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Risk Capital and Markets: A Temporary Retreat or Long Term Pull Back?

As inflation has taken center stage, markets have gone into retreat globally, and across asset classes. In 2022, as bond rates have risen, stock prices…

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As inflation has taken center stage, markets have gone into retreat globally, and across asset classes. In 2022, as bond rates have risen, stock prices have fallen, and crypto has imploded, even true believers are questioning what the bottom for markets might be, and when we will get there. While it is easy to call the market movement in 2022 a correction and to argue that it is overdue, it is facile, and it fails to address the question of why it is happening now, and whether the correction is overdone or has more to go. In this post, I will argue that almost everything that we are observing in markets, across asset classes, can be explained by a pull back on risk capital, and that understanding the magnitude of the pull back, and putting in historical perspective, is key to gauging what is coming next.

Risk Capital: What is it?

To put risk capital in perspective, it is best to start with a definition of risk that is comprehensive and all-inclusive, and that is to think of risk as a combination of danger (downside) and opportunity (upside) and to consider how investments vary in terms of exposure to both. In every asset class, there is a range of investment choices, with some being safer (or even guaranteed) and others being riskier.

Risk capital is the portion of capital that is invested in the riskiest segments of each market and safety capital is that portion that finds its way to the safest segments in each market

While risk and safety capital approach the market from opposite ends in the risk spectrum, one (safety capital) being driven by fear and the other (risk capital), by greed, they need to not only co-exist, but be in balance, for the market to be healthy. When to two are not in balance, these imbalances can have profound and often unhealthy effects not just of markets, but also on the overall economy. At the extremes, when risk capital is absent and everyone seeks safety, the economy and markets will atrophy, as businesses and investors will stay away from risky ventures, and when risk capital is too easy and accessible, risky asset prices will soar, and the economy will see too much growth in its riskiest segments, often at the expense of more stable (and still necessary) businesses.

Risk Capital's Ebbs and Flows

It is a common misconception that the risk-takers supply risk capital (risk takers) and that the investors who invest for safety draw from different investor pools, and that these pools remain unchanged over time. While investor risk aversion clearly does play a role in whether investors are drawn to invest in risk or safety capital, it obscures two realities:

  1. Variation within an investor's portfolio: Many investors, including even the most risk averse, may and often do  set aside a portion of their portfolios for riskier investments, drawn by the higher expected returns on those investments. For some investors, this set aside will be the portion that they can afford to lose, without affecting their life styles in any material way. For others, it can be the portion of their capital with the longest time horizon (pension fund savings or 401Ks, if you are a young investor, for example), where they believe that any losses on risk capital can be made up over time. For still others, it is that segment of their portfolios that they treat las long shot gambles, hoping for a disproportionately large payoff, if they are lucky. The amount that is put into the risk capital portion will vary with investor risk aversion, with more risk averse investors putting less or even nothing into the riskiest assets, and less risk averse investors putting in more.
  2. Variation across time: The amount that investors are willing to put into risk capital, or conversely redirect to safety capital, will change over time, with several factors playing a role in determining whether risk capital will be plentiful or scarce. The first is market momentum, since more money will be put into the riskiest asset classes, when markets are rising, because investors who benefit from these rising markets will have more capital that they are willing to risk. The second is the the health and stability of the economy, since investors with secure jobs and rising paychecks are more willing to take risks. 

There are two macro factors that will come into play, and both are in play in markets today. The first is the return that can be earned on guaranteed investments, i.e., US treasury bills and bonds, for instance, if you are a investor in US dollar, since it is a measure of what someone who takes no or very low risk can expect to earn. When treasury rates are low or close to zero, refusing to take risk will result in returns that are very low or close to zero as well, thus inducing investors to expose themselves to more risk than they would have taken in higher interest rate regimes. The second is inflation, which reduces the nominal return you make on all your investments, and the effects of rising inflation on risk capital are complex. As expected inflation rises, you are likely to see higher interest rates, and as we noted above, that may induce investors to cut back on risk taking and focus on earning enough to cover the ravages of inflation. As uncertainty about inflation rises, you will see reallocation of investment across asset classes, with real assets gaining when unexpected inflation is positive (actual inflation is higher than expected), and financial assets benefiting when unexpected inflation is negative (actual inflation is less than expected).

And Consequences

    If you are wondering why you should care about risk capital's ebbs and flows, it is because you will feel its effects in almost everything you do in investing and business. 

  1. Risk Premiums: The risk premiums that you observe in every risky asset market are a function of how much risk capital there is in play, with risk premiums going up when risk capital becomes scarcer and down, when risk capital is more plentiful. In the bond and loan market, access to risk capital will determine default spreads on bonds, with lower rated bonds feeling the pain more intensely when risk capital is withdrawn or moves to the side lines. Not only will default spreads widen more for lower-rated bonds, but there will be less bond issuances by riskier companies. In the equity market, the equity risk premium is the price of risk, and its movements will track shifts in risk capital, increasing as risk capital becomes scarcer. 
  2. Price and Value Gaps: As those of you who read this blog know well, I draw a contrast between value and price, with the former driven by fundamentals (cash flows, growth and risk) and the latter by mood, momentum and liquidity. The value and price processes can yield different numbers for the same company, and the two numbers can diverge for long periods, with convergence not guaranteed but likely over long periods.

