November 21, 2022Scroll down
A quick recap.
FTX, one of the world’s largest cryptocurrency exchanges, valued at over $32 billion just weeks ago, filed for bankruptcy on November 11th. The crisis began when a crypto news site, CoinDesk, reported FTX’s affiliated hedge fund, Alameda Research, held $5 billion in FTT coins issued by FTX itself. FTX had apparently been funneling deposits to its hedge fund, which itself was making risky crypto bets to boost FTX’s profits. Reacting to the CoinDesk disclosure, rival crypto platform Binance announced it would sell over $500 million of FTT tokens held in its reserves as a matter of “risk management”. This led to panic among FTX users, who rapidly requested withdrawals amounting to $6 billion in a matter of days. In the crypto version of a bank run, FTX found itself with an $8 billion hole in its balance sheet and declared itself insolvent. Just like that, more than 100,000 creditors saw billions of dollars of equity value evaporate. Such events are perhaps less surprising given the notorious lack of regulation in the crypto space.
A bigger crypto crisis?
The failure of FTX is likely just the tip of the iceberg within the broader world of crypto. Conspicuously absent from most crypto conversation is any sense of basic risk management principals, including consideration of the quality of investors’ collateral. Binance, FTX’s aforementioned rival, holds nearly $75 billion worth of crypto in its reserves, including roughly 40% of the firm’s own tokens. Such institutions often use assets issued by peers to shore up their so-called ‘reserve capital’, with the entire system backed by collateral created out of thin air. As history demonstrates, during times of exuberance, unregulated firms can far outpace regulated peers in profitability by taking on greater risk—only to come undone when sentiment turns. We expect to see more turmoil before all is said and done; in the long-run, today’s crashes will inform tomorrow’s regulation.
Classic bull market bezzle.
In financial parlance, the word ‘bezzle,’ describes a temporary gap between the perceived value of a portfolio of assets and its long-term economic value. This gap typically widens during boom times and periods of irrational exuberance, when there is a net increase in psychic wealth. Of course, this reasoning applies beyond crypto space, especially in the wake of an epic bull market in risk assets across the globe that had been running for over a decade going into January 2022. In today’s tight monetary environment and thinking back to spectacular busts of past bull markets, it wouldn’t be surprising to see more FTX-like debacles before we reach the end of this down leg in the cycle.
A second look at inflation.
Taking a closer look at inflation trends, one finds that US CPI accelerated significantly in April and May 2021 due to reopening from Covid (see below). The upshot is that on a year-over-year basis, CPI looked better in April and May 2022, due to a mechanical “base effect.” By the same token, it seems likely the marginal moderation in October’s CPI data was not really a peak, and US inflation could stay on a high plateau until mid-2023. As Fed officials have observed, there is a risk that US inflation has become entrenched at this point, with evidence that it is now transmitting to the labor-intensive service sector, where prices tend to be stickier—at least until recession brings them down. As such, we expect US investors will either face a recession on the back of much higher interest rates than the current market forecasts, or a “new normal” of persistently high inflation/prices with correspondingly lower equity/bond valuations.
Don’t fight the Fed.
For the third time this year since February, markets have again been showing bullish signs. As in the previous two rallies, current market relief is driven by the notion that US inflation has moderated, along with better-than-expected PPI data, which investors believe will make the Fed dovish on its plan for future rate hikes. Despite that, reading comments by Fed officials and research staff, it seems clear that US central bankers are intent on maintaining restrictive policy as long as inflation runs much higher than its 2% target. We conclude that investors hoping for a Fed-led rally are unduly optimistic. If anything, such irrational exuberance makes Jerome Powell’s life that much harder, as the Fed will be inclined to signal greater hawkishness, pulling investors’ expectations back to reality.
What else could go wrong?
As we have mentioned in past updates, while investors’ interest in inflation makes sense, CPI may be hogging the spotlight, as one of this bear market’s key story arcs is the threat a sequence of super-sized rate hikes poses to corporate earnings. In our view, the market has still not fully priced significant downside risk in earnings. While stocks have fallen substantially since peaking in January, most the S&P 500 companies are today only pricing a drop in earnings of 5% next year, which is a very benign decline, even without a harsh interest rate environment. Indeed, we see substantially greater risk and certainly don’t think current macro data support a soft landing as the base case for US stocks, despite temporary bullishness on inflation leading equity valuations to a recent rebound.
Trading Treasuries gets harder.
Not all investors will have noticed that the Fed has recently started buying back illiquid bonds to improve liquidity in the world’s largest fixed income market. As often happens in times of extreme volatility, a deterioration in bond market liquidity has exacerbated in recent months. A key contributor to the drop in liquidity was the Fed’s effort—called Quantitative Tightening or ‘QT’—to pull back from buying Treasuries, creating tighter financial conditions as part of its presently hawkish orientation. Meanwhile, the Bank of Japan, typically one of the largest Treasuries buyers, has been selling its Treasuries to stabilize its currency. Since 2020, there has been less demand on the market to absorb the excess supply of US government bonds; many banks have pulled back as primary dealers and more hedge funds and high frequency traders have stepped in from the private sector, introducing more leverage into the system. Unfortunately, such private sector liquidity providers tend to be “weak hands” during market turmoil, leading markets to freeze at the worst possible time. The same liquidity squeeze is happening quietly in mortgage bond markets. While we don’t expect a crisis like that observed in the gilts market weeks ago, we do see bond market volatility persisting for some time to come.