Navigating the Storm Ahead
All Eyes On Macro
Political Pressures Weigh On The Fed
With the Fed signaling to begin monetary tightening, financial markets have been particularly volatile to start 2022. The Fed is indeed serious about attempting to raise interest rates and reduce their balance sheet, however, given the U.S. fiscal position, we believe that attempt will be short-lived. Any sign of crisis would have the Fed backpedal and loosen monetary policy again. Our view is that the U.S. Dollar hegemony is at risk of losing its currency reserve status. Eventually, we expect the world will adopt Bitcoin as a neutral reserve asset. However, sequencing is important here. Investors must contend with two realities:
the cyclicality of growth and inflation after a historically strong 2021, and
the secular inflationary consequences of Monetary Policy 3 (coordinated monetary and fiscal stimulus).
Of course, the COVID-19 policy response in 2020 – 2021 was necessary to protect global economies from collapse, however that adrenaline shot of money and credit is now producing a self-reinforcing cycle of spending and income growth (outpacing supply), which is creating persistent inflation.
Let’s recall the Federal Reserve has two specific public mandates:
Promote maximum (inclusive) employment – which has been achieved, even across major demographics, age cohorts, and education levels
Maintain price stability (ie/ keep inflation near 2%) – which after 7% inflation in December, is quickly becoming a political issue for the Biden Administration
However, there is a third unspoken mandate:
Maintain properly functioning financial markets – when push comes to shove (think 2008 Global Financial Crisis, 4Q18 Repo Market crisis, and 2020 COVID-19 crisis), the Fed will intervene to assist financial market volatility by easing monetary policy and printing money
With the Fed’s first mandate currently satisfied, political pressures from the Biden Administration are now building to “fight inflation” ahead of the November midterm elections (at a time where Biden’s approval ratings continue to drop).
As a result, the Fed has signaled they will tighten monetary policy (raise interest rates and reduce the Fed balance sheet) to fight consumer price inflation under the guise of a strong labor market and economy. However, during Fed Chairman Powell’s remarks two weeks ago, he noted that there is risk inflation may remain more persistent than previously anticipated. Recall, this is this the same Fed who said inflation would be “transitory” last year.
We believe the Federal Reserve is walking into an obvious policy mistake by beginning to tighten monetary conditions ahead of an economic slowdown, especially given the geopolitical, domestic, and macroeconomic risks. Specifically, our take is that the Federal Reserve is being co-opted by political pressures, despite being held up as an independent institution. Former Fed Trader Joseph Wang put this aptly:
“The Fed is government. It’s much more post-office than bank. You can think of it as a business that can’t fail run by people who can’t be fired.”
The Cyclicality of Growth & Inflation
Getting the big picture right is the most important thing in investing. As the great Ray Dalio said:
“I knew which shifts in the environment caused asset classes to move around, and I knew that those relationships had remained essentially the same for hundreds of years. There were only two big forces to worry about: growth and inflation.”
So, when it comes to predicting how financial markets will move, we need to pay close attention to the cyclical dynamics of growth and inflation. While the labor market has markedly improved since the depths of the COVID-19 pandemic, 2022 is lapping very strong YoY growth and inflation from 2021. As a result, we expect the majority of 2022 to be in the DEFLATION macro regime, as YoY GDP growth and inflation probabilistically decelerate. Equities, commodities, and crypto have historically underperformed in this environment.
We also believe there is a material downside to real GDP growth expectations following 5.7% growth in 2021 (fueled by historic levels of MP3). For some context, the 5-years preceding 2019 averaged 2.2% real GDP growth. Looking forward, The Fed (and Wall St. consensus) expects U.S. real GDP to aggressively grow 4% in 2022.
We would argue 2021’s economic growth was an anomaly, especially given the easy YoY compare from 2020 wherein most of the country was shut down. 2021 growth benefited from record levels of fiscal stimulus – which seems unlikely in 2022 now that Biden’s Build Back Better Plan is dead. Estimates show the lack of fiscal stimulus will be a 3% headwind on real GDP growth in 2022. As well, there is a material risk mid-single-digit inflation can persist (vs. the Fed’s estimate of 2.7% inflation in 2022), which will continue to raise the cost of living, and weigh on consumer balance sheets.