    I argue that investors play the value game, buying investments when the price is less than the value and hoping for convergence, and that traders play the pricing game, buying and selling on market momentum, rather than fundamentals. At the risk of generalizing, safety capital, with its focus on earnings and cash flows now, is more likely to focus on fundamentals, and play the investor game, whereas risk capital, drawn by the need to make high returns quickly, is more likely to play the trading game. Thus, when risk capital is plentiful, you are more likely to see the pricing game overwhelm the value game, with prices often rising well above value, and more so for the riskiest segments of every asset class. A pull back in risk capital is often the catalyst for corrections, where price not only converges back on value, but often overshoots in the other direction (creating under valuations). It behooves both investors and traders to therefore track movements in risk capital, since it is will determine when long term bets on value will pay off for the former, and the timing of entry into and exit from markets for the latter.
  3. Corporate Life Cycle: The ebbs and flows of risk capital have consequences for all businesses, but the effects will vary widely across companies, depending on where they are in the life cycle. Using another one of my favorite structures, the corporate life cycle, you can see the consequences of expanding and shrinking risk capital, through the lens of free cash flows (and how they vary across the life cycle).

    Early in the corporate life cycle, young companies have negative free cash flows, driven by losses on operations and investments for future growth, making them dependent on risk capital for survival and growth. As companies mature, their cash flows first become self sustaining first, as operating cash flows cover investments, and then turn large and positive, making them not only less dependent on risk capital for survival but also more valued in an environment where safety capital is dominant. Put simply, as risk capital becomes scarcer, young companies, especially those that are money-losing and with negative cash flows, will see bigger pricing markdowns and more failures than more mature companies.

Risk Capital: Historical Perspective

How do you track the availability and access to risk capital over time? There are three proxies that I will  use, and while each has its limitations, read together, they can provide a fuller measure of the ebbs and flows of risk capital. The first is funds invested by venture capitalists, with a breakdown further into types, from pre-seed and seed financing to very young companies to capital provided to more young companies with more established business models, as a prelude to exit (acquisition or IPO). The second is the trend line in initial public offerings (number and value raised), since companies are more likely to go public and be able to raise more capital in issue proceeds, when risk capital is plentiful. The third is original bond issuances by the riskiest companies (below investment grade and high yield), since these issuances are more likely to have a friendly reception when risk capital is easily available than when it is not.

Let’s start with venture capital, the typical source of capital for start ups and young companies for decades in the United States, and more recently, in the rest of the world. In the graph below, I trace out total venture capital raised, by year, between 1995 and 2021, in the US: 

Source: NVCA Yearbooks
The dot-com boom in the 1990s created a surge in venture capital raised and invested, with venture capital raised peaking at more than $100 billion in 2000, before collapsing as the that bubble burst. The 2008 banking and market crisis caused a drop of almost 50% in 2009, and it took the market almost five years to return to pre-crisis levels.   In the just-concluded decade, from 2011 to 2020,  the amount raised and invested by venture capitalists has soared, and almost doubled again in 2021, from 2020 levels, with venture capital raised in 2021 reaching an all-time high of $131 billion, surpassing the 2000 dot-com boom levels, albeit in nominal terms. Along the way, exits from past venture capital investments, either in IPOs or in M&A, have become more lucrative for the most successful companies, with 43 exits that exceeded a billion (the unicorn status) in 2021. 

If success in venture capital comes from exiting investments at a higher pricing, initial public offerings represent the most lucrative route, and tracking the number of initial public offerings over time provides a window on the ebbs and flows of risk capital, over long periods. Using data made public by Jay Ritter on IPOs, I track the number of IPO and dollar proceeds from offerings in the graph below from 1980 to 2021:
Source: Jay Ritter
As you can see, IPOs go through hot periods (when issuances surge) and cold ones (when there are relatively few listed), with much of the last decade representing hot periods and 2000/01 and 2008/09 representing periods when there were hardly any offerings. While the number of IPOs in 2021 is still below the peak dot-com years, the proceeds from IPOs has surged to an all-time high during the year.

    In the final graph, I look at corporate bond offerings, broken down into investment grade and high yield, by year, from 1996 to 2021:

Source: SIFMA

Here again, you see a familiar pattern, with the percentage of high-yield bond issuances tracking the availability of risk capital. As with IPOs, you see big dips in 2000-01and 2008-09, reflecting market corrections and crises, and a period of easy access to risk capital in the last decade. Again, the percentage of corporate bond issuances hit an all-time high in 2021, representing more than a quarter of all bond issuances. In sum, all three proxies for risk capital show the same patterns over time, pulling back and surging during the same time periods, and with all three proxies, it is clear that 2021 was a boom year.

An Update

The last two and a half years may not represent much time on a historical scale, but the period has packed in enough surprises to make it feel like we have aged a decade. We started 2020 with a pandemic that altered our personal, work and financial lives, and in 2022, at least in North America and Europe, we have seen inflation reach levels that we have not seen for decades. Looking at the 30 months through the lens of risk capital can help us understand not only the journey that markets have gone through to get where they are today, but also perhaps decipher where they may go next. In the graph below, I look at venture capital, IPOs and high yield bond issuances over the last two and a half years:


The first thing to note is that there was a pullback on all three measures in the first quarter of 2020, as COVID put economies into deep freeze and rolled markets. The big story, related to COVID, is that risk capital not only did not stay on the side lines for long but came surging back to levels that exceeded pre-COVID numbers, with all three measures hitting all-time highs in 2021. In a post in late 2020, I argued that it was the resilience of risk capital that explained why markets recovered so quickly that year, even as the global economy struggled, that year, and pointed to three explanatory factors. The first was the perception that the COVID shut-down was temporary, and that economies would come back quickly, once the immediate threat from the virus passed. The second was the decline in interest rates across the globe, with rates in developed market currencies (US $, Euro, Japanese Yen etc.) moving towards zero, increasing the costs of staying on the sidelines.  The third was a change in investor composition, with a shift from institutional to individual investor market leadership, and increased globalization.

