How the Fed Could Fail

Bitcoin is a hedge against inflation worse than this. |

Exploring the transformation of value in the digital age By Michael J. Casey, Chief Content Officer May 14, 2021 Sponsored by If you were forwarded this newsletter and would like to receive it, sign up here. Not a great week for crypto markets, the worst of which came Tuesday and Wednesday. First, a report from the Securities and Exchange Commission suggested it might not be so keen on a bitcoin ETF after all. Then a surprisingly high April consumer price index (CPI) readout raised fears that an inflation-wary Federal Reserve might turn off the money machine that has propped up stocks, bonds and cryptocurrencies this past year. Finally, to top it off, Tesla CEO Elon Musk went cold on bitcoin, sending its price into a tailspin that drove it below $50,000.    This week's newsletter deals with all these issues, with the main column arguing that we need a longer-term view to understand bitcoin's relationship with inflation, one that focuses on a bigger problem than monthly increases in the CPI, and that is the risk of a debt-fueled monetary breakdown.   That big-picture perspective dovetails with the grand theme of this week's Money Reimagined podcast. As part of our lead-up to CoinDesk's Consensus conference starting May 24, with a lineup that includes Federal Reserve Governor Lael Brainard, Bridgewater Associates founder Ray Dalio and former Treasury Secretary Lawrence H. Summers, we wanted to focus on the big geopolitical themes that those speakers will highlight.   So, Sheila Warren and I talked to Bruno Macaes, a Portuguese politician, author and influential thinker on geopolitical trends, and Tomicah Tillemann, the director of the Digital Impact and Governance Initiative at the New America think tank. The conversation took a surprising turn, as both guests essentially said that if the U.S. plays its cards right, it could turn the current moment of economic uncertainty to its advantage. But to do so, they said, it must embrace the principles of open systems and open society that lie at the heart of the crypto ethos.    Have a listen after you read the newsletter. A message from Tezos You've heard about crypto, DeFi, and clean NFTs. Now discover Tezos. Artists, conservationists, entrepreneurs, comic book fans, and collectors around the world are envisioning how to build, create, and use Tezos in new and unexpected ways. Discover how people are re-imagining the world around you on Tezos. What Kind of Inflation Hedge Is Bitcoin?  Illustration: Rachel Sun/CoinDesk Hats off to Nathaniel Whittemore. On Monday, the host of CoinDesk's Breakdown podcast highlighted the many signs of rising prices in the U.S. economy – in lumber, copper and truck drivers' wages, for example – and asked if it was a sign that inflation was taking hold even if it's not represented in the data. Then, on Wednesday, the April consumer price index was released: up 4.2% on the year, the fastest inflation in 13 years.    This, naturally, spooked world markets as investors reasoned that the Federal Reserve will need to unwind its accommodative monetary stance earlier than expected. The sell-off included bitcoin, which then went into a more precipitous decline Wednesday evening after Elon Musk tweeted that Tesla would no longer be accepting the cryptocurrency for its cars.    Moments like this tend to confound people inside and outside of the crypto space. Isn't bitcoin supposed to be a hedge against inflation?    To that I say, no, not in the sense that it will rise automatically when the CPI is up and fall when it eases. There are still plenty of speculators who treat bitcoin as a risk asset akin to stocks. To them, anything that creates uncertainty around the future of monetary policy hits BTC as hard as stocks, if not harder.    It's more appropriate to think of bitcoin as a hedge against a wholesale debasement of fiat currencies in the further-off future when governments, faced with untenable fiscal burdens, are left with no choice but to monetize their ballooning debt burdens. Of course, that also results in inflation, since devaluing currencies will translate into higher prices for everything, quite possibly hyperinflation. But that's separate from the short-term, pandemic-driven demand-and-supply factors that are currently showing up in the CPI.   In other words, if you buy into the bitcoin thesis that it will be a "digital gold" hedge against a more unstable monetary state, you can make the argument that its moment is yet to come.   Still, in that context, this week's CPI result is important. Landing in a global economy that's still far, far from healthy, a resurgence in consumer price inflation could expedite that long-term reckoning with debt. That's a worry for the world. But it's generally bullish for bitcoin.    A Vicious Circle   Let's game this out, shall we?    First, consider the issue currently roiling markets. Investors are worried higher inflation threatens the Fed's dual mandate to achieve full employment and stable prices. Any signs it is failing on the latter could prompt it to pare back its aggressive quantitative easing (QE) policy of asset purchases, which helped drive a long-running rally in both stock and bond markets this past year.    On the surface, that's a legitimate concern. The Fed's current long-run inflation target is 2%, and while it has signaled a willingness to let inflation surpass that threshold during the pandemic and its aftermath, it can't afford to let the numbers run too high for too long without doing something about it. Failing to act could undermine its legitimacy, upon which its power and effectiveness rests.    