BitMEX founder: Inflation has become the new normal in the world, and I am cautiously bullish on Bitcoin

Source: bitmex

Author: Arthur Hayes, Co-founder of BitMEX

Compiled by: Odaily Planet Daily/Moni

From a macro-humanistic perspective, war is always destructive and consumes a vast amount of energy.

Human civilization transforms the potential energy of the sun and the earth into food, shelter, and entertainment, while war is an act of consuming energy to destroy the achievements of human civilization. Although one side may "win" and achieve some resource-driven goal by defeating the enemy, humanity ultimately fails.

In this article, we will interpret the crypto capital market, but we must view humanity as a whole; currency and assets are for the benefit of everyone, not just a specific imagined structure. Every life and structure requires energy to support and build, which means that the more we waste, the greater the negative impact on all of humanity.

So now, our greatest waste may be currency, and the most obvious impact it brings is------inflation. We must be prepared to protect the value of our financial assets.

Seeing the Truth from Behind

Currently, the monetary policies of countries around the world are arguably the most accommodative in history. Against this backdrop, some countries have recently experienced alarming conflicts. I know that every country's central bank is trying its best to cope with inflation and has promised to address it properly; however, almost every country's central bank is still continuously printing money.

By observing some charts comparing policy interest rates with official inflation indicators, we find that the "official" inflation indicators released do not fully represent the prices faced by ordinary citizens. I believe that these statistics are processed and beautified, while in reality, consumer price inflation has seriously worsened, and even the official data is a mess.

U.S. Federal Funds Rate - U.S. CPI = U.S. Real Interest Rate (currently -7%)

Eurozone Deposit Rate - Eurozone CPI = Eurozone Real Interest Rate (currently -5%)

Bank of England Rate - UK CPI = UK Real Interest Rate (currently -5%)

The three charts above show [Policy Rate - Officially Released Consumer Price Inflation Index]. As you can see, since the outbreak of the COVID-19 pandemic, real interest rates have become significantly negative. Imagine if you currently have $1, or €1, or £1 in your wallet, and by next year, the value of these fiat currencies suddenly drops by 5% to 7%.

If workers' wages also rise accordingly, then there would be no problem; however, for most wage earners or hourly workers, their wages have not increased in line with the depreciation of the currency in their physical or digital wallets.

As you can feel, the public is greatly dissatisfied that their wages are completely unable to keep up with the rising prices of food, energy, and transportation. What politicians are currently doing is letting their "independent" central banks control inflation. There is no dispute that central banks must raise policy rates; however, there is controversy over the extent of their rate hikes and how quickly they should complete them.

If the Federal Reserve raises rates six times this year, the entire financial world will surely present an apocalyptic scene. In fact, the U.S. federal funds futures market has long predicted the results of rate hikes, assuming that the Fed raises rates by 0.25 percentage points each time, ultimately pushing the so-called "policy rate" to 1.5%.

We know that the current CPI inflation rate in the U.S. has soared above 7%. In this case, even if the inflation rate is halved to 3.5% by the end of 2022, the real interest rate on the dollar would still be -2%.

The above chart shows the term structure of Eurodollar futures. To derive the yield on dollar deposits held outside the U.S., subtract the futures price from 100. For example, if the Eurodollar futures price is 98.00, the yield would be 2%.

I have a lot to say about the importance of the Eurodollar market, but to sum it up: it is the most important interest rate market in the world, heavily influenced by Federal Reserve policy.

If we look at the trend curve, we will find that Eurodollar futures are expected to peak at nearly 2.5% by September next year, as the market anticipates that the Fed will raise short-term rates. Therefore, these futures trends reflect the three-month dollar deposit rate. It can be said that 2.5% is completely insufficient to combat the current level of inflation, especially considering the medium to large-scale war factors that will affect global energy use in the next year.

Despite U.S. politicians' calls to "fix inflation," the final execution has not been satisfactory. Why is that? Because the policy rate level that could lead to a financial crisis becomes lower with each economic recession.

The above chart shows the lower bound of the federal funds rate since 1990. We find that each major global financial crisis has been triggered by the accumulation of leverage and debt in certain areas of the financial market. Once the Fed raises rates, the bubble will burst, as blind financing will increase the cost for speculators.