    The first half of 2022 has been a trying period for markets, and as inflation has risen, it is having an effect on the availability of and access to risk capital. There has been a pullback in all three proxies for risk capital, albeit smaller in venture capital, than in IPOs and in high-yield bond issuances in the first few months of 2022. That pullback has had its consequences, with equity risk premiums rising around the world. In the graph below, I have updated the equity risk premium for the S&P 500 through the start of July 2022:

Spreadsheet for implied ERP

The chart reveals how unsettling this year has been for equity investors, in the United States. Not only has the implied ERP surged to 6.43% on June 23, 2022, from 4.24% on January 1, 2022, but stocks are now being priced to earn 9.45% annually, up from the 5.75% at the start of the year. (The jump in ERP may be over stated, since the forward earnings estimates for the index, from analysts, does not seem to be showing any upcoming pain from an expected recession. )

As inflation and recession fears have mounted, equity markets are down significantly around the world, but the drop in pricing has been greatest in the riskiest segments of the market. In the table below, I look at the price change in the first six months of 2022 for global stocks, broken down by quintiles, into net profit margin and revenue growth classes:
Source for raw data: S&P Cap IQ

Note that high growth, negative earnings companies have fared much worse, in general, during the 2022 downturn, than more mature, money-making companies.  The fear factor that is tilting the balance back to safety capital from risk capital has also had clear consequences in the speculative collectibles space, with cryptos bearing the brunt of the punishment. Finally, there are markdowns coming to private company holdings, both in the hands of venture capitalists, and public market investors (including mutual funds that have been drawn into this space and public companies like Softbank).

    The big question that we all face, as we look towards the second half of the year, is whether the pullback in risk capital is temporary, as it was in 2020, or whether it is more long term, as it was after the dot-com bust in 2000 and the market crisis in 2008. If it is the former, there is hope of not just a recovery, but a strong rebound in risky asset prices, and if it is the latter, stocks may stabilize, but the riskiest assets will see depressed prices for much longer. I don't have a crystal ball or any special macro forecasting abilities, but if I had to guess, it would be that it is the latter. Unlike a virus, where a vaccine may provide at least the semblance of a quick cure (real or imagined), inflation, once unleashed, has no quick fix. Moreover, now that inflation has reared its head, neither central banks nor governments can provide the boosts that they were able to in 2020 and may even have to take actions that make things worse, rather than better, for risk capital. Finally, at the risk of sounding callous, I do think that a return of fear and a longer term pullback in risk capital is healthy for markets and the economy, since risk capital providers, spoiled by a decade or more of easy returns, have become lazy and sloppy in their pricing and trading decisions, and have, in the process, skewed capital allocation in the economy. If a long-term slowdown is in the cards, it is almost certain that the investment strategies that delivered high returns in the last decade will no longer work in this new environment, and that old lessons, dismissed as outdated just a few years go, may need to be relearned. 

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How The State Of Global Markets Could Be Pushing The Federal Reserve To Adopt Bitcoin

Analyzing the precarious positions of the world’s fiat economies can drive a conclusion that the Federal Reserve will have to adopt bitcoin.

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Analyzing the precarious positions of the world’s fiat economies can drive a conclusion that the Federal Reserve will have to adopt bitcoin.

This is an opinion editorial by Mike Hobart, a communications manager for Great American Mining.

Photo by Daniel Lloyd Blunk-Fernández via Unsplash

In the wee hours of the morning on Friday, September 23, 2022, markets saw yields on the U.S. 10-year bond (ticker: US10Y) spike up over 3.751% (highs not seen since 2010) shocking the market into fears of breaching 4% and the potential for a run in yields as economic and geopolitical uncertainty continued to gain momentum.

Source: TradingView

Yields would slowly grind throughout the weekend and at approximately 7:00 a.m. Central Time on Wednesday, September 28, that feared 4% mark on the US10Y was crossed. What followed, approximately three hours later, around 10:00 a.m. on Wednesday, September 28, was a precipitous cascade in yields, falling from 4.010% to 3.698% by 7:00 p.m. that day.

Source: TradingView

Now, that may not seem like much cause for concern to those unfamiliar with these financial instruments but it is important to understand that when the U.S. bond market is estimated to be about $46 trillion deep as of 2021, (spread across all of the various forms that “bonds” can take) as reported by SIFMA, and taking into consideration the law of large numbers, then to move a market that is as deep as the US10Y that rapidly requires quite a lot of financial “force” — for lack of a better term.

Source: TradingView

It’s also important to note here for readers that yields climbing on the US10Y denotes exiting of positions; selling of 10-year bonds, while yields falling signals purchasing of 10-year bonds. This is where it is also important to have another discussion, because at this point I can hear the gears turning: “But if yields falling represents buying, that’s good!” Sure, it could be determined as a good thing, normally. However, what is happening now is not organic market activity; i.e., yields falling currently is not a representation of market participants purchasing US10Ys because they believe it to be a good investment or in order to hedge positions; they are buying because circumstance is forcing them to buy. This is a strategy that has come to be known as “yield curve control” (YCC).

“Under yield curve control (YCC), the Fed would target some longer-term rate and pledge to buy enough long-term bonds to keep the rate from rising above its target. This would be one way for the Fed to stimulate the economy if bringing short-term rates to zero isn’t enough.” 

–Sage Belz and David Wessel, Brookings

This is effectively market manipulation: preventing markets from selling-off as they would organically. The justification for this is that bonds selling off tend to impact entities like larger corporations, insurance funds, pensions, hedge funds, etc. as treasury securities are used in diversification strategies for wealth preservation (which I briefly describe here). And, following the market manipulations of the Great Financial Crisis, which saw the propping up of markets with bailouts, the current state of financial markets is significantly fragile. The wider financial market (encompassing equities, bonds, real estate, etc.) can no longer weather a sell-off in any of these silos, as all are so tightly intertwined with the others; a cascading sell-off would likely follow, otherwise known as “contagion.”

