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Arthur Hayes: Even if I'm wrong about the Fed, I still believe cryptocurrencies will rise sharply

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Even if the Fed has to keep raising interest rates, Bitcoin will be able to survive.

Original author: Arthur Hayes

Original translation: GaryMa Wu said blockchain

Note: This article is a translated version of the original text, and some content has been deleted and summarized during the translation process. Due to space limitations or other reasons, some details or information may not be fully translated or deleted. We recommend that readers refer to the original text while reading this article for more comprehensive information.

American market participants are not so patient on the journey to accumulate more wealth. In our never-ending search for the next bull market, we often ask ourselves: "Are we there yet?" And in the cryptocurrency market, we often ask ourselves when the shitcoins we hold in our wallets will be able to approach the highs of November 2021 again.

More savvy traders are looking for leading indicators that may indicate that a bull market is approaching, with the goal of determining when to go all in on the cryptocurrency market. Like a Pavlovian dog, we have been trained by our central bank masters to buy financial assets whenever they cut rates or print a lot of money to expand their balance sheets. We hang all our attention on these scammers’ every word, hoping they will provide free money that drives risk asset returns.

Fed Balance Sheet (white) and Bitcoin (yellow), with an initial index value of 100

During the Fed’s massive money printing spree during the pandemic, Bitcoin has outperformed the Fed’s balance sheet growth by 129%, confirming that our reflexive investment based on the proclamations of the false prophet, Fed Chairman Powell, has been quite profitable.

Since the Fed began raising rates in March 2022, a group of macroeconomic analysts have been trying to guess when the Fed will stop. I present to readers a list of reasons why I believe the Fed’s rate hike cycle will eventually lead to some kind of financial disaster that will require them to cut rates and expand their balance sheet.

On March 10th of this year, Silicon Valley Bank and Signature Bank had serious balance sheet problems under the Fed’s policies. By that Sunday night, it was clear that the banks were hopeless and that unless the Fed and the US Treasury really wanted to practice the values of free market capitalism and let a poorly managed traditional financial company fail, some form of bailout was imminent. As expected, the Fed and the Treasury intervened and provided a bailout in the form of the Bank Term Funding Program (BTFP). The BTFP provided unlimited life to the US banking system, where banks could hand over their junk US Treasury bonds to the Fed and receive new US dollars in return. These US dollars were then provided to depositors, who chose to run away because money market funds (MMFs) were offering interest of more than 5% while bank deposits were paying close to 0%.

This is a critical moment. I, and many others, believed that the Fed had definitely stopped raising rates. The Fed’s real priority was protecting banks and other financial institutions from failure, and the underwater bond rot spreading throughout the financial sector threatened the entire system. It seemed that the Fed’s only option was to cut rates, restore the health of the U.S. banking system, and then watch Bitcoin quickly rise to $70,000.

But that was not the case. Instead, the Fed raised rates three more times between March and today.

When your predictions are consistently wrong, it’s time to revisit what you thought was true and explore some “if I continue to be wrong” scenarios. In this case, that meant starting to think about whether my portfolio could survive if the Fed continued to raise rates.

Last week, I gave a keynote at the Korea Blockchain Week conference, exploring the question of whether Bitcoin could still rise if the Fed and other major central banks continued to raise rates. For those who weren’t there, or who think I was moving too fast on some concepts, here’s a short post exploring that question.

What if?

What if the US doesn't have a recession?

What if inflation doesn't fall?

What if the US financial system doesn't collapse?

If all of this holds true, then we can expect the Fed and other major central banks to raise interest rates further rather than cut them.

Real Rates Past and Present

What is the real rate of return? The real rate of return is a rather fuzzy concept, and the definition varies from person to person. My (slightly simplified) definition is that if I lend money to the government, I should at least get a return that matches the growth rate of nominal gross domestic product (GDP). If I get less than that, the government is profiting at my expense.

