Interest-ing Times (Part I)
Surviving the 2022 Macro Storm: Why Crypto is Not Out for the Count
by Ryan Shea
- 2022 was a shocker for investors. It was one of the worst years in living memory for global asset markets as investors were caught off guard when inflation took off and central banks finally decided to go after it in hot pursuit.
- What was bad for tradfi assets proved especially toxic for crypto. The major tokens all witnessed price declines between 50-70% last year and some – notably Luna/Terra and FTT – barely survived.
- Many investors are wondering what it means for the world’s newest asset class. The doomsters are hoping it will prove to be an “extinction event” for crypto.
- As has happened many times in the past predicting crypto’s demise will, in my judgement, prove to be a mistake. The sector may be down, but it is most definitely not out.
- In this article, the first in a three part series, I examine how the evolution of the crypto eco-system was, and will continue to be, shaped and influenced by the macro backdrop and explain why this is not the end for crypto.
There is no doubt, 2022 was a shocker for investors. As the following table (courtesy of BlackRock) neatly illustrates it was one of the worst years in living memory for global asset markets with only commodities and cash ending up in positive territory. Indeed, as equities and bonds fell in tandem the standard 60/40 portfolio, which implicitly assumes a negative (zero worst-case) correlation between the two asset classes, recorded its worst performance in a century, nuking many investors’ P&Ls in the process.
Annual Asset Class Returns
Clearly, the escalation in geopolitical tension following Russia’s decision to invade Ukraine in late February, and the resultant jump in risk investor aversion, played a pivotal role in the poor showing by global asset markets. But, as hinted at by cash witnessing one of its strongest relative performances of the past decade (2018 being the exception), collective central bank penance for misjudging the inflation outlook was unquestionably another major, if not the major, contributing factor weighing on asset prices.
Lulled by over a decade of benign price trends, and having witnessed central banks repeatedly label the previous year’s rise in inflation as transitory, investors were caught off guard when inflation took off and central banks finally decided to go after it in hot pursuit. The chart below gives some idea of just how dramatic the shift in monetary policy stances in the major advanced economies was last year relative to the preceding decade – see chart. This was the central bank policy equivalent of a handbrake U-turn.
Key Interest Rates – Major Advanced Economies
What was bad for traditional assets proved especially toxic for crypto. The major tokens all witnessed price declines between 50-70% last year and some – notably Luna/Terra and FTT – barely survived. The proximate cause for this dreadful performance has been well-documented by me and others and does not need to be rehashed. What matters now is what, if any, longer-run implications last year’s events will have on the sector.
In my previous research note I outlined three trends I consider will impact during 2023. This note goes beyond those trends by delving into the structure of the crypto eco-system, whose evolution was, and will continue to be, shaped and influenced by the macro backdrop. The hope is by anticipating likely changes this will help crypto investors to profitably navigate through the coming year and beyond.
Down But Not Out
Without doubt the crypto doomsters – the tulip-bulbers/Ponzi-schemers/greater-fool advocates – hoped the severe macro shock of 2022 would deal a fatal blow to crypto; an extinction event if you will – see image.
As has happened many times in the past predicting crypto’s demise will, in my judgement, prove to be a mistake. Indeed, one key positive takeaway from last year is that it provided the underlying technology with a serious stress test. The price of crypto-assets may have fallen sharply, but the core infrastructure held up well in the face of a tumultuous deleveraging episode reminiscent of that experienced in the tradfi world just over a decade earlier. Bitcoin’s blockchain continued to function without incident, with miners spitting out blocks containing transactions every 10 minutes. The same applied to almost all of the major blockchains. In fact, Ethereum also managed to implement the Merge, transitioning its consensus protocol from Proof-of-Work to Proof-of-Stake, during the midst of the cryptowinter - a not inconsiderable technical challenge. Even crypto critics – including Peter “blockchain will live on” Schiff – must acknowledge the technology held-up well.
