HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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February 28, 2021

The future & bitcoin are more expensive but for different reasons

The future isn't what it used to be - it's now more expensive  

The recent rise in the US 10 year bond yield has set alarm bells ringing. This is not a surprise, it is the most important interest rate benchmark in the world. Bill Clinton’s political advisor, James Carville has been quoted a lot this week when he said: I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody. Having been a seemingly benign force for decades the bond market is stirring. However, there are differing views about why this happening and its significance.

One view is that a normal upwardly sloping yield curve is a return to rationality and normality. It allows, for example, banks to make a return in what they do best, borrowing short and lending long. If the banks can make money they can lend more and it is all part of a classic mean reversion play of a recovering economy.

In a more fundamental sense, this move informs us that the future is no longer what it was previously; it is now more expensive. All the companies that derive the bulk of their value in the future, are no longer as attractive. We have, year to date, collectively changed our preference for the present versus the future. And why not? The next 12months look like they could be rather better from a growth perspective than any time in living memory as we open up and start spending again. Furthermore, Uncle Joe Biden is passing legislation to boost everyone’s spending power.

The problem is perhaps similar to when we put in a pumped hot water system into an Edwardian London house to get a more powerful shower. The boiler and pump were both top of the range, but they have to run at half power to avoid blowing the pipework. Since we shut down the world economic system, we have injected an extra-strong pump into the system, which we are yet to turn back on. We don’t know if our system can take the pressure about to be pumped through it.

A partial recovery has already experienced supply chain constraints. Commodity, oil, and other raw material prices have spiked, and we seem to be running low on critical semi-conductors. We do not yet know if these are just relative price changes or signals of inflation. Understanding the difference is critical to understanding the future direction of financial markets. I remain concerned enough to retain my position in gold and other commodities. I think fine wine, stamps and other collectables are options if you have domain expertise. The move to date in bitcoin has been more of a happy coincident, its use as a hedge against inflation remains unproven, but is still probable.

Bitcoin, VHS and the English language - network winners

Last year I bought some gold and bitcoin to insure myself against the risk of inflation. It was a ten-year view based on my concern about increasing public debt levels and evidence that governments were likely to monetise this debt. My thesis was that both assets were likely to remain in fixed supply relative to that of money over the coming decade as governments doubled down on quantitative easing and found other ways to stimulate their economies from the devastation of the COVID lockdowns. I was adamant that whatever happened, I would allocate a small amount into these assets and just leave it to work as protection against the risk of long-term monetary debasement.

Six months into my ten-year strategy, in dollar terms I am down about 15% on my gold and up about 200% on my bitcoin (depending on which day or hour I check). What has happened in the last six months to cause such a dramatic variance in the performance of assets that seemed to offer similar degrees of inflation protection? As the loss to date on my gold bet illustrates, my investment thesis has not played out as I thought, at least not yet.

The break-even inflation rate on 10 year US treasuries (a measure of inflationary expectations) has stepped up, but only from very depressed (deflationary) levels seen in the first half of 2020 to a rate of about 2%, which has been the typically benign level seen over the last decade. If a 3 fold change in the bitcoin price was due to people worrying about inflation, it might be realistic to assume that inflationary expectations would have seen a much larger increase. By implication, I surmise there are forces other than inflationary fear impacting the price of bitcoin. It could be that bitcoin has replaced gold as the main market for currency debasement phobia to make itself apparent. While bitcoin does have some advantages over gold as a store of value, I don’t see this as the main factor.

Almost weekly another financial institution is either allocating capital to bitcoin or aiding the flow of capital into bitcoin. PayPal, Square, MicroStrategy and most recently, Tesla have all allocated corporate assets to bitcoin. Bank of New York Mellon and JP Morgan have recently joined Fidelity in offering bitcoin custody and services, Coinbase has filed for a market listing and investors such as Ruffer and Paul Tudor Jones have publicly allocated funds to bitcoin. The reality is bitcoin has undergone a phase transition and tacked resolutely towards the mainstream of money and finance. It has not arrived, but it has come a long way, and much further than any of the previous failed attempts at creating a digital currency.

Yet there remains an understandably widespread scepticism about the rise of bitcoin and its sustainability. The FT and its readers are largely bitcoin sceptics (albeit there is evidence that a few FT writers are softening their stance). Comments left in the FT readers area include:  “it isn’t an asset as it has no cash flows to value”;”it will be, or should be outlawed”; “when Central Banks issue digital currencies no one will want to own bitcoin”; “I can’t use it to buy my groceries, so it isn’t money”; I even saw “why would I want to use a money that is in limited supply when I can hold money that there is lots of”, and actually I think it was a serious comment. Established and social media have lots of theories about what is driving the bitcoin price. It’s a speculative bubble. It is Elon Musk. It is the Reddit revolutionaries in their basements frittering away their furlough cheques on GameStop shares and cryptocurrencies. In many ways, bitcoin has replaced Brexit as the most contentious issue in the FT comments section.

Twitter is the place where the true bitcoin believers hang out. Here the revolutionaries of liberty, the hodlrs, are on the long march against the evils of fiat money and the state aggression used to protect its monopoly power. These libertarian die-hards and techno-utopian dreamers see the de-centralised blockchain verification protocol as a thing of beauty and redemption.

The reality is that both these camps will be disappointed in the way bitcoin evolves. For bitcoin to have a non zero value does not rely on the end of liberal democracy and the collapse of fiat money. It does not even require a significant increase in inflation. Bitcoin has risen from its proof of concept stage in 2009 and passed through three halving cycles each of which had a similar positive impact on its market value. The current cycle is distinguished by the transition to institutional adoption. At its recent high of $58 000, the market value of all bitcoin reached a trillion dollars, twice the value of silver but still only a tenth of the value of gold. With a global capital market structure based on an estimated $17tn of bonds offering a negative yield to redemption, it is not difficult to see why this might be happening.

This phase transition of bitcoin from unlikely outsider to mainstream adoption is an evolutionary process involving multiple previous dead ends. Who remembers: beenz.com, egold, digicash, and cybercash? Just a handful of prior failed attempts to create a workable digital currency. (Bill Gates wanted Digicash to be bundled into Windows).

Bitcoin was not perfect in conception and has had several important adaptations in its twelve-year life. But it is in a winner takes most race. Just as VHS videotapes were technically inferior to Betamax and the English language could never compare to German for its logical structure and ease of use, bitcoin has gained an invaluable network advantage in becoming an accepted digital store of value. Inflation might just help it along a bit quicker.

Jeremy

28/02/2021

Ealing

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