The Brief

What follows is a brief recount (with elaboration and input from myself throughout) of a Twitter Spaces discussion led by Demetri Kofinas, host of the “Hidden Forces Podcast,” which has been one of my favorite sources of information and elaboration on geopolitical machinations of late. This article is meant solely for education and entertainment, none of what is stated here should be taken as financial advice or recommendation.

Host: Demetri Kofinas

Speakers: Evan Lorenz, Jim Bianco, Michael Green, Michael Howell, Michael Kao

What we have been seeing over recent months is that central banks across the world are being forced into resorting to YCC in an attempt to defend their own fiat currencies from obliteration by the U.S. dollar (USD) as a dynamic of the Federal Reserve System of the United States’ aggressive raising of interest rates.

Source

An additional problem to the U.S.’s raising of interest rates is that as the Federal Reserve (the Fed) hikes interest rates, which also causes the interest rates that we owe on our own debt to rise; increasing the interest bill that we owe to ourselves as well as those who own our debt, resulting in a “doom loop” of requiring further debt sales to pay down interest bills as a function of raising the cost of said interest bills. And this is why YCC gets implemented, as an attempt to place a ceiling on yields while raising the cost of debt for everyone else.

Meanwhile this is all occurring, the Fed is also attempting to implement quantitative tightening (QT) by letting mortgage-backed securities (MBS) reach maturity and effectively get cleared off their balance sheets — whether QT is “ackchually” happening is up for debate. What really matters however is that this all leads to the USD producing a financial and economic power vacuum, resulting in the world losing purchasing power in its native currencies to that of the USD.

Now, this is important to understand because each country having its own currency provides the potential for maintaining a virtual check on USD hegemony. This is because if a foreign power is capable of providing significant value to the global market (like providing oil/gas/coal for example), its currency can gain power against the USD and allow them to not be completely beholden to U.S. policy and decisions. By obliterating foreign fiat currencies, the U.S. gains significant power in steering global trade and decision making, by essentially crippling the trade capabilities of foreign bodies; allied or not.

This relationship of vacuuming purchasing power into the USD is also resulting in a global shortage of USD; this is what many of you have likely heard at least once now as “tightening of liquidity,” providing another point of fragility within economic conditions, on top of the fragility discussed in the introduction, Increasing the likelihood of “something breaking.”

The Bank Of England

This brings us to events around the United Kingdom and the Bank of England (BoE). What transpired across the Atlantic was effectively something breaking. According to the speakers in Kofinas’ Spaces discussion (because I have zero experience in these matters), the U.K. pension industry employs what Howell referred to as “duration overlays” which can reportedly involve leverage of up to twenty times, meaning that volatility is a dangerous game for such a strategy — volatility like the bond markets have been experiencing this year, and particularly these past recent months.

When volatility strikes, and markets go against the trades involved in these types of hedging strategies, when margin is involved, then calls will go out to those whose trades are losing money to put down cash or collateral in order to meet margin requirements if the trade is still desired to be held; otherwise known as “margin calls.” When margin calls go out, and if collateral or cash is not posted, then we get what is known as a “forced liquidation”; where the trade has gone so far against the holder of the position that the exchange/brokerage forces an exit of the position in order to protect the exchange (and the position holder) from going into a negative account balance — which can have the potential of going very, very deeply negative.

This is something readers may remember from the Gamestop/Robinhood event during 2020 where a user committed suicide over such a dynamic playing out.

What is rumored to have occurred is that a private entity was involved in one (or more) of these strategies, the market went against them, placing them in a losing position, and margin calls were very likely to be sent out. With the potential of a dangerous cascade of liquidations, the BoE decided to step in and deploy YCC in order to avoid said liquidation cascade.

To further elaborate on the depth of this issue, we look to strategies deployed in the U.S. with pension management. Within the U.S., we have situations where pensions are (criminally) underfunded (which I briefly mentioned here). In order to remedy the delta, pensions are either required to put up cash or collateral to cover the difference, or deploy leverage overlay strategies in order to meet the returns as promised to pension constituents. Seeing how just holding cash on a corporate balance sheet is not a popular strategy (due to inflation resulting in consistent loss of purchasing power) many prefer to deploy the leverage overlay strategy; requiring allocating capital to margin trading on financial assets in the aim of producing returns to cover the delta provided by the underfunded position of the pension. Meaning that the pensions are being forced by circumstance to venture further and further out onto the risk curve in order to meet their obligations.

Source

As Bianco accurately described in the Spaces, the move by the BoE was not a solution to the problem. This was a band-aid, a temporary alleviation strategy. The risk to financial markets is still the threat of a stronger dollar on the back of increasing interest rates coming from the Fed.

Howell brought up an interesting point of discussion around governments, and by extension central banks, in that they do not typically predict (or prepare) for recessions, they normally react to recessions, giving credit to Bianco’s consideration that there is potential for the BoE to have acted too early in this environment.

One very big dynamic, as positioned by Kao, is that while so many countries are resorting to intervention across the globe, everybody seems to be expecting this to apply pressure on the Fed providing that fabled pivot. There’s the likelihood that this environment actually incentivizes individualist strategies for participants to act in their own interests, alluding to the Fed throwing the rest of the world’s purchasing power under the bus in order to preserve USD hegemony.

Oil

Going further, Kao also brought up his position that price inflation in oil is a major elephant in the room. The price per barrel has been falling as expectations for demand continue to slide along with continual sales of the U.S.’s strategic petroleum reserve washing markets with oil, when supply outpaces demand (or, in this case, the forecast of demand). Then basic economics dictate that prices will diminish. It is important to understand here that when the price of a barrel of oil falls, incentives to produce more diminish, leading to slow downs in investment in oil production infrastructure. And what Kao goes on to suggest is that if the Fed were to pivot, this would result in demand returning to markets, and the inevitability for oil to resume its ascent in price will place us right back to where this problem began.