Obviously, the government wants to raise money at a rate that is lower than the economic value of its debt. Using financial repression to ensure nominal GDP growth rates above bond yields has been the policy of all the most successful export-oriented Asian economies since the end of World War II. Japan, South Korea, and others have used this strategy since the end of World War II to export their way out of the devastation their countries experienced after the end of World War I. Governments must use their banking systems to implement this type of financial repression. Banks are instructed to offer low interest rates to depositors. Then, the government puts in place restrictions to prevent them from moving money out of the system. Banks are then told to lend at low interest rates to large heavy industrial enterprises that are state-backed or tied to the government.

Deposit Rates < Corporate Loan Rates < Nominal GDP Growth

The result is that these industrial companies that require large capital expenditures get cheap financing to quickly build modern manufacturing bases. The government then uses these manufacturing bases to accumulate sovereign wealth, which is reinvested in US Treasury bonds and other dollar-denominated financial assets. These funds can supposedly be used in times of economic hardship. Ordinary people can get high-paying blue-collar manufacturing jobs that are guaranteed for life. Compared to their previous lives as agricultural peasants, when their living standards were very difficult, now they work for large companies with full benefits and work eight hours a day. This is a major improvement for them.

Real Yield = Government Bond Yield - Nominal GDP Growth

This financial repression strategy only works when funds cannot leave the banking system. This is why countries such as South Korea have closed capital accounts. Or in the case of Japan, it’s virtually impossible for the government to get foreign financial firms to advertise or accept Japanese depositors, and as a result, the average Japanese investor is stuck with working with Japanese banks for negative real returns. However, in the current digital age, this strategy has become much harder to execute, especially given the rise of alternative, decentralized financial systems like Bitcoin. When real returns are negative for a long time, depositors can now leave before the door closes (or at least they think they can).

Let’s look at real returns in the US from the beginning of 2022 until now.

US 2-Year Treasury Yield Minus US Nominal GDP Growth

I use the 2-Year Treasury Yield to represent government bond rates because it is the most popular and liquid tool to track short-term interest rates. As you can see, real rates are indeed negative when the Fed starts raising rates in March 2022. Even though the Fed has been raising rates at an unprecedented pace, real rates are now only slightly positive. If you substitute the 10-year or 30-year yield for the 2-year, real rates are still negative. This is why it is foolish to buy long-term bonds with your own money. Institutions still do it because financial responsibility ceases to exist when you are a fiduciary playing on behalf of others and earning fat management fees for your intelligence and ability.

When I consider the chart above, my next question is, “What kind of real returns can we expect going forward?” The Atlanta Federal Reserve publishes a “GDPNow” forecast, which is an instant estimate of real GDP growth for the current quarter. As of September 8, the Fed predicts that growth in the third quarter will be incredibly large, at 5.7%. To get the nominal growth rate, I add another 3.7%, which I calculated by looking at the average difference between nominal growth and real growth over the past six quarters.

GDP now up 5.7% in real terms + GDP deflator up 3.7% = Nominal GDP up 9.4% in Q3

Forecasted Q3 real yield = 2-year Treasury yield 5% - Nominal GDP up 9.4% in Q3 = -4.4% real yield

What the hell is going on! Conventional economics says that when the Fed raises rates, growth in a very credit-sensitive economy will slow. Common sense would tell us that nominal GDP growth should fall and real interest rates should rise in this situation. But that is not the case.

Let’s see why.

No Money, No Sweetness

Governments make money by collecting taxes and then spend it on various things. If spending is greater than tax revenue, then they will issue debt to finance the deficit.

The main exports of the United States are finance. Therefore, the government earns a lot of capital gains tax revenue from the stock and bond markets.

The 2020-2021 pandemic bull market generated a lot of tax revenue from the rich. However, starting in early 2022, the Federal Reserve began to raise interest rates. Higher interest rates had a rapid impact on the financial asset market. This is the main reason why good guy scammers like Sam Bankman-Fried and crypto entrepreneurs like Su Zhu and Kyle Davies fell.

Below is a chart of the returns of the S&P 500 (yellow), Nasdaq 100 (white), Russell 2000 (green), and Bloomberg U.S. Aggregate Total Return Bond Index (magenta) from the start of 2022 to date, relative to 100.

