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By Arthur Hayes
Posted April 9, 2020
Forky (Source: Pixar Animation Studios)
Shazaam! You snap your fingers and COVID has disappeared, you can exit lockdown and continue on with your life. How do you feel? Are you as optimistic as you were in January? Do you trust your government to put your health and safety first? Do you trust your government to tell you the truth in a timely manner, or will it juke the stats when it suits them? Do you trust the media to speak truth to power? Will you wash your hands once an hour furiously, or blithely touch your eyes, nose, and mouth with zero fucks given?
If, once we’re out of this, you can honestly say that everything has gone back to how it was in early January of this year, then happy days. It may well be that we are in for a V-shaped economic recovery. But if, as I believe, your world view has fundamentally changed, the fictions that underpinned your life have shifted dramatically. As we consider the most important price, the price of money and its nature, predicting the collective fiction we believe in becomes of utmost importance.
Money, true money, which is divorced from industrial utility, is nothing more than a fiction which allows us to exchange labour and capital efficiently so that real goods and services can be produced. Without this fiction … the conveniences of modern society would cease to exist. There are three prevalent monetary fictions whose interrelationships post-COVID will completely change.
Government Fiat, aka The USD = Fiction + Violence
We know the USD has value because contracts and taxes owed will be collected at the barrel of a gun if necessary. The dollar derives value from a strong belief the United States can raise taxes to pay back its debts.
Gold = Fiction + Physical Scarcity
Gold has no widespread industrial use case. It is just shiny, physically scarce, malleable, and has captivated human attention for millennia. Therefore it has value.
Bitcoin = Fiction + Cryptographic Scarcity
Bitcoin has value because a piece of open source code is collectively run by many guarantees that only 21 million units will ever exist. Therefore it has value.
After the senseless destruction of human lives in WWII, the victors sat down in Bretton Woods and created the modern financial system underpinned by the USD. We still are under the yoke of the USD today.
The USD used to be worth its weight in gold, $35/oz to be exact until 1971. Tricky Dick wanted to fight a war while giving out goodies at home. “Free Shit, Vote for Me!” That’s the best way to win any election. However, he couldn’t stomach a run on the nation’s gold so he severed the relationship. Since then, the value of USD has depended entirely on trust.
Fast forward to January 2020. The US has the most liquid financial market and is completely open to all capital. All major commodities and trade is priced in dollars. Therefore if you are a country or company doing international business you must have access to those dollars.
That’s great for everyone when the beat is going strong. The Federal Reserve has a global obligation to keep dollars in good, cheap supply. That is why they have FX swap lines with the major central banks. The world is short on the dollar and only demure academic-looking Federal Reserve governors can provide them.
Countries and companies can easily earn dollars by selling knick knacks to rich Americans. 70% of American GDP is driven by consumption. It makes the world go round. Hundreds of millions of peasants have been lifted out of abject poverty so that they can produce cheap iPhones, AirJordans, or F150s, all so the parent “American” company can enjoy record profit margins.
Europeans are not far behind in their consumption. Europe and America combined represents the global demand for goods. Absent them, who the fuck is going to buy this dog shit at insane markups?
Deng Xiaoping on his Southern Tour unleashed the Chinese upon the world after a hundred year hiatus. They began powering the luxury goods, travel, and education sectors after gaining serious wealth from the offshoring of manufacturing from West to East.
Sorry for waxing philosophical, I’m no modern day Thoreau and I certainly don’t live on a pond. Keeping it simple: China sells shit in dollars that Americans and Europeans buy.
Uh oh, COVID… China shut down production to fight the virus, meaning no dollar income. Then Americans and Europeans caught it and shut down their economies, meaning no more demand.
Once China “opened” again for business and started making stuff, there were no orders from the West as they were all watching PornHub at home and ordering GrubHub. If they aren’t vegging-out, they’re worried about when their next paycheck will arrive to pay for fuck-off expensive medical care. The moral of this sorry tale is that China ain’t earning dollars.
And they are not alone. No major manufacturing or services hub is earning any dollars. But they need them to pay for raw commodities and to pay back their dollar liabilities. It would be all gravy if their central bank could print dollars, but Mon Dieu! They cannot lah.