I agree with Kao’s positions here.

Kao continued to elaborate on how these interventions by central banks are ultimately futile because, as the Fed continues to hike interest rates, foreign central banks simply only succeed in burning through reserves while also debasing their local currencies. Kao also briefly touched on a concern with significant levels of corporate debt around the world.

China

Lorenz chimed in with the addition that the U.S. and Denmark are really the only jurisdictions that have access to 30-year fixed rate mortgages, with the rest of the world tending to employ floating-rate mortgages or instruments that institute fixed rates for a brief period, later resetting to a market rate.

Lorenz went on, “…with rising rates we’re actually going to be crimping spending a lot around the world.”

And Lorenz followed up to state that, “The housing market is also a big problem in China right now… but that’s kind of the tip of the iceberg for the problems…”

He went on, referring to a report from Anne Stevenson-Yang of J Capital, where he said that she details that the 65 largest real estate developers in China owe about 6.3 trillion Chinese Yuan (CNY) in debt (about $885.5 billion). However, it gets worse when looking at the local governments; they owe 34.8 trillion CNY (about $4.779 trillion) with a hard right hook coming, amounting to an additional 40 trillion CNY ($5.622 trillion) or more in debt, wrapped up in “local financing vehicles.” This is supposedly leading to local governments getting squeezed by China’s collapse in its real estate markets, while seeing reductions in production rates thanks to President Xi’s “Zero Covid” policy, ultimately suggesting that the Chinese have abandoned trying to support the CNY against USD, contributing to the power vacuum in USD.

Bank Reserves

Contributing to this very complex relationship, Lorenz re-entered the conversation by bringing up the issue of bank reserves. Following the events of the 2008 Global Financial Crisis, U.S. banks have been required to maintain higher reserves in the aim of protecting bank solvency, but also preventing those funds from being circulated within the real economy, including investments. One argument could be made that this could be helping to keep inflation muted. According to Bianco, bank deposits have seen reallocations to money market funds to capture a yield with the reverse repurchase agreement (RRP) facility that is 0.55% higher than the yield on treasury bills. This ultimately results in a drain on bank reserves, and suggested to Lorenz that a furthering of the dollar liquidity crisis is likely, meaning that the USD continues to suck up purchasing power — remember that shortages in supply result in increases in price.

Conclusion

All of this basically adds up to the USD gaining rapid and potent strength against nearly all other national currencies (except perhaps the Russian ruble), and resulting in complete destruction of foreign markets, while also disincentivizing investment in nearly any other financial vehicle or asset.

Now, For What I Did Not Hear

I very much suspect that I am wrong here, and that I am misremembering (or misinterpreting) what I have witnessed over the past two years.

But I was personally surprised to hear zero discussion around the game theory that has been occurring between the Fed and the European Central Bank (ECB), in league with the World Economic Forum (WEF), around what I have perceived as language during interviews attempting to suggest that the Fed needs to print more money in order to support the economies of the world. This support would suggest an attempt to maintain the balance of power between the opposing fiat currencies by printing USD in order to offset the other currencies being debased.

Now, we know what has played out since, but the game theory still remains; the ECB’s decisions have resulted in significant weakening of the European Union, leading to the weakness in the euro, as well as weakening relations between the European nations. In my opinion, the ECB and WEF have signaled aggressive support and desire for developments of central bank digital currencies (CBDCs) as well as for more authoritarian policy measures of control for their constituents (what I see as vaccine passports and attempts at seizing lands held by their farmers, for starters). Over these past two years, I believe that Jerome Powell of the Federal Reserve had been providing aggressive resistance to the U.S.’s development of a CBDC, while the White House and Janet Yellen have ramped up pressures on the Fed to work on producing one, with Powell’s aversion to development of a CBDC seeming to wane in recent months against pressures from the Biden administration (I’m including Yellen in this as she has, in my opinion, been a clear extension of the White House).

It makes sense to me that the Fed would be hesitant to develop a CBDC, aside from being hesitant to employ any technology that is not understood, with the reasoning being that the U.S.’s major commercial banks share in ownership of the Federal Reserve System; a CBDC would completely destroy the function that commercial banks serve in providing a buffer between fiscal and monetary policy and the economic activity of average citizens and businesses. Which is precisely why, in my humble opinion, Yellen wants production of a CBDC; in order to gain control over economic activity from top to bottom, as well as to gain the ability to violate every citizens’ rights to privacy from the prying eyes of the government. Obviously, government entities can acquire this information today anyway, however, the bureaucracy we have currently can still serve as points of friction to acquiring said information, providing a veil of protection for the American citizen (although a potentially weak veil).

What this ultimately amounts to is; one, a furthering of the currency war that has been ensuing since the start of the pandemic, largely going underappreciated as the world has been distracted with the hot war occurring within Ukraine, and two, an attempt at further destruction of individual rights and freedoms both within, and outside of, the United States. China seems to be the furthest along in the world with regards to development of a sovereign power’s CBDC, and its implementation is much easier for it; it has had its social credit score system (SCS) active for multiple years now, making integration of such an authoritarian wet dream much easier, as the invasion of privacy and manipulation of the populace via the SCS is providing a foot in the door.

The reason I’m surprised that I did not hear this make it into discussion is that this adds a very, very important dynamic to the game theory of the decision making behind the Fed and Powell. If Powell understands the importance of maintaining the separation of central and commercial banks (which I believe he does), and if understands the importance of maintaining USD hegemony with regards to the U.S.’s power over foreign influence (which I believe he does), and he understands the desires for bad actors to have such perverse control over a population’s choices and economic activity via a CBDC (which I believe he might), he would therefore understand how important it is for the Fed to not only resist the implementation of a CBDC but he would also understand that, in order to protect freedom (both domestically and abroad), that this ideology of proliferation of freedom would require both an aversion to CBDC implementation and a subsequent destruction of competition against the USD.

