The BoE returns to QE, the ECB and the Fed are not far behind

Central banks’ appetite for monetary integrity started to fray in September 2022 as the BoE restarted its QE programme in the midst of bond market volatility and resulting pension fund liquidity pressures. Developed Market bonds and currencies - the foundation of the financial system - are trading like Emerging Market, which is not a healthy sign. Central banks continue to use money as a tool to maintain political order, calling the foundation of the financial system into question. TLDR: Central banks’ inability to maintain monetary integrity creates a compelling argument for alternative monetary technologies, like bitcoin, and that case will grow stronger still as central banks pivot to looser monetary policy over the coming quarters.

Conclusions

Merge: technical success but fully priced
Extreme DM bond and FX reveals systemic fragility and confirms monetary regime change theme
BoE caves, restarts QE to ‘bailout’ troubled pension funds
Europe expected to follow the UK
Unsound monetary and fiscal policies maintained due to energy crisis
The Fed is not far behind as bond market volatility ratchets up
RUB out-performance reveals importance of scarce assets and fiscal prudence
Relative bitcoin strength emerging as correlation to equity markets declines

Merge: Buy the rumour, sell the fact

Relatively speaking, September was a boring month in crypto markets. The Ethereum merge went through without a hitch, which is good news given the technical complexity of the upgrade and the deluge of errors that could have taken place. Despite the technical success, Ethereum came under substantial pressure vs. both the USD and BTC in September. ETH fell 14.8%, while BTC fell 2%. As we said at the start of August, current conditions are not particularly favourable for high-beta assets - like Ethereum - and a lot of good news was already priced into the asset so the post merge under-performance did not surprise us.

Much bigger news developments took place in traditional financial markets in September. The weakness in bond and currency markets was quite something to behold and is another sign-post of the on-going monetary regime change, which highlights the value proposition of alternative monetary technologies.

Foundational monetary assets or junk bonds?

Barclays Aggregate - "the flagship measure of global investment grade debt" - experienced its weakest year on record thus far (graph from Jim Bianco). These pristine credit rating bonds are the foundation of the financial system, yet they are trading like junk bonds, which is not the sign of a healthy financial system.

Positive bond-equity correlation pressures pension funds

Potentially even more concerning: bonds and equities are declining at the same time.

Many large investment funds are built on the premise that bonds and equities are negatively correlated. These fund managers expect bonds to protect value when equities weaken. This thesis is no longer correct. The chart below from Michael Gayed shows the performance of US bonds and the S&P500 during major equity market downturns since 1962. Never before have bonds weakened by more than the S&P500 during an equity market downturn, until 2022.

Simultaneous bond and equity weakness places immense pressure on pension funds that hold a large proportion of these assets. Governments will, in turn, be under pressure to bailout of pensions due to the social instability of prospective pension defaults.

Bank of England caves, Restarts QE

September provided an example of this dynamic as the Bank of England (BoE) restarted its Quantitative Easing (QE) program to effectively bailout a few distressed pension funds.

The collapse of the price of UK bonds "gilts" in recent weeks, caused a liquidity crisis for Liability Driven Investment (LDI) funds, which are essentially leveraged long gilts on behalf of pension funds. The BoE stepped in to support gilts, allowing LDI funds to exit their positions in an orderly fashion and prevent pension fund insolvency.

The BoE is between a rock and a hard place! Restarting QE when the UK inflation is sitting at 10%, while HM Treasury decided to loosen the fiscal purse strings last week and the DXY is screeching higher has sent Cable (GBPUSD) to its lowest levels since 1985! A weaker exchange rate will exacerbate Britain's inflation concerns.

The BoE argues that this round of bond purchases will be temporary and that they will be "unwound in a smooth and orderly fashion once risks to market functioning are judged to have subsided". But this is a well worn story. The proof is in the pudding. You tell me which looks temporary, BoE balance sheet expansion or contraction?

Politicians do what is politically expedient, not what they should do. Money should be a politically neutral technology that facilitates savings and trade, but it is a political tool to maintain political order. This has been the reality for many decades but it will become far more egregious as we approach the end of one of the greatest debt bubbles in history.

Europe to follow the UK

The UK is not alone with its predicament. Handelsblatt reports that Germany is expected to announce a price can for household and business gas prices that could cost as much as 5% of GDP. What do you think this will do to German Bund yields and what are the implications for German pension funds and insurers?

Much the same as the UK. Similarly to the UK, German inflation is not far away from double digits.

