Behind the sudden plunge of Bitcoin

09-10

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Like Pavlov's dogs, we all believe that the correct response to a rate cut is BTFD. This behavioral response stems from recent memories of the U.S.'s efforts to curb inflation. Whenever there is a threat of deflation, which is scary for financial asset holders (i.e., wealthy people), the Fed responds forcefully by pressing the button on the printing press. The U.S. dollar is the global reserve currency, creating an easy monetary environment for the world.

The result of global fiscal policy to combat the COVID-19 pandemic has ended the era of deflation and ushered in an era of inflation. Central banks have belatedly acknowledged the inflationary effects of the pandemic, justified monetary and fiscal policies, and raised interest rates. Global bond markets, most importantly the US bond market, believe that our monetary masters are serious about defeating inflation and are not sending yields to the moon. However, the belief is that the central bankers will continue to increase the price of money and reduce the money supply to appease the bond market. This is a very dubious assumption given the current political environment.

I will focus on the U.S. Treasury market because the U.S. dollar is the world's reserve currency, and therefore the U.S. Treasury market is the most important debt market in the world. All other debt instruments, regardless of the currency they are issued in, have an impact on Treasury yields in some way. Bond yields combine market expectations for economic growth and inflation. The "Goldilocks" economic scenario is growth with little or no inflation. The "Big Bad Wolf" economic scenario is growth with a lot of inflation.

The Fed has shown the Treasury market its commitment to fighting inflation by raising its policy rate at the fastest pace since the early 1980s. From March 2022 to July 2023, the Fed raised rates by at least 0.25% at each meeting. During this period, the 10-year Treasury yield never exceeded 4%, even as the government-manipulated inflation index hit a 40-year high. The market is satisfied that the Fed will continue to raise rates to eliminate inflation, so long-term yields will not go to zero.

US Consumer Price Index (white), US 10-Year Treasury Yield (gold), Fed Funds Cap (green)

All this changed after the Jackson Hole central bank high-level meeting in August 2024. Powell said that the Fed will pause interest rate hikes at the upcoming September meeting. But the shadow of inflation still hangs over the market. This is mainly because the main driver of inflation is the increase in government spending, and government spending shows no signs of weakening.

MIT economists found that government spending is the most important factor in triggering inflation.

On the one hand, politicians know that high inflation rates reduce their chances of reelection. But on the other hand, providing voters with free benefits through currency devaluation can improve their chances of reelection. If you only give out benefits to your inner circle, and these benefits are paid for with the hard-earned savings of your competitors and supporters, the political trade-off will favor more government spending. Therefore, you will never lose an election. This is exactly the policy pursued by the administration of US President Biden.

Total government spending is at an all-time high during peacetime. Of course, I use the word “peaceful” relatively, with an eye only to the feelings of the citizens of the Empire; the past few years have been hardly peaceful for the poor souls who have died or continue to die as American-made weapons have fallen into the hands of democratic fighters.

If taxes were raised to pay for this largesse, then the spending wouldn't be a problem. The problem is that raising taxes is a very unpopular thing for incumbent politicians to do. So, that's not happening.

Against this fiscal backdrop, on August 23, 2024, Fed Chairman Powell said at the Jackson Hole conference that they will pause rate hikes at the upcoming September meeting. The more the Fed raises rates, the more it costs the government to finance the deficit. The Fed can stop this profligate behavior by making it more expensive to finance the deficit. Government spending is the main driver of the Fed's attempt to quell inflation, but it refuses to continue raising rates to succeed. So, the market will do the work for the Fed.

After the speech, the yield on the 10-year Treasury bond quickly rose from about 4.4% to 5%. This result is amazing considering that even if the inflation rate reaches 9% in 2022, the 10-year Treasury yield will only hover around 2%; 18 months later, after the inflation rate has fallen to about 3%, the 10-year Treasury yield is heading towards 5%. The rise in interest rates led to a 10% drop in the stock market and, more importantly, people once again worried that regional banks in the United States would fail due to losses in their Treasury bond portfolios. Faced with rising costs to finance the government deficit, reduced capital gains tax revenue due to falling stock markets, and a potential banking crisis, Yellen took action to prevent the stock market from collapsing.

As I wrote in Bad Gurl, Yellen gave forward guidance that the U.S. Treasury would issue more Treasury bills (T-bills). The net effect of this move was to pull money out of the Fed's reverse repo program (RRP) and put it into T-bills, which could be re-leveraged throughout the financial system. This announcement was made on November 1, 2023, and triggered a bull market in stocks, bonds, and crypto.

Bitcoin fluctuated from the end of August to the end of October 2023. However, after Yellen injected liquidity, Bitcoin began to soar, eventually hitting an all-time high in March of this year.

Market outlook

History doesn’t repeat itself, but it always rhymes. I failed to recognize this in my last Sugar High article, in which I talked about the impact of Powell’s payroll pivot. I was a little perturbed because I was a consensus view on the positive impact of the upcoming rate cut on risk markets. On my way to Seoul, I happened to glance at my Bloomberg watchlist, where I track the daily changes in RRP. I saw that it was up from the last time I checked, which puzzled me because I expected it to continue to fall based on the U.S. Treasury’s net T-bill issuance. I dug a little deeper and found that the rise began on August 23, the day of Powell’s speech.

Next, I considered whether the increase in RRP could be explained by misrepresentation of financial statements. Financial institutions often misrepresent the position of their balance sheets at the end of the quarter. In the case of RRP, financial institutions typically deposit money into the facility at the end of the quarter and withdraw it the following week. The third quarter ended on September 30, so misrepresentation of financial statements could not explain the surge.

