Arthur Hayes Column: New Predictions for the Bottom

Author: BitMEX Founder Arthur Hayes

Compiled by: Wu Zhuocheng, Wu Says Blockchain

The Real Inflation Problem

The prerequisite for the bull market to begin is for the Federal Reserve and central banks to pause interest rate hikes and keep their balance sheets unchanged. During the current rate hike cycle, the CPI has retreated, but the income of the average American worker is also decreasing. Given that this year is a midterm election year in the U.S., as November approaches, this will become an increasingly significant issue, and the ruling Democratic Party will need to do something to correct it.

As voters work harder for less money, inflation becomes extremely important to them. The red bars in the chart above indicate that whichever party comes to power will face the current problem.

The Federal Reserve has done an excellent job of suppressing asset prices, to the extent that the return on U.S. 10-year Treasury bonds in 2022 is the worst since 1788. However, ordinary people are more concerned about the prices of energy and food. By destroying demand through a negative wealth effect, it can substantially slow the rise in energy and food prices. The theory posits that the wealthy consume these resources far more than the average citizen. Therefore, interest rate hikes can force the wealthy to reduce consumption, thereby suppressing inflation in energy and food prices in the process.

In a recent speech, Governor Waller stated, "I support tightening policy by another 50 basis points at a few meetings. In particular, I will not put a 50 basis point rate hike on the table until I see inflation rates drop closer to our 2% target. Moreover, by the end of this year, I support keeping the policy rate above neutral levels to reduce demand for goods and labor, making it more consistent with supply, thereby helping to control inflation."

If the world were not in a world war, the above approach might work. However, today the U.S. and NATO are openly providing advanced weapons to Ukraine so that its armed forces can engage directly with Russia. Although there is no direct kinetic confrontation between the West and Russia, the West is economically at war with Russia through various sanctions.

Russia and Ukraine together produce a large amount of energy and food, and the longer this conflict drags on, the less opportunity other countries will have to obtain these critical resources. What is truly frightening is that even if the war ends, the complex systems will not return to previous output levels in a linear manner. Due to the current disruptions, we may lose a significant amount of global agricultural and energy output for decades. To make matters worse, Russia and Ukraine provide a large portion of the world's fertilizers, and without these exports, agricultural yields in other countries may also decline sharply. Furthermore, if Russia has to shut down oil and gas wells due to a lack of buyers who can logistically receive them, it could take decades to restore current production levels.

The Federal Reserve will continue to seek to reduce demand for energy and food, but unless comprehensive trade with Russia and Ukraine is restored, the prices of both will continue to rise. If trade cannot be restored, then the U.S. will have to resort to another common solution to address this issue.

That is to provide energy and food subsidies, which will keep these essentials at affordable prices. Subsidies can take various forms. Imposing windfall taxes on private companies that "price gouge," price controls on various goods, and direct government checks (also known as food stamps) are all potential forms of subsidies.

But in any case, the government will need to generate more cash, which means expanding the fiscal deficit by issuing more government bonds. But who will buy these bonds?

In a wartime economy, central banks lose their independence and merge with the Treasury. This happened after World War II and will happen again now. The central bank will press the button and immediately start purchasing all the debt issued by the Treasury at politically appropriate interest rates.

The external effect of this policy is to accelerate global inflation and famine. The most severely affected will be countries in the Global South, which lack the capacity to print money to solve their macroeconomic problems. The U.S. issues the global reserve currency and has the most powerful military, so it will be fine, obtaining everything it needs at the expense of everyone else. The EU will be in a similar situation, as the euro is the second most used currency in trade. Europeans are experts in subsidies, which distort demand and ensure domestic entities receive preferential treatment compared to the rest of the world. However, if the wealthiest citizens globally do not curb their consumption in the face of reduced global output, it will be others who starve.

I bet the Federal Reserve will tighten monetary policy more aggressively in the third quarter, even if the S&P 500 and Nasdaq 100 indices fall below 3000 and 10000, respectively. Because they must suppress the prices of energy and food, not just risk assets. But if energy and food inflation does not see meaningful adjustments by then, politicians will have to provide subsidies to appease agitated voters.

These subsidies will be paid for with printed money from the Federal Reserve, and we will soon see a bull market in risk assets again. If the omniscient hedge fund expert Felix Zulauf is to be believed (according to his recent correspondence), the next event will be a major collapse in the financial markets, as fiat currency will self-destruct under the greatest money printing machine in human history.

But what follows is a recovery of the bubble, which may happen just a few quarters later. We must now ask ourselves: Is this the bottom of the current cryptocurrency bear market?

Bottom Fishing

Given that cryptocurrencies are the last free market globally and will be incorporated into the recovery of risk faster, we have reason to believe that the recent waterfall of TerraUSD and LUNA can create a market bottom.

I want to connect two theories.

1. Based on performance adjusted for fees, most tech venture capital firms are expensive beta tools for the overall market. Therefore, as inflation crushed benchmarks like Netflix, as users chose to eat rather than pay for the privilege of watching more mediocre Netflix originals, some of the most successful tech companies in the world, such as Facebook, saw user growth stagnate or even decline, and the general financing and IPO environment deteriorated rapidly in the first quarter of 2022. Coupled with rising nominal interest rates, you can imagine the pain of those brothers in Patagonia and khakis in Silicon Valley, Beijing's Zhongguancun, and Mayfair.

