Market corrections and the Federal Reserve

BTC-Price-Chart-Dec04-2021
Source: Coinmarketcap.com

Stocks (esp. growth / riskier stocks) and crypto markets took a tumble this week. You may be thinking: ‘Wait, I thought the Black Friday sale Noah mentioned was last week?’

We just had another correction! What’s happening?

The answer lies in the broader macroeconomic environment.

Federal Reserve Chairman Jerome Powell stated on Tuesday that the Fed may taper their asset purchases faster than previously anticipated. “We’re now looking at an economy that’s very strong and inflationary pressures that are high… [it may be] appropriate to wrap up our purchases a few months earlier [than expected],” said Powell.

OK, what the heck does that mean and how does it relate to crypto?

Let’s talk about what the Fed is doing, the consequences, and what this means for crypto.

The Federal Reserve’s Market Manipulation

Throughout the past ten years, the Federal Reserve has practiced a program of quantitative easing. I’ll spare you the details of this unmitigated disaster. But, basically, the Federal Reserve is constantly buying trillions of dollars of assets (bonds, stocks, mortgage-backed securities) and holding them on their balance sheet.

Currently, the Federal Reserve is holding more than $8.7 TRILLION of assets (see below).

Fed-Reserve-Assets-Chart
The size of the Federal Reserve’s asset holdings in trillions of dollars. Source: statista.com

That’s approx. $500,000 every single day from when Jesus was born until now (shout-out to advent season & my favorite advent poems here).

The goal of quantitative easing (QE) is to “stimulate” the economy by increasing the amount of cash sloshing around in the system. The thinking goes like this: if there is more cash, then people will spend and/or invest more. This will keep us out of a recession.

So, does it work?

Eh, yes… but the cure is probably worse than the disease.

What are the consequences of QE?

It’s true that injecting tons of cash into the economy through gov’t manipulation can cause an increase in spending and investments.

But, besides the fact that it can cause/worsen inflation, QE is devastating for all of us because it causes everyone to spend & invest money based upon incorrect economic calculations. It goes something like this:

  1. market interest rates are supposed to accurately reflect how much we collectively value money right now vs. money in the future
  2. our ENTIRE ECONOMY makes plans, constructs buildings, hires staff, and allocates resources based on interest rates

Therefore, when interest rates are artificial, our entire economy is essentially mismanaging trillions of dollars.

To explain it another way, you can think of our entire economy like millions of people building a house. This house represents the wealth & standards of living that we all enjoy. When the Fed manipulates interest rates, it’s like they’ve changed our tape measure so that 9 inches now equals 1 foot. For a while, it’s great. We all think we have more than enough lumber for the house and promptly start planning to build an unnecessary deck in addition to our original plans. We measure the lumber, make cuts, put the house together, etc… everything is fine!

Until it’s not.

Eventually, reality will hit. All the incorrect measurements we used will cause instability across the entire house. Parts of the house may collapse. Or, even worse, given the intricate interdependencies that exist in both houses & complex first-world economies, the whole thing collapses.

This is essentially what happens in our boom & bust economic cycles. Our entire economic system is built upon measurements (eg, interest rates) that don’t actually reflect how much people value money now vs. later.

So, quantitative easing can kick the pain down the road… but it’s also responsible for inflation & the mismanagement of trillions of dollars.

We all pay the price.

What does this mean for crypto?

If the Fed moves forward with reducing its QE program, our entire economy will see higher interest rates and lower inflation (relative to current rates). Both of these developments are generally bearish for riskier investments, including crypto.

How so?

  1. Higher interest rates = less capital for investing: means people can people can more easily obtain financing for investments. Thus, demand for riskier and/or growth investments can obtain capital to invest in projects/assets they may take to turn a profit (and could decrease a lot in short-term).
  2. Lower inflation = less demand for yield: when inflation is high and interest rates are low, investors are forced out on the risk curve. This is basically a fancy way of saying that when inflation is high, you have to take more risk with your savings account just to beat inflation and breakeven. In other words, if inflation is 15% annually, then your investments need to return at least a 15% profit to make even… and if you leave the money in a bank account, then you’ll get wrecked. So, in a world where inflation isn’t as bad, people will feel less of a need to put their money into growth stocks or riskier assets like crypto. If inflation is low, a lot of people might be OK with government bonds that only paying like 2% annually.
Bonds-outperformed-stocks-last-six-months-tweet
caption for image

All this to say, if the Fed moves forward with reducing its QE program, then we will see volatility and corrections in the equity/crypto markets. We’re getting a taste of that now. But, will the Federal Reserve actually move forward with reducing QE?