The sector may be down, but it is most definitely not out. To explain why we need to go back to the very beginning of crypto.
Bitcoin was unleashed on the world 14 years ago. By happy accident (or design) its release coincided with a substantial change in the global macro backdrop, most importantly, interest rates. Prior to 2009 real long-term interest rates in the fiat world - proxied by 10-year yields on US Treasury Inflation Protected (TIP) bonds in the chart below – averaged 2%. Following the Great Recession (2007-2009) this average fell to just 0.3% (period averages shown by the green lines), which is very low by historic standards.
10-Year TIPs Yields
Source: Fred database
I say happy accident because unlike money held in the commercial banking system Bitcoin does not earn interest. This absence of positive cash flows means investors can only profit from such cryptocurrencies if the price goes up in the future. For the crypto doomsters this is a dynamic that has similarities with a Ponzi scheme, wherein early investors are only able to profit when later investors are suckered in, justifying – in their minds – their nihilistic view of the sector. However, this ignores the fact that low interest rate environments are beneficial for all non-interest bearing assets of which Bitcoin is just one example. There is another famous one, championed by the likes of Peter “blockchain will live on” Schiff, that I am sure many Bitcoin fans can already guess… gold.
The reason why a low interest rate environment is advantageous to such assets is because it means the opportunity cost of holding them versus cash or fixed-income instruments like bonds is low. Conversely, when interest rates are high, the opportunity cost of holding them is also high making them less attractive to investors. This is the theory at least, but it holds true in practice.
We can demonstrate this by looking at the correlation coefficients between gold and Bitcoin versus long-term real interest rates over the past decade. While the correlation between the price of gold and real long-term interest rates fluctuates, as can be seen in the following chart the majority of the time it is below zero (green line) meaning that falling real yields correspond to a rising gold price and vice versa.
180-day Rolling Correlations
Source: Author calculations
Now take a look at the orange line. It shows the same rolling correlation for real long-term interest rates but versus Bitcoin. In terms of magnitude, the correlation coefficients are somewhat lower than for gold but, on average, they also tend to be below zero. Bitcoin behaves in a similar fashion to gold, albeit in a less pronounced manner, which is the reason why the correlation between Bitcoin and gold is typically positive (blue line).
Given the interest rate environment in the post Great Recession period this negative correlation should have translated into substantial price gains for non-interest bearing assets such as gold and Bitcoin, and it did. Since January 2009 gold has rallied from $850 per troy ounce to more than $1,850, a 218% increase. Bitcoin has, of course, done even better. (Percentages are silly given the starting base was to all intents and purposes zero, but for those interested Bloomberg noted in a recent article that it was up 1,609,706,971% since inception).
For almost the entirety of Bitcoin’s life interest rates (both real and nominal) were unusually low making it the perfect environment for a newly created non-interest bearing financial asset to thrive. In fact, one can probably go further and argue that absent such a favourable macro backdrop, Bitcoin would have floundered because in a world where people were able to earn positive real returns by keeping cash in the bank there would have been little incentive to embrace a radically different alternative. Moreover, given Bitcoin was the seminal cryptocurrency and very much a proof-of-concept in its very early years, the entire crypto industry would likely not have been built had Bitcoin been still-born.
Having confirmed that non-interest bearing assets do well in low interest rate environments, implying the last decade provided the perfect “macro nursery” for Bitcoin, the natural follow-up question is when – as has occurred more recently - the interest rate environment becomes less favourable what happens?
Bubble, Bubble, Boil Then Trouble
Economists and financial market participants have long recognized that during periods of abundant global liquidity – characterized by low real long-term interest rates - investors respond by increasing their appetite for risk as the returns available on safer assets are no longer viewed as sufficiently attractive. This phenomenon is labelled “reaching for yield” because investors allocate capital to higher-yielding, higher-risk assets. Sustained for a sufficiently long period of time, it can lead to asset price bubbles, defined as when asset prices overshoot their fundamental valuations. The reason for this irrational exuberance, to borrow the language of former Fed Chairman Alan Greenspan, is simple: nothing attracts investors to an asset class more than positive price momentum (good old FOMO – the fear of missing out).
