This period is a “macro moment” for financial markets.
Cryptocurrencies have entered another correction cycle, with the price of bitcoin and ether down about 35% from their November highs.
Interest rates are rising as central banks take measures to fight inflation; higher yields could offer an alternative to other asset classes. This reaction illustrates a principle of economics 101.
Yet, for the first time in the history of “free markets,” that assumption could be incorrect. Why? Because central banks can never raise rates meaningfully again. The era of Paul Volcker hiking rates to over 20% to kill the energy-led inflation of the 1970s is a thing of the distant past.
The ‘Death of Fixed Income’ revisited
In April 2020, I published an article originally titled “The Death of Fixed Income and the Rise of Bitcoin.” In it, I postulated that fixed income as an investable asset class, which comprised some part of 50% of most investment portfolios, was dead and buried, never again to be seen as a safe haven for portfolio investment, positive returns and savings.
The rationale is that in reaction to the Great Recession of 2008 and the malaise of a recovery that ensued, central banks drove interest rates to zero and below. Meanwhile, governments printed fiat debt to levels that could never be repaid, let alone serviced should interest rates rise meaningfully. Investors would need to move capital aggressively out of fixed income and into stocks, real estate, safe haven commodities such as gold and silver, and other alternative assets such as private equity, venture capital, collectables such as art and fine wine, and cryptocurrencies, specifically bitcoin, in order to find alpha.
Indeed, over an 18-month period, that is exactly what happened. The S&P 500 stock index rallied from 2,300 to 4,800 while the Nasdaq outperformed its peers trading up from 6,900 to 16,000. Gold traded up from $1,650/oz. to $2,000 before leveling off mid-range around $1,800 for the past year. Real estate ripped higher.
And bitcoin? It exploded from a March 2020 low of under $4,000 to a high of $69,000 this past November, before retracing to its current level around $42,000 at the time of publication.
COVID-19's impact on the global system
It’s now February 2022. The world has been hacked by COVID-19 and its latest variant, Omicron. Many expect this pandemic will be part of our new normal like the cold or flu.
Governments worldwide have written blank checks to support failing businesses and then some. Workers and students have been off campus for what feels like a lost two years. The Federal Reserve’s balance sheet is now at a record $8.9 trillion.
A supply chain crisis has created havoc with everything from lumber to computer chips to used cars, culminating in the recent spike in inflation to an annualized 7% – a level not seen in 40 years. Markets have taken notice as the Federal Open Market Committee (FOMC) has changed its tune from “inflation is transitory” to “inflation is concerning.” Economists now expect the Fed to hike the Fed Funds rate to a total of between 1% and 2% this year from its current 0-25 basis points (bps).
In the past two months, major stock indices have fallen 10% to 15%, led by the tech-heavy Nasdaq. U.S. two-year Treasury note yields have risen some 90 basis points to about 1.55%, and the U.S. 10-year yields have risen 60 bps to about 1.95%. The yield curve has flattened in anticipation of the coming rate hikes.
The emperor has no clothes
Stanley Druckenmiller, one of the great traders of this generation, stated in May that should the yield on the U.S. 10-year note rise to 4.9%, the United States would be paying 30% of annual GDP simply to service the interest on outstanding debt. What that means is that we, the collective debt-ridden world, are broke, and that policy (both monetary and political) is simply to buy time and maintain the calm. Rates will rise, but the pace and extent of the moves will be limited by geopolitical agreements not to rock the boat of the global economy and expose the emperor of debt who truly has no clothes.
Yes, central banks are going to begin raising interest rates. Setting the extent of rate hikes aside for a moment, the investor community has to ask itself a question: At what interest rate would one consider putting fixed income securities back in an investment portfolio? Differentiate between a risk asset, such as low credit-rated bonds that may offer 5% to 10% but are as risky as equities, from government guaranteed securities. Would 3% yields on a 10-year note attract investment capital? How about 5%?
The point is, there is no viable interest rate level that will attract savers to the fixed income markets. At current interest rate levels, and given projected inflation, holding a dollar for 10 years creates a roughly 18% loss in purchasing power, so how does an investor protect oneself?
The cosmic shift out of bonds has not ended. The jet fuel of potential higher rates will propel those who have not abandoned fixed income to seek investments in other asset classes. Higher yields will accelerate bond sales as fixed income investors will soon have paper losses in their portfolios. Yes, they can still hold their bonds and clip their coupons, but should investors want to sell those assets prior to maturity, they will likely be selling at a loss.
Thus, the premise of my 2020 article has evolved but not changed. Alternative assets to fixed income are the only assets that offer alpha for investors. The bear case for stocks is that higher yields represent a threat to an overvalued market. It is my belief that the argument doesn’t hold water given the limited upside for yields.
That does not mean that markets can’t sell off. They do, in the normal course of valuation. But given the investable landscape, the downside is limited. With all due respect to British investor and mega-bear Jeremy Grantham, equity markets are not going down 45% from current levels.
The role of cryptocurrencies in the new normal
Let’s circle back to cryptocurrencies. They are a risk asset, as defined by their volatility. In the long run (the next three to seven years), I expect them to become uncorrelated to other asset classes but if one looks at a chart of the Nasdaq and a chart of bitcoin over the past two years, they look markedly similar. Bitcoin is 13 years old, still in its infancy, and is currently considered by investors as an allocation to technology. Yet, bitcoin as discussed is, at its essence, digital gold: a store of value for the world.
In this newly inflationary world I believe bitcoin is the ultimate disinflationary asset, and it is the “hardest” money that exists. It is independent of the monetary policies of fiat printing nations. Its value is derived by its fixed, limited supply, and by demand which, with a current estimated user base of 150 million to 200 million people globally, is still tiny and growing in a world of 8 billion.
Ether, another disinflationary crypto asset, can be thought of as digital oil: a blockchain of blockchains whose use case is a building block for the decentralized world to come. Think of Ethereum as Legos, a toy that became a builder’s model. As decentralized finance (DeFi) grows, as the world of non-fungible tokens (NFT) expands and as the metaverse becomes more real, Ethereum will likely be the base layer of that geometric growth.
The bottom line
I do not expect stocks to sell off meaningfully from here and, by implication, I don’t think cryptocurrencies will see an accelerated sell-off from current prices. Part of my confidence is based on the concept that there’s too much money chasing investment returns, and as said, there are a limited number of places to put it.
Gold and commodities should perform well if one expects an inflationary spiral, but my expectations are that those fears are overdone. The balance of my confidence comes from a deep understanding that bitcoin is the ultimate safe harbor in a world of unsustainable debt. We are living in “The Roaring Twenties” and the global powers that be will do everything they can to maintain that perception.
I believe we have another two to five years before the emperor is exposed, although uncertainties such as Russia and Ukraine, China and Taiwan and the South China Sea, North Korea and Iran do keep intruding on our collective peaceful sleep.
Bitcoin, ether and much of the cryptocurrency ecosystem are a long-term buy and hold for my portfolio. DeFi is an exciting and unstoppable force, and in my opinion is Traditional Finance 2.0. This $1.7 trillion asset class (down from $3 trillion two months ago) is here to stay.
Remain open minded and inquisitive, and HODL on.
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