THE FED HASN’T TIGHTENED MUCH
The Fed hasn’t really tightened financial conditions yet. Over the past few years, inflation has gone up much more than the fed funds rate. It is equally important that the Fed has not undone any of their manipulation of the government bond and mortgage markets.
Real rates – the rate an investor receives after inflation – are near the worst they’ve ever been.
We’ll discuss it at greater length later in the letter, but the obvious point is: you can’t tame runaway inflation with fed funds 600 basis points LOWER than inflation. The Fed will be forced to tighten much more than the markets currently forecast.
It was well over a year ago that real fed funds broke the negative all-time record set in February 1975. In the 70’s, we had YoY inflation just a touch higher – at 11.2%, but the Fed was really fighting it – with fed funds at 6.24%. So the real fed funds rate was -4.96%.
This Fed cruised right through that milestone. Going all the way to -8.30% in March 2022 when they finally began removing that massively accommodative policy. By the time they began tightening, YoY CPI was already 8.5%. Unbelievable.
As the table below shows, we are still 7.77 percentage points below the 50-year average real fed funds rate. Another 75 bps won’t do it. The Fed will ultimately have to tighten several hundred basis points more.
I still believe that fed funds will not stop rising until they are at least 4-5%.
I love this line:
“The whole point of 75-basis-point increases is to tighten financial conditions. Each time Jay Powell has raised rates, ironically, he has eased financial conditions because of his unwillingness to acknowledge the Fed is prepared to take the country into a recession in order to eliminate the inflation scourge.”
— Bill Ackman, Founder & CEO of Pershing Square Capital Management, Twitter, July 27, 2022
BOND REAL RATES ALSO MASSIVELY NEGATIVE
While is it now consensus that the Fed allowing inflation to get 830 bps above their overnight policy rate was a huge failure, few are addressing the equally important and continued policy error – pushing the long-term government and mortgage bond yields well below free-market levels.
As Bill Ackman said so well, the Chair of the Fed refuses to allow long rates to adjust to a fair-market level (much higher). With this, the Fed is still providing massive stimulus to interest rate-sensitive sectors like housing and motor vehicles.
The real rate of return is the yield a bond investor receives after inflation. For U.S. 10-year notes, the average real rate over the fifty years before Quantitative Easing (1957-2007) is +2.63%.
The Fed’s decision to print half of our country’s GDP and use it to push up the price of bonds has forced the real rate to negative 5.85%.
The gray area is our brave new world of unlimited bond purchases. We are now an incredible 8(.)48 percentage points below average.
No economically-rational investor would buy something guaranteed to lose 585 bps every year. That’s why the Fed bought bonds equivalent to 200% of all mortgage issuance in 2020 and 2021. No rational actor would do that.
TAYLOR RULE
According to a June Fed report, the economist John Taylor’s rule-based nominal rate target today is 6.92%, about double current expectations.
I think the robot knows better than humans.
The rate will end up closer to the Taylor Rule than current forecasts.
“The Taylor rule is one type of targeting monetary policy used by central banks. The rule was proposed by American economist John B. Taylor, economic adviser in the presidential administrations of Gerald Ford and George H. W. Bush, in 1992 as a central bank technique to stabilize economic activity by setting an interest rate.
“The rule is based on three main indicators: the federal funds rate, the price level and the changes in real income. The Taylor rule prescribes economic activity regulation by choosing the federal funds rate based on the inflation gap between the desired (targeted) inflation rate and the actual inflation rate; and the output gap between the actual and natural level.
“According to Taylor, a central bank implements a stabilizing monetary policy when it raises the nominal interest rate by more than an increase in inflation. In other words, the Taylor rule prescribes a relatively high interest rate in the situation when actual inflation is higher than targeted. The main advantage of a general targeting rule is that a central bank gains the discretion to apply multiple means to achieve the set target.”
— Wikipedia
RECESSION PROBABILITY
I find is surprising that economists still only think a recession is a 45% chance. But then, economists are notoriously late in forecasting downturns – they missed negative growth in the first and second quarters of this year.
The U.S. economy has experienced twelve recessions since World War II. Each one included two features: economic output contracted and unemployment rose.
