Arthur Hayes’ latest blog post The Federal Reserve’s downfall is imminent, and Bitcoin will become the hero.
Arthur Hayes predicts the Federal Reserve's downfall and Bitcoin's rise.
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Nowadays, everyone managing funds is conducting in-depth research on how the Federal Reserve’s response to inflation in the early 1980s compares to the current situation. Powell believes he is the Paul Volcker of this moment (Paul Volcker, who is considered the Fed Chairman who ended inflation in the 1970s), so we can expect him to try the same approach (bold rate hikes) to get rid of inflation in the United States. Since the end of 2021 when the Fed first revealed that it would begin tightening monetary policy through rate hikes and balance sheet reduction, he has said so in almost every interview.
The problem is that the economic and monetary conditions in the United States today are very different from those in 1980. The methods that worked in the past under ideal conditions will not succeed in today’s difficult and competitive era.
Through this article, I want to show readers the reasons why the Federal Reserve is destined to fail, and the more they try to use Volcker economics to correct the “course,” the more they will push the United States in the opposite direction of their expected goals. The Fed hopes to reduce domestic inflation in the United States, but the more they raise interest rates and reduce the balance sheet, the more incentives they provide to wealthy asset holders. The U.S. federal government will demand a change in strategy from the Fed, and I will quote a paper written by Dr. Charles Calomis, an economics professor at Columbia University, published by the St. Louis Federal Reserve Bank. The Federal Reserve System is quietly telling the market that it has made mistakes and outlining a path to redemption. As we know, the path to redemption always requires more financial repression and money printing. Good news for Bitcoin!
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Controlling the Quantity or Price of Currency?
The Federal Reserve currently wants to control both the quantity and price of currency but has difficulty grasping the order.
The Federal Reserve controls the quantity of currency by changing the size of its balance sheet. The Fed buys and sells U.S. Treasury bonds (UST) and U.S. mortgage-backed securities (MBS), which affects the rise and fall of its balance sheet. When the balance sheet expands, it is called quantitative easing (QE); when it contracts, it is called quantitative tightening (QT). The trading desk of the Federal Reserve Bank of New York manages these open market operations. With the Fed holding and trading trillions of dollars’ worth of U.S. Treasury bonds and MBS, I believe the U.S. fixed income market is no longer free because there is an entity that can print money at will, unilaterally change banking and financial rules, always trading in the market, and fixing interest rates in politically convenient positions. Unless you want to suffer, do not confront the Fed.
When Volcker became chairman of the Federal Reserve, he proposed what was then considered a crazy policy: targeting the quantity and allowing the price of money (Federal Funds Rate “FFR” or short-term interest rate) to fluctuate with market desires. Volcker didn’t care if short-term interest rates skyrocketed, as long as money/credit was withdrawn from the financial system. It is important to understand this; in the 1980s, the Federal Reserve could raise or lower its policy rates, but it did not attempt to force the market to trade at that level. From the perspective of the Federal Reserve, the only thing that changed was the size of its balance sheet.
Recently, the Federal Reserve has sought to ensure that short-term market rates match its policy rate. The Federal Reserve achieves this goal by setting rates between its reverse repurchase agreements (RRP) and interest on reserve balances (IORB), thus keeping its policy rate within bounds.
Approved participants, such as banks and money market funds (MMFs), are allowed to deposit dollars with the Federal Reserve on an overnight basis and earn the reverse repurchase (RRP) rate set by the Federal Reserve. This means that retail and institutional depositors will not earn yields on dollar-denominated bonds lower than this rate. Why take on more credit risk and earn less interest than depositing with the Federal Reserve at a risk-free basis?
In order to keep a certain amount of bank reserves deposited with the Federal Reserve, the Federal Reserve bribes banks by paying interest on these balances. The interest on reserve balances (IORB) rate is another limiting factor that prevents banks from lending to individuals, companies, or the U.S. government at rates lower than what they can obtain risk-free from the Federal Reserve.
There is also an argument that the Federal Reserve must pay interest to RRP and IORB depositors in order to reduce the flow of money. In total, nearly $5 trillion is held in these facilities; imagine what levels of inflation would be if these funds were actually used to create loans in the real economy. The Federal Reserve, through its quantitative easing (QE) program after the 2008 financial crisis, created so much money that it pays billions of dollars in interest each month to isolate these funds and prevent them from flooding the monetary system. Whatever the reasons, in order to “save” the fiat banking system from destruction time and time again, they have created a terrible situation for themselves.