In the context of these past two years, it’s mathematically unlikely that real GDP will grow 4% and that inflation will normalize to 2.7% in 2022. That said, we believe the market has not yet priced in this information, and the more recent volatility has been due to questions around tightening monetary policy. Putting this all together, we would argue there is material downside risk in financial markets due to a growth scare in the next 1-2 quarters.
The Secular Inflationary Consequences
As discussed in our last letter, monetary tightening weighs heavily on financial market performance. However, it appears in the coming months, the Fed is willing to take that risk and tighten, or else it (and the Democratic party by extension) risks losing credibility. But as they say on Twitter, “you can’t taper a Ponzi.”
It’s true – the post-1971 Petrodollar system is a Ponzi scheme the U.S. government and Fed are trying to keep going by continuing to issue more debt. However, the only tangible way to normalize the economy at this point is to let inflation continue to devalue the USD and de-lever U.S. debt/GDP of 122%. This of course is because devaluation and death are the only two endgames for any fiat currency, as described by Ray Dalio in The Changing World Order.
The U.S. has an acute fiscal problem that will likely end in an inflationary deleveraging and the loss of currency reserve status. We have too much debt on the Fed balance sheet, too large trade deficits, insufficient foreign UST buying, and have created an economy where U.S. tax receipts don’t cover our government’s most important programs (social security, health, Medicare, net interest, veteran’s benefits, etc.). Assuming the U.S. will never default on social entitlements or USTs, the Fed will always step in to print the difference if expenses cannot be covered.
We believe financial assets that have historically benefited from QE (Bitcoin, crypto, gold, real estate, equities, etc.) will continue to bubble with greater volatility as the dollar system unravels. Interestingly, this is the same dynamic we saw in the price of gold in Weimar marks as the Reichsbank (the German Central Bank until 1945) throttled between fiscal austerity and monetary debasement, ie/ tighter and looser monetary policy. To be clear, we are not suggesting the USD ends in hyperinflation, we are simply using Germany as a useful analog to think about the unwinding fiat system.
The key here is that if you own hard assets (Bitcoin, real estate, gold, businesses, etc.) during a monetary debasement, the value of your investments will increase over time if you just hold and never sell. For those not actively managing risk, holding hard assets during this Fourth Turning is the best and stress-free way to become wealthy over time.
As such, any material weakness in financial markets due to monetary tightening or slowing economic conditions would signal a good buying opportunity, as the Fed will undoubtedly backpedal from tightening into easing to satisfy their third unspoken mandate – maintain properly functioning financial markets.
The Great Power Competition (West vs. East)
Furthermore, we believe the Fed is severely underestimating the potential for persistent inflation via supply chain disruptions as a matter of geopolitical competition. A recent Chinese whitepaper on export controls released in late December said the following:
“The world is undergoing profound changes of a scale unseen in a century, with an increase in destabilizing factors and uncertainties, disruption to international security and order, and challenges and threats to world peace. The status and role of fair, reasonable, and non-discriminatory export control measures are growing in importance as an effective means to address international and regional security risks and challenges and safeguard world peace and development.”
Though the above statement is powerful on its own, two weeks later Chinese President Xi Jinping spoke at the World Economic Forum, warning the U.S. and Europe against a rapid rise in interest rates, suggesting it would “slam the breaks” on the global recovery from the pandemic. When we take these two statements together in the context of China’s Zero COVID policy, it sounds like a veiled threat to the Fed and ECB. Reading between the lines, we believe President Xi Jinping meant “don’t raise interest rates or else we will continue to wreak havoc on your supply chains well into 2022 and beyond.” By choosing to raise interest rates, the Fed and ECB are prioritizing their domestic problems (fighting inflation) at the expense of China’s demand for global economic recovery.
We also continue to worry about a looming global energy shortage that could trigger an inflationary recession. The Bank of England now expects to see inflation above 7% in the coming months due to surging energy prices and similar to the U.S. is raising interest rates to combat higher prices. And while Chancellor of the Exchequer Rishi Sunak signed an aid package to help households, the assistance will be exhausted in April, at which point Brittons should expect to see household energy costs increase by almost $950!
