Yield Curve Control: Bitcoin’s Rocket Fuel to $1M
The fuel to Bitcoin’s path to $1M
(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)
In previous articles I mentioned about the inevitable downfall of the current financial system and the need for a new paradigm, which will eventually drag Bitcoin to once unreasonable price targets preached by moon boys without really knowing why or how it will happen. In his most recent articles, Arthur Hayes mentions about the inevitable implementation of Yield Curve Control from the Fed, which he sees as the fuel to Bitcoin’s rocket ship to $1M. In this article we’ll discuss what yield curve control is and look at historical case studies to predict how it would benefit Bitcoin if the Fed implements such monetary policy.
Before digging into YCC let’s recall what the Fed’s mandate is. The US Federal Reserve led by chairman Jerome Powell has a dual mandate: low sustainable inflation and full employment. The Fed is independent from the US Government and the board has a 14 year mandate. They monitor the levels of inflation and unemployment through monetary tools that commonly include the short term Federal Funds Rate and Open Market Operations consisting of buying and selling securities on financial markets to shrink or expand the Fed’s balance sheet according to economic needs. In my previous article Business Cycle Manufacturing .gov I discussed how these policies directly affect financial markets and the economy as they coincide with bull and bear market phases.
To vulgarize market cycles and put simple, low interest rates stimulate spending and economic activity, thus incentivizing low unemployment, while higher interest rates have the opposite effect. Too much spending and high economic activity results in high demand for goods and services which in turn puts upward pressure on general prices and thus affects inflation and people’s purchasing power. The Fed has to find the right balance of monetary policy deployment. They use different tools to measure economic activity. The most notable one being CPI (Consumer Price Index), which measures the price fluctuations of a basket of goods and services over time. This particular metric currently displays a level of inflation of over 8%, a level not seen since the 1980s. This means that consumers lose 8% of purchasing power year over year, or to vulgarize again, that $100 from last year is now worth $92. At current level of inflation, it would take 9 years for the purchasing power of the US Dollar to be divided by 2, ie $100 today would be worth $50 in 9 years.
Hence why the Fed is actively working on dragging inflation down, by gradually hiking interest rates since Q1 this year, and reducing their balance sheet which rose by $4T during the Covid crisis. And don’t be fooled by politicians politicking. The current level of inflation is the direct impact of Fed’s policy, and US Government spending, although they are blaming it on exterior forces such as the war in Ukraine, or supply chain disruptions coming from China. The Fed’s Quantitative Easing policies started well before and are now being felt by Main Street through inflation.
As argued in Business Cycle Manufacturing .gov, the Fed won’t be successful in taming inflation in the long run after terminal rate is reached mid 2023. There are structural flaws in the Fed’s balance sheet, the level of M2 money, the foreign dependence of US Treasury demand, and how behind the curve the Fed got as it is implementing hawkish policies in an already weakened economy. So they will have to re-stimulate and get back to some sort of Quantitative Easing. The Fed has reached a point of non return in its policies which will require the introduction of new monetary tools.
What is Yield Curve Control? First off it is important to understand that bond yields are inversely correlated to their demand. As bond prices go up, yields go down and vice versa. So what the Fed does under Quantitative Easing environment is buy bonds to keep yields low and ultimately boost the economy. However the Fed also faces the dilemma of having to maintain rates at a sustainable balance over time so that it fulfills its low inflation mandate. While QE boosts the economy with low short term interest rates, it isn’t forward looking and often involves a later necessary Quantitative Tightening to revert unwanted side effects, namely unsustainable levels of inflation, which is exactly the environment the economy is currently in. Yield Curve Control is a tool the Fed can use to achieve longer term control on interest rates by buying and selling fixed income instruments. Unlike QE, YCC seeks to buy as much bonds as necessary to maintain the pre-determined rates along the yield curve. To summarize, QE influences yields, while YCC guarantees them along different maturities across the yield curve.
The argument for YCC is that the Fed is facing a dilemma. Lower inflation, but keep it high enough to dilute the levels of debt attained under QE. With over 8% inflation, the Fed would have to hike to 6% in a perfect world in order to bring it back to its 2% target. But at 6% the economy would plummet and the US Government would have to face potential defaults on its debt as interest payments would quickly close the gap with tax receipts. That’s a case where the US would simply go broke, and the it will not do so willingly. So the Fed is left with one solution: collide with the US Treasury by having inflation under control while allowing the USG to service its debt long term. There is no way around it at a 125% debt to GDP ratio.
There is one instance where YCC was previously used in the US. In 1942–43 the Fed commenced significant purchases of Treasury Bills to help the government finance WW2. It did so by pegging short term interest rates on Treasury Bills and capping longer term rates on Treasury securities. This resulted in negative real interest rates, helping the US government dilute the debt and effectively finance and win the war without going broke.
What is the likelihood of seeing the Fed implementing such policy? Inevitable considering the amount of debt accrued over the past 3 years while inflation keeps running hot. Inflation is the Fed’s short term issue, and they are resolving it with QT. But once it is tamed enough, the economy will need a re-boost, and QE will not be adapted as we would go back to square one with inflation. QT also has its limitation. The Fed cannot hike to a point where it would make the USG go broke. We know that YCC is part of the tools the Fed is considering so it is not a fantasist theory. The FOMC also recently announced that it is closely monitoring the effects of YCC in Japan, Australia and New Zealand. While QT and rate hikes are currently in use to have a short term “quick emergency” impact, it is not adapted for long term needs.