A RECESSION ALMOST CERTAINLY ALREADY STARTED
We have already had two consecutive quarters of negative GDP growth, -1.6% in Q1 2022 and -0.9% in Q2 2022. While not the BEA’s defining criterion, it’s a strong sign we’re in a recession now. Unfortunately, the Fed’s policy mandate is not “Keep tightening until you cause a recession.” It’s to aim for maximum employment and price stability. That will take a ton more tightening.
As we mentioned last month, we are very likely already in a recession.
FOMC
Larry Summers has been right all along. The Fed can’t stop until inflation – which is literally out of control – is brought back to 2%. That almost certainly will include a recession.
“If the economy looks like it’s slowing, it will be tempting to stop raising interest rates, and indeed, people in the market are expecting that interest rates will come down, beginning in December or January. I think that would be a serious error.
“I think we are unlikely to restore inflation to target levels in scenarios that don’t involve a recession at some point.”
— Larry Summers, Former Treasury Secretary, Yahoo! Finance, August 3, 2022
Summers says he thinks inflation will be with us for some time given strong economic growth last year, along with supply-chain issues, unless we have a recession.
THE PROMISE OF BLOCKCHAIN TECHNOLOGY
We highly recommend that you take six minutes to watch this clip. It’s an articulate and simple explanation of the importance of our industry. Below are highlights from the video:
“What does Bitcoin do? It’s simple. It lets you send and receive value to and from anyone in the world using nothing more than a computer and an Internet connection. Now why is it revolutionary? Because unlike every other tool for sending money over the Internet, it works without the need to trust a middleman. The lack of any corporation in between means that Bitcoin is the world’s first public digital payments infrastructure. And by public, I simply mean available to all and not owned by any single entity.
“With Bitcoin, the ledger is the public blockchain and anyone can add an entry to that ledger, transferring their bitcoins to someone else, and anyone regardless of their nationality, race, religion, gender, sex or creditworthiness can for absolutely no cost create a Bitcoin address in order to receive payments digitally. Bitcoin is the world’s first globally-accessible public money.
“It’s a computer science breakthrough and it will be as significant for freedom, prosperity, and human flourishing as the birth of the Internet.
“The Internet removed single points of failure in communications infrastructure and ushered in a wave of competition among new media corporations building on top of its public rails.
“…it is our best hope, and as with the Internet in the 1990s, we need a light touch pro-innovation policy to ensure that these innovations flourish in America for the benefit and security of all Americans.”
— Peter Van Valkenburgh, Director of Research at Coin Center, October 2018
THE UPCOMING ETHEREUM MERGE :: THEMATIC CALL
We are hosting a discussion about “The Merge” and what it means for Ethereum’s scalability, monetary policy, and sustainability as the network undergoes its biggest update since launch. Pantera Co-CIO Joey Krug will be interviewing Isidoros Passadis from Lido and Noam Hurwitz from Alchemy.
The call will take place on August 30th at 9:00am PDT.
TAKEAWAYS FROM “THE MERGE” BY ERIK LOWE
Ethereum will soon undergo its most significant update since launch. “The Merge” is one in a series of protocol updates in the Ethereum roadmap that marks a huge advancement towards the long-term sustainability and scalability of the global-computing network.
The key takeaways are:
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Full migration to Proof-of-Stake (PoS) from Proof-of-Work (PoW) → Ethereum becomes more sustainable
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Ethereum issuance rate reduced by 90% → Ethereum is likely to become a deflationary asset
“The Merge” is expected to occur on September 15th, 2022.
Ethereum Becomes More Sustainable
Moving to Proof-of-Stake will have a major impact on Ethereum’s sustainability with an estimated reduction in energy consumption by 99.95% – obviously a big improvement from an environmental, social, and governance (ESG) perspective.
For context, Proof-of-Work and Proof-of-Stake are consensus mechanisms that enable a network of computers to agree on its current state. In this case, a network of computers is what collectively secures and maintains a blockchain – which is really just a database of transactions. Put simply, consensus mechanisms are what enable blockchains to function securely and in a distributed manner.
The 99.95% energy reduction will come from Ethereum’s transition away from Proof-of-Work – a process that uses electricity and hardware as the main costs to secure the network. In a Proof-of-Stake system, the main cost to secure the network is capital in the form of staked tokens, and it does not require much electricity at all.
