Bitcoin in the Age of War and Post-Inflation | Arthur Hayes: Fiat at Peak, Capital Will Flow to Scarce Assets

We are entering an era where the order of nations is changing, a time when the spark of war could ignite at any moment. In this age, military needs will continuously squeeze civilian demands, making global inflation difficult to halt. Now, setting aside the pain that war brings to humanity, how should we manage our investment portfolios? I am not immediately turning to commercial issues to alleviate the sorrow of war, but we must prepare our assets to cope with the consumption of resources for ourselves and our families. Therefore, compared to other TradFi markets, the cryptocurrency market will experience ups and downs first. Remember, real interest rates will still be negative. Once prolonged negative real interest rates erode the purchasing power of fiat currencies, the rush into scarce assets will be brilliant.

(This article is authorized for reprint from BlockBeats, original article here)

Original Title: "Annihilation"
Original Author: Arthur Hayes (Founder of BitMEX)
Original Translation: Zhuocheng Wu, Wu Blockchain

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Let's observe some charts describing policy interest rates and official inflation indicators. Official data is beautified, but even so, it still looks like a disaster.

US CPI (currently at -7%)

Eurozone CPI (currently at -5%)

UK CPI (currently at -5%)

The above three charts show official CPI data, representing real interest rates. As you can see, real interest rates have been severely negative since the pandemic. Imagine having a dollar, euro, or pound in your wallet. Next year, the value of that fiat currency will suddenly drop by 5% to 7%. If workers' wages also rise by this much, then it's not a problem. However, for most salaried or hourly workers, their wage increases have not kept up with the depreciation of the fiat currency.

Politicians are now instructing "independent" central banks to control inflation. Central banks worldwide must raise policy rates—this is not up for debate. What is contentious is the extent to which they decide to hike rates and how quickly they aim to complete the hikes.

If the Fed were to hike rates six times this year, the entire financial world would paint a doomsday scenario. This is what the federal funds futures market predicts. If they were to raise rates by 0.25% six times, their policy rate would reach 1.5%. Even if the U.S. inflation rate above 7% halves by year-end, real interest rates will still remain at -2%.

The above image shows the Eurodollar futures contract term structure. To calculate the yield on holding U.S. dollar deposits outside the U.S., subtract the futures price from 100. For example, if the Eurodollar futures price is 98.00, the yield is 2%.

The importance of the Eurodollar market in Europe could be the subject of thousands of words, but in short, it is the most critical interest rate market globally. This market is heavily influenced by Fed policy.

If we look at the Eurodollar futures curve, it will peak at nearly 2.5% in September next year. The market anticipates the Fed will raise short-term rates, as these futures benchmark the three-month dollar deposit rate. 2.5% is not enough to counter the current inflation levels, not to mention various medium or large-scale conflicts that will completely distort global energy use in the next 12 months.

Politicians have given a directive— "fix inflation." Central banks will comply, but only to a certain extent. Why? Because nominal rates that could lead to financial crises tend to get lower with each economic downturn.

The image above shows the chart of the Federal Funds rate floor since 1990. Every major global financial crisis has been due to the accumulation of leverage and debt in certain areas of the financial markets. When the Fed hikes rates, it bursts bubbles as financing costs rise.

After the first Gulf War and Iraq War, the Fed moved away from low rates, raising rates by about 5% to 6% by the end of 1994. This led to the Mexican financial crisis, with the U.S. Treasury bailing out U.S. banks in Mexico and the Fed taking slight easing measures. Years later, as rates rose to nearly 6%, the Asian financial crisis erupted. The increase in dollar financing costs led the Asian Tigers to seek economic assistance from the IMF and World Bank.

We all know what happened in the tech industry in 2000. The chart clearly shows that the Fed raised rates again after the Asian financial crisis. Higher financing costs dashed the hopes and dreams of the tech utopia, followed by a complete stock market crash.

Then came the 9/11 attacks, and the Fed cut rates, inflating the real estate bubble. Subsequently, rates soared by 5%, eventually reaching the peak in the U.S. real estate market in 2006. By 2008, losses from subprime mortgage derivatives infected the entire global financial system and caused a sensation!

After another 7 years of zero rates, the Fed began raising rates to slightly above 2% by the end of 2018/early 2019. Following the rate hike, the economy began to experience a comprehensive recession by the end of 2019, which turned into one of the most severe contractions in history due to the global pandemic.

6%, then 5%, then 2%—every decade, financial markets suddenly collapse as nominal rates continue to rise. With low or negative rates and the need for returns, global system debt and leverage exploded post-COVID-19, making it challenging for global financial markets to withstand a 2% nominal rate.

Looking at the charts above, the primary central banks' inflation rates are far behind, and with a 2% policy rate, real interest rates would still be negative. Unless workers start receiving larger pay raises, they will continue to suffer month after month from the damage caused by consumer price inflation. This is the secret to "social restructuring," let's revive the Jacobins.