As you can see, no one has made money since the beginning of 2022. As a result, revenue from capital gains taxes has fallen sharply. The Congressional Budget Office estimates that realized capital gains as a share of GDP were about 9% in 2021. As the Fed moves to combat inflation, these taxes are falling rapidly.

"Processing of data from the Internal Revenue Service (IRS) shows a sharp increase in realized gains in 2021, reaching 8.7% of GDP, the highest level in more than 40 years, according to CBO estimates."

Also, remember that the top priority for any politician is getting re-elected. The older generation of "baby boomers" has been promising relatively free health care, and the general American public likes to consume energy at a level that is far higher per person than the rest of the world. Given these two facts, it is safe to assume that politicians who campaign on cutting health care spending and/or the defense budget will not be re-elected. On the contrary, as populations age and the world becomes more multipolar, governments will continue to increase spending in both areas. If spending is rising and revenues are falling, the deficit must rise. Since GDP is just a snapshot of economic activity, when the government spends money, it by definition increases GDP - regardless of whether the spending is truly productive or not.

U.S. Government Deficit as Percent of Nominal GDP

The rising deficit must be financed by selling more bonds. By the end of the year, the U.S. Treasury must sell an additional $1.85 trillion in bonds to pay down old debts and cover the budget deficit. Furthermore, on top of having to issue these bonds, the Fed is also raising interest rates, which further increases the amount of interest the U.S. Treasury must pay.

As of the end of the second quarter, the U.S. Treasury was spending $1 trillion per year on interest payments to debt holders. Given that most wealth is concentrated in the top 10% of households (which means that these households hold most of the government debt), the U.S. Treasury is actually handing out benefits to the rich in the form of interest payments.

When the aristocrats have accumulated enough money to pay for the most important parts of life (housing and food), what do they buy? They spend it on services. About 77% of the U.S. economy is service-related. To summarize: when interest rates rise, the government pays more interest to the rich, the rich consume more services through the interest income, and GDP grows further.

Circles of mutual adulation

Let's put it all together and walk through how Fed rate hikes increase nominal GDP, which produces more Fed monetary tightening.

The Fed has to raise rates to fight inflation.

I will never get tired of this photo. Powell looks like a fool while Biden points a pen at him and instructs the Fed to fight inflation.

Financial asset prices fall, then tax revenues fall too.

With the exception of a few standout tech stocks like Nvidia, most companies that make physical products are suffering from rising credit costs and falling credit availability, which in turn drives their stock prices down. In terms of the world’s largest asset market, bonds are on track for a second straight year of losses on a total return basis. With broader stock and bond markets still below their 2021 highs, the government’s capital gains tax revenues have fallen sharply.

At the same time that tax revenues are falling, the government is spending more, and so are the deficits, leading to higher deficits. The more the government spends, the bigger the deficit. If more spending = higher deficits, and more spending also = higher nominal GDP growth, then logically higher deficits = higher nominal GDP growth.

Because of high interest rates, the U.S. Treasury must issue more bonds at higher interest rates.

Wealthy savers have not had as much interest income for more than two decades.

The wealthy will use their interest income to consume more services, which further drives nominal GDP growth.

Roughly 77% of U.S. GDP is made up of the service sector.

Inflation becomes stubborn because nominal GDP growth > government bond yields.

Higher bond yields do not curb U.S. government spending because the U.S. government is a net winner from this situation. When the government finances itself at a rate lower than the growth generated by the debt growth, the debt-to-GDP ratio actually falls. This is exactly the same policy the U.S. government adopted after World War II to pay off the country's huge war debt.

The Fed must raise interest rates to fight inflation.

As GDP growth continues to outpace bond yields, inflation will rise from its current "sluggish" level and remain high. As long as inflation is well above the Fed’s 2% target, they have to keep raising rates.

