Podcast Summary
Understanding the Macro Environment for Crypto Investments: Macro Alf explains the importance of the bond market in the global economy and emphasizes its stability as crucial for risk acceptance and crypto asset growth.
The current state of macro markets plays a significant role in the recovery of crypto and other risk-on assets. Macro Alf, the guest on the show, provides valuable insights into the macroeconomic environment and educates listeners about the structure of macro markets. He emphasizes the importance of the bond market in the global economy and explains that ensuring its stability is crucial for people to accept risk again. By understanding the macroeconomic landscape and the role of various markets within it, listeners can gain a better perspective on what it will take for the world to go risk-on and for crypto assets to reach new all-time highs. Macro Alf's analysis offers a well-reasoned and thoughtful perspective on the current state of the macro environment and its impact on crypto investments.
Understanding Macroeconomics is Essential for Crypto Investors: Learn macroeconomics basics, pay attention to inflation, interest rates, geopolitical tensions, and the shift to DeFi and NFTs, use tools for asset security and management, and navigate crypto landscape with layer 2 solutions.
Understanding macroeconomics is crucial for anyone with assets in crypto and traditional markets, especially during uncertain times. Macro refers to long-term trends and cycles that intersect with financial markets. Elf, a former head of a $20 billion investment portfolio and author of the Macro Compass newsletter, advises Bankless listeners to pay attention to macro factors, even if they're novices. Currently, there are several macro themes impacting the financial world, including inflation, interest rates, geopolitical tensions, and the ongoing shift to decentralized finance (DeFi) and non-fungible tokens (NFTs). As a listener, it's essential to learn the basics of macroeconomics, such as how bonds work, to make informed decisions about your portfolio. Additionally, tools like Ledger hardware wallets and Nexo's financial services can help secure and manage your assets during these uncertain times. Lastly, layer 2 solutions like Across's cross-chain bridge enable faster and cheaper transactions between different blockchain networks, making it easier to navigate the evolving crypto landscape.
Cyclical Economic Slowdown: Reversal of Money Inundation: The economy is experiencing a cyclical slowdown due to reversal of unprecedented money creation, leading to growth, earnings, and risk asset challenges in the second half of 2022 and beyond.
We are currently experiencing a cyclical economic slowdown, which will dominate the economic trend for the next year or two. This cycle is a reversal of the cycle we saw in 2020 and 2021, during which both real economy money (money that reaches our bank deposits) and financial economy money (liquidity within the financial system) were increased at an unprecedented pace. This led to sharp nominal growth and inflationary pressures. However, these effects have a lag, and we are now seeing the lagged effects of this money inundation reversing. Real economy money growth has slowed down, and financial economy money (liquidity) is being removed from the system through quantitative tightening. This double tightening of real and financial economy money will lead to lagged effects on growth, earnings, inflation, and risk assets in the second half of 2022 and beyond. It's important to understand that there are two tiers of money in the economy: the money we interact with as individuals and corporates, and the financial money used by institutions. The paradigm shift is from both tiers of money increasing rapidly to both tiers of money being destroyed or at least the rate of creation slowing down significantly. This shift is already causing growth, earnings, and risk asset problems, and the full effects may not be felt for 9 to 12 months or even longer.
Housing market as a microcosm of the economy: Economic phenomena, like the housing market, have a lag effect. Central banks' actions to combat inflation can impact the economy and asset prices for up to 18 months.
The housing market, which represents around 15% of US GDP and is highly leveraged, serves as a microcosm of the broader economy. When interest rates are low and incomes are growing, housing prices and activity surge, leading to inflation. However, when interest rates rise and incomes shrink, housing prices and activity fall, leading to deflation. This lag effect can impact the economy and asset prices for up to 18 months. The Federal Reserve and other central banks are now actively reducing financial liquidity to combat inflation, which will likely lead to a reversal of the economic trends seen in 2021. This principle is not limited to the housing market, but applies to many industries and economies around the world. It's important to remember that economic phenomena often have a lag effect, and it's crucial to consider this when analyzing economic trends.
Money creation and destruction cycles: From 2020 to 2021, money was created leading to inflation and asset price growth. Now, money is being destroyed, causing asset price declines, potential job losses, and decreasing incomes. This cycle is expected to slow down inflation in 2023.
