Yuriy Anosov
Jul 16 · 9 min read

Macro shocks that negatively affect global markets have typically been catalysts in the demand for safe haven assets like Gold and Silver throughout history. These dynamics have held relatively constant throughout the modern investing period and assuming that Bitcoin serves as an alternative to gold and silver, its demand characteristics, as a safe haven asset, can be defined as similar to that of precious metals.

Looking at some of the most recent financial crises; the 1979 energy crisis was caused by the Iranian Revolution that resulted in a 4% global oil production reduction and a subsequent doubling in the price of oil over the next year which led to a downturn in the broader global economy. In the early 2000s a recession was brought about by the dot com bubble that was spurred by excess speculation and overvaluation of internet companies. Of course, the biggest financial downturn in recent history that started in 2007 was caused by the collapse of the subprime mortgage market when the accelerated delinquencies and foreclosures led to mass devaluations of housing related securities.

Today we look at corporate credit in the United States and why I believe it will be the cause of the next global financial downturn that will reverberate through all major asset classes and will cause a flight to safety that will ultimately benefit the price of Bitcoin.

Looking at the profile of corporate credit markets since the mortgage crisis, US companies have been taking full advantage of the low rate environment and leveraging themselves at a growing pace.

The amount of corporate debt relative to GDP over the last few years has pushed above the previous peak reached during the mortgage crisis. The rate of this growth has been slowing down, in line with the steady hiking cycle of the Federal Reserve from December 2015 to December 2018, however, as we have seen during the Dec 2018 meeting, the policy reversal by the fed to stop hiking and be patient with further policy changes. Just a short 6 months later they signaled at the June 2019 meeting that a rate cut this year and beyond may be likely. This is setting up an environment where corporations are much more likely to expand their borrowings of continuously cheap funds.

There are many reasons why the fed is pulling back on their tightening plans. Although they will likely never admit it, I believe that a primary reason is that policy is reactionary to the price levels of US equities. With a 7% fall of the S&P 500 during the month of May, the Fed quickly changed tune to signal to the markets that prices will be supported resulting in a record high of the S&P 500 just last Friday (July 5 2019). The second reason, is political pressure; anyone with a Twitter account knows exactly how President Trump feels about the Fed, every time the market falls, the President is quick to blame the Fed, he criticizes their policies on Twitter (the screenshot below is just a recent tweet of many that are published anytime there is a Fed decision or any major Fed speech), in the financial media and in all manner of interviews as well as attempted, although so far unsuccessfully, to insert ultra-dovish members to the Federal Reserve Board. Although the Fed is a politically independent entity, I think that most fund managers will agree that this is not entirely true as political pressures have a history of indirectly influencing the Fed, even prior to the Trump presidency.

Finally, the divergence from other global central banks, such as the ECB and BOJ, which continue to provide accommodative monetary policy, is a net negative for the United States as a divergent monetary policy often creates a stronger dollar, which makes it tough for American companies to compete on a global scale and causes ripples across global supply chains.

As of June 25, 2019

Just last week, the future implied probabilities of a July rate cut have been at 100% as shown by the screenshot above from the Bloomberg WIRP function that analyzes the chances for the likelihood and size of a potential move in interest rates. Particularly of interest is the historical analysis at the bottom that is showing how quick the market rate expectations can change in a very short period of time.

Last thing to mention about interest rates is that predicting their path is incredibly complex as there are many drivers that are constantly changing with time. The below image is from a Wall Street Journal article from a couple weeks ago, showing predictions over time from 50 economists on the direction of interest rates. The average forecast for the end of June was 3.39% on the ten-year. Note that no one predicted anything below 2.5%.

What does all of this mean for US corporate credit and the probability of its collapse? I think that as companies are short term focused in nature given the environment of equity-linked incentive structures of executives, we will see interest rate cuts translate directly into further leveraging of company balance sheets as borrowing at low rates, particularly at long maturities, establishes a low hurdle rate for investment and cause executives whose incentives are aligned with this phenomenon to execute on this strategy.

The below chart shows that the next four years have a very substantial $4.7 trillion chunk of maturities across the rating spectrum coming due that will either be easily refinanced if interest rate policies start on a downward trajectory per current expectations. However, if rates remain at current levels or go up, companies will have a difficult time rolling over their debt and we will see a systematic cycle of company defaults and broader difficulty in sustaining their operations.

