Take Crypto & the Points — Part 1
Takeaways:
· US dollar-denominated wealth is levered over 25:1.
· Adding extraordinary amounts of liquidity to bank balance sheets recently confirms the Fed understands the acute potential risks from another credit crisis — de-leveraging, potentially accelerating monetary regime change.
· The best reason sophisticated investors should explore crypto assets and blockchain businesses today is prudent portfolio diversification.
A decreasing percentage of investors use macroeconomics as an input to better understand financial asset values. Ignoring the broad view can be risky. Those that have given it some thought know that economies and markets have lost their cyclical nature because economic policymakers have figured out how to manage commercial and economic incentives using financial levers. For every consequential occurrence or natural phase in an economic cycle that might otherwise negatively impact output growth, inflation, employment and financial asset prices; there has been an equally powerful policy reaction, such as interest rate cuts, QE, currency devaluations, capital controls, trade re-negotiations and now, “Not QE” — overnight and term-repurchase agreements that are liquefying bank balance sheets and financial markets.
The most visible example of exogenous economic and financial management was the bail-out following the financial crisis in 2008, which was, in reality, a successful bailout of the US dollar. Credit is simply a claim on currency and so systemic credit risk equals systemic currency risk. Could that happen again? Yes. Most investors do not appreciate that virtually all financial assets have become credit too, regardless of their “intrinsic value”, because intrinsic values are measured in the cash flow of the same credit-based currency. So, both formal credit and financial assets are currency derivatives. Their values are only as good as the underlying currency, which is managed by central banks and sovereign currency boards.
Peak Fiat?
There is about $100 trillion of USD-denominated stocks, bonds and M2, plus multi-trillions more in real estate and other assets theoretically contracted to be monetized someday with US dollars. There is only about $4 trillion in USD base money that ostensibly collateralizes it. In short, USD-denominated capital (i.e., wealth) is levered at least 25:1. (The graph below shows only USD-denominated credit, and does not include M2, equity, non-public market debt, real estate, etc., which also have values ultimately dependent upon the leverage ratio of USD credit-to-USD base money.)
Against this backdrop, the Fed’s “Not-QE” since last September is a very telling initiative given that there was no obvious existential threat to the economy or markets that might have triggered it, other than the building sentiment that a global economic slowdown was in the cards for 2020. Despite the “the cleanest dirty shirt” status of the USD, it would face extreme dilution through acknowledged QE were there to be a global recession. That could lead to losing its status as the world’s only reserve currency.
The Dollar is more than a currency to the United States government. It is the primary tool policymakers use to manage global trade, control shipping lanes and influence foreign policy. Its fall as the world’s only reserve currency would lessen US government influence over the global economy.
Not QE suggests that policymakers will not let economies take their natural course. Can this state of affairs prevail? Seems unlikely. Global central banks have already dropped interest rates to record low and negative yields; assets are highly levered, directly and indirectly, and their values are full; the US is already in its longest output expansion without a recession; and the largest portion of wealth is held in an age cohort starting to reduce risk and shrink balance sheets. Fiat (i.e. political) monetary regimes usually last no longer than 60 years. A new one seems inevitable.
Modern Monetary Theory (MMT) is a concept that places government currency monopolies at the center of economies. It proposes that governments use fiscal incentives to target output growth and employment. The goal is to use money creation to achieve full employment. When inflation occurs, fiscal authorities would then raise taxes or issue new sovereign debt to mop up excess money in the system. MMT has not yet been formally endorsed by sovereign authorities in capitalist economies; however, monetary policymakers seem to be adopting aspects of it already.
MMT won’t work. For the first time ever there is digital software that promises to: provide the means for sovereigns like China to challenge the Dollar’s unilateral reserve currency status; allow un-banked peoples around the world to grow economies without ties to the USD; allow savers everywhere to store and transfer value online using un-levered currency and assets; and allow investors with 100% exposure to dilute-able fiat currencies and their financial asset derivatives to hedge their portfolios. With global access to competitive currencies, single or federated governments can no longer rely on their currency monopolies to direct domestic output, employment or inflation (and asset prices).
The almost 50% of Americans living paycheck to paycheck should continue supporting and being proud of US dollars…as long as they stay employed and there are no shortages of goods and services. Widening wealth and income gaps should not necessarily lead to a loss of faith in the Dollar. However, it seems reasonable (and not xenophobic) to argue that if the US dollar and its credit and financial derivatives sneeze, then the world would catch a pretty severe cold. A global credit event — whether or not economists anticipate or declare a formal recession — opens the door for lost fiat market share.
Economic policymakers that allow currencies to be levered beyond the point of being in the same valuation universe as asset values are effectively in the business of creating imbalances: imbalances that separate the wages of owners and labor, imbalances that separate access to goods and services, and imbalances that can foment geographic hostilities. The more exogenous managers synthesize stable global supply and demand through monetary, fiscal and trade policies, the greater these imbalances become.
Imagine a world with one global wage and price scale. To have one global currency users would have to trust one authority. Could it be open-source software available to anyone in the world with an internet connection? Should anyone interested in storing wealth have 100% exposure to US dollars, fiat currencies priced against them, or their financial assets derivatives?