Currently, the Federal Reserve sets short-term interest rates and manages the size of its balance sheet. Powell has disagreed with his idol Volcker in a very important aspect. In order to effectively manipulate short-term interest rates, the Federal Reserve must print money and deliver it to depositors of RRP and IORB. However, the problem with doing so is that if the Federal Reserve believes it must simultaneously raise rates and reduce the size of its balance sheet in order to curb inflation, it is like cutting off one’s nose to spite one’s face.
First, let’s take a look at the banking system in isolation to understand why the current policies of the Federal Reserve are counterproductive. When the Fed engages in quantitative easing (QE), it purchases bonds from banks and credits reserves to their deposit accounts at the Fed (i.e., increasing IORB). Conversely, when it engages in quantitative tightening (QT), the opposite occurs. If the Fed only engages in QT, then IORB will steadily decline. This means that banks must reduce lending to the real economy and demand higher rates to obtain any loans or securities investments, as they hold billions of dollars in high-yielding bonds purchased from the Fed. This is one side of the equation.
On the other hand, banks still hold around $3.2 trillion in IORB that they don’t need, and these funds are deposited with the Fed, earning interest. Every time the Fed raises rates, it hands billions of dollars each month to the same banks.
The Fed continuously adds (QE) and subtracts (QT) reserves from banks as it attempts to control the quantity and price of money. Later, I will mathematically demonstrate how futile this is, but I want to provide some background before presenting some tables.
Quantitative tightening (QT) does not directly affect ordinary individuals and corporate depositors; however, the Fed also influences these groups by distributing billions of dollars each month to reverse repurchase agreement (RRP) counterparties. The reason the Fed distributes cash to these individuals is because they want to control the price of money. This also directly offsets the contractionary effect of QT, as the Fed distributes free funds to wealthy rentiers (individuals, corporations, and banks). If you have a large sum of cash and want to engage in zero financial analysis with zero risk, you can deposit it with the Fed and earn nearly a 6% yield. Every time the Fed raises rates, I cheer because I know I will receive more free funds in my money market fund account.
To summarize the contradictions of the Fed, here are some convenient tables.
From these two tables, you would conclude that the Fed is still tightening, as a total of $57.47 billion in liquidity is being drained per month. However, I omitted an important source of free funds release: interest payments on U.S. Treasuries. In the next section, I will explain how the actions of the Fed impact the U.S. government’s ability to raise funds by selling bonds. When this factor is taken into consideration, Mr. Powell’s efforts appear even more unrealistic.
The era of simple interest rate hikes to solve inflation is over
One historical backdrop to Paul Volcker ending inflation in the 1970s is that in 1980, U.S. debt as a percentage of GDP was 30%, compared to 118% today. Such a large debt has a significant impact on the effectiveness of interest rate hikes, as the U.S. Treasury needs to issue more new bonds to pay off old ones, provide funds for interest payments on current debt, and finance government expenditures, ultimately resulting in the Treasury having to pay enormous interest.
CPI Index: Services Account for a Large Proportion
Why is the US economy growing rapidly while regional banks are struggling? Various indicators show that small businesses, which are driving the US economy, are facing difficulties. This is because the rich are spending lavishly in the service sector.
According to normal logic, when people receive subsidies, they would purchase daily necessities guided by the government’s thinking, thus driving commodity inflation. However, the rich already possess all these things. When you give money to the rich, they will spend more on services and buy more financial assets.
Services account for a large portion in the Consumer Price Index (CPI) basket. The Federal Reserve has proposed a “super core” inflation index, which basically refers to services.
Powell and his team are focused on significantly reducing this inflation index. However, if every time they take measures (raising interest rates), it actually makes the biggest service consumers richer, how can this inflation decrease?
Differentiation of Asset Returns
Before I continue to look into the future, let’s take a look at recent developments.
We need to know that even though the Federal Reserve is injecting liquidity into the market, it does not mean that all assets will rise.
Using March 8, 2023, as a benchmark (the day Silvergate Bank filed for bankruptcy), I observed the performance of the US Regional Bank Index (white), Russell 2000 Index (green), Nasdaq 100 Index (yellow), and Bitcoin (magenta).
Except for the too-big-to-fail banks, regional banks performed poorly, falling by 24%.
Regional banks themselves are in jeopardy, so the companies that employ people and drive the US economy rely on regional banks for credit. However, with their balance sheets so damaged, these banks cannot provide credit. Therefore, these companies will continue to be unable to expand and in many cases go bankrupt. This is what the Russell 2000 Index tells us, which is mainly composed of smaller companies. In the past quarters, this index has hardly risen.