Both have the same objectives of achieving distributed consensus while making it extremely difficult to allow a single entity to gain control over the network (i.e., a 51% attack). The latter is ensured by making it physically or economically unfeasible to achieve that level of control.
In the case of Bitcoin under Proof-of-Work, someone would have to purchase enough hardware and electricity to achieve more than 50% of the hashing power of the network.
In the case of Ethereum under Proof-of-Stake, someone would have to accumulate more than 50% of the total staked tokens in the network.
Both scenarios are extremely capital-intensive and would cost the attacker more than they’d gain, rendering them unlikely to occur.
After “The Merge”, 60% of blockchain market cap will not be energy-intensive.
You can dig a bit deeper into consensus mechanisms here.
Ethereum Supply Becomes Deflationary
If you were wondering why the event is called “The Merge”, it is in reference to the “merging” of the Ethereum Mainnet (execution layer) with the Beacon Chain (consensus layer) that has been running in parallel since December 2020. The Ethereum that facilitates our DeFi transactions today is the execution layer, which runs on Proof-of-Work. The Beacon Chain utilizes Proof-of-Stake. The merging of the two is when Ethereum transitions to Proof-of-Stake. So how does this relate to issuance and supply?
Currently, the issuance of new Ethereum is about 14,600 ETH/day, which is the aggregate of 13,000 ETH from mining rewards on Mainnet and 1,600 ETH from staking rewards on the Beacon Chain. After “The Merge”, there will be no Proof-of-Work and thus no mining rewards, leaving just 1,600 ETH/day in staking rewards.
A year ago, the London upgrade went live, which introduced a minimum fee (known as a base fee) for every transaction to be considered valid. That fee is then burned, resulting in approximately 1,600 ETH removed from the total supply each day based on an average gas price of 16 gwei, according to the Ethereum website. (A gwei is one-billionth of one ETH.)
After “The Merge”, Ethereum’s issuance rate of 1,600 ETH/day in staking rewards minus the fees burned nets out to zero. Subtracting penalties incurred by validators (e.g. getting slashed for misbehaving) and ETH that is lost over time, this would make Ethereum issuance net negative. In the context of today’s inflationary environment, Ethereum’s shift towards a potentially deflationary asset is an exciting prospect.
You can read more about “The Merge” here.
BANKLESS INTERVIEW HIGHLIGHTS
The Past Few Months
Ryan Sean Adams: Can you guide us through what’s been happening over the last three months?
Dan: “We’ve had a long bull market in everything – rates, equities, crypto – and in bull markets, people take on more and more leverage.
“In crypto, most lending entities were started in 2017. They enjoyed the ride we’ve had since crypto was in the low single-digit thousands in price. Some of them took on excessive leverage, and when a market goes down 80% it’s really dangerous.
“I think the perspective everybody should have is, anytime you have a super disruptive technology, people are going to try all kinds of business models. It’s like the internet in the ’90s – some of them work, some don’t, some get lucky, some have bad luck. In the end though, the underlying technology is fantastic and blockchain is going to be incredibly important.”
Joey: “I remember when I first joined Pantera, Dan said something about ‘pooled asset vehicles tend to be limited by their least liquid asset.’ Lenders started letting people borrow against collateral that they consider to be close to one to one, which wasn’t anywhere close to that from a liquidity standpoint.
“If you look at GBTC, there are two liquidity question marks there. It takes six months to be able to sell it after you buy it. There are firms that would let you borrow against that in cash at very high loan value ratios, even though the underlying asset couldn’t be sold at all. Even once it was liquid, the trading volume of GBTC versus Bitcoin is no match. GBTC is a much more illiquid asset – it trades in the over-the-counter markets.
“People basically borrowed against this very illiquid asset and, when they needed to sell, it started causing cascading liquidations. If you have a lot of money in a very liquid asset borrowed against something that’s very illiquid, the market impact upon selling is going to be disproportionately higher.”
DeFi vs. Wall Street
Ryan: What would you say to the criticism “DeFi is the same as Wall Street”?
Joey: “They are quite different in some really key ways. Historically on Wall Street, there’s not a ton of transparency into what’s actually going on. In 2008 no one (even people at these companies) knew what their derivatives exposure was. When you had the bailouts, the government was both guessing on how much money they needed to use to actually do the bailouts, and also didn’t know the derivatives’ exposure until long, long after everything had occurred. You have all these weird situations in traditional finance due to things not being transparent, where you don’t actually know what’s going on, you don’t know what your actual risk is.