Another dynamic to look at that can shorten the time to a potential collapse is the profile of the current investment grade debt pile. A quick primer for those new to corporate debt ratings, is that they are divided into two classifications “Investment Grade” (IG) and “High Yield” (HY), IG representing bonds that are rated AAA down to BBB- and HY representing bonds that are rated BB+ and below. The below chart shows that the BBB rated bonds are currently 50% of the total outstanding IG bonds. Additionally you can see that over the last decade or so, this concentration of bonds is the highest level it has been and has continued to grow rapidly since the subprime mortgage crisis.

What does this mean in the context of how the collapse will start? The fallen angel effect is when an IG bond gets downgraded to HY (one notch from BBB- to BB+). Since the majority of these bonds are held by large mutual funds with mandates that state that the fund is required to only have IG holdings, once a bond gets downgraded to an HY rating, these funds become forced sellers of the bonds, flooding the market with supply. This cycle can quickly turn into a death spiral if there is enough force in the initial stages. If interest rates remain high, and companies will have trouble rolling the debt, downgrades will start occurring and will cause proxy selling by active managers looking to predict which issues will be downgraded next, which further exacerbates the spiral.

As with the first article in the series, I would like to perform the same experiment where the output will be a range of Bitcoin prices. As the first step, we need to establish a few assumptions:

· $900 billion of corporate debt is maturing in 2020.

· Assume that 5% of this debt will default in one way or another causing a domino effect rotation out of corporate credit and bank loan funds into safe haven assets.
·A scenario where the debt does not get rolled over due to tighter issuance standards or lower market demand but has a detrimental impact on company operations given the liquidity squeeze is considered a default under this assumption.

· The total outstanding debt not including financial firms but also including bank loans is ~$15 trillion. (Deloitte research)

· Assume that 10% of these funds will be either auto-liquidated given some of the dynamics explained previously or will be rotated into gold, silver and other equivalent assets.

· Assume that 2% of the total funds that will be rotated into gold and silver will go into Bitcoin.
· I made the same 2% assumption in my last article where I investigated a potential EUR debt crisis. I received a lot of feedback regarding the validity of this assumption. Although there is not an exact mathematical derivation of this assumption, I think that as more institutional investors evaluate the universe of ‘store of value’ assets, Bitcoin is becoming more and more accepted as an alternative. Now, I am not saying that a pension plan or even a mega fund will put 100% of the safe haven/store of value allocation to Bitcoin, but I do believe that allocation will be diversified among a wider amount of assets, Bitcoin being amongst them, increasing over time.

· Current Bitcoin market-cap (July 7th 2019) is at ~$205 billion with ~17.8 million Bitcoin outstanding.

· Most importantly, this price analysis strictly assumes that the rotation out of corporate credit into Bitcoin is the only event that is affecting its price and is doing so in isolation from the plethora of other factors that impact or will impact Bitcoin pricing.

· Finally, I believe that what I described will happen to corporate credit will only be the root cause and the beginning of a much broader global recession that will affect a very wide range of assets outside of credit which will have more cash flowing from risk assets to safe haven assets in general which will have a further positive effect on the price of Bitcoin.

Given that some of the assumptions above are difficult to accurately predict, I think that the below chart with a range of possible values for what pricing we can expect if the base Bitcoin price remains what it is today ($11,518 per BTC as of July 7th 2019) all else equal.

The base case shows a 14.6% price appreciation in Bitcoin assuming 2% of the cash rotation into gold will go to Bitcoin and that approximately a 10% rotation from the total $15 trillion AUM of corporate credit outstanding. There are ways that the US government can step in, slow down and further push back the day of reckoning of this economy that is fueled by debt in almost every area. One of the most telling statistics I ran across recently is in this interview with Jeffrey Gundlach, one of my favorite bond managers. Gundlach says (at 7:02 into the video) that the national debt grew by 6% of GDP while nominal GDP grew by 5%, suggesting that the entire increase in GDP was debt based. And if you research different parts of the economy closely, there are many similarities where the vast majority of growth is caused by government policies that favor mass borrowing and overleveraging. These dynamics are priming the economy to experience a correction that will be outside the scope of the world’s governments to control (with the exception of Austerity practices which governments tend to avoid at all costs), US corporate credit being just the initial domino to fall. Overall, this is a great reason why the decentralized Bitcoin can eventually serve as a macro stabilizer in the future during a recession event. With every recession, monetary controls will continue to fade away from global central banks and be more controlled by the free market that will without a doubt in my mind be using decentralized technology to make it happen.

Galois Capital

OTC Trading and Algorithmic Market Making in Crypto

Yuriy Anosov

Written by

Yuriy is a trader at Galois Capital, a quant crypto focused hedge fund.

Galois Capital

OTC Trading and Algorithmic Market Making in Crypto

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