Tech giants are not heavily dependent on banks, and the recent AI frenzy has also benefited them. If the US banking system is unhealthy, tech companies don’t care either. People with idle capital are willing to chase after tech stocks time and time again. This is why the Nasdaq 100 Index has risen by 24% since the banking crisis.
One of Bitcoin’s value propositions is that it is an antidote to a broken, corrupt, and parasitic fiat banking system. Therefore, as the banking system collapses, Bitcoin’s value proposition becomes even stronger. As a result, as the denominator of fiat currency increases, Bitcoin’s value in fiat currency will also increase. That’s why Bitcoin has risen by 18% since March.
Caught in a Dilemma
Inflation is always a top concern for any population. If people can work hard and buy more with less money, they actually don’t care about the personal traits of those in power. However, when the prices of gasoline or beef skyrocket, politicians who must run for re-election will be caught in a dilemma. Good politicians know that if there is inflation, they must control it.
The Federal Reserve will continue this absurd strategy of trying to control the quantity and price of money because politics demands it. Powell cannot stop until politicians signal him to solve everything. As the 2024 US election approaches, the Federal Reserve is more paralyzed than ever before. Powell does not want to change the Fed’s policy between now and November next year because he is afraid of being accused of supporting a certain political party.
But the math doesn’t add up. There must be a change. Just look at the chart below – depositors continue to withdraw funds from banks with low deposit rates and deposit them into MMFs, essentially depositing funds into the Fed. If this continues, small banks in the US will continue to go bankrupt one after another, which will be a direct impact of the Fed’s policy.
In addition, due to declining tax revenues and soaring fiscal deficits, the US Treasury is increasing the amount of bonds issued. With the rise in currency prices (provided by the Fed) and the increase in debt issuance, interest expenses will become larger and larger. There must be a way to solve this problem…
The best thing about those in power now is that, although they may be intellectually dishonest, they won’t lie to you. Fortunately, they will also tell you what they will do in the future. You just need to listen.
Fiscal Dominance
For those who want to understand how the Federal Reserve and the US Treasury are doing well in both math and politics, there is a great read: the most important paper published earlier this year by the Federal Reserve Bank of St. Louis. They have a research institution that allows renowned economists to publish papers. These papers influence the policies of the Federal Reserve. If you take investment seriously, you must read this paper in its entirety. I will just quote some parts of it.
Dr. Calomiris explains in detail what fiscal dominance is and its practical implications. Here is a brief summary for the readers:
● Fiscal dominance means that the accumulation of government debt and deficits may have an impact on increasing inflation, and this impact will “dominate” the intention of the central bank to maintain low inflation.
● Fiscal dominance occurs when the central bank must formulate policies not to maintain stable prices, but to ensure that the federal government can raise funds in the debt market. At this time, the government’s bond auction may “fail” because the market demands a very high interest rate for the issuance of new bonds, to the extent that the government withdraws the auction and chooses to print money as an alternative.
● Because the government needs the debt yield to be lower than nominal GDP growth and/or inflation, investors are not interested in buying these debts. This is the definition of negative real interest rates.
● In order to find a “fool” to buy these debts, the central bank needs to require commercial banks to deposit a large amount of reserves with it. These reserves do not earn interest and can only be used to purchase government bonds. (So the “fool” here refers to commercial banks.)
● As the profitability of commercial banks declines, they are unable to attract deposits for lending because the interest rates they are allowed to offer on deposits are much lower than nominal GDP growth and/or inflation.
● Since depositors cannot obtain real returns in banks or government bonds, they turn to financial instruments outside the banking system (such as cryptocurrencies). In many cases, commercial banks themselves actively participate in transferring funds to different jurisdictions and/or asset classes to obtain fees from their clients. This is called financial disintermediation.
● An unsolved mystery is whether commercial banks have enough political power to protect their clients and promote this financial disintermediation.
So why go through all this trouble instead of simply telling the Federal Reserve to lower interest rates? Because, as Dr. Carolomiris puts it, this is an “invisible” tax that most Americans will not notice or understand. It is politically more convenient to keep rates higher when inflation is still eroding the American middle class, rather than openly instructing the Fed to start cutting rates and stimulating the market again, or worse, cutting government spending.
Dr. Carolomiris’ paper presents a very solid “solution” to the problems of the Federal Reserve and the US Treasury, namely that if fiscal dominance is pursued, weakening the banks is the best policy choice.