As mentioned, in the post Great Recession period real long-term interest rates remained very low for a protracted period. This fuelled speculation (literally!) of an “everything bubble” where pretty much all asset prices became fundamentally overvalued, including – by definition - cryptocurrencies. While the “everything bubble” is just a hypothesis, such widespread and substantial wealth destruction triggered by last year’s swift liquidity reversal and concomitant surge in real long-term interest certainly lends credence to it.
Asset price bubbles and subsequent bursts are obviously nothing new in financial markets. Five of the biggest asset bubbles in history were the Dutch tulip bubble of the 1630s, the South Sea Bubble of the 1720s, the Japanese real estate bubble of the 1980s, the 1990s Dotcom bubble and more recently the 2000s US real estate bubble, the pricking of which was the catalyst for the Great Recession.
When asset price bubbles burst they are painful for those caught up in them, but they are not necessarily fatal for the asset class in question. Japanese and US real estate is still investible as are tech stocks. What marks out the survivors is the asset class must have a non-zero fundamental value to which the price eventually converges.
Crypto doomsters believe last year’s price slump is fatal because it is predicated on their belief that cryptocurrencies are not backed by anything and have no intrinsic value making them fundamentally worthless (unlike gold). There is, in short, nothing above zero for their prices to converge to. I disagree, cryptocurrencies are backed by something and this gives them fundamental value. To understand why we need to take a look at money and its history.
Who’s Got Your Back?
Fiat money truly came into existence in 1971 when President Nixon closed the gold window, thereby severing the US dollar’s backing by the barbarous relic. Without this metallic anchor, what backs it and all the other fiat currencies is the fiscal solvency of the issuing government. In more formal terms, the net present value of government liabilities (debt) needs to be lower than the net present value of future tax receipts for fiat money to maintain its purchasing power. The rationale is fairly straight forward. If governments cannot pay liabilities out of tax revenues the only alternative to default (when debt is denominated in a currency you issue this disruptive outcome can easily be avoided) is to fire-up the printing press. More money, printed out of thin air at zero cost, chasing the same number of goods eventually means higher prices (inflation). Money’s purchasing power gets eroded.
In a world where governments adopt prudent fiscal policies fiat money is fine and it is able to serve as a store of value. However, as Satoshi Nakamoto observed in a early Bitcoin forum post, and echoing the long-held views of gold bugs, governments have a chequered history when it comes to maintaining the value of fiat money. History is full of examples where fiat money has failed (typically it loses its value slowly, before quickly accelerating in a cascade-like fashion).
Unlike fiat money, which can be easily and cheaply printed, gold is finite in supply and producing more is costly. Prior to 1971, when money was backed by gold, these naturally-occurring supply constraints were supposed to compel governments to behave in a fiscally responsible manner because they knew they could not simply print their way out of insolvency. As such, it was a mechanism to ensure money maintained its purchasing power.
In this gold === money world, there is a rather obvious reason why people own gold. However, in the post 1971 fiat money world where the link to gold has been severed what is the rationale for owning gold? Why does it still have any value given, like Bitcoin, it doesn’t generate positive cash flow? Or put another way, what backs gold?
Gold bugs like to argue the yellow metal has fundamental (intrinsic) value because it is a commodity that can be used in industry. This sounds plausible, but a breakdown of global gold demand shows that “industrial” demand for gold forms only a minor percentage of the total. The highest demand is from jewellery, followed by private investment, central bank purchases and, finally, the industrial use – technology - which accounts for just 8% of total demand – see chart below.