A mini EM currency meltdown occurred at the tail end of March. The Fed’s response was to offer swap lines to additional central banks, but not China. That has eased the pressure a bit. But take a look at the CDX EM HY CDS spread. It looks like a West Hollywood blowout hairdo.
The conventional wisdom is that the Fed can print money until the dollar gets cheap enough. But US banks tend to hoard USD and refuse to lend. There are a variety of regulatory reasons why they cannot, and why take the risk during a global depression. Better to be safe and make sure your balance sheet is rock solid.
Simple simple. The Fed can print as much USD as it likes, but the companies and countries that need it the most will not get it. The most important one is China. China’s currency is not convertible and in the eyes of Western Europe and America, it was responsible for this virus. Whether that is true or not is not the point. Do you think for a second any US politician would stand up and ask the Fed to print money so the Chinese economy can survive the COVID pandemic?
The virus supposedly originated in a Wuhan live animal market. The West believes Beijing downplayed or lied about its severity. Then, all of a sudden, it shut the country because it was a serious problem. Too bad a few million infected Chinese travelled the world and started the party. Truth is not the point here; the narrative rules all. This is an election year, and China bashing is in full swing. Cue The Seinfield Soup Nazi, “No dollars for you”.
The USD is STRONK and will destroy the global economy.
The only country which can credibly enact the appropriate amount of fiscal stimulus to weather the storm is the US. No other country has the option to depreciate their currency to the degree necessary to generate economic activity at a level which honours the credit in the system and promises to their plebes. Remember that all raw commodities are priced in dollars, if you print too much money to monetise your government debt, your currency craters and inflation runs rampant. At that point, the Jacobins enter the street and you better not be munching on a cake.
That summarises how I see events playing out over the next decade. I have no idea on timing, but the strong USD will break the back of the global economy and force a reset. The question is what the new system will look like.
Gaze into my portfolio to see my soul:
Long USDCNH 2y 8.00 calls Long USDKRW 1y 1600 calls Long CDX EM CDSI Sprd (I don’t have this on yet, but I’m waiting for my levels on the rebound in markets)
Central banks will devalue against a hard digital asset. What that digital asset is, I have no clue. But, it may include a linkage to bitcoin. The USD fiction is over.
It’s time for a new mental crutch.
Do you believe in Physical or Cryptographic scarcity?
After a societal fetish for all things fiat, the pendulum will swing wildly towards what is hard and scarce. Traditionally investors expect a weak gold or bitcoin price when the dollar is strong.
But dollars cannot be had, and trust in government Frankenstein currencies will evaporate. Gold is the historical best choice. It also is widely owned by central banks. The best way to rebase a currency is an extremely high gold price. This happened during the 1970’s oil crisis, and the Fed raised interest rates to a level where it became silly to own gold when you could earn 20% investing in US Government debt.
This time around, the Fed cannot raise rates. That would destroy the finances of the USG who must hand goodies to all. Remember this is now QE 4 Da People / QE 4eva. The US electorate will not tolerate another exclusive financial services bailout. They will get paid to sit at home, watch NetFlix, aka the Tiger King, and refrain from using their assault rifles to initiate a modern day Whiskey Rebellion.
Therefore, there is not an alternative asset which entices people away from gold as the legacy of Bretton Woods system breaks down. The stock market of the Land of the Free will become a political tool. The US Treasury, powered by the Fed, will buy all government and corporate debt. They will buy equities. They will buy consumer loans. You would think that stocks are the place to be if the government is buying the Index. But let’s remember the Nikkei in 1989. The BOJ now owns upwards of 30% of the Japanese equity market, and the Nikkei is still 50% below its ATH. And I’m only speaking in nominal terms. Try deflating that by the BOJ balance sheet … REKT.