But now consider the obvious outcome if and when the Fed starts to seriously tighten monetary policy. Naturally, interest rates will rise, potentially very sharply.    In normal times, that would be welcomed, as tighter monetary conditions would cool an overheated economy and contain price increases.    But these are not normal times. The COVID global economy is a story of massive economic pain, of looming, unrealized losses for a host of industries on the wrong side of the work-from-home zeitgeist and of surging debt – most important, fiscal debt. If interest rates rise too far, they will make that debt fundamentally unserviceable.    How much debt? Well, according to the nonpartisan Congressional Budget Office's latest projections, if existing policies and laws were to remain in place, U.S. federal debt would reach 102% of GDP this year, rise to a record-high 107% by 2031 and then almost double to 202% of GDP by 2051. The IMF's rule of the thumb is that a debt-to-GDP ratio above 80% can sow debt crises.   This trajectory is fed by three sources: The debt previously issued to pay for the fiscal stimulus after the 2008 financial crisis, the new debt needed to cover the Trump and Biden administrations' responses to the pandemic, and the as-yet unissued debt to pay for a surge in Medicare and Social Security claims from Baby Boomers.    The bond market is acutely aware of these numbers. As such, it will freak out if interest rates rise too far too fast. Even the most incremental increase will add trillions to the government's debt servicing costs.   The Fed faces a vicious circle, as do the European Central Bank, the Bank of England, the Bank of Japan and the People's Bank of China, all of which face similar, if not worse, debt outlooks. They will have no choice but to monetize their debt.    End Game At first, central banks will do this indirectly, as they've already been doing. They will expand QE, by which they buy bonds and other assets in the secondary market. But pretty soon they will run out of enough of those to buy. So, they'll hold their noses and buy newly issued debt from their governments.    This will undermine central banks' legitimacy, but they will have no choice. The inevitable result: a collapse in the value of fiat currencies, the flip side of which is an appreciation in all things money can buy: yes, consumer goods, but more important, scarce assets - gold, real estate and bitcoin.    This, by the way, is the thesis of legendary investor Ray Dalio. He will be talking to me as one of the main keynotes at CoinDesk's Consensus conference on Monday, May 24, about the 75-year debt cycle that the world finds itself in and how the debasement of money is its inevitable result.    It's a rather scary idea, but it's the issue people need to keep their eyes on, not the knee-jerk responses to month-by-month changes in the CPI.  Off the Charts DeFi Summer 2.0? Remember the DeFi Summer of 2020? There was an explosion of new protocols built as "legos" on top of each other. As market participants imported their ether or wrapped bitcoin into the ecosystem and tried all sorts of new yield farming tricks to earn money from lending, borrowing or both, the world of decentralized finance went berserk. The ultimate measure of that was "total value locked," which by mid-September broke through the $10 billion level to mark a major milestone.    Now we're starting to hear about DeFi Summer 2.0. Excitement is growing over a host of new advances: a more sophisticated version 3.0 of popular automated market maker Uniswap, a host of new Layer 2 applications – which will, in theory, curtail the problem of network congestion and high gas fees – and, maybe, just maybe, the introduction of some Wall Street money into the space. All this will make DeFi Summer 1.0 look "tame," says one observer of the space.    So, if the excitement is growing, are players deploying funds to get ahead of it? Are we seeing it in the TVL numbers? A look at the screenshot charts from data provider DeFi Pulse provides an answer, and it is "it depends." Certainly, as the above chart shows, if we measure the total value in terms of its dollar value, there has been a steady rise in the amount of funds ported into the DeFi world. But that dip at the end of the chart tells us something: that this measure is highly dependent on the dollar value of the cryptocurrencies invested. This week saw a huge sell-off in both ether and bitcoin, the two biggest cryptocurrencies deployed as collateral in DeFi lending platforms. So, naturally, the dollar value fell.    What, then, if we look at these numbers over the same time frame in terms of the actual cryptocurrencies locked?  This is DeFi Pulse's measure of total ether locked in DeFi. (Note: it counts actual ETH locked; it is not the total value expressed in ether terms.) It looks like there was a big surge of activity early in April, possibly around the time of the deployment of Uniswap V3. But since then, there seem to have been some liquidations.    It's not clear why such a drop-off would happen. One explanation is that people and institutions want that ether for other money-making ends, including new ETH-backed funds or staking projects. But given that ether continues to be the most important collateral currency in DeFi, the number offers some caution on the prospect of a summer surge.  