Distribution of gold demand worldwide by sector in 2021
I would posit, and I am more than happy to hear from anyone with a contradictory perspective, that the top three sources of gold demand, accounting for more than 90% of the total, are uncorrelated with the fourth source of demand. That is to say, people don’t choose to wear shiny gold necklaces and rings, and investors and central banks don’t hold gold bullion, because it is a good electrical conductor making it useful component for the iPhone 14 nor because it doesn’t react with many other substances making it useful to dentists.
The overwhelming reason why people own gold is because it is a reliable store-of-value, namely it maintains its purchasing power irrespective of the actions of the fiscal authority. It provides a way for people to “insure” themselves against spendthrift governments deploying the printing press.
Now consider Bitcoin. It shares many of gold’s attributes, namely divisibility, fungibility, portability and durability (full nodes all maintain copies of the blockchain and are widely distributed across the globe). In addition, Bitcoin has finite supply that is costly to increase because Bitcoin miners have to pay considerable up-front costs to solve the Proof-of-Work algorithm in order to be able to create blocks containing transactions and earn the block reward that adds to the existing supply of Bitcoin. The cost of mining, which attracts the ire of many environmentalists (often misplaced for reasons I outlined in my previous research note) is what protects the integrity of the Bitcoin blockchain because it makes it very expensive to corrupt (prohibitively so as I argued in a recent research note).
These similarities are not accidental, they are by design. Satoshi took many of the features of gold and incorporated them into the Bitcoin code base. About the only major design difference is Bitcoin has no industrial use. Does this mean it has no fundamental value? Given, as I noted above, industrial demand for gold accounts for less than 10% of overall demand, it is stretching credulity to suggest that absent an industrial use-case gold would be worthless. People clearly own and demand gold it for its non-industrial use-cases and the most obvious one is its ability to provide a hedge against badly-run fiat money systems, ie. to maintain its purchasing power. Bitcoin is able to serve the exact same purpose. This is what provides gold (mostly) and Bitcoin (totally) with underlying fundamental value.
In many regards, Bitcoin’s ability to provide a fiat money hedge means it should be viewed as a competitor of gold. Perhaps that explains why Peter Schiff and other gold bugs are so anti-crypto. They recognize it’s considerable potential to undermine demand for the yellow metal, especially as Bitcoin is digital making it much more closely aligned with how the world has evolved and, as I noted in a recent research note, much easier to move cross border and self-custody.
Another important aspect of the store-of-value characteristic that very often gets ignored is the need for social acceptability. Gold can only be a good store-of-value if it is widely accepted either directly as payment for goods and services in the future, or reliably convertible into something else that is widely accepted as payment for goods and services in the future. In either case widespread social acceptance is a necessary but not sufficient condition for gold to serve as a store-of-value. Obviously, gold’s social acceptance did not occur overnight. People did not collectively wake up one morning and decide this yellow shiny rock would be a good way to store wealth. It took centuries, if not millennia, for gold to establish this reputation.
Before its release in 2009, when only Satoshi knew about Bitcoin obviously its value was zero. As he garnered interest in his project and as more people began analysing it and kicking the tyres of the code, people become more comfortable and accepting of blockchain technology and started exchanging coins. Eventually on December 10, 2009 someone decided to pay the princely sum of $5 for 5,050 BTC (worth $92,281,680 at the time of writing – what a trade!).
Satoshi’s decision to incorporate many of gold’s features was smart for several reasons, one of which was that it allowed Bitcoin to lean on gold’s credibility as a store-of-value. A track record based on long historical experience could be replaced by logic (same features = same outcome), making adoption much faster.
Fourteen years later, and nurtured via a decade long period of low interest rates, the number of Bitcoin addresses with a non-zero balance exceeded more than 43 million in December according to the on-chain metrics company glassnode – see image. A considerable number of people clearly believe Bitcoin is, and will continue to be, worth more than zero (otherwise why bother hanging on to it). Like gold before it, Bitcoin has achieved a degree of social acceptance, admittedly it is still a long-way short of mainstream adoption but the speed of its uptake is impressive and the direction of travel pretty clear.