After the first Gulf War with Iraq, the Fed ended the low-interest-rate era, raising rates by about 5% to 6% at the end of 1994. However, this led to the Mexican peso crisis, which was ultimately resolved with the intervention of the U.S. Treasury and a slight reduction in rates by the Fed.

However, a few years later, when rates rose to nearly 6%, the Asian financial crisis broke out. Due to the increased cost of dollar funding, the "Asian Tigers" sought economic assistance from the International Monetary Fund and the World Bank.

We all know what happened in the tech sector in 2000. The chart clearly shows that the Fed slightly lowered rates after the Asian financial crisis and then raised them again. The rising cost of funding ended the hopes and dreams of a technological utopia, followed by an unexpected stock market crash.

Then, in 2001, the 9/11 terrorist attacks occurred in the U.S., prompting the Fed to start cutting rates and promoting real estate. However, after rates soared to 5%, by 2006, the U.S. real estate market began to show signs of a bubble. Until 2008, the outbreak of the U.S. subprime mortgage crisis affected the entire global financial system, triggering a global financial tsunami!

After that, after experiencing 7 years of 0% interest rates, the Fed raised rates again to slightly above 2% until the end of 2018/early 2019. After rates rose, a general recession began at the end of 2019, compounded by the outbreak of the global COVID-19 pandemic, leading to the most severe contraction in economic activity in history.

6%, then 5%, then 2%------almost every decade, the financial market nominal interest rates decline. Given the explosive growth of global systemic debt and leverage due to low or negative interest rates and the need for yield after the COVID-19 pandemic, I believe that even a nominal interest rate of 2% in the global financial market cannot be sustained.

Looking at the chart above, it becomes clear that if calculated at a 2% policy rate, the interest rate remains negative. Unless workers begin to receive significantly larger raises, they will continue to suffer from inflation month after month. So, let's talk about------

The Inflation Narrative

Every asset class has a constantly changing narrative, but a key indicator for judging asset value is------whether it can effectively hedge against inflation. Many people instinctively believe that, as a scarce asset, Bitcoin and other cryptocurrencies should be good inflation hedges.

For many years, this idea may have been correct, but recently Bitcoin's performance seems to be more "risky" than "safe," as it has not become an appreciating asset when the market declines.

Frankly speaking, the significant rise in Bitcoin's price is largely due to the COVID-19 pandemic prompting many central banks to start massive money printing. In other words, Bitcoin needs to "digest" this rapid rise in a short time; once liquidity begins to tighten, Bitcoin's performance may not be as good as you expect.

However, let's not consider the issue of negative interest rates for now; instead, let's look at how past macroeconomic conditions have affected Bitcoin's performance. In March 2020, Bitcoin's price was about $4,500, but by November 2021, it had soared to nearly $70,000. Subsequently, central banks changed their stance------they began to take the right measures to curb inflation, and the market quickly reacted, causing the crypto bull market to stall.

The above chart shows the comparison of Bitcoin (yellow line) and U.S. 2-year Treasury bonds (white line) since September 2021. In my view, the stagnation of the Bitcoin bull market is due to the tightening of global liquidity.

As many countries' central banks (like the Fed) are expected to raise nominal interest rates in the future, the market began to reprice the credit of fiat currencies, resulting in an eightfold increase in the yield of U.S. 2-year Treasury bonds------while on the other hand, Bitcoin's price has been consolidating and starting to decline slightly.

At this point, gold has finally begun to slowly emerge from the trough. Due to the continued negative dollar interest rates, gold has started to rise towards $2,000. Furthermore, although nominal dollar interest rates have risen in the short term, gold prices continue to rise because the real interest rate on the dollar remains negative.

Ultimately, in the context of fiat currency depreciation, gold's value-preserving properties begin to take effect, regaining the attention of investors. I expect Bitcoin will eventually experience a narrative similar to gold, where investors will rediscover Bitcoin's value.

However, for investors, the most important thing is to remain patient and tame your itchy fingers, avoiding the impulse to click the buy button, so that you can re-enter or reallocate financial market assets when the right moment arrives.

If the current situation in Eastern Europe escalates into a medium or large-scale global conflict, what might happen? Let's first analyze the current market environment:

1. Due to environmental issues, many countries have decided to reduce investments in hydrocarbon production and exploration, leading society to replace cheap hydrocarbons with relatively expensive wind and solar energy (measured by the energy produced and the energy investment required).