Inflation

Every asset is being discussed as to whether it can effectively hedge against inflation. Many instinctively believe that as a scarce asset, Bitcoin and other cryptocurrencies are good inflation hedges. In the long run, they may be right; however, in the short term, the price behavior of Bitcoin more resembles a risk asset than an appreciating asset in times of negative real interest rates.

Bitcoin has clearly benefited substantially from the global central bank money printing spree induced by the pandemic. It needs to digest the high valuations, but this will be futile if liquidity continues to tighten. Now, let's temporarily remove negative rates from the picture.

Bitcoin surged from $4,500 in March 2020 to nearly $70,000 in November 2021. But then central banks worldwide changed their stance—claiming they will take the right actions and curb inflation. These comments alone were enough to push short-term rates higher, leading the crypto bull market into stagnation.

The image above shows the comparison between Bitcoin (yellow line) and 2-year U.S. Treasury bonds (white line) since September 2021. In my view, the stagnation in the Bitcoin bull market is due to tightening global liquidity conditions. Expecting central banks to hike nominal rates in the future, the market repriced fiat credit, causing 2-year yields to rise eightfold, leading Bitcoin to a slight sideways movement.

However, gold has finally begun to stir in its grave. With rates remaining in negative territory, it started climbing towards $2,000. Short-term nominal rate hikes, and gold still rising, as real rates remain negative. Therefore, the historical trend of gold maintaining value in the face of fiat depreciation has recently regained investor attention. I anticipate Bitcoin will eventually go through a similar process. However, "eventually" is key—patience and the ability to control buying impulses are crucial to re-entering the space or reallocating assets at the right time.

War

Let's consider some scenarios that could occur if the current conflict in Eastern Europe escalates into a medium or large-scale global conflict.

Due to environmental concerns, many countries have underinvested in the production and exploration of fossil fuels, leading to the substitution of relatively expensive wind and solar energy for cheap fossil fuels (measured by the energy each produces relative to the energy investment required). As humans, our survival requires energy, so people are paying more for it. Some might argue that the cost of fossil fuels does not fully reflect their negative environmental externalities, but for a household, they are now spending 50% more to heat their homes in harsh winters.

Over the past 50 years, the world has printed the most money in human history. Since the average age of the population in all major economies is aging, the productivity to repay the growing mountain of debt will decrease. But to keep the game going, central banks must print money to be able to nominally repay old debts. No government will actively default on its domestic currency debts; instead, inflation is used as a substitute.

Post-pandemic, inflation will rise. Relatively scarce labor typically gains the upper hand over capital, demanding more significant compensation for work, hence raising global costs continuously. Robots are not ready yet, so companies still need to employ those "essential" workers.

The central banks of the most developed economies will need to significantly raise rates to achieve positive real rates. However, the nominal rate levels at which the financial system might collapse are at historically low levels, and a slight increase from current levels by 1% to 2% could potentially lead to the collapse of certain financial and real sectors of the economy.

Wars are usually conflicts over resources or market access. The aim is either "I want your energy reserves" or "I want to force you to buy my stuff." Ideological "isms" are just a veil for economic realities, which is why one flag attacks another. As mentioned at the beginning, humanity has never benefited economically from conflict systemically. Therefore, in a situation where one country seizes another's resources or markets, prices tend to rise universally.

If you've played the game "Risk," read Brzezinski's "The Grand Chessboard," or Mackinder's "The Geographical Pivot of History," you can clearly see that conquering the Eurasian landmass means conquering the world. This continent has the world's largest population and holds a significant proportion of natural resources like energy and metals.

If as a global society, we cannot agree on fair ways to share these resources, we have never done so—wars between nations become inevitable. There have been relatively calm periods, but we seem to have passed those now. Any disruption in energy supply in a region will further destabilize the already precarious situation. With ongoing conflict, energy will not become cheaper. The fear of war alone will disrupt trade, as entities hoard energy and engage in trade under more disadvantageous conditions.

Returning to monetary policy, what will central banks do when politicians wield the war saber while demanding they curb inflation?

Scenario 1: Curbing Inflation

To properly curb inflation, central banks must lower real rates to at least 0%. This would require policy rates of over 6%—which seems difficult to comprehend given the current financial market conditions. However, this is the minimum rate necessary to curb inflation and correct all imbalances of the past 50 years.

Remember, a significant portion of current energy inflation is not a monetary phenomenon but rather due to long-term underinvestment in the cheapest energy sources and war. These are two issues that central banks cannot resolve. Hence, they might hike rates, hike again, and hike again, and energy prices will never decline. Then, once the global economy collapses, per capita energy demand will significantly decrease as consumption patterns have already been drastically reduced, causing energy prices to suddenly drop.