We have experienced a period of money creation from 2020 to 2021, leading to inflation, asset price increases, and home price growth. Now, we are in a money destruction period where real and financial money is being destroyed, leading to falling asset prices, potential job losses, and decreasing incomes. This cyclical trend is expected to result in a slowdown of inflation in 2023. The money destruction period started around the end of 2021 and will likely continue into 2023 and 2024. The credit impulse metric, which measures the growth in real economy money, peaked in Q4 2021, and we have already started seeing the first signs of economic slowdown with declining forward-leading indicators and earnings. The labor market, a coincident indicator, will be the next to show signs of slowing down. Inflation, a lagging indicator, will follow suit but with a delay. Overall, understanding the distinction between cycles, cyclicals, and long-term trends is crucial for effective macro investment strategies.
Unprecedented economic cycle with higher highs and lower lows: The current economic cycle features extreme volatility due to massive fiscal response and exogenous shocks, leading to dramatic earnings growth but a need to focus on potential growth as organic growth stalls since the 1980s.
The current economic cycle, driven by unprecedented real and financial money printing and exacerbated by the pandemic shock, has resulted in more volatile extremes compared to previous cycles. The highs have been higher, and the lows have been lower. This cycle's uniqueness lies in the combination of massive fiscal response and an exogenous shock, leading to an overstimulation of the economy. As a result, earnings grew dramatically in 2021, but economic activity is expected to slow down in response to the withdrawal of stimulus. Additionally, the economy's inability to generate organic growth since the 1980s, due to demographic changes and declining labor force growth, necessitates a focus on potential growth, which was roughly 4.5% in the US at that time.
Cyclical Boosters and Inevitable Economic Slowdown: The economy's reliance on credit creation and debt accumulation for growth has led to increasing debt levels and economic cycles with higher highs and lower lows. Central bankers and policymakers can attempt to soften the landing, but an economic slowdown is inevitable as the debt must be absorbed.
The global economy has been relying on cyclical boosters, such as credit creation and debt accumulation, to supplement poor organic growth due to demographic changes and diminishing productivity gains. This process has led to increasing economic debt levels, and the resulting cycles have featured higher highs and lower lows. The speaker argues that this trend is an inevitability, as the economy must absorb the debt and grow at a slower rate. Central bankers and policymakers may try to soften the landing, but ultimately, the economy must go through this process.
Central banks facing discomfort and taking aggressive actions: Central banks, including the Federal Reserve, are feeling uncomfortable with the current economic climate and taking more aggressive actions than usual to regain credibility and control the situation, which could lead to significant job losses and increased unemployment rates.
Central banks, including the Federal Reserve, are facing unprecedented challenges and are feeling uncomfortable with the current economic climate. This discomfort is leading policymakers to take more aggressive actions than usual to regain credibility and control the situation. For example, Jerome Powell's statement about the inevitable pain households will experience during the tightening process is a departure from the usual central bank jargon. This pain could result in significant job losses and increased unemployment rates, potentially bringing back memories of the 2008 financial crisis and its aftermath. The economy is no longer in a controllable or status quo environment, and the discomfort felt by policymakers is driving them to act strongly to prevent further damage to their credibility. Additionally, there are parallels between the current situation and the late 1990s, including a dotcom mania and excessive risk-taking in certain sectors, as well as inflation rates over 4%. These historical parallels add to the sense of uncertainty and the need for strong action from central banks.
High inflation limiting Fed's response in 2000s, similar impact today: High inflation hinders Fed's actions, causing equity declines, labor market losses, and strong dollar, with current bond market volatility posing challenges for institutional investors and potential instability in financial markets
The high inflation rates in the early 2000s, similar to today, limited the Federal Reserve's ability to respond to economic downturns. This was evident in the earnings declines and labor market losses, which led to a sharp drop in equity markets and a strong appreciation of the dollar despite rate cuts. The current volatility in the bond market, with realized volatility at its highest since the financial crisis, has significant implications for institutional investors, who manage trillions of dollars in assets. The high volatility in the bond market can make it challenging for these investors to meet their asset allocation mandates, potentially leading to further instability in financial markets. The current situation may not provide a good buying opportunity for risk assets until the economic damage has been fully incorporated. The recent trend of Bitcoin being less volatile than the 10-year treasury is a notable development, but the high volatility in the treasury market may not be a cause for celebration.
Bond market volatility can shake the foundations of financial institutions: Bond market instability can force large investors to sell riskier assