James Butterfill is Investment Strategist at a leading European digital asset investment firm CoinShares.
Investors have spent the last 10 years, following unprecedented levels of quantitative easing (QE), expecting to see inflation start to kick in, only for it not to happen. Perhaps one of the most plausible explanations is that the transmission mechanisms have not worked as expected, with QE often being used unproductively as companies have taken advantage of low bond yields to buy back shares rather than growth initiatives. It took a global health crisis (COVID) to expose the worn-out global logistics network, highlighting major supply bottlenecks that have helped drive inflation to levels not seen in the United States since June 1982.
Bitcoin’s Sensitivity to Fed Actions
We’ve seen in the final minutes of the FOMC that the US Federal Reserve (Fed) is growing increasingly concerned about the inflationary threat in the US, prompting them to consider ending QE tapering sooner than expected by investors. markets while looking at 4 interest rate hikes in 2022 rather than the consensus of just 2 about 6 months ago. This time, it looks like the US Federal Reserve may end the taper and raise interest rates again like it started in 2015.
What will happen to Bitcoin (BTC) in a rising rate environment? Bitcoin is up 51% 6 months after the first rate hike in 2015, but we believe Bitcoin has matured considerably since then and is therefore likely to perform differently, and likely in line with other real (inflationary) assets. Therefore, analyzing how other real assets have performed in previous rate hike cycles is likely to give us an idea of how Bitcoin may perform.
The Anatomy of Interest Rate Hikes
While each historical rate hike cycle is different in some way, there are similarities. To better represent today’s scenario, we have identified five of the nine potential periods of post-Bretton Woods tightening cycles. The periods of December 1976, December 1986, February 1994, and June 2004 and 2015 are closest to today in that they represent periods when rates were falling or relatively low for a long period of time before. . We are encouraged by the fact that the analysis shows a surprising consistency in each of the five periods observed.
Gold and industrial commodities tend to appreciate during rate hikes
Gold is an example where performance has not been consistent: in 1976, 1986 and 2004 prices rose by 22%, 25% and 11% respectively, while in 1994 prices fell by 2 .6% one year after the first increase. Inflation was probably the cause of the increases in 1976 and 1986, but not in 2004, when inflation was better controlled. A key differentiator in 1994 was that real interest rates increased by 3%, while in the other periods they remained stable or negative, confirming that the rise in real interest rates tends to be negative for gold. Industrial commodities, another real asset, tend to behave similarly during cycles of rising rates. The S&P 500 is technically a real asset and initially tends to rally, but then starts to sell off, likely due to tighter credit conditions weighing on corporate profitability.
The USD is generally selling contrary to popular belief
Prior to rate hikes, the USD tends to hold steady or rise, but either way it has been volatile and has fallen an average of 7% in one year. This fact may be counterintuitive because the contraction of the money supply leads to a decrease in the circulation of dollars. We think the most likely explanation for this is that markets tend to fully assess the prospect of a stronger economy and improving job market before the event happens. It seems the USD is behaving the same way, since November 2021 the USD has strengthened against a wide range of currencies, while Bitcoin, which trades inversely to the USD , sold.
The Fed is lagging the curve – raising the risk of policy error
Monetary policy needs to be proactive and since inflation is a lagging indicator of the state of the economy, one could argue that the Fed is already behind the curve. Keep in mind that monetary policy also has a lagged impact on the economy by 1-2 years, so interest rate hikes from today are unlikely to have a immediate impact.
The liquidity created by QE and exceptionally low interest rates have created a high-risk conundrum for the Fed. As QE is phased out and interest rates begin to rise, this increases the risk of a disorderly correction in the equity and bond markets which have become so dependent on this stimulus and have been driven to record levels. On the one hand, the Fed has a mandate to control inflation, but it also has a mandate to stabilize prices, so it is very difficult to see how the Fed can control both at the present time.
The firepower (how much interest rates can be raised) of the FED also needs to be considered and, at first glance, household debt service ratios look healthy, averaging 9.1 % of household debt spent on debt servicing, lowest point since records began. Companies also appear healthy, with net debt to EBITDA (earnings before interest, tax, depreciation and amortization) at 1.3 years versus a long-term average of 1.7 years. This suggests that the Fed has substantial firepower to raise interest rates before it begins to stress the economy.
Although there are some sectors of the economy where net debt to EBITDA doesn’t look as healthy, especially utilities, energy and healthcare, which are worse off now than before. the 2008 financial crisis. Although technology’s net debt to EBITDA is at its highest level since 1998, it remains low compared to other sectors. One of the unintended consequences of raising interest rates too aggressively could be increased defaults and unemployment in these crucial sectors of the economy, causing social unrest and greater political instability.
Real assets should benefit
We believe that Bitcoin is likely to behave similarly to gold and other real assets, being valued in US dollars and being of fixed supply. We have already seen in December 2021 and January so far this year that Bitcoin is extremely sensitive to the threat of interest rate hikes, having sold almost 30% off its highs in what we believe is a reaction to inflation and the growing likelihood of more rate hikes in 2022. Longer term, we see that there is a high risk of policy error by the Fed (waiting too long and then raising interest rates too aggressively), with the USD then selling off, both likely to support Bitcoin and other real assets.
The play first appeared in CoinShares Digital Asset Outlook 2022.
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