Therefore, the Federal Reserve may require a large portion of reserves to be held as reserves, eliminate the payment of interest on reserves, and terminate payments on RRP balances. Government agencies should not offer yields higher than long-term government bonds. Given that the entire purpose of this action is to keep long-term government bond yields below inflation and nominal GDP growth, it will no longer attract investors to deposit funds into money market funds (MMFs) and/or purchase US Treasury bonds. Therefore, the current lucrative yield obtained from cash will disappear.
Essentially, the Federal Reserve will end its attempt to control the price of money and instead focus on the quantity of money. The quantity of money can be changed by adjusting bank reserve requirements and/or the size of the Federal Reserve’s balance sheet. Short-term interest rates will be significantly reduced, likely to zero. This helps regional banks become profitable again as they can now attract deposits and earn profitable spreads. It also makes financial assets outside of big tech companies attractive again. As the stock market rises overall, capital gains taxes increase, helping to fill the government’s coffers.
Why is weakening the banks the best policy choice?
Firstly, reserve requirements, unlike new taxes enacted through legislation (which may be blocked in the legislative body), are regulatory decisions made by financial regulatory agencies. It can be implemented quickly, assuming regulatory agencies with the power to change policies are influenced by fiscal policy pressures. In the case of the United States, the decision to require reserves to be held against deposits and whether to pay interest on them depends on the Federal Reserve Board’s decision.”
The Federal Reserve is not accountable to the public like elected representatives. It can act at will without the approval of voters. Democracy is good, but sometimes dictatorship is faster and stronger.
Secondly, because many people are unfamiliar with the concept of inflation tax (especially in societies that have not experienced high inflation), they do not know they are actually paying it, which makes it very popular among politicians.
Financial Disintermediation
Financial disintermediation refers to cash flowing out of the banking system and into alternatives due to negligible interest rates. Bankers have come up with various novel ways to offer customers products with higher yields, as long as the fees are substantial. Sometimes, regulatory agencies are not satisfied with this “innovation.”
Fiscal dominance has occurred in the United States during the Vietnam War. To maintain rate stability in the face of high inflation, U.S. regulators imposed deposit rate caps on banks. In response, U.S. banks established branches outside of London, mostly in London, that were not subject to U.S. banking regulatory control and could freely offer market rates to depositors. Thus, the Eurodollar market was born, and it and its associated fixed-income derivatives became the world’s largest financial market in terms of trading volume.
Interestingly, efforts to control something often lead to the creation of a larger, harder-to-control monster. Even today, the Federal Reserve and the U.S. Treasury Department have almost no complete understanding of all the intricacies of the Eurodollar market created by U.S. banks to protect their profitability. Similar situations can also occur in the crypto field.
These leaders of large traditional financial intermediaries, such as banks, brokerage firms, and asset management companies, are among the smartest people on Earth. Their entire job is to predict political and economic trends in advance and adjust their business models to survive and thrive in the future. For example, Jamie Dimon has long emphasized the unsustainability of the US government’s debt burden and fiscal spending habits. He and his peers know that a reckoning is coming, and the result will be the sacrifice of their financial institutions’ profitability to fund the government. Therefore, they must create something new in today’s currency environment, similar to the Eurodollar market of the 1960s and 1970s. I believe that cryptocurrency is part of the answer.
The continuous suppression of cryptocurrency by the United States and Western countries mainly targets the operators in the non-traditional financial circle, making it difficult for them to conduct business. Think about it: Winklevii (two tall, handsome, Harvard-educated, tech billionaire men) – why can’t they get approval for a Bitcoin ETF in the United States, but Larry Fink, who is aging and in the Blackstone Group, seems to be sailing smoothly? In fact, cryptocurrency itself has never been the problem – the problem lies in who owns it.
Now do you understand why banks and asset management companies suddenly became enthusiastic about cryptocurrency shortly after their competitors collapsed? They know that the government is about to invade their deposit base (i.e., weakening the banks), and they need to ensure that the only available antidote to inflation, cryptocurrency, is under their control. Traditional financial (TradFi) banks and asset management companies will offer cryptocurrency exchange-traded funds (ETFs) or similar types of managed products that allow customers to exchange fiat currency for cryptocurrency derivatives. Fund managers can charge exorbitant fees because they are the only players who allow investors to easily convert fiat currency into cryptocurrency financial returns. If cryptocurrency has a greater impact on the monetary system in the next few decades than the Eurodollar market, traditional finance can recover the losses caused by unfavorable bank regulations by becoming the gateway to the trillions of dollars in deposits.