Investing in Financial Asset Abstractions
For investors, the only ways to generate a return on any currency is to lend it or speculate on its exchange rate vis-à-vis other currencies. Against this backdrop, what is the “intrinsic value” of the US dollar — the taxing authority of the US Treasury (currently about $2.5 trillion/year) and the ability of the Fed to print as many USD as it wants so that all accounts can be settled? What about the 200 other dirtier shirts around the world implicitly or explicitly pegged to Dollars?
Only in financial economies with 25:1 leverage would there be very little savings in non-interest bearing assets. A “saver” in USD or any other fiat currency has incentive to put accumulated wealth into market-priced (i.e. “risk”) assets that may potentially overcome necessary future inflation.
Heavy-handed central bank policies following the 2008 financial crisis have driven financial asset prices higher, as manifest through record low-yielding sovereign debt, tight credit spreads and high cap-weighted equity indexes. It is interesting to note that industrial commodity prices are not at record highs because they better reflect waning economic demand, and 40% of S&P 500 companies lost money in 2019, despite cap-weighted indexes making new highs.
Prices and real values of financial assets have parted ways — prices reflecting short-term credit-driven liquidity; real values not reflecting how much necessary dilution is baked into the assets’ underlying currencies. Most financial asset investors have also lessened their sponsorship of discretionary trading and investing, as expressed through program trading volume in the equity markets (> 90%) and the collapse of allocations to value investing, most alpha-seeking strategies and idiosyncratic investment opportunities. Fundamental analysis has become less important than the last price.
George Soros’ notion of currency pricing being reflexive (rising and falling exchange rates are most apt to continue beyond all fundamental metrics), can now be applied to financial assets. This makes sense given the argument above that financial assets are currency derivatives, and that both are greatly levered with abstract intrinsic values.
Beta-returns through index exposure have become the only option that can accommodate market breadth and depth. It has paid since 2009 for index exposure to be long-only across liquidity driven markets. The implication of staying long financial asset indexes today is that most investors believe central banks will continue to increase bank balance sheet liquidity at a rate that promotes “risk-on” exposure and nominal ROIs that beat the risk-free rate (zero) — but also that the underlying currency will not be diluted more than the nominal ROI being managed by central bank monetary policies.
Market Capture => Monetary Regime Change
So, central banks hold the key to financial asset returns, which are essentially currency derivatives. The primary mission of central banks is to oversee and protect the solvency of member banking institutions. Their secondary mission is their more public economic mandates, effectively helping increase annual output growth with moderate inflation and full employment.
It is questionable whether a credit-based economy could withstand deflation or extended periods of disinflation. Both would make debt repayment more difficult for households, businesses and governments, which in turn would threaten the solvency of banks that count loans as assets.
Hyperinflation is triggered by money printing, which is a choice of policymakers that beats the alternative. It is done mechanically by central banks conjuring new base money and giving it to primary banks, which would then distribute it in the form of consumer credit. In 2009, the Fed avoided high inflation (let alone hyperinflation) by initiating Interest on Excess Reserves (IOER), in effect paying banks a risk-free rate of interest on new base money sufficient to incentivize them not to lend it out. (It is an ironic malapropism to call the paltry collateral backing 25:1 leverage “excess reserves”.)
Banks are structured to thrive in periods of modest inflation, and even brief periods of hyperinflation, because their profitability and viability rely on interest rate spreads separating their assets (loans) and liabilities (deposits). Deflation or extended periods of disinflation or hyperinflation would threaten the wherewithal of borrowers, which in turn would threaten bank assets. As a result, central banks include inflation targets that diminish the purchasing power of savers in their currencies.
The traditional (and widely accepted) difference separating nominal from real GDP — output growth less goods and service inflation (i.e., consumer price inflation) does not capture the affordability imbalances discussed above. It seems likely these imbalances will eventually be manifest in other less obvious ways. How many times have established institutions declared “no one could have foreseen that event!”? Next time around, the consequences should be that much more acute.
What if there is a widespread loss of confidence in US dollars? Technically, the Fed not have to make good on all USD-denominated credit — only the credit underwritten by their member banks. Total bank assets today in the US are not quite $18 trillion, which means that the Fed is obligated to print only about $14 trillion in base money for its banks ($18 trillion — $14 trillion in “excess reserves”). The other $84 trillion-plus of implicitly contracted USD credit would be theoretically left out in the cold. Banks would be protected but borrowers and non-bank lenders would not.
Nevertheless, most of us would expect the Fed and other central banks to produce however much base money is necessary to stabilize their currencies and economies via the oft-feared “helicopter drop”. Their mission would be to re-establish confidence in their currencies. It is anyone’s guess if this would succeed, but either way the process of hyper-inflating and distributing new currency to creditors and debtors would diminish the purchasing power of savers in both risk and non-risk assets.
The point here is not to predict if, when, how, why or what will trigger a loss of confidence in the current global monetary regime and its impact on today’s un-reserved fiat-denominated wealth. The point is to call attention to the almost complete store of wealth in currency derivatives. The best reason to explore crypto assets and blockchain businesses today is prudent portfolio diversification.
Paul Brodsky