As a result, people have to pay more for everything because, as humans, surviving in the current social structure requires energy. Some may argue that the cost of hydrocarbons does not fully reflect their negative environmental externalities------but when a household has to pay more than 50% extra to heat their home during a harsh winter, all issues come to light.

2. Over the past 50 years, countries around the world have printed the most money in human history. On the other hand, the aging population problem in all major economies is becoming increasingly severe, meaning that the ability to repay debt will become lower and lower.

To keep the game going, central banks must continue to print money to "pay old debts with new money." Taking the U.S. as an example, the U.S. government will not voluntarily allow its currency to default, so it is willing to tolerate widespread inflation.

3. After the COVID-19 pandemic, many countries have seen rising inflation rates, and labor has become relatively scarce. In today's "post-pandemic era," global costs are continuously rising because there are fewer workers left on the production line, leading them to demand higher wages and benefits, and robots are not yet ready, so businesses still need workers.

4. As the central bank of the world's most developed economy, the Fed needs to significantly raise interest rates to achieve positive real interest rates. However, the nominal interest rate level of the dollar is at a historical low, and once the nominal interest rate is at a historical low, some financial and real economies may face collapse risks.

Returning to the issue of currency, when those politicians demanding the Fed control inflation wield their swords, what will central bankers do? I believe there are three possibilities:

Scenario 1: Curb Inflation

To appropriately control inflation, central banks must at least bring the dollar to a 0% real interest rate, which means the policy rate needs to exceed 6%------considering the current state of the financial market, this seems unlikely, but this number is the minimum necessary interest rate level to curb inflation and correct all imbalances from the past 50 years.

It should be noted that the current surge in energy prices (oil prices) is largely not due to monetary factors, and central banks may be powerless to address this, so they may raise rates, raise rates, and raise rates again, while energy prices may never decrease. Then, once the global economy collapses, per capita energy demand will significantly decline because we have drastically reduced consumption patterns------meaning that energy prices may suddenly plummet.

If dollar interest rates rise to 5% or 6%, it may cause some damage to the global economy, but compared to the 2008 global financial crisis, the economic impact of rate hikes is really minor. Of course, economic turmoil will eliminate some businesses, but ultimately it will push humanity onto a more sustainable growth path.

However, this rebalancing is undermining social stability. If real interest rates stabilize and then rise sharply enough to crush the world economy, leading to a decline in energy usage, then aside from volatility hedges (like investing in cryptocurrencies), there will be no other way to save you.

But I believe this scenario is unlikely to happen.

Scenario 2: Mislead the Market

For most of 2022, we may have been easily misled by the market.

In many financial media outlets, you will see central bank governors appearing, telling politicians that they are serious about combating inflation. Bankers raise policy rates to the range of 1% to 2%------because the futures market tells them they need to do so, and that's it.

But even doing so, the dollar's real interest rate remains negative, which is very important during times of war or near-war, why? Because governments need to spend money to fight or prepare for war, and they need to pay for the costs of war.

By keeping real interest rates negative while ensuring that nominal government bond rates are below nominal GDP growth rates, the U.S. government can afford financing and reduce its debt/GDP ratio. Implementing negative real interest rates is essentially the U.S. government stealthily transferring wealth from savers. Although this nominal policy rate level will lead to economic recession, it will not significantly change the social structure, and the U.S. government can still afford war funding.

However, the problem here is that the Fed cannot control energy costs, and energy costs may continue to become more expensive. Moreover, since the Fed's monetary policy remains accommodative towards government spending, the U.S. government will continue to crowd out private enterprises in energy use, meaning energy costs will continue to rise, and ultimately, a lack of anti-inflation belief may lead to social unrest.

Dollar interest rates are closely related to our investment portfolios, but first, we must remain patient.

If the Fed and other central banks raise rates, asset prices will be suppressed, and at that time, the first to escape from the "massacre" will be Bitcoin and cryptocurrencies, as the crypto market is the only freely traded market that all humans with internet access can participate in.

Thus, compared to other TradFi markets, the crypto market will likely fall first and then rise. Remember, our analysis is based on the assumption that real interest rates will remain negative; once persistent negative real interest rates erode the purchasing power of fiat currencies, scarce assets will undoubtedly benefit.

