarching effect of all this action, however, is to devalue fiat currencies. And given that COVID-19 is a global event, we would expect to see other central banks around the world race to devalue their fiat currencies as well. This should benefit real assets of all kinds but should be especially incremental to non-income producing stores of value like gold, art, collectibles, and Bitcoin.

Our view on inflation is that while expectations are likely to rise, current monetary and fiscal policy is unlikely to create runaway inflation in the short to intermediate-term simply because it is too hard to do that while demand has collapsed. Coming out of the GFC the topic on everyone’s mind was “is the cure worse than the cold?” meaning would all the money printing used to save the economy create rampant inflation? Numerous physical gold and gold-miner funds were set up by top managers with this viewpoint at the time. However, an objective analysis of history tells us that the promised hyperinflation inflation never came. Economists today scratch their heads and wonder why inflation has been so persistently low, which is why the Fed is emboldened to be bigger and faster.

The Path Forward

How will we know this is all working? Markets are resuming to normalcy, but we are far from out of the woods. First and foremost we need to address the root cause of current economic issues, the public health crisis, and rapidly growing virus. Without that, all bets are off. On the market and monetary policy front though, we need to see inflation expectations rise back up again, real rates decline, and credit spreads to compress. We’ve seen some movement in the right direction, but it’s too soon to say we’ve made real progress. We’ll keep updating you as we track the progress though. Keep watching this space.

That’s all the time we have this week. Please reach out with any questions, comments, or feedback on our work. Get our weekly wrap and daily news delivered directly into your inbox here.