It’s also important to understand that the U.S. is not necessarily concerned with the USD gaining too much power because we largely import the majority of our goods — we export USD. In my opinion, what follows is that the U.S. utilizes the crescendo of this power vacuum in an attempt to gobble up and consolidate the globe’s resources and build out the necessary infrastructure to expand our capabilities, returning the U.S. as a producer of high quality goods.

This Is Where I May Lose You

This therefore opens up a real opportunity for the U.S. to further its power… with the official adoption of bitcoin. Very few discuss this, and even fewer may recall, but the FDIC went around probing for information and comment in its exploration of how banks could hold “crypto” assets on their balance sheets. When these entities say “crypto,” they more often than not mean bitcoin — the problem is that the general populace’s ignorance of Bitcoin’s operations cause them to see bitcoin as “risky” when aligning with the asset, as far as public relations are concerned. What’s even more interesting is that we have not heard a peep out of them since… leading me to believe that my thesis may be more likely to be correct than not.

If my reading of Powell’s situation were correct, and this all were to play out, the U.S. would be placed in a very powerful position. The U.S. is also incentivized to follow this strategy as our gold reserves have been dramatically depleted since World War II, with China and Russia both holding signficant coffers of the precious metal. Then there’s the fact that bitcoin is still very early in its adoption with regards to utilization across the globe and institutional interest only just beginning.

If the U.S. wants to avoid going down in history books as just another Roman Empire, it would behoove it to take these things very, very seriously. But, and this is the most important aspect to consider,I assure you that I have likely misread the environment.

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This is a guest post by Mike Hobart. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

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Economics

Dollar Slump Halted as Stocks and Bonds Retreat

Overview: Hopes that the global tightening cycle is entering its last phase supplied the fodder for a continued dramatic rally in equities and bonds….

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Overview: Hopes that the global tightening cycle is entering its last phase supplied the fodder for a continued dramatic rally in equities and bonds. The euro traded at par for the first time in two weeks, while sterling reached almost $1.1490, its highest since September 15. The US 10-year yield has fallen by 45 bp in the past five sessions. Yet, the scar tissue from the last bear market rally is still fresh and US equity futures are lower after the S&P 500 had its best two days since 2020. Europe’s Stoxx 600, which has gained more than 5% its three-day rally is more around 0.9% lower in late morning turnover. The large Asia-Pacific bourses advanced, led by a nearly 6% rally in Hong Kong as it returned from holiday. Similarly, the bond market, which rallied with stocks, has sold off. The US 10-year yield is up around seven basis points to 3.70%, while European yields are 7-14 bp higher. Peripheral premiums are also widening. The dollar is firmer against most G10 currencies, with the New Zealand dollar holding its own after the central bank delivered was seems to be a hawkish 50 bp hike. Emerging market currencies are mostly lower, including Poland where the central bank is expected to deliver a 25 bp hike shortly. After rising to $1730 yesterday, gold is offered and could ease back toward $1700 near-term. December WTI is consolidating after rallying around 8.5% earlier this week as the OPEC+ decision is awaited. Speculation over a large nominal cut helped lift prices. US and European natural gas prices are softer today. Iron ore is extended yesterday’s gains, while December copper is paring yesterday’s 2.35% gain. December wheat is off for a third session, and if sustained, would be the longest losing streak since mid-August.  

Asia Pacific

The Reserve Bank of New Zealand quickly laid to rest ideas that the Reserve Bank of Australia's decision to hike only a quarter of a point yesterday instead of a half-point was representative of a broader development. It told us nothing about anything outside of Australia. The RBNZ delivered the expected 50 bp increase and acknowledged it had considered a 75 bp move. In addition, it signaled further tightening would be delivered. It meets next on November 23, and the market has more than an 85% chance of another 50 bp hike discounted.

Both Australia and Japan's final service and composite PMI were revised higher in the final reading. Japan's service PMI was tweaked to 52.2 from 51.9. It was 49.5 in August. Similarly, the composite is at 51.0, up from 50.9 flash reading and 49.4 in August. In Australia, the service and composite PMI were at 50.2 in August. The flash estimate put it at 50.4 and 50.8, respectively. The final reading is 50.6 and 50.9 for the service and composite PMI.

Softer US yields weighed on the dollar against the yen. On Monday, it briefly traded above JPY145. Today, it traded at a seven-day low, slightly above JPY143.50. US yields are firmer, and the greenback has recovered and traded above JPY144.50 in early European turnover. The intraday momentum indicators are getting stretched, and the JPY144.75 area may cap it today. The Australian dollar traded to almost $.06550 yesterday but has struggled to sustain upticks over $0.6520 today. Initial support is seen in the $0.6450-60 area. Trade figures are out tomorrow. The New Zealand dollar initially rose to slightly through $0.5800 on the back of the hike but has succumbed to the greenback's strength. It returned little changed levels around $0.5730 before finding a bid in Europe. The US dollar reached CNH7.2675 last week and finished last week near CNH7.1420. It fell to almost CNH7.01 today and bounced smartly. A near-term low look to be in place, a modest dollar recovery seems likely. 

Europe

UK Prime Minister Truss will speak at the Tory Party Conference as the North American session gets under way. We argued that calling retaining the 45% highest marginal tax rate a "U-turn" was an exaggeration and misreading of the new government. It was the most controversial part of the mini budget apparently among the Tory MPs. This was a strategic retreat and a small price to pay for the other 98% of Kwarteng's announcement. Bringing forward the November 23 "medium-term fiscal plan" (still to be confirmed with specifics) is more about process than substance. The fact that she seems to be considering not making good her Tory predecessor pledge to link welfare payments to inflation suggests she has not been chastened by the cold bath reception to her government's first actions. However, on another front, Truss is changing her stance. As Foreign Secretary she drafted legislation that overrode the Northern Ireland Protocol unilaterally. In a more profound shift, she has abandoned the legislation and UK-EU talks resumed this week Truss is hopeful for a deal in the spring. Lastly, we note that the UK service and composite PMI were revised to show smaller deterioration from August. The service PMI is at 50 not 49.2 as the flash estimate had it. It was at 50.9 previously. The composite remains below 50 at 49.1, but the preliminary estimate had it at 48.4 from 49.6 in August. 