2. The following theory comes from one of the smartest cryptocurrency traders I know. I haven't done the work to verify his theory, but logically, it makes sense. He speculated that the event that burst the TerraUSD bubble originated from VC's over-the-counter trading, as they needed to cash out their LUNA positions with minimal market impact.

Due to the transparency of the blockchain, early VCs would be easily discovered if they sold large amounts of LUNA positions. The protocol allows LUNA holders to exchange 1 dollar of LUNA for 1 UST at the current LUNA/UST market price. The LUNA will be burned, creating an equal amount of UST, with no market impact on the broader LUNA value. Using over-the-counter (OTC) trading, venture capital firms exchanged large amounts of UST for other stablecoins like USDT, USDC, or even fiat dollars, so as not to affect the market. The end result was a significant increase in the supply of UST, which ultimately affected its price peg.

This liquidity amounted to nearly 5 billion dollars. The beginning of the collapse of TerraUSD occurred when the peg slightly broke. This was because the supply of UST was too large relative to other stable currencies like USDT and USDC. Once the peg began to slightly break and confidence in a quick recovery weakened, the negative convexity of the algorithmic stablecoin design took over and generated an unstoppable downward force.

Putting these two events together, the inflation-driven contraction of venture capital balance sheets and the bursting of the Luna bubble, my theory is that the broader risk-averse environment prompted them to cash out their successful LUNA investments at the same time. The global risk aversion movement is manufactured by the Federal Reserve. Therefore, the collapse of TerraUSD is an indirect result of global central banks tightening liquidity. Thus, I believe this event brought pain, and this pain will occur in a few months as the Federal Reserve and other countries continue to tighten liquidity conditions.

Let me be clear, I am not blaming the collapse of TerraUSD on the Federal Reserve. Its collapse was inevitable, and anyone who has read the white paper or studied algorithmic stablecoins can understand that. My point is that the Federal Reserve provided the catalyst for what was ultimately going to happen. Fortunately, because cryptocurrencies do not have government bailouts, we quickly found the true clearing price, can now heal, and then continue to move towards our goals.

I firmly believe that cryptocurrencies lead the broader market. Data supports this, as during the recent cryptocurrency market crash, the correlation between Bitcoin/Ethereum and the Nasdaq 100 index broke. Below, let’s revisit the correlation charts to see how they all sharply declined.

In order, here are the 10-day, 30-day, and 90-day rolling correlation charts between Bitcoin and the previous month's Nasdaq 100 futures contracts.

Below are the 10-day, 30-day, and 90-day rolling correlation charts between Ethereum and the previous month's Nasdaq 100 futures contracts, in order.

As you can see, in this recent crash, cryptocurrencies decoupled from the broader risk asset space. This is good on a macro level, but there are other cryptocurrency market indicators pointing to a local bottom.

Let’s focus solely on Bitcoin and Ethereum, as they are my benchmark cryptocurrency assets. Both cryptocurrencies are in a bull market of a larger cycle. What I mean is that the prices of Bitcoin and Ethereum are rising at the lowest points of each bear market.

BTC

This is a chart from glassnode that helps me conceptualize the three main Bitcoin price cycles. The maximum drawdown compared to the previous cycle's all-time high (ATH) reached a local bottom. Below is a table representing the three main cycles.

ETH

Ethereum has gone through two cycles. The first cycle began when the coin was first freely traded after its ICO issuance, and the second cycle began after Ethereum bottomed out following the ICO boom of 2017/2018.

Do not take these as precise science; we can roughly derive a range that corresponds to what we believe is the local bottom. For Bitcoin, it is between $25,000 and $27,000. For Ethereum, it is between $1,700 and $1,800. (In May, his prediction was $20,000 and $1,300)

If I had a natural language processor that crawled all articles about cryptocurrencies on mainstream financial media, I could plot a language sentiment indicator. Even without a powerful model, a rough search of high-click articles published by Bloomberg, Financial Times, Wall Street Journal, etc., would reveal the pain that global cryptocurrency traders feel about the market.

My bottom checklist:

1. The correlation between Bitcoin/Ethereum and the Nasdaq 100 index is decreasing.

2. The current price levels are very close to the historical highs of the previous cycle.

3. Mainstream financial media is gloating, saying how foolish and greedy those who invested in cryptocurrencies for short-lived wealth are.

A typical characteristic of a bottom is that the most steadfast bulls are forced to sell assets, and LFG is such a role. The release of 80,000 Bitcoins makes me more confident that Bitcoin is at the bottom of this cycle in the $25,000-$27,000 range.

Politics must align with the macroeconomic environment; while the bottom may have arrived (I hope so), it does not mean that prices will automatically recover quickly.

The market will stage an impressive bear market rally, allowing many loss-making traders to exit with the rebound. Right now, many traders are sitting on losses of 50% to 90% and are unwilling to exit at bottom prices. Therefore, any rebound will face selling pressure, and only by absorbing all this selling pressure can we welcome a bull market.

In previous articles, I made the argument that I believe Ethereum can reach $10,000 by the end of the year. Given the recent massacre, many readers are wondering if I still believe in this target. In short, I am confident in the price but not in the timing.

My political theory is based on the assumption that the core principle of inflation that American voters care about is energy and food, not risk assets. Therefore, while interest rate hikes have significantly lowered the prices of risk assets, voters will not be pleased.

The Federal Reserve will not hide its shift; those waiting for signals will receive them. For patient traders with time spans of several years, waiting is worthwhile. For those trading short-term, good luck.