A common statement often heard in crypto is it’s “Still Early”. But equally in some tangible sense it is also “Too Late”. Just like the genie, cryptocurrencies and blockchain technology cannot be put back in the bottle. Last year’s shenanigans were, without doubt, unhelpful in further fostering crypto adoption, but it is well-recognized that the problems were not down to the technology. It was entirely due to the dubious practices and behaviours of individuals – the bad habits of tradfi, unfortunately, proved to be quite transferable into crypto. The industry will learn from its mistakes and governments are in the process of providing greater legal/regulatory clarity, which will give the sector an increased perception of legitimacy and raise consumer safety. These are positive steps that will support a further rise in crypto adoption.
The second threat is from an interest rate environment that remains less than favourable. If the surge in real interest rates had come much earlier in Bitcoin’s life I would have had grave concerns, as I remarked earlier. However, with social acceptability having risen to the extent it has I am much less worried. Admittedly, high(er) interest rates could weigh on Bitcoin’s price performance but it will not derail Bitcoin adoption unless it prompts the public to reassess the need for a fiat hedge.
Recall, fiat money is backed by fiscal solvency of the issuing government. Given public debt ratios are at, or near, record highs in most advanced economies, the backdrop remains extremely challenging to put it mildly. Central banks can do nothing about this, in fact, as I outlined last February their actions over the past year, if anything, make it worse. To wit,
“Monetary policy cannot succeed on its own. This is something I think a lot of people fail to appreciate. (In terms of cryptocurrency implications, the Fed going it alone is bearish in the short-term, but longer-term, because of the implied rise in the debt-to-GDP ratio, it is bullish as it keeps alive the fiat failure possibility). ”
Nothing about this longer-term assessment has changed. If anything it is being strengthened. To understand why take a look at the next chart, which shows the downside of rate hikes before QT. Fed earnings remittances (aka profits) to the Treasury have fallen off a cliff. Their bloated balance sheet is losing money on a mark-to-market basis. Of course, central banks can have negative equity (the Fed isn’t going to go bust), but the optics are clearly not great. More immediately, it means less money is going into the US government coffers – hardly a positive when your debt-to-GDP ratio stands at 123%.
Fed Earnings Remittances Due to the U.S. Treasury
Source: Fred database
Until the Fed pivots (a rate cut before year-end is my expectation) the macro environment will remain challenging for Bitcoin. But, it will be more than able to weather the storm because the fiscal backdrop - globally - remains so problematic and monetary tightening implemented over the past year only makes things worse. As a result, demand for fiat-money hedges will remain robust meaning a higher interest rate environment is just a speed bump in the road, nothing more.
In the next part of this series, looking at the impact of higher fiat money interest rates on crypto I will turn my attention to the second doomster fallacy about crypto – the lack of a positive cash flow.
Until next time.
Ryan Shea, crypto economist
 Government bonds are widely viewed by multi-asset funds as an income-generating hedge to equities.
 Solana – the blockchain championed by Sam Bankman-Fried suffered a several outages last year – see: https://news.bitcoin.com/solana-network-suffers-another-outage-cyber-capital-founder-says-downtime-is-another-consequence-of-bad-design/
 The genesis block contained a reference to the lead article in The Times newspaper dated January 3, 2009 – see: https://twitter.com/CoinbitsApp/status/1610185593769832449
 Bitcoin’s anonymous creator Satoshi Nakamoto is a conspiracy theorist magnet, some of who posit that the entire project was created by the CIA – a theory that was subsequently incorporated in the fictional book Waking Up Rich by James Robb. (It’s an easy and enjoyable read so worth checking out – see: https://www.amazon.com/Waking-Up-Rich-Bitcoin-trillion-dollar-ebook/dp/B09DWZG145 )
 Ie adjusted for inflation. Modern economists do not buy into the concept of money illusion beyond the short-term. Hence it is real, or inflation-adjusted, interest rates not nominal interest rates that matter – see: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3650471
 As shown by the data contained in this Bank of England Working paper, since the 14th century (so eight centuries of data), global real interest rates have only been lower than the post Great Recession period during WWI and WWII – see: https://www.bankofengland.co.uk/working-paper/2020/eight-centuries-of-global-real-interest-rates-r-g-and-the-suprasecular-decline-1311-2018
 By this I mean interest is not a feature in the Bitcoin core code. As I will discuss later in this research note the crypto eco-system has evolved such that users can now earn interest on Bitcoin by utilizing it outside of the base network. They can also earn interest by holding cryptocurrencies that use the Proof-of-Stake consensus protocol.
