August 2022 Review

The crypto market has suffered a torrid 12 months, with prices of Bitcoin and Ethereum remaining severely depressed. It has significantly underperformed the S&P 500 and gold over this timeframe, both of which are also down to some extent.

Of course, this is measured off the back of all-time highs for crypto around this time last year. Over any longer timeframe, crypto remains by far the best-performing asset.

The drop in prices is in part due to concerns over rampant inflation and an imminent global recession.

Understanding the role and price action of cryptocurrencies inevitably involves a review of global central banking. This is the illness for which cryptocurrency is the cure. To understand where the crypto cure may be heading we need to review the patient's symptoms and vital signs including inflation, interest rates and debt.

Inflation

Inflation continues to head higher across all the major economies.

The US may be starting to show some signs of a reversal following a sharp rise in interest rates and massive drawdowns in the US strategic energy reserves to temporarily limit the impact of rising energy costs.

Meanwhile, in Europe, inflation continues to accelerate, with forecasts of double-digit inflation this year and peak inflation as high as 20% next year. The energy crisis is rapidly pushing up costs on almost all products and is also putting energy suppliers under severe financial strain.

At the time of writing, it appears that a 1.5 trillion Euro bailout will be required for European energy companies to cover margin calls on their hedged energy price positions. The European Central Bank looks likely to stump up the cash, which of course will need to be printed, thereby leading to even further inflation. To put this in perspective, the bailout is twice the size of the US bailout of the entire banking sector in 2008. There is potential for a similar bailout in the UK.

Governments are capitulating to public demands for an energy price cap. This will have the effect of supporting demand, whilst there remains a shortage of supply. Basic economics tells you that high demand and low supply equals further price rises. In addition, the government will inevitably need to print more money to support the cost of the price cap, which will further fuel inflation.

There is growing public pressure to reach a negotiated settlement with Russia over Ukraine. Such a deal could rapidly reduce energy costs, but unfortunately, governments currently appear determined to continue to support the war effort. Whichever way you look at it, continued high inflation across Europe seems inevitable. High inflation in the US in the long term also seems inevitable, although the shorter-term direction is less predictable.

Interest Rates

In an attempt to tame inflation, the US is leading the pack in central bank rate rises. The EU and UK are also raising rates, but are lagging behind the moves made by the US.

The aim of rate rises is to reduce demand and thereby lower costs and inflation. This seems unlikely to be effective as the inflation crisis appears to be primarily an issue of increasing supply costs, rather than too much demand.

The efforts of the central banks to reduce inflation are being hampered by endless government stimulus programmes that support demand through subsidised prices etc. Of course, all that additional spending also has to be funded through further inflationary money printing.

Currency Values

The US dollar continues to strengthen, supported by multiple macro factors including:

• Accelerating US interest rates compared to Europe and Japan.
• Perceived safe haven against an increasingly unstable Europe and perma-lockdown China.
• Energy self-sufficiency.
• Geographic distance from Ukraine.
• Stable US economy, for now.

The strong dollar will help to reduce US import costs, which could see inflation reduce more quickly in the US than elsewhere.

The US economy remains stable, for now, but the strong dollar will affect exports and tourism, and may eventually lead to wage and job cuts.

US Inflation

Whilst the US Dollar strengthens, US inflation remains extremely high at 8.5%. The FED continues to hope that this inflation is transitory, and they may be right as the strong dollar continues to lower import costs.

While the US has raised interest rates to 3%, they remain way behind the current inflation rate of 8.5%. Ordinarily, central banks will look to raise rates above the level of inflation in order to tame it. Currently, the CME Group forecasts rates peaking next year at around half the current level of inflation.

When Will the FED Pivot?

So, all of that brings us to the key question for crypto and markets in general: When will the FED pivot, and start to reduce rates?

Let's start by looking at the CME Group data, that forecasts the interest rate probability out 12 months ahead. The chart below shows the rate at which interest rates were forecast to peak.

We can see that at their highest, they were forecasting a peak interest rate of 4.1%. That forecast has now dropped to 3.9%. The gradient of the chart is reducing, indicating that we may be getting closer to a consensus on the eventual peak rate and when it will occur.