The Achilles’ Heel

Mr. Powell can keep raising rates as long as the market is willing to accept rates below nominal GDP growth. But Mr. Nakamoto gave the world an alternative financial system that includes a fixed-supply currency and a decentralized, nearly instant payments network called Bitcoin. Banks have unprecedented competition. (Sure, you could take money out of a bank and buy gold before, but using heavy gold in everyday life is impractical.)

If the market demands US Treasuries that yield at least 9.4% (equal to the forecasted nominal GDP growth), the tables will turn. Then the Fed must either prohibit banks from allowing funds to move to digital fintech companies that offer physical cryptocurrencies, or it must restart quantitative easing (aka money printing) and buy bonds to ensure that their yields are less than nominal GDP growth. I will continue to remind you that buying ETFs does not take your money out of the traditional financial system. The only escape route is to buy Bitcoin and withdraw it to your own wallet, for which you will hold the private keys.

It is reasonable to assume that the market will get tired of handing over profits to the government when there is a financial escape route like Bitcoin. But for the rest of this analysis, I will assume that the Fed will be able to continue on its path of raising interest rates without too much money fleeing the US banking system.

Changes in the Financial Climate

We are taught to believe that when interest rates rise, the prices of risky financial assets such as Bitcoin, stocks, gold, etc. should fall. But, as the government has continued its spending spree and pushed up GDP, the real yield one might seem to be earning on a seemingly valuable ~5% government bond might actually be closer to -4% – meaning risk assets remain a very attractive option for investors.

Investors’ search for a positive return on real yields has given rise to the Bitcoin bull run, which officially began on the fateful weekend of March 10, 2022. Since then, the Bitcoin price has risen by nearly 29%. Despite the fact that the price has tested $30,000 several times and failed to break out, Bitcoin still trades at its pre-bank subsidy level of $20,000.

The market is quietly telling us that if the Fed continues to raise rates, real rates will become even more negative and will remain that way for the foreseeable future. If this were not the case, shouldn’t Bitcoin be hovering around $16,000? The reason we haven’t reached $70,000 is because everyone is focused on the nominal federal benchmark rate, rather than the real rate compared to the US’s staggeringly high nominal GDP growth. But the message is slowly trickling out through various mainstream media government propaganda mouthpieces like the Washington Post:

"It's really shocking to see this in an economy with low unemployment. Nothing like this has ever happened. A good, strong economy with no new emergency spending - but the deficit is so big. It's so big in one year that you think there must be some weird weirdness going on."

As it becomes clear that holding bonds is a fool's game even with short-term nominal interest rates at 5.5%, fringe capital will start to seek hard-core financial assets. Certain assets like Bitcoin, big tech/AI stocks, productive farmland, etc. will continue to rise and baffle most financial analysis experts (who are really just ordinary fiduciaries of mediocre intelligence and ability who get fat management fees for using other people's money). They don't understand why Bitcoin can hold up because they see manipulated markets controlled by the Fed buying assets like Treasury Inflation Protected Securities (TIPS) yields - which (seemingly) are positive and rising.

Leaving aside the faulty analysis we are sure to read in the mainstream financial news, I believe I have demonstrated that Bitcoin can survive even if the Fed has to keep raising rates. This gives me peace of mind because while I still think the base case is that the Fed is forced to cut rates to near zero and restart the QE money printing press, I still believe the cryptocurrency can rise significantly even if I am wrong.

The reason Bitcoin has such a positive convex relationship with Fed policy is that the debt-to-GDP ratio is so high that traditional economic relationships have broken down. This is similar to how if you raise the temperature of water to 100 degrees Celsius, it will remain a liquid until it suddenly boils and turns into a gas. In extreme cases, things become nonlinear — and sometimes binary.

The U.S. and global economies are in such an extreme state. Central banks and governments are trying to use the economic theories of yesteryear to deal with the new conditions of today; at the same time, a global debt-to-GDP ratio of 360% is creating a perverse situation that requires a rethinking of correlations between assets.

It is indeed possible to teach an old dog new tricks, but only if the dog has the will to learn. The scoundrels we tolerate who rule in our name have no such desire to learn. Therefore, Master Satoshi will punish them with the mighty power of Bitcoin.