Germany's announcement of the weekend of a 200 bln euro off-budget "defensive shield" has spurred more rancor in Europe. Not all countries have the fiscal space of Germany. Two EC Commissioners called for an EU budget response. They seem to look at the 1.8 trillion-euro joint debt program (Next Generation fund) as precedent. This is, of course, the issue. During the pandemic, some suggested this was a key breakthrough for fiscal union, a congenital birth defect of EMU. However, this is exactly what the fight is about. If there is no joint action, the net result will likely be more fragmentation of the internal markets. Still, the creditor nations will resist, and Germany's Finance Minister Linder was first out of the shoot. While claiming to be open to other measures, Linder argued that challenge now is from supply shock, not demand. On the other hand, the European Parliament mandated that all mobile phones, tablets, and cameras are equipped with USB-C charge by the end of 2024. The costs savings is estimated to be around 250 mln euros a year. No fiscal union, partial banking, and monetary union, but a charger union.

The final PMI disappointed in the eurozone. The Big 4 preliminary readings were revised lower, suggesting conditions deteriorated further since the flash estimates. It was small change, but the direction was uniform. On the aggregate level, the service PMI was revised lower to 48.8 from 48.9 and 49.8 in August. The composite reading eased to 48.1 from 48.2 preliminary estimate and 48.9 in August. Italy and Spain, for which there is no flash report, were both weaker than expected, further below the 50 boom/bust level. France was the only one of these four that had a composite reading above 50 and improved from August. Separately, France reported a dramatic 2.4% rise in the August industrial output. The median forecast in Bloomberg's survey was for an unchanged report. Lastly, we note that Germany's August trade surplus was a quarter of the size that economists (median in the Bloomberg survey) expected at 1.2 bln euros instead of 4.7 bln. Adding insult to injury, the July balance was revised to 3.4 bln euros from 5.4 bln.

The euro stalled near $1.00 yesterday, the highest level since September 20. However, it has come back better offered today and fell slightly below $0.9925 in early European activity. Initial support is seen around $0.9900 and then $0.9840-50. The euro finished last week slightly above $0.9800. We suspect that market may consolidate broadly now ahead of Friday's US jobs report. The euro's gains seem more a function of short covering than bottom picking. Sterling edged a little closer to $1.15 but could not push through and has been setback to about $1.1380. The intraday momentum indicators allow for a bit more slippage and the next support area is around $1.1350.

America

Fed Chair Powell has explained that for inflation, one number, the PCE deflator best captures the price pressures. However, he says, the labor market has many dimensions and no one number does it justice. Weekly initial jobless claims fell to five-month lows in late September. On the other hand, the ISM manufacturing employment index fell below the 50 boom/bust level for the fourth month in the past five. The JOLTS report showed the labor market easing, with job openings falling by nearly a million to its lowest level in 14 months. Yet, despite the talk about the Reserve Bank of Australia's smaller cut as some kind of tell of Fed policy (eye roll) and the drop in JOLTS, the fact of the matter is that the market view of the trajectory of Fed policy has not changed. Specifically, the probability of a 75 bp hike is almost 77% at yesterday's settlement, which is the most since last Monday. The terminal rate is still seen in 

Attention may turn to the ADP report due today but recall that they have changed their model and explicitly said that it is not meant to forecast the national figures. Those are due Friday. Also, along with the ADP data, the US reports the August trade figures today. We are concerned that the US trade deficit will deteriorate again and note that dollar is at extreme levels of valuation on the OECD's purchasing power parity model. That may be a 2023 story. What counts for GDP, of course, is the real trade balance, and in July it was at its lowest level since last October. Despite the strong dollar, US goods exports reached a record in July. Imports fell to a five-month low, which, at least in part, seems to reflect the difficult in many consumer businesses in managing inventories. The final PMI reading is unlikely to draw much attention. The preliminary reading had the composite rising for the first time in six months but still below the 50 at 49.3. The ISM services offer new information. The risk seems to be on the downside of the median forecast for 56.0 from 56.9.

Yesterday, we mistakenly said that would report is August building permits and trade figure, but they are out today. Permits, which likely fell for the third straight month, as the tighter monetary policy bits. The combination of slowing world growth and softer commodity prices warns the best of the positive terms-of-trade shock is behind it. The trade surplus is expected to fall for the second consecutive month. Even before the RBA delivered the 25 bp rate hike, the market had been downgrading the probability of a half-point move from the Bank of Canada. Last Thursday, the swaps market had it as a 92% chance. At the close Monday, it had been downgraded to a little less 72%. Yesterday, it slipped slightly below 65%. Further softening appears to be taking place today, even after the RBNZ's 50 bp hike. The odds have slipped below 50% in the swaps market.

After finishing last week slightly above CAD1.38, the US dollar has been sold to nearly CAD1.35 yesterday. No follow-through selling has been seen and the greenback was bid back to CAD1.3585. The Canadian dollar has fallen out of favor today as US equity index futures are paring gains after two strong advances. There may be scope for CAD1.3630 today if the sale of US equities resumes. The greenback has found a base around MXN19.95. The risk-off mod can lift it back toward MXN20.10-15. Look for the dollar to also recover more against the Brazilian real after bouncing off the BRL5.11 area yesterday.