And here's total bitcoin locked – a measure that stems from the wrapped bitcoin token, a contract that allows holders of bitcoin to lock up their funds in a contract that's then converted into an ERC20 token. All up, there hasn't been much of a change over the past three months – save for two odd occurrences that look like technical glitches. If anything, however, there has been a modest increase since April. So maybe bitcoin HODLers are looking to DeFi again.  Overall, the data are a bit of a wash. Given all the big developments in the space, there's still good reason to expect that DeFi Summer 2.0 is around the corner. But, as ever with still-young crypto markets, don't be counting your sushi/pizzas/yams just yet. A message from Residual Our software platform leverages blockchain's near instantaneous, immutable settlement capabilities and eliminates latency and costly transaction fees. By bridging the gap between traditional financial services and today's cutting edge technology, unFederalReserve can help thousands of non-bank lenders and borrowers around the world. The eRSDL community is diverse and inclusive, encourages engagement and ongoing support for each other, and is dedicated to DeFi projects that de-risk at every opportunity. We are pleased to welcome the first product in our ecosystem, the Reserve Lending platform - the beginning of a robust treasurer's tool kit that will streamline future banking transactions. The Conversation Musk Spoils the Party Illustration: Rachel Sun/CoinDesk Oh, Elon, how could you?    Wednesday evening's bitcoin sell-off was indisputably driven by this tweet from Tesla CEO Elon Musk. Why the violent reaction in crypto markets? It goes back to February 8, when Musk kicked off a new bout of bitcoin price gains in announcing that Tesla had bought $1.5 billion in bitcoin and planned to accept the cryptocurrency in payments. And now he has a change of heart.    Given that Musk, one of the three richest people on Earth, had recently turned himself into the most influential player in the crypto meme wars, his apparent reversal into someone spreading serious doubt prompted all sorts of reactions on Crypto Twitter.   J.P. Koning cleverly reminded us that the actual impact of this position change is meaningless, at least in terms of bitcoin demand and supply dynamics. But the point here is not that Tesla is curbing actual bitcoin transactions per se. It's about the signaling, most important to future buyers. In warning that bitcoin might not be such an environmentally friendly investment, Musk, with his 54 million followers, is giving license to ESG-conscious investors who might have been on the fence about buying it to say no.    And that needled people.    Author and hard-money bitcoin advocate Saifedean Ammous was predictably snarky, but his sharp and to-the-point tweet neatly highlighted a hypocrisy in Musk's position. Meanwhile, Chainstone Labs CEO and Satoshi Roundtable founder Bruce Fenton found a pointed way to tell everyone to move on. A message from Coindesk Unlocked 101 at Consensus by CoinDesk 2021   The countdown is on to Consensus by CoinDesk, our virtual big-tent event this May. For those who need a primer or to brush up on the fundamentals, we're hosting Unlocked 101, a free educational series designed to give you the tools you need to navigate crypto. Sessions run May 4–20, covering the basics of Bitcoin, DeFi, scams and hacks and the NFT boom. Register for Unlocked 101.   Relevant Reads Bitcoin ETF Ever?  In its endless wait for a U.S.-approved bitcoin exchange-traded fund, the Bitcoin community had more ups and downs this week. Mostly downs. CoinDesk's coverage started with Sebastian Sinclair's take on the upbeat assessment from Eric Balchunas, an ETF analyst at Bloomberg Intelligence, on the prospects of the Securities and Exchange Commission approving a bitcoin ETF this year. Balchunas was swayed by the solid performance of Canada's ETFs and the possibly crypto-friendly leanings of new SEC Chairman Gary Gensler. But a day later that optimistic take seemed premature. As Nikhilesh De and Danny Nelson reported, an SEC report poured cold water on those hopes with a rather downbeat assessment of bitcoin markets and that hinted that it was not going to rush into an ETF approval after all. So what's one of the more high-profiles submitters of a number or pending ETF approval requests doing? As Danny Nelson reported, mutual fund manager VanEck has begun stashing bitcoin into a new private fund and courting well-heeled investors who meet accredited investor standards. Meanwhile, Bitwise has decided it will find another way for mainstream investors to get exposure to cryptocurrencies. Daniel Palmer reported that the crypto asset manager had launched an ETF of 30 companies that can be considered "pure-plays" in the sector, including Coinbase and MicroStrategy. A message from CoinDesk Bitcoin Miner Metrics: Hashrate and Thermocap   How is hashrate calculated? What does thermocap represent? What do hashrate ribbons say about bitcoin price cycles? This research note looks at Bitcoin miner metrics and how investors can use them to glean insight into the asset's price and network fundamentals. Download the free report here. ATTENTION: Scammers have been sending fraudulent emails with links to sites disguised to look like coindesk.com. If you are in doubt about a link, type https://www.coindesk.com directly into your browser; do not copy and paste. Remember, if something seems too good to be true, it probably is. Money Reimagined   A newsletter from CoinDesk   See Previous Editions Copyright © 2021 CoinDesk, All rights reserved.    250 Park Avenue South New York, NY 10003, USA You can manage your preferences here or unsubscribe from all CoinDesk email.