“The CeFi companies built on top of DeFi, like Celsius, had the same problem. If Celsius showed on their website what was the clarity horizon of a dollar deposited in Celsius, I don’t think we’d be talking about Celsius today, because they wouldn’t have had customers. If the customers saw that – ‘if you withdraw all your money, it’s going to take you two years. And by the way, your money is in assets that have a hundred percent plus annualized fall’. The average person doesn’t know what that means, but the press would cover it and tell people what it means – which in this case means your money’s really risky. It’s not like your deposit in USDC and it’s some low-risk thing.”
Dan: “Transparency, that’s the whole thing about blockchain – it’s all out there for somebody to see. DeFi projects all let you see what’s happening. Whereas, as Joey said, if you really knew what was happening behind the curtain in some of these centralized lenders, you probably would’ve never lent them any money.
“The Lehman story is so interesting because when it went under, nobody knew what their risks were to the firm, and nobody knew what collateral they had. Everyone just grabbed anything they could. Abrogated contracts didn’t give back collateral. It was all just a huge mess. At the beginning, people were like, ‘$120 billion loss, it’s all terrible, world’s coming to an end.’ Six years later, bankruptcy proceedings, etc. over, they lost $3.9 billion – a tiny amount relative to the crazy damage it did to the entire world. It would’ve been so much better for the US Treasury to just write a check – ‘Here’s $3.9 billion, we’re done, let’s move on’. It was crazy, because nobody knew, a total black box.
“That’s the beauty of DeFi – protocols will have all their information out there and you can make a choice. Do you want to do business on Maker Dao, for example? You can look at all the stats and decide if it’s a good idea or not.
“Take Mt. Gox, a failed CeFi project. We’re still dealing with the bankruptcy. That was seven years ago and it’s still going on and on and on. Whereas in DeFi, we’re already done. We already had the May crisis and it’s over, and we’re on to the next thing. Not one taxpayer paid a dime.
“The next generation of centralized lenders are going to be forced to provide more transparency. We did a five-year experiment in the total black box and it didn’t work great. Whether it’s by commercial motivations or regulators (probably both), people aren’t going to want to lend billions of dollars to entities where they don’t know what they’re doing.
“We even saw that with Credit Suisse and other big lenders to family offices – they had no idea how much leverage their clients were taking.
“Everybody is learning that lesson, both in crypto and in the normal securities markets. They’ll be forced to disclose more about how much leverage they have, what the imbalance is between the timeframe of their liabilities and their assets. Regulators probably are going to get more active and require more transparency.”
Joey: “Second is risk controls. There’s this great saying in software, “worse is better”. I think you can think about that in risk control systems. On Wall Street, people come up with these really complicated risk control mechanisms where people convince themselves that they know more than everyone else and that their risk mechanism is right. You saw this with the credit default swaps issue in 2008. If you look back over the last 300 years of financial history, you see it so many times – whether it’s Long-Term Capital Management or Three Arrows Capital or anyone else.
“In DeFi it’s very simple – if your loans are within a certain percent of the collateral threshold, you start to get liquidated. If you don’t top up the collateral, you get liquidated. It’s very basic. A lot of people in traditional finance say, ‘Oh, that’s super inefficient’. Yes it’s less efficient, but it also means that if I’m depositing money in it, I don’t need to trust Compound/Aave/Maker to call some supposedly rich person at 3:00 AM and have them top up their collateral. And often in these collapses what you find out is, people who you thought were supposedly rich actually aren’t, or they borrowed the same money 10 times from 10 different venues. No one is talking to each other, no one actually knows. DeFi is much simpler; these problems don’t exist. Sure, it’s less efficient, but it’s also much, much less risky.”
DeFi Is Too Referential Critique
Ryan: “DeFi is too self-referential. . . there’s no real world assets, even when you’re collateralizing things it’s other DeFi token.” What do you think about this comment?
Joey: “If you look through the history of financial tech innovations, people have used that criticism every single time. Whether it’s the invention of the joint stock company a few hundred years ago, to the invention of options, swaps, every derivative that’s ever existed – people have used that criticism. What’s interesting about it is, it’s both true and wrong. In the beginning, new technologies are used a lot for speculation. They are very self-referential. When the internet first came out, it was a bunch of academics sending each other their papers for peer review. Pretty self-referential.