Despite Chairman Powell’s comments, it’s all still pretty uncertain for a few reasons:

  1. Ongoing supply chain issues: there was a phenomenal interview this week on RealVision.com in which bond expert Steven Van Metre basically argues that the Fed tapering QE is the worst thing possible right now because supply chain issues are a major reason for inflation. So, tapering QE won’t fix things but will just add a recession on top of the current issues.
  2. Upcoming midterm elections: Van Metre furthermore argues that the only reason the Fed really wants to taper is because they are seeing public pressure and blame placed on them for inflation. But, this begs the question: if the Fed begins to taper and it triggers a recession, will they continue? Seems like the answer based on history is no.
  3. New COVID variants like Omicron: although I think policymakers (esp. in Australia) are losing their ever-loving minds, many countries are still applying insane risk/reward calculations to COVID and enacting draconian lockdowns whenever there is an uptick in cases (even though death rates are clearly very different due to vaccines). This could be recessionary for everyone, everywhere…and if that’s the case, the Fed isn’t going to want to tighten its policies.
  4. Weak jobs report: the jobs report released yesterday was not great. Basically all the metrics were lower than expected and the number of jobs added this past month was the lowest since December 2020. It could be a lot worse, but it’s not exactly a green light for the Federal Reserve to starting showing tough love to our economy.

Beyond all this, even if the Fed does reduce QE, crypto is marching onward. Like I said last week, I don’t think the bull run is close to being over. The underlying revolution in crypto is volatile, bumpy, frothy at times… but it’s very real. Blockchain technology is revolutionizing the financial industry right in front of our eyes. There will be major corrections along the way. But this asset class is still likely to do a 100x over the next ten years as institutional infrastructure is built, mainstream adoption increases, and the technology becomes across all economic sectors.

My advice is to take some money off the table during the next rally if you need it in the short-term. Of course, it’s also best to stay away from the frothy/bad investments like Dogecoin, Cardano, and EOS.

My top three favorite assets right now are:

  1. Bitcoin (BTC): mainly because institutional adoption is increasing & bitcoin’s status as the most decentralized, digital store of value is completely unmatched. The truly decentralized & virtually unhackable network is at escape velocity. If you think bitcoin is boring or outdated, you should read this article from Lyn Alden highlighting the unique status of bitcoin as a digital asset.
  2. Terra Luna (LUNA): I absolutely love this cryptoasset because, if you hold LUNA, you essentially own a piece of equity in the fastest growing stablecoin in crypto. Its UST stablecoin is pegged to the value of the dollar and, whenever more UST is created, LUNA is burned (kind of like a stock buyback). If we enter a more bearish period, many crypto users could decide to sell their assets. But, they won’t sell their assets for dollars… they will sell their assets for stablecoins like UST. So, LUNA could see positive price action even if the broader crypto market pulls back because its value can grow even as investors are fleeing for safety. We are seeing this in real-time right now: LUNA is recovering from this market correction faster than any other asset. If you haven’t read it yet, check out this complete profile on LUNA & Terra Money.
  3. Ether (ETH): Ethereum’s network adoption is clearly chartable. Currently, the network is somewhat unusable by normal people because the transaction fees are so high. But, this is a feature not a bug. The high transaction fees are really just contributions to a super high network security budget; which will ensure that institutions feel comfortable using the network into the future. The solution for normal users will be scaling solutions running on top of the network’s base layer. These scaling solutions are seeing parabolic growth right now. On top of all that, ETH is launching an upgrade in 2022 that will further deflationary pressure on the asset. Oh – and those high transaction fees are translating to a P/E ratio of less than 25 right now. Honestly, it’s kind of flying under the radar right now because retail investors are frustrated with the fees. But, institutional money & adoption could cause crazy growth in 2022.
Eth-asset-metrics
Ethereum asset metrics include a current P/E ratio of less than 25. Source: Token Terminal

In full disclosure, I mostly hold LUNA & a few other assets because I see their upside as the greatest right now. But, if some of the uncertainty continue, I will likely be looking to rotate some of my other investments so that BTC & ETH comprise larger portions of my portfolio.

All right friends, that’s a wrap on the markets. Put away the phones and enjoy the advent season. It’s an honor to write you.