If rates were to rise to levels of 5% or 6%, the global economy would be shattered; compared to 2008, it would seem like a kindergarten. This reset would lead many uneconomic businesses to fail, but it would set humanity on a more sustainable growth trajectory. However, this rebalancing is undermining social stability—especially for financial asset holders who influence all policies.

If real rates tend to stabilize and then rise sharply, causing a severe impact on the world economy due to a significant drop in energy use, there will be nowhere to hide except for volatility hedges (even cryptocurrencies). I will continue to increase investments in volatility hedge fund managers whom I endorse. Fortunately, banks are still selling mispriced foreign exchange and interest rate options to them.

This is a scenario that I believe is less likely to occur.

Scenario 2: Sustaining Inflation

This is the basic situation for most of 2022.

Central banks are appearing in financial media, telling politicians they are serious about combating inflation. Bankers are raising policy rates to a range of 1% to 2%—the futures market tells us this, and that's it. At this level, real rates are still negative, which is crucial during times of war or near-war, as governments need to spend on war, and citizens don't like direct taxation to foot the bill for wars. Governments always resort to inflation as a secret means to fund wars.

By keeping real rates negative and nominal bond rates lower than nominal GDP growth rates, governments can afford financing and reduce their debt-to-GDP ratio. Negative real rates siphon wealth from savers to the government.

This nominal policy rate level will lead to an economic recession, but it won't significantly alter the social structure, and governments can still afford the cost of war.

One issue is that central banks again cannot control energy costs, which may continue to rise. Also, as their monetary policy remains loose on government spending, governments will continue to crowd out the private sector in energy use. Thus, energy costs will keep rising, and a lack of anti-inflation beliefs may lead to social unrest.

Because it's related to our portfolio, patience is key. If you are already in what you consider benchmark crypto assets (mine are Bitcoin and Ethereum), stay there. Don't short your ideal allocation—sit in your chaise longue, open a bottle of low-intervention wine, read a book (not TikTok), and relax. If you are a diligent day trader, remember that the transition of risk assets to inflation hedges will happen at lightning speed. Currently, it's in slow motion for you, crawling sideways. So don't be greedy—get in, get out, and get long to live long.

(The original text says "get in, get out, and get long," seeming to be a pun, implying both living long and going long.)

I wrote this article over the weekend when the conflict between Russia and Ukraine seemed brief and the Western response was calm. However, the war is ongoing, and to disentangle from Russia, the West seems prepared to endure economic pain. Russia (and any territory seen as Ukraine in the future) is a major supplier of food and energy. Removing these supplies from the global market will lead to high inflation.

Additionally, we cannot be certain of the financial consequences once disentangled. You never know where the cockroaches on a financial institution's balance sheet are hiding unless you understand market volatility. Therefore, it should be assumed that disentanglement will lead to a few major financial institutions facing financial distress. Given the significant leverage in the financial system, this distress could escalate into a global financial crisis.

The political reaction of the West to Russia provides an opportunity for global central banks to abandon their commitment to fighting inflation. I'm unsure if they can do this politically, as global efforts to exclude Russian energy will only continue to drive inflation higher. Therefore, I cautiously favor Bitcoin, and I am trying some Bitcoin and Ethereum call options. This may be a bit overtrading, but I just love the market.

The March federal funds futures indicate the market believes the Fed will raise rates by 0.25%. However, closely monitor the Fed's favorite speeches and the op-ed columns in the Wall Street Journal. The Fed will probe whether the current conflict-induced or actual market disruptions are severe enough to warrant a more "dovish" theme. Depending on market and political reactions, they may believe they can continue to maintain zero rates politically.

It needs to be clear that I'm not ready to support my gas-guzzling G-Wagon and add more exposure to cryptocurrencies. In the face of changing circumstances, caution is essential. Central bank officials will provide a clear "all hands on deck" signal for inflation with the cryptomancy. The first sign will be whether the Fed deviates from the market's expected 0.25% rate hike in mid-March. My basic view remains that the crypto market will fall again before we reach new highs.

Scenario 3: Accelerated Inflation

A severe global conflict will completely change the rules of the game. Inflation will be the name of the game, as the political necessity shifts from "let's fight inflation and keep the middle class economically dignified" to "that flag over there is evil and must be defeated, so it's your duty, citizens, to win the war by enduring inflation."

Price controls, rationing, and inflation will become the new normal in every country so that all available resources are used for the military. Domestic currency will be spent as soon as it is earned. Gold, Bitcoin, and other cryptocurrencies will be hoarded. This will be the action of Gresham's law. Getting into gold and crypto markets will be more challenging as capital controls will limit the ability of ordinary citizens to protect themselves from inflationary theft.

In reality, the value of most fiat-priced financial assets will be lower than toilet paper. Yes, your stock portfolio may nominally rise, but the price of milk, butter, eggs, sugar, etc., will increase faster than your cheap stock index funds.

I genuinely hope this doesn't happen. You will read about the daily ravages and destruction caused by war on citizens in different societies. The level