“But as time goes on, people figure out new use cases for these technologies. They figure out new ways to use them in the real world. You fast forward 5-10 years and no one makes that criticism anymore. Or at least, people who do make that criticism, nobody cares because it’s so obvious that they’re wrong. Imagine saying the internet’s just self-referential and pointless today. Tons of people said that back in the ’90s. You can pull up videos of tons of talk shows where the hosts are making fun of Bill Gates saying, ‘What’s this crazy thing that you call the internet? Kind of seems like a joke.’ The same thing is true with the history of the automobile, ‘Well, my horse is faster so I don’t need that car.’ People are very shortsighted when it comes to tech innovation.
“That is somewhat true today, but it’s starting to change. Doing stuff in the real world is harder than the virtual world, but I think we’re starting to see more and more of this. It’ll probably start to take off more with derivatives that are pegged to real world assets – synthetics has a bunch of new traction recently, for example. Then there are things that already take place in the real world on Maker Dao. It’s pretty primitive and early, but I think if we have this conversation again in five years, it won’t look primitive and early anymore.”
Dan: “Any new technology has people that want to speculate on it, right? There are probably a hundred million people that actually use crypto in real world situations every day, transmitting money across borders etc. Then there are some people that are speculating on it. The fact that there are speculators isn’t new/negative – it happened in the dot com boom, it happened in all kinds of booms that we’ve had over centuries.”
DeFi Worked Great
Ryan: How well did DeFi hold up through this storm?
Joey: “If you look at what’s different about DeFi, the main thing is in how it worked – it’s just much faster at liquidating people. DeFi has simple liquidation mechanisms versus CeFi companies. CeFi mechanisms don’t work that way. I have friends who have used those companies, and I know that when they’re close to liquidation, they’ll often give them 24-48 hours to top up their liquidity. And that’s even if they’ve fallen below par value, because they just trust them as a counterparty. There’s a lot of risk in doing that. In DeFi, you don’t really have that issue.”
Dan: “I think Joey’s spot on. In DeFi it’s just code and collateral. You can’t con code. You can’t lie to it. You can’t say you’ve got more assets than you do. You have to post the assets and the code owns the assets and controls the assets. So DeFi really is superior.”
Quick Macro Takes
Dan: “My main view for the next 12 months is crypto’s going to decouple from the macro story and trade on its own fundamentals. A lot of people are using it, DeFi worked, etc.
“On the macro side, I think the Fed are going to have to hike a lot more than people are talking about. The Fed’s mandate is to hike until they get core CPI below 2% – that’s going to take a couple of years, things are going to take forever.
“So overall, I think rates will keep going up, and crypto’s going to go up.”
Joey: “What we’re looking forward to:
DeFi: A lot of interesting stuff is happening in DeFi. We’re finally starting to see DeFi numbers like TVL start to get back in an uptrend. The total market cap of DeFi is approximately $20 billion. The crypto market cap is a trillion. I think it’s absurd for DeFi to be anything less than 10%. I would actually argue much, much higher than that – 20/30% of the total crypto market. And so, over the long run, we’re very bullish on DeFi.
Ethereum: Look at what’s upcoming with Ethereum 2.0 and all the rollups on top (Arbitrum, Optimism, StarkWare). I think ETH is going to look really interesting coming into the next bull market, because it’s going to be the first time that it actually scales. You could argue in the last cycle that you could sort of use things like Polygon, but now there are a bunch of different solutions. They all actually work. People will be able to work out a lot of the UI/UX issues over the next 6-9 months. As we go into the next cycle over the next two years, DeFi is actually going to scale, which is something that we’ve been talking about forever, but will finally actually be here. We’re super excited for that.”
Check out the full interview here.
REAL VISION INTERVIEW HIGHLIGHTS
Raoul Pal: How do you think about the upside downside risk reward here?
Dan: “The best time to buy is when people are predicting how the next 50% downdraft is going to happen. That would have been really useful at $65,000. Nobody was saying that, instead everybody was massively bullish at $65,000.
“Now that we’re at $20,000, people are all like ‘we have another 50% to go’. That’s the best time to buy, when everyone’s now an expert on bear markets, that’s a great sign that it’s time.