Meanwhile, Russia recently agreed to a 30-year contract to supply natural gas to China in a new pipeline to be priced in Euros, not USDs. Given the building tensions over Ukraine, the U.S. is increasingly entering a position where it has deteriorating relationships with both Russia and China. And in fact, both countries have a vested interest in seeing the end of the USD hegemony.
Russia, as the largest energy exporter, has created an economic symbiosis with China, the world’s largest goods exporter, all while de-dollarizing trade between the two nations. Not only is Vladimir Putin one of the world's strongest geopolitical strategists, but he has also recently begun to take it a step further by publicly announcing Russia boasts “competitive advantages” in Bitcoin mining.
Alternatively in the U.S., the Biden Administration recently called for the regulation of digital assets such as Bitcoin, Ethereum, and NFTs as a “matter of national security,” in sharp contrast to Arizona proposing legislation to make Bitcoin legal tender. Thankfully there is a growing cohort of pro-Bitcoin politicians who believe Bitcoin could help the U.S. economy from our fiscal time bomb. Therefore, we would say that it is a matter of U.S. national security that we adopt Bitcoin to remain #1 in the global world order.
Bitcoin Is Still A Risk-On Asset…For Now
Recently Bitcoin and crypto markets have traded similarly to high beta equities (ie/ a more volatile Nasdaq 100). According to the International Monetary Fund, “there’s a growing interconnectedness between virtual assets and financial markets.” This of course makes sense given Bitcoin is an emerging macroeconomic asset. However, between 2017 – 2019, Bitcoin’s correlation to the S&P 500 was just 0.01, but after the COVID-19 pandemic began, that correlation jumped to 0.36.
As Bitcoin continues to become institutionalized, we believe macroeconomic forces will influence Bitcoin’s price more than the on-chain data, especially during periods of high volatility. This is because institutions treat Bitcoin as a risk-on asset, similar to equities. That said, diamond-hand Bitcoiners (like myself) philosophically believe Bitcoin is the safest risk-off asset, given its non-state attributes and scarcity.
However, the reality is that diamond-hand Bitcoiners are still the minority in the market (albeit a growing group). We currently have no data to suggest that Bitcoin will decouple from equity market performance in 2022. And while there is a very loud cohort of Bitcoin maximalists on Twitter screaming for Bitcoin’s decoupling moment, in the meantime, we need to manage risk appropriately.
If equities sell-off meaningfully in 2022 due to monetary tightening and a growth scare, we would expect digital assets (including Bitcoin) to sell off as well. Remember – liquidity dries up at the edges of the risk spectrum, and Bitcoin and crypto are very much at the end of the curve.
Is Bitcoin a no-brainer buy at $40,000? Absolutely. But I could also say the same about Bitcoin at $10,000, $30,000, or even $100,000. If you’re purchasing Bitcoin with a 5+ year time horizon, theoretically every price is a good price. And that may be a perfectly fine way to manage your net worth, however as an active risk manager, I need to set aside my biases and manage our portfolio using #math, not narratives.
Bear Market Rally or Bull Market Back On?
To put in perspective how far we’ve come in such a short period – almost 90 days ago Bitcoin was trading at $68,441. Bitcoin made a low of $32,950 in late January but has since recovered quickly above $43,000. The key question investors are trying to answer is if Bitcoin’s recent strength is:
the decoupling thesis is playing out, or
a bear market rally that should be sold and/or shorted.
Based on the macroeconomic headwinds facing global economies in the coming quarters, we would argue this move up is most likely a bear market rally, and less likely to be the beginnings of a decoupling. That said, there is some evidence to suggest demand for Bitcoin continues to build and some encouraging on-chain data. We would remind you that there was also encouraging on-chain data earlier in January as well, which did not equate to higher price action. So it’s important to keep in mind that macro forces have recently superseded on-chain data.
Net Unrealized Profit/Loss (NUPL) gives us a way to measure overall market profitability as a percentage of the total market cap. With Bitcoin trading above $43,000, NUPL is currently at 0.45, meaning 45% of the Bitcoin market cap is in an unrealized profit – putting us in the optimism/anxiety range (depending on if you’re bullish or bearish).