We can look at the Japanese Yield Curve Control case study to balance the pros and cons of such policy. Japan started implementing YCC in 2016 as it sought to control inflation and dangerously high level of debt to GDP (currently 250%!) caused by QQE (Quantitative and Qualitative Easing) combined with NIRP (Negative Interest Rate Program). TLDR, the Japanese economy is facing deflationary pressures so the BoJ stimulates the economy through asset purchasing on one side, and keeping control of interest rates on the other by capping yields through YCC so that the country doesn’t default on its debt. YCC has been achieving the desired plan, however it is now under pressure as the Fed and rest of the world are tightening. And we have seen the market testing the BoJ’s credibility and willingness to maintain its stance despite forces going against it. As a result the 10 Yield went through the 0.25% cap multiple times this month until the BoJ stepped in to purchase bonds. Unlimited bid power confirmed for now.
The impact on Japan is currency devaluation. As the Fed is tightening and the BoJ keeps printing, the Yen is taking a beating against the US Dollar. This stimulates exports as Japanese goods become cheaper while the USD gains purchasing power vs the Yen, but puts upward inflationary pressure on the Japanese domestic economy as imports become more expensive. This is going to become a growing issue in Japan as its trade balance is negative and the country is energy dependent. It will have to survive economic pain while the Fed is tightening or give up on YCC to let yields explore higher territories and allow the market to freely decide a point of equilibrium.
Although YCC does begin to display some limitations in Japan due to the specific economic structure of the country, the US is in a much stronger position to implement it successfully as it has done before during WW2. Stronger economy, more energy self sufficient, world reserve currency, and more resources allowing it to have more control on its trade balance over time.
In Business Cycle Manufacturing .gov I argue that the Fed is stuck in an endless loop of QE followed by QT and re-QE as the economy is in constant need of stimulation and Central Bank intervention. I also argue that inflation will not be tamed long term once the Fed is done with its hawkish plan around mid 2023. This causes an issue for the US, but also for foreign holders of US debt. As inflation will continue its slow grind up over time, foreign countries will loose incentives to purchase US Treasuries. Why would they hold a bond yielding 1% when inflation runs at 8%, and newly issued bonds payout 3%? They could in fact, dump their existing UST holdings, driving yields up and forcing the Fed to intervene and buy it back. And as countries will not be encouraged to purchase UST, they will have to find other venues to park their money. Wink wink Gold and/or Bitcoin.
The unlikelihood of inflation being tamed long term means that Western economies will have to live with a new paradigm. Governments will have to face social unrest and unleash universal basic income, subsidies specific industry sectors, while stimulating the economy with budget packages related to infrastructure improvements and climate change incentives policies. This means more spending and debt, and thus the need to cap yields in order to finance it. The world is also not safe from another pandemic or war. These events require money printing.
Fixed income won’t be attractive under high inflation and stock indexes will not enjoy eased price discovery as they have for the past 20 years because of poorer real rates of return. Investors will have to look for alternatives and money will have to be parked somewhere else. US Treasuries will not be the go-to for countries anymore while stocks will get back to single digits yearly average returns. That’s how Gold and Bitcoin come into play.
Why does Bitcoin stand a chance against Gold? Gold is undoubtedly the historical monetary reserve asset in human history. But it has some flaws and may not be adapted to how the world has evolved. If a country like China decides to save in Gold rather than US Treasuries, the US will be pushed to politically discourage it. And Gold can easily be seized. There are recent examples with Venezuela having issues claiming its Gold held at the Bank of England, and Afghanistan struggling to touch its 22 tons held in a New York vault while Biden used Afghan State funds to finance programs here and there. Gold is not easy to move around, and can easily be used to sanction a country, which ultimately impacts its economy and people. Retail investors also face a political risk holding Gold, and we have the 1933 Executive Order 6102 to remind it.
Bitcoin was originally created as an alternative to fiat currencies, but also and more importantly as an alternative to Gold. It is more scarce than Gold, easy to move around and store. No more need to rely on a willing country to release the Gold bars and ship it. The decentralized aspect is also important. As long as there is a willing buyer and seller, no third party can intervene and stop them from transacting. Recent events showed us that sovereign States are actively looking for alternatives to the US Dollar dependence and the risk associated with Gold. Bitcoin not only needs user adoption to grow, but also needs to move around. A large user base adoption without transaction traffic makes it useless and thus worthless. So contrary to what most crypto people think, we need regulation and a clear framework, which will allow for mass adoption by States, banks, and merchants. Bitcoin needs to be held and move around.
Assets such as Gold and Bitcoin are long term assets that need constant cash inflow to hold their value and appreciate in price. Long term inflation and Central Bank + Government spending guarantee their survival over time. While Quantitative Easing manufactures brief artificial asset bubbles, Yield Curve Control will provide a more organic growth and insure Bitcoin’s success. Unlimited bid from the Fed to buy UST to cap yields and allow the economy to grow while granting the US Government to service its debt in a sustainable way is the recipe that will drag Bitcoin to the moon.