The only problem is that traditional finance has already created a negative impression of cryptocurrency to the point where politicians actually believe it. Now, traditional finance needs to change the narrative to ensure that financial regulatory agencies provide them with the space to control capital flows, because the federal government needs to do so when implementing this implicit inflation tax on bank depositors.
Banks and financial regulatory agencies can easily find common ground by restricting any physical redemption of cryptocurrency financial products. This means that anyone holding these products will never be able to redeem and receive physical cryptocurrency. They can only exchange and receive dollars, which will be immediately reinvested into the banking system.
A deeper question is whether we can maintain Satoshi Nakamoto’s values when there may be trillions of dollars worth of financial products pouring into the traditional financial system. Larry Fink doesn’t care about decentralization. What impact will asset management companies like Blackstone, Vanguard, and Fidelity have on Bitcoin improvement proposals? For example, proposals to enhance privacy or resist censorship. These large asset management companies will be eager to offer ETFs that track publicly listed cryptocurrency mining companies. Soon, miners will find that these large asset management companies will control a significant voting power over their stocks and influence management decisions. I hope we can remain loyal to our founders, but the devil is waiting, offering many irresistible temptations.
Transaction Plan Related
The question now is how to adjust my investment portfolio, sit tight, and wait for the policy prescription described by Dr. Carlo Milis to take effect.
Currently, cash is a good choice, as only tech giants and cryptocurrencies have beaten it in terms of financial returns. I have to make a living, unfortunately, holding tech stocks or a large portion of cryptocurrencies won’t generate income for me. Tech stocks don’t pay dividends, and there are no risk-free Bitcoin bonds to invest in. Getting a nearly 6% return on my fiat reserve funds is great because I can cover living expenses without having to sell or borrow against my cryptocurrencies. Therefore, I will continue to hold my current investment portfolio, which includes fiat currency and cryptocurrencies.
I don’t know when the US Treasury market will collapse, forcing the Fed to take action. Given the political demands for the Fed to continue raising interest rates and reducing its balance sheet, it is reasonable to assume that long-term interest rates will continue to rise. The yield on 10-year US Treasury bonds recently broke 4%, reaching a local high. That is why risk assets like cryptocurrencies have been hit. The market believes that higher long-term interest rates pose a threat to perpetually invested assets such as stocks and cryptocurrencies.
Felix predicted various severe market adjustments in his recent note, including cryptocurrencies. His views are still worth considering. I need to be able to generate income and be able to handle market volatility in cryptocurrencies. My investment portfolio is prepared for this purpose.
I believe I have the right future forecast because the Fed has already indicated that bank reserve balances must grow, and it can be foreseen that the banking industry is not satisfied with this. The rise in long-term US Treasury yields is a symptom of deep-seated corruption in the market structure. China, oil-exporting countries, Japan, the Fed, and others are no longer buying US Treasury bonds for various reasons. In the case of the usual buyers going on strike, who will buy trillions of dollars of debt that the US Treasury must sell in the coming months at low yields? The market is moving towards the scenario predicted by Dr. Carlo Milis, and there may eventually be a failed auction that forces the Fed and the Treasury to take action.
The market has not yet realized that the faster the Federal Reserve loses control over the US Treasury market, the faster it will resume rate cuts and quantitative easing. Earlier this year, the Fed abandoned monetary tightening by expanding its balance sheet by billions of dollars in a few trading days to “save” the banking system from the impact of bank defaults in various regions, which has already proven this point. An abnormal US Treasury market is beneficial for risk assets with limited supply, such as Bitcoin. However, this is not the way investors traditionally train themselves to think about the relationship between risk-free government bonds and risk assets denominated in fiat currency. We have to go downhill to go uphill. I don’t intend to fight the market, just sit tight and accept this liquidity subsidy.
I also believe that at some point, more investors will do the math and realize that the Federal Reserve and the US Treasury Department are distributing billions of dollars to wealthy depositors every month through their merger. This money has to flow somewhere, and some of it will flow into technology stocks and cryptocurrencies. Despite the mainstream financial media’s catastrophic sound on issues related to a significant drop in cryptocurrency prices, there is a lot of cash that needs to find suitable investment objects in financially scarce assets like cryptocurrencies. While some people believe that the price of Bitcoin will fall below $20,000 again, I tend to think that we will hover around $25,000 in early Q3. Whether cryptocurrencies can withstand this storm will be directly related to the number of new interest income earners.
I’m not afraid of the weaknesses of cryptocurrencies, I will embrace them. Because I don’t use leverage in this part of the portfolio, I don’t care about significant price drops. By using algorithmic strategies, I will patiently buy several “altcoins” that I believe will perform well when the bull market returns.