“Also, time itself heals a lot of wounds, right? Whatever leverage people had, it’s been eight months since we were at the highest. That stuff gets worked out over that period of time. We’re already well past the average length of a bear market or had the same depth. We’ve been down for eight months – it’s very easy for me to see the low being in June and we’re back to the next cycle.”
Raoul Pal: Are you getting inflows or are people still like ‘let’s wait and see’?
Dan: “Massive public pension plans, endowments, etc. are getting in. This is actually a great time because they’ve spent four or five years working through all their diligence, their investment committee, educating their trustees, etc. They’ve finally got a ‘yes’ and now everything’s pulled back, it’s actually a lot cheaper.
“We haven’t seen enough ‘pull the trigger’ yet, because most investors are really triaging their portfolio. This has been a once-in-a-generation shock on macro markets and blockchain. Everyone is pulling back and trying to make sure they understand the liquidity positions, etc.
“But I do think we’re in a pretty good spot where a lot of institutions did recently get an approval. In many cases, they allocated 10 basis points to blockchain. They have $100 billion or hundreds of billions under management – and so that means $100 million in blockchain. I’ve seen commodities become an asset class over the years, emerging markets, etc. – I can easily see blockchain being an asset class five years from now.
“10 basis points isn’t the answer, right? It’s going to be 500-800 basis points or could be some much bigger number. That’s another reason I’m really bullish on this space – I’ve seen a lot of massive entities go through the really hard thing of going from zero to one. Now that they’re in and have 10 basis points, they can easily go to 20 basis points, or 50, or 100, or 500.”
Raoul Pal: What sectors are you looking at?
Dan: “DeFi is incredibly cheap right now – I think DeFi should be a huge chunk of what somebody is investing in.
“The next frontiers are things like blockchain gaming, NFTs – they are just getting to a critical mass now that enough people are using them.
“But an important point to everyone out there who is trying to have a handful of things in your portfolio, don’t go too all in on any one.”
Raoul: NFTs are quite an outstanding technology. What do you think?
Dan: “It’s a totally new art form. It’s really easy to make fun of NFTs – ‘you paid $x million dollars for just a little piece of software code?’. Marcel Duchamp put a urinal on a wall in Paris 100 years ago, it’s now worth $150 million. It’s a porcelain urinal.
“Art is about the concept and the community. Each generation has their own art (Wall Street had a bunch of graffiti artists). In 10 or 20 years, they’re going to have been a really important piece of art.
“One of the reasons people like art is that it’s fun, right? It’s community, it’s sharing. I was talking to a very, very successful businessman who’s also famous in the art world – he’s super negative on NFTs. There are probably a few collectors that really do buy art because they love the art and they put it in a warehouse in Geneva, and nobody ever sees it. Most people buy art to put it on their living room walls and show their friends, right?
“How many people can get through your living room? Even if you’re really a socialist, it’s not that many. You can get a lot of people to see your NFT collection. It’s just so much easier to share. I think that’s going to bring a ton of people into the blockchain space. NFTs are super important and in ways that a lot of people haven’t really focused on yet.
“These things take decades; it’s not going to happen overnight. Gen Z people buying NFTs are going to be the 50/60-year-old wealthy people in 30 years. They’re probably not going to be buying a Renaissance painting, right?
“The new generation gets to pick who wins and there is a very technically literate group coming up that is growing up with NFTs.”
Raoul Pal: What is the most stupid mistake you’ve made investing in crypto?
Dan: “Honestly, selling anything. There’s a ton of things I wish I bought or regret not doing, but the only deep regrets are ever selling anything.
“If people have the financial and emotional resources to stay in the trade, you have to, because blockchain is going to change the world and that means prices are going to be much higher in the long run.
“Just view it as venture and try and put it away and look at it 5/10 years from now.”
Check out the full interview here.
BITCOIN PRICE CYCLES
Pantera has been through nine years of bitcoin cycles and I’ve traded through 35 years of similar cycles. I strongly believe that we’ve seen the lows for crypto. The decline from November 2021 to June 2022 was spot on the typical cycle. We’re done with that and beginning to grind higher.
BUBBLES
Cool graphic of various bubbles over the decades…Energy, Tech, Financials, Tech…
Good luck out there,