 As Max Keiser – who according to his twitter profile is the “high priest of Bitcoin” – correctly noted in 2015: “You can’t taper a Ponzi scheme” – see: https://twitter.com/maxkeiser/status/562986284726382592?lang=en
 Interestingly, much has been made of the increased correlation between Bitcoin and stocks over the past few year or so, especially US tech stocks, fuelling the Bitcoin is a risk asset narrative, whereas its rising correlation with gold over the past year appears to have gone largely unnoticed. As per the research note detailed in footnote 3 above, the Bitcoin as a risk asset and as digital gold are not competing narratives, but rather intimately connected for reasons that I have not seen elaborated on elsewhere.
 With profound apologies to the bard.
 Keynes’s description of gold standard (and by proxy gold) in 1924.
 Some may argue that the value of fiat money is backed by the reputation and credibility of the central bank to ensure price stability. However, even when central banks are formally independent – as most are these days – the ultimate backstop is the government because central banks act as the government’s agents and if they do not comply with the government’s instructions they can be replaced or nationalized as the BoE found out in 1946 – see: https://www.legislation.gov.uk/ukpga/Geo6/9-10/27/enacted
 Almost zero cost in the case of bank notes and coins.
 One of the most cited examples is German hyper-inflation in the early 20th century. For those interested I recommend the following book, which covers the period – see: https://www.amazon.co.uk/When-Money-Dies-nightmare-Hyper-Inflation/dp/1906964440/ref=asc_df_1906964440/?tag=googshopuk-21&linkCode=df0&hvadid=311024204769&hvpos=&hvnetw=g&hvrand=14832615459990950472&hvpone=&hvptwo=&hvqmt=&hvdev=c&hvdvcmdl=&hvlocint=&hvlocphy=1006886&hvtargid=pla-583630005570&psc=1&th=1&psc=1
 I say supposed because it didn’t always work. Even with the gold manacle they managed to overspend – typically during wars – and governments how found themselves in a precarious fiscal position abandoned the gold standard.
 Yes I include jewellery because it is considered a symbol of status and wealth, especially in India one of the largest markets for gold.
 All firing up the printing press does is raise the supply of money relative to gold, boosting its price in fiat money terms.
 Something many people fail to appreciate is that anything which has an intrinsic use – such as gold in the tech industry – detracts from its ability to function as money. Supply shocks, triggered by industrial innovation for example or in gold case the finding of new ore deposits that can be extracted more cheaply, also constitute monetary shocks, which is far from ideal.
 Even in a world where governments are fiscally prudent and the fiat money they issue is sound, demand for such hedges would be low but would always have some non-negative value for the same reason that out-of-the-money long-dated options always have positive value (ie “Never say never”).
 For a humorous take on this take a look at the following youtube video (Warning: it contains strong language). Although it is supposed to be a Bitcoin parody, it is clearly pertinent to gold – see: https://blog.trakx.io/crypto-reserve-ations/ https://www.youtube.com/watch?v=YHjYt6Jm5j8
 By going it alone I was referring to without supporting US fiscal constraint, not Fed policy diverging from those of other central banks.