For perspective, Bitcoin bottomed at $29,700 (NUPL 0.35) during the May 2021 selloff due to China banning Bitcoin mining (during the REFLATION macro regime, when accelerating YoY growth and inflation was a tailwind). The only way NUPL could be less than 0 is if Bitcoin trades below the average price of all Bitcoins held (realized price), or $24,000. While Bitcoin has broken below its realized price before (during the capitulations of early 2015 and March 2020), we view this scenario as very unlikely.
The recent rise in NUPL may give some investors optimism, however, we remain skeptical that Bitcoin is fully recovering and going to retest all-time highs from here. We believe at current levels, Bitcoin's medium-term (1-2 quarters) risk skews to the downside, though we may see short-term (1-3 weeks) strength as momentum builds and incremental macroeconomic data starts showing the post-Omicron bounce.
To recap, the realized price is the on-chain cost basis for all Bitcoin holders in aggregate. Therefore, we could make an argument that $24,000 is the floor price of Bitcoin. Decomposing that – short-term holder realized price measures the average price of all Bitcoins that have been held for less than 155 days. The current STH realized price is around $47,000 (near Bitcoin’s annual open), which can act as a ceiling during a bear market, or act as resistance during a bull market.
STH realized price has been decreasing recently, suggesting coins previously bought at higher prices by short-term holders are being sold at a loss. For us to get constructive on Bitcoin’s decoupling thesis, we would want to see Bitcoin reclaim and hold above the STH realized price.
Finally, after a 5-month downtrend of whales (any entity that owns more than 1,000 Bitcoin) in the market, we’re starting to see a slight reversal. Typically it’s the institutions who buy the dips and sell into strength as retail FOMOs into Bitcoin when the price rises. While the number of non-zero Bitcoin addresses continues to increase no matter the price action, seeing an increasing number of whales suggests institutions are continuing to purchase Bitcoin, a bullish demand-side datapoint.
We remain confident that purchasing Bitcoin at $40,000 on a long enough time horizon will be one of the best decisions of your life. That said, from a risk management perspective, we believe it’s likely we will get another opportunity to purchase Bitcoin (and other crypto assets) at better prices in the coming quarters if the Fed tightens into a growth scare. However, the average investor would benefit immensely from simply dollar-cost averaging.
Rule #1 – There’s Bitcoin, and Then Everything Else
I want to reiterate our simplistic but essential framework to think about the web3/digital assets/crypto space. There’s Bitcoin, and then everything else.
While Bitcoin will eventually decouple from risk markets, it’s unlikely the rest of the crypto market has that ability. Bitcoin is a monetary asset, designed to serve as a medium of exchange and store of value, which some people view as a safe-haven asset during volatile times.
Meanwhile, Layer-1 blockchains and decentralized applications are networks that sustain economic activity, and the reality is that users are less likely to engage in DeFi and NFTs during a recession. Bitcoin is truly a monopoly in its own right and needs to be viewed as such.
With that in mind, we’ve begun using fractally modeled, stochastic volatility-adjusted price ranges to determine good entry and exit points for our positions. Based on recent models, Bitcoin is currently trading at the 68th percentile of its short-term (20-day) fractal range and the 73rd percentile of its long-term (90-day) fractal range.
Following the strong price action over the weekend, Bitcoin’s mathematical trend and momentum flipped positive. We would note, however, that on 12/24/21 we also saw Bitcoin’s momentum improve from negative to neutral, but that improvement was short-lived as momentum turned negative again only 4 days later. At times, the trend and momentum signals can give head fakes, so we would be cautious and not read too much into it just yet, given the headwinds we have been describing.
For more info on how fractal models and stochastic volatility works, I would suggest reading:
The Misbehavior of Markets: A Fractal View of Financial Turbulence by Benoit Mandelbrot
Fractal Market Analysis by Edgar E. Peters
We believe Bitcoin has a unique value proposition as a non-state, scarce reserve asset during a sovereign debt crisis, ie/ the downfall of fiat money – a privilege that the broader crypto market does not have. Over time we expect Bitcoin to be treated as a safe haven asset but expect the rest of crypto to be treated as a speculative, publicly-traded venture market for the foreseeable future.