The once mighty US stock market will be a corral of zombie big corporates who had the connections to suck from the teat of the US tax payer. That wouldn’t be so bad if inflation can be kept at bay. However, as the world recovers we have an infinite amount of fiat currency chasing a finite supply of real goods. SMEs represent 60 – 80% of most countries’ economies. These companies, due to their small size and limited connections, pay a high price for credit if it can be obtained. Even with all the well meaning government SME lending programs, a large portion of SMEs will no longer be in existence by the time they can actually access the funds. Complex systems do not recover in a linear fashion.
Therefore, an infinite amount of pledged fiscal and monetary assistance will chase non-existent supply. That leads to inflation. Global stock markets will also become political tools, not efficient allocators of capital. The wrong signals will be sent, the wrong goods will be produced. Can the hipsters handle a $40 smashed avo toast?
The best inflation hedge of human civilisation to date, gold, will be repriced higher. It’s the only thing you can own if you believe in Fiction + Physical scarcity. How high can it go? Take the ratio of the total amount of credit to base money. That multiplier serves as guidance to a possible future for gold. Another possible outcome is the creation of a digital financial non-USD dominated system.
If they dare to come out in the open field and defend the [dollar] standard as a good thing, we shall fight them to the uttermost, having behind us the producing masses of the nation and the world. Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a [dollar] standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of [the USD]. -Satoshi Nakamoto’s Democratic Convention Speech 2020
Will a cabal of central banks rebase their currency using a digital hard crypto? Maybe. Could there be a basket of digital fiat currencies where the central banks hold a sufficient amount of gold? Maybe.
All I know is the setup for bitcoin, the hardest form of digital money, could not be better. All manners of trust have evaporated. In order to solve for demand and supply destruction, governments will embark on the greatest fiscal stimulus binge the world has ever seen. It will not be paid for by tax receipts, it can’t be because 30% of the population is out of a job, it will be paid for by the printing press. The kicker is that, in order to hand money directly to the people, governments will have to digitise their currencies. That will educate the populace on digital money. Once they understand fiat digital money, they will seek out the hard version to avert the ravages of inflation. If you believed that Libra could educate the masses on the joys of digital currencies, just imagine when everyone on Basic spends their food stamps via a mobile app.
Remember, the supply of goods will be insufficient because of the SME destruction during the global shutdown. Inflation in what you need, deflation in what you want. Digital finance meets wealth preservation equals Bitcoin. ‘Nuff said.
That was a lot of words to get to that conclusion. Now let’s trade it.
In a global margin call, the market will find leverage and punish it.
In a global margin call, all liquid assets will be sold to finance holdings of illiquid ones.
In a global margin call, correlation = 1.
We are in the midst of a global margin call on all risky assets. The reason why every asset class gets the stick is that weak hands used leverage to juice their short volatility strategies.
The BitMEX open interest halved. Leveraged traders got carried out. Platforms who lent dollars to miners against bitcoin (errbody needs dollars), force sold as the market puked.
Leverage was punished, just like in every other asset class. However on a relative basis, Bitcoin in Q1 still outperformed the S&P 500. Its correlation with SPX reached a local high.
Leverage was extinguished on the downside. The BitMEX XBTUSD swap open interest is rebuilding slowly and, as traders get their sea legs and inflation expectations adjust, the search for inflation hedges will begin in earnest.
This is Act One of a global rebalancing. Every pocket of pricing distortion brought about by leverage will be exploited. Buy the dip at your peril.
Bitcoin will be owned unlevered. Could the price retest $3,000? Absolutely. As the SPX rolls over and tests 2,000 expect all asset classes to puke again. As violent as the Q1 collapse in asset values was, we have almost 100 years of imbalances to unwind the ancien régime. My end of 2020 price target remains $20,000.
Everyone knows the shift is upon us, that is why central bankers and politicians will throw all of their tools at this problem. And I will reiterate, that is inflationary because more fiat money will chase a flat to declining supply of real goods and labour. There are only two things to own during the transition to whatever the new system is, and that is gold and bitcoin.
If you think I’m full of shit, or a stark-raving Cassandra, remember what you believed in pre and post-COVID. Can your mental model revert back to January 2020? I will take my inflation adjusted pocket rockets (gold and bitcoin), and call your Bretton Woods seven two off suit. All in, mother fuckers.