Then I wondered, as T-bill yields fell, would money market funds (MMFs) seeking the highest and safest short-term dollar yields sell T-bills and park the cash in RRPs? I pulled up the following chart, showing 1-month (white), 3-month (yellow), and 6-month (green) T-bills. The vertical lines mark the following dates: Red line - the day the BoJ raised rates; Blue line - the day the BoJ gave in and announced that it would not consider future rate hikes if they thought the market would not react well; Purple line - the day of the Jackson Hole speech.

Money market MMF fund managers must decide how to get the highest yield from new deposits and expiring Treasury bills. The yield on RRP is 5.3%, and if the Treasury bill yield is slightly higher, the funds will be invested in Treasury bills. Since mid-July, the yield on 3-month and 6-month Treasury bills has been lower than the yield on RRP. However, this is mainly due to market expectations of aggressive easing by the Fed due to the unwinding of carry trades triggered by the strengthening of the yen. The yield on the 1-month bill is still slightly higher than the RRP yield, which makes sense because the Fed has not given advance guidance on a rate cut in September. To confirm my guess, I plotted the RRP balance.

RRP balances typically decline until Powell announces a September rate cut at the Jackson Hole conference on August 23 (indicated by the white vertical line in the chart above). The Fed meets on September 18 and will cut the Fed Funds rate by at least 5.00% to 5.25%. This confirms the expected move in the 3-month and 6-month Treasury bills, with the 1-month Treasury bill yield starting to close the gap. RRP yields only decline the day after a rate cut. Therefore, between now and September 18, this instrument will offer the highest yield among suitable yield instruments. Predictably, RRP balances rise immediately after Powell's speech as MMF managers maximize current and future interest income.

Bitcoin initially surged to $64,000 on the day of the Powell salary pivot, but has given back 10% of its fiat USD price over the past week. I believe Bitcoin is the most sensitive tool to track USD fiat liquidity conditions. Once RRP began to rise to around $120 billion, Bitcoin plummeted. Rising RRP suppresses currencies because they sit inertly on the Fed’s balance sheet and cannot be re-used in the global financial system.

Bitcoin is extremely volatile, so I accept the criticism that I may be reading too much into one week's price action. But my interpretation of events fits perfectly with the observed price action and cannot be explained by random noise. Testing my theory is easy. Assuming the Fed does not cut rates before the September meeting, I expect T-bill yields to remain below RRP yields. Therefore, RRP balances should continue to rise, while Bitcoin will at best fluctuate around these levels and at worst slowly decline to $50,000. Let's wait and see.

My shift in perspective has kept me hesitant to hit the “buy” button. I’m not selling cryptocurrencies because I’m pessimistic about the short term. As I’ll explain, my pessimism is temporary.

Out-of-control deficit

The Fed does nothing to control the biggest driver of inflation: government spending. Governments only cut spending or increase taxes when financing deficits becomes too expensive. The Fed’s so-called tightening is just lip service, and its independence is just a fun story to tell to its gullible economist believers.

If the Fed doesn’t tighten conditions, the bond market will tighten. Just as the 10-year Treasury yield unexpectedly rose after the Fed paused, a Fed rate cut in 2024 will push yields toward a dangerous 5%.

Why are 10-year Treasury bonds yielding 5% so dangerous to the health of America's fake financial system? To answer that question, it's because bad girl Yellen felt it necessary to step in and inject liquidity at that level last year. She knows better than I do how broken the banking system is in the face of a sharp rise in bond yields; given her behavior, I can only guess at the extent of the problem.

Like a dog, she has conditioned me to respond to certain stimuli. A 5% 10-year yield would put a stop to a bad bull market. It would also rekindle concerns about the health of the balance sheets of banks that are not “too big to fail.” Mortgage rates would rise, reducing housing affordability, a big issue for American voters in this election cycle. All of this would likely happen before the Fed cuts rates. Given these circumstances and Yellen’s unwavering loyalty to Democratic candidate Kamala Harris, these red-soled shoes will trample the “free” markets to dust.

Apparently, bad girl Yellen will not stop until she has done everything in her power to ensure Kamala Harris is elected President of the United States. First, she will begin draining the Treasury General Account (TGA). Yellen may even provide forward guidance on her desire to drain the TGA so that the market will quickly react as she desires… pushing it higher. She will then instruct Powell to stop quantitative tightening (QT) and possibly restart quantitative easing (QE). All of this monetary manipulation is bullish for risk assets, especially Bitcoin. Assuming the Fed continues to cut rates, the size of the money supply injections must be large enough to offset the rise in RRP balances.

Yellen must act quickly or the situation could turn into a full-blown voter confidence crisis in the U.S. economy. This would mean Harris’ defeat at the ballot box…unless by some miracle a flood of mail-in ballots is discovered. As Stalin said, “It is not those who vote, but those who count the votes that count.”

If this happens, I expect intervention to begin in late September. Between now and then, Bitcoin will at best continue to fall, and Altcoin will likely fall further.

I had publicly said that the bull run would resume in September. I changed my mind, but this does not affect my positioning in any way. I still hold a long position in an unleveraged manner. The only new additions to my portfolio are the purchases of some solid Altcoin projects at increasingly deep discounts, which are far below what I consider fair value. Once the fiat liquidity taps are predictably raised, the tokens of those projects whose users need to pay real money to use the product will soar.

My short-term market predictions are no better than a coin flip for professional traders with monthly P&L targets or weekend traders using leverage. My long-standing bias is that the incompetent people running the system will solve all problems by printing money. I write these articles to put current financial and political events into context and see if my long-term assumptions are still valid. But I promise that one day my short-term predictions will be more accurate... maybe... I hope so :).

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Disclaimer: The content above is only the author's opinion which does not represent any position of Followin, and is not intended as, and shall not be understood or construed as, investment advice from Followin.

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