As we saw over the past 2 years, however, certain sectors of the web3 universe have at times gone through bullish and bearish phases independent of Bitcoin’s price action. That said, recently Bitcoin, crypto, and equity markets have been highly correlative. Adding onto that, we’re starting to several assets change their momentum and trend into either neutral or positive, led by Bitcoin’s strength.
Now, we’re not saying this change in momentum/trend is a signal to start piling into these assets given the medium-term headwinds, but it has piqued our interest. The change in signals is more likely reflective of how volatile these markets currently are. We view Bitcoin specifically as the freest financial market, and as such, information gets priced quickly into markets. We still think it’s too early to flip aggressively bullish here given the macro backdrop, however, we are paying close attention.
Before we wrap up, I want to highlight news items across different Layer-1 blockchains that came up during the most recent market selloff. Market volatility (either in a positive or negative direction) is a formidable stress test for smart contract ecosystems, and January 2022 was no different. Some Layer-1 protocols held up (in terms of usability), while others stumbled. Below are notable callouts to have on your radar:
Cardano (ADA) – A few weeks ago we saw the launch of Cardano’s highly anticipated first Automated Market Maker (AMM) Decentralized Exchange (DEX), SundaeSwap, which due to network congestion limited the ability for users to process swaps – not a great start for a project that has continuously overpromised and underdelivered
Harmony (ONE) – Earlier in January the Harmony blockchain experienced network outages for 19 hours due to an overwhelming amount of spam traffic. You can read more about the post-mortem here. For a network that is supposed to facilitate the transfer and storage of substantial amounts of capital, events like this are not encouraging and can dampen trust in a protocol over time
Solana (SOL) – Solana again experienced degraded network performance due to the market crash which caused more than two-thirds of transactions to fail on Solend, leading to the auto-liquidation of decentralized loans on the network. While the Solana team has promised to reimburse users for lost funds, it begs to question how a $30+ billion network can still have so many issues
Binance Chain (BSC) – Crypto’s most centralized Layer-1 blockchain Binance Smart Chain saw one of its lending protocols, Quibit Finance fall victim to an $80 million exploit a few weeks ago. This incident just goes to show how challenging security is for multi-chain protocols, even if the Layer-1 is centralized itself
Wormhole (SOL-ETH) – The biggest news last week in crypto was the $326 million hack on Wormhole, where Solana’s bridge was manipulated into minting wrapped-Ethereum. While we believe bridges are necessary for creating a multi-chain world, we believe the path will be long and dangerous
We’re dealing with a very volatile market driven by many forces:
a weaker consumer balance sheet as inflation persists and growth begins to decelerate,
ongoing energy shortages globally,
the U.S. Fed tightening monetary policy in response to political pressures,
an ongoing great power competition vs. China and Russia,
the U.S fiscal bubble that will likely end in an inflationary deleveraging,
a building appetite for Bitcoin from institutions,
and Layer-1 blockchains that continue to experience network outages and security exploits despite continuous venture investment and brain-drain from web2/Wall St.
After three months in a persistent downtrend, Bitcoin (and the broader crypto market) has caught a bid with the market finally trading above $40,000. However, with the aforementioned macro and market headwinds, the key question investors must ask is:
Is this a bear market rally that should be sold and/or shorted, or
has the crypto bull market begun again? (ie/ is Bitcoin’s bottom in)
The reality is no one knows. Based on our models and research, we believe it’s mathematically likely we will begin to see a growth scare in the economy within the next 1-2 quarters as the Fed tightens monetary policy in the middle of the DEFLATION macro regime. Based on our back-testing, Bitcoin and crypto have historically materially underperformed during this regime.
That said, we have a secular bias towards Bitcoin and crypto. Netizen Capital’s thesis is predicated upon Bitcoin replacing the USD hegemony as a global neutral reserve asset and Layer-1 smart contract platforms forming the foundation for our future decentralized financial system.
As such, we continue to hold a small core long position of our favorite ideas, though have enough cash on hand to begin hedging/shorting if our quantitative signals suggest we do so. Given our medium-term macro-outlook, we are more likely to sit on our hands right now rather than be aggressive buyers, despite the recent momentum we’ve seen. We believe there will be an opportunity to buy our favorite assets at more reasonable prices later this year.
Stay safe out there.