The U.S. government does not want to genuinely curb consumer demand and government spending by raising rates to restructure society; after all, once the elections are over, the political pressure to combat inflation will disappear.

Once again, for crypto traders, patience is key.

If you are already in benchmark crypto assets (my benchmark crypto assets are Bitcoin and Ethereum), do not sell indiscriminately or short. At this time, you can open a bottle of wine or read a book (don't scroll through TikTok), and then calm down. If you are a dedicated trader buying and selling cryptocurrencies daily, remember that the market downturn may be temporary compared to the narrative of inflation-hedging assets, so do not be greedy------go in, go out, and look long-term.

(Note: This article was completed over the weekend, when it seemed that the Russia-Ukraine conflict would be brief, and the Western response was calm. However, the war continues, and the West appears prepared to endure economic pain to decouple from Russia. But it should be noted that Russia is a major supplier of food and energy, and losing these supplies in the global market could lead to high inflation.

Additionally, if the West truly decouples from Russia, we cannot accurately predict what the consequences will be. You never know where the problems are hidden on the balance sheets of financial institutions until you see market volatility. Therefore, a reasonable assumption is that once the West decouples from Russia, it will lead to some large financial institutions facing financial difficulties, which could turn into a global financial crisis.

However, the Western political response to Russia provides a window for global central banks to abandon their commitments to combat inflation. I am not sure if they can truly do this, so I cautiously remain bullish on Bitcoin. I am trying to invest in some call options for Bitcoin and Ethereum.

Federal funds futures indicate that the market believes the Fed will raise rates by 0.25% in March. However, please closely monitor the views and statements of major investment banks and the Fed's mouthpiece, The Wall Street Journal; the Fed's stance may change based on market and global geopolitical trends, and they may believe that continuing with a 0% rate should not be a problem.

It is important to clarify that the rise in oil prices will still occur, and I am not prepared to invest more in cryptocurrencies. In the face of changing market conditions, purchasing any asset must be done with great caution. If the Fed deviates from market expectations and raises rates by 0.25% to 0.50% in mid-March, then financial leverage could cause cryptocurrencies to decline again.)

Scenario 3: Accelerated Dollar Printing Press

An intense global conflict will completely change the game, and perhaps the dollar printing press will accelerate.

Price controls, rationing, and inflation will become the new normal for countries, as this is the only way to allocate all available resources to the military. Gold, Bitcoin, and other cryptocurrencies will increasingly be hoarded, which is where Gresham's Law begins to take effect.

(Note: Gresham's Law is an economic principle, also known as the law of "bad money driving out good money," meaning that in a bimetallic currency system, when two currencies circulate simultaneously, if one depreciates, its actual value relative to the other currency will be lower, and the "good money" with a higher actual value than its nominal value will be widely hoarded, gradually disappearing from the market, while the "bad money" with a lower actual value than its nominal value will flood the market.)

In this scenario, entering the gold and crypto markets will become more difficult, as some capital control policies will emerge, preventing many ordinary citizens from protecting their assets, ultimately leaving them to be "looted" by inflation.

In fact, the value of most financial assets denominated in fiat currency will decrease, perhaps becoming as worthless as toilet paper. Yes, nominally, your stock portfolio may rise, but the prices of milk, butter, eggs, sugar, and other essentials will rise faster than your free index fund.

I really hope this does not happen. But unfortunately, the history of humanity is a history of conflict.

If you believe that a bad situation is likely to occur, you should prepare in advance and take precautions.

That is to say, you can take some idle financial assets and purchase globally recognized stores of value, such as real estate and stocks, gold, Bitcoin, and other cryptocurrencies.

Perhaps at some point in the future, when global conflicts end, you hope your assets will not depreciate. No one can escape the impact of war; all you can do is protect your assets------if you don't believe it, just watch Downton Abbey again.

Conclusion

Now, everyone has a smartphone in their pocket, which is a mass communication tool for instant sharing of knowledge. However, while we can all remain idealistic and hope that the spread of information can change humanity's tendency to wage war, we must be prepared not to let our wealth fall victim to inflation.

Of course, this does not mean we should ignore short-term price trends, but overall, we can take a longer view and seize the right timing for buying and selling assets.