DM central banks have erred on the side of monetary expansion due to their fear of the persistent inflation experienced in Japan. Much to the chagrin of Modern Monetary Theorists (who advocated for even more aggressive monetary & fiscal policies), loose monetary and fiscal policies are not a panacea to economic ills. Western economies are now learning the consequences for their actions.

As a number of analysts have pointed out, the BoE actions resemble those of Emerging Market central banks, not one the worlds most prestigious central banks. Emerging Markets like Turkey have followed the path of deficit spending and loose monetary policy for many years. These policies have resulted in persistently high inflation.

Unfortunately, there is no easy way out of this conundrum. Monetary and fiscal normalisation are exactly what is required but, as we have seen time and time again, widespread defaults are politically unpalatable, which is why I am convinced that loosen monetary and fiscal policies are not far around the corner.

The US won't be far behind

European economies are in deep trouble but the US and the Fed are not far behind. Renowned investor Stanley Druckenmiller's recently gave his take on the global debt and spending crises - it is not a pretty picture (listen from 2 minutes).

The Fed has remained tough on inflation but I expect that something very similar to the British situation is not far away away. The MOVE index of US bond market volatility has hit its highest levels since the 2008 Global Financial Crisis. The US Fed Funds Rate had declined substantially by the time the MOVE index had reached this point. I expect the market will test the Fed's appetite for defaults soon. Remember, illiquidity within US bond markets was the trigger for the March 2020 monetary stimulus

Wharton business professor Jeremy Siegel thinks the Fed is already in a disastrous position

Russian RUB reveals the benefits of scarce assets, like oil, gold and bitcoin

On the other side of Europe, the Russia RUB has been one of the better performing currencies, gaining 20% vs. the USD this year. By comparison the EUR, GBP, JPY, CNY, ZAR and TRY have lost 14%, 17%, 27%, 12%, 13.5% and 40% respectively vs. the USD. The reason for RUB out-performance is that its currency is effectively tied to scarce assets and Russia has run much more prudent fiscal policies. Russia settles oil for RUB, which creates demand for the currency and Russia's sits on a large FX reserves in gold. Additionally, Russia's debt to GDP is under 20%, which is one of the lowest in the world.

Oil is generally not a great monetary asset because it is not particularly easy to store in large quantities and the price is generally more volatile than a pure store of value asset. But at a time where fiat currencies are being debased at such aggressive rates, investors are utilizing oil for its store of value qualities. This does raise an interesting thought experiment regarding bitcoin's volatility, which can be seen by its detractors as a reason to discount its monetary characteristics. I.E. Volatility may be the least of your worries when the value of fiat currencies are being eroding so aggressively.

Returning to Russia, it's aggressive foreign policies would have be very difficult without its prudent financial policies. And the impact of the war in Ukraine would be far less noticeable on the rest of the world if it wasn't for imprudent financial policies in the west. Unfortunately, the west is too far down the road for financial prudence and hence it is the responsibility of individuals, communities and companies to invest in sound monetary assets that enforce some degree of financial prudence on the holders thereof.

Relative bitcoin strength emerging

Bitcoin has held up pretty well in the last month relative to the S&P500 and Nasdaq. This could merely imply that bitcoin is going to play catch-up and may experience bigger relative declines over the coming months. However, there is a case to be made that the current bear market is running out of steam. Capitulation has already been seen amongst holders and miners, long-term holders dominate supply and the bear market is comparable with previous bear markets in terms of percentage price declines and length of time since the peak. It is too early to determine conclusively, but we have also seen the 90-day correlation of 10-day returns between the S&P500 and BTC fall to the lowest levels since March 2022. Ideally, I would like to see the correlation approach 0 again but this is the first notable sign of decoupling in 7 months.

Returning to Stanley Druckenmiller's interview last month, he went on to say, "I could see crypto currency having a big role in a Renaissance because people just aren’t going to trust the central banks." Well said, Stanley. Would you rather put your 'trust' in bitcoin's mathematical algorithms or a bunch of politicians facing immense pressure to bailout numerous special interest groups over the coming years?

It would be a lie to say that a bear market does not trigger difficult searching questions. It hurts to experience deep and extended declines in net worth and it makes sense that one should question ones decisions under these conditions. But in writing these articles, pulling the lense out and getting a sense of the broader macro conditions my conviction is reinforced again and again. Investing in sound money assets is not only as attractive an investment opportunity as ever but it is morally expedient to be working on a solution to some of the worlds biggest problems because it is clear as day that are politicians are not.

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