As central banks pumped trillions in liquidity to boost the world post the Covid induced slowdown last year, debt to GDP ratios across the board have skyrocketed to levels not seen since World War II. It was just two years ago, towards the end of 2018, when the Fed first considered tapering liquidity to reign in its balance sheet. But then, yet another crisis emerged and this one was the repo market. After the markets stabilized by the end of 2019, it was about to be hit by yet another Armageddon, Covid-19. At first glance this appeared worse than the financial crisis even as the entire world came to a halt, as it took oil prices down $30/bbl.
What did central banks do? The only thing they know how to do, print yet even more. What central banks should do is normalize their balance sheets when financial markets are recovering and the momentum is positive. But they are too scared to do so in fear of ruining the recovery. And when they do start thinking about tapering, the market momentum is already close to its peak as the car is running out of juice. This causes the markets to collapse, and low and behold, the Fed freaks out and stops tapering, only to print yet again even more! Rinse and repeat. This has been the cycle since 2008!
It is because of this behavior of central banks that the die-hard believers of Bitcoin are so invested in it. It is meant to be the true diversification asset from all these Fiat currencies and asset classes. As central banks debase their currencies even further, Bitcoin is meant to be the only vehicle that should appreciate in value. This theory is exacerbated by its own demand/supply metrics that goes through a halving cycle every four years which is meant to reduce its supply by half. This is an extremely positive tailwind already for a story that is seeing a greater adoption. And it has worked very well. On Saturday we saw Bitcoin fall over 20% on the open, so what happened?
Early on, Bitcoin was traded and held by pure cryptocurrency fanatics, pure anti-establishment traders who saw it being the only way to transact and store their dollars as they did not trust the financial system. As its awareness grew, more hedge funds and institutions started adopting it. But it is important to understand that Bitcoin then becomes part of the same global risk asset management system as other asset classes in their portfolios. So it must succumb to the same VAR and PnL drawdowns as the very people who trade it have to manage risk. It is quite ironic that the one asset that was truly meant to be a diversification tool, ended up being just the same as the rest, just on a slightly higher beta.
As we move into the end of the year, the big question is what action will the Fed take now that we have almost reached full employment. If they do taper, will financial markets be able to survive without the free juice that has been fed to it over and over again for the past decade? The bonds and rates market have been showing signs of distress over the past few months as the yield curve started flattening, suggesting a Fed policy error was in the making. Distress picked up in other assets slowly and started to get priced into equities and positions were getting unwound. Omicron was just the match that lit the fire. We are going through a paradigm shift, and Bitcoin too will not be left unscathed, despite its ardent fans.
But what can the Fed do? This time inflation is running close to 6%-8% year over year, and inflation is the key word echoed across all trading floors and in political circles. Jerome Powell, who is appointed again for another term, is now a puppet to Biden to play into their inflation worries. The Fed should play a preemptive role, but it has always played a reactionary one. It only acts after a crisis hits. The only problem is that this time growth is plateauing at a time of heightened inflation, so they cannot print more or else the market will fall into an abyss of stagflation! It remains to be seen how much conviction they have and do what is necessary. In the meantime, as fund managers scramble to find alpha, it is important to remember that at the end of the day, it is all just one big macro trade!