 


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Spread & Containment

Plunging pound and crumbling confidence: How the new UK government stumbled into a political and financial crisis of its own making

Liz Truss took over as prime minister with an ambitious plan to cut taxes by the most since 1972 – investors balked after it wasn’t clear how she would…

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The hard hats likely came in handy recently for Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng. Stefan Rousseau/Pool Photo via AP

The new British government is off to a very rocky start – after stumbling through an economic and financial crisis of its own making.

Just a few weeks into its term on Sept. 23, 2022, Prime Minister Liz Truss’ government released a so-called mini-budget that proposed £161 billion – about US$184 billion at today’s rate – in new spending and the biggest tax cuts in half a century, with the benefits mainly going to Britain’s top earners. The aim was to jump-start growth in an economy on the verge of recession, but the government didn’t indicate how it would pay for it – or provide evidence that the spending and tax cuts would actually work.

Financial markets reacted badly, prompting interest rates to soar and the pound to plunge to the lowest level against the dollar since 1985. The Bank of England was forced to gobble up government bonds to avoid a financial crisis.

After days of defending the plan, the government did a U-turn of sorts on Oct. 3 by scrapping the most controversial component of the budget – elimination of its top 45% tax rate on high earners. This calmed markets, leading to a rally in the pound and government bonds.

As a finance professor who tracks markets closely, I believe at the heart of this mini-crisis over the mini-budget was a lack of confidence – and now a lack of credibility.

A looming recession

Truss’ government inherited a troubled economy.

Growth has been sluggish, with the latest quarterly figure at 0.2%. The Bank of England predicts the U.K. will soon enter a recession that could last until 2024. The latest data on U.K. manufacturing shows the sector is contracting.

Consumer confidence is at its lowest level ever as soaring inflation – currently at an annualized pace of 9.9% – drives up the cost of living, especially for food and fuel. At the same time, real, inflation-adjusted wages are falling by a record amount, or around 3%.

It’s important to note that many countries in the world, including the U.S. and in mainland Europe, are experiencing the same problems of low growth and high inflation. But rumblings in the background in the U.K. are also other weaknesses.

Since the financial crisis of 2008, the U.K. has suffered from lower productivity compared with other major economies. Business investment plateaued after Brexit in 2016 – when a slim majority of voters chose to leave the European Union – and remains significantly below pre-COVID-19 levels. And the U.K. also consistently runs a balance of payments deficit, which means the country imports a lot more goods and services than it exports, with a trade deficit of over 5% of gross domestic product.

In other words, investors were already predisposed to view the long-term trajectory of the U.K. economy and the British pound in a negative light.

An ambitious agenda

Truss, who became prime minister on Sept. 6, 2022, also didn’t have a strong start politically.

The government of Boris Johnson lost the confidence of his party and the electorate after a series of scandals, including accusations he mishandled sexual abuse allegations and revelations about parties being held in government offices while the country was in lockdown.

Truss was not the preferred candidate of lawmakers in her own Conservative Party, who had the task of submitting two choices for the wider party membership to vote on. The rest of the party – dues-paying members of the general public – chose Truss. The lack of support from Conservative members of Parliament meant she wasn’t in a position of strength coming into the job.

Nonetheless, the new cabinet had an ambitious agenda of cutting taxes and deregulating energy and business.

Some of the decisions, laid out in the mini-budget, were expected, such as subsidies limiting higher energy prices, reversing an increase in social security taxes and a planned increase in the corporate tax rate.

But others, notably a plan to abolish the 45% tax rate on incomes over £150,000, were not anticipated by markets. Since there were no explicit spending cuts cited, funding for the £161 billion package was expected to come from selling more debt. There was also the threat that this would be paid for, in part, by lower welfare payments at a time when poorer Britons are suffering from the soaring cost of living. The fear of welfare cuts is putting more pressure on the Truss government.

a man in a brown stocking hat inspects souvenirs near a bunch of UK flags and other trinkets
The cost of living crisis in the U.K. has everyone looking for deals where they can. AP Photo/Kirsty Wigglesworth

A collapse in confidence

Even as the new U.K. Chancellor of the Exchequer Kwasi Kwarteng was presenting the mini-budget on Sept. 23, the British pound was already getting hammered. It sank from $1.13 the day before the proposal to as low as $1.03 in intraday trading on Sept. 26. Yields on 10-year government bonds, known as gilts, jumped from about 3.5% to 4.5% – the highest level since 2008 – in the same period.

The jump in rates prompted mortgage lenders to suspend deals with new customers, eventually offering them again at significantly higher borrowing costs. There were fears that this would lead to a crash in the housing market.

In addition, the drop in gilt prices led to a crisis in pension funds, putting them at risk of insolvency.

Many members of Truss’ party voiced opposition to the high levels of borrowing likely necessary to finance the tax cuts and spending and said they would vote against the package.

The International Monetary Fund, which bailed out the U.K. in 1976, even offered its figurative two cents on the tax cuts, urging the government to “reevaluate” the plan. The comments further spooked investors.

To prevent a broader crisis in financial markets, the Bank of England stepped in and pledged to purchase up to £65 billion in government bonds.

Besides causing investors to lose faith, the crisis also severely dented the public’s confidence in the U.K. government. The latest polls showed the opposition Labour Party enjoying a 24-point lead, on average, over the Conservatives.

So the government likely had little choice but to reverse course and drop the most controversial part of the plan, the abolition of the 45% tax rate. The pound recovered its losses. The recovery in gilts was more modest, with bonds still trading at elevated levels.

Putting this all together, less than a month into the job, Truss has lost confidence – and credibility – with international investors, voters and her own party. And all this over a “mini-budget” – the full budget isn’t due until November 2022. It suggests the U.K.‘s troubles are far from over, a view echoed by credit rating agencies.

David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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