The forecast date of peak interest rates (the FED pivot date) is also being brought forwards. In May 2022 the pivot was forecast to take place in 450 days time (August 2023). It is now forecast to take place in 194 days time (March 2023).

The FED has also started its quantitive tightening programme and has reduced its balance sheet by $0.14Tn. However, the US government will inevitably be calling on the FED to monetise more government debt to support its latest spending and stimulus programmes. It seems highly unlikely that the FED can make any meaningful reduction to its balance sheet.

The US has already had two consecutive quarters of negative GDP growth, indicating that it is likely already in recession. The unemployment rate (a lagging indicator) remains low, but has just started to edge up last month. If a full-blown recession is confirmed then the FED will be under increased pressure to reverse its rate rise and quantitive tightening programmes.

The next FED announcement dates are 21 Sept 2022, 2 Nov 2022 and 14 Dec 2022.

Impact On Government Debt Interest

The US federal debt currently stands at an eye-watering $30.5 trillion, and on this debt it pays $400 billion in annual interest. That works out at an average interest rate of approximately 1.3%.

Now the FED has already raised rates to 2.4%, which means when the government has to refinance its debt, its annual payments will increase to $738 billion. That's about the same as the annual defence budget.

If rates increase to the forecast peak rate of around 4%, then interest payments will increase to $1.23 trillion. That's more than the entire annual social security budget.

The total tax revenue for US government is approximately $4 trillion per year. The table below shows what proportion of this revenue would be spent purely on debt interest payments for each of these scenarios:

So, at just 4% interest rates the government would spend a staggering 31% of its entire tax revenue purely on debt interest payments. If interest rates were to increase to match current inflation levels of around 8%, then over 60% of tax revenue would be spent purely on interest payments.

This assumes that tax revenues remain the same and government debt doesn't increase, both of which are highly unlikely. Tax revenues are likely to drop sharply if the US enters a recession, and the government is still running an annual deficit of close to $1 trillion per year, so we can expect the debt to rise by this amount annually.

What Happens Next?

So where does that leave the US? Let's consider the scenarios:

The FED Continues Aggressive Rate Increases

The FED might continue to raise rates aggressively in order combat inflation. Whilst a short-term spike might be sustainable, any long-term persistence of high rates will bankrupt the government. This would leave the government with the only option of issuing even more debt, which it would ask the FED to monetise onto its balance sheet. Not easy when the FED is trying to start quantitative tightening rather than easing. All this additional money will eventually drive inflation even higher.

The FED Starts Reducing Rates

If the FED start to reduce rates then that could trigger a drop in the value of the dollar from its current highs. This would increase import costs for the US, thereby further increasing inflation.

It's easy to see how the FED is going to start coming under immense pressure from the government to play ball and continue to monetise endless quantities of new debt for them. It seems highly likely that the US government will continue to issue more debt and hope to inflate away its problems. However, this could only work if government spending was massively reduced at the same time, which seems highly unlikely.

If a major recession is about to occur, it will be the most anticipated recession in financial history. Somehow it feels like the government and the FED will fudge their way through this crisis, perhaps with the strong dollar temporarily reducing inflation concerns. We would then see the FED pivot and reduce rates in the early part of 2023. All of this will just kick the can down the road towards an even greater financial crisis just a few years away. And that's just the US, one of the strongest economies in the world. The scenarios for Europe are multiple times worse.

A FED pivot will probably put some confidence back into dollar-dominated risk assets, including cryptocurrencies. If this scenario plays out then we hope to see cryptocurrencies starting to recover in early 2023.

Whichever way you look at it, inflation is here to stay and is likely to increase. Whilst the crypto market has been hit hard over recent months, more and more people are watching their own fiat currencies rapidly devalue and the cost of living is becoming the number one concern globally. People are increasingly looking for alternative places to store their wealth. Gradually, they are learning about the benefits of fixed supply cryptocurrenices that can't be manipulated by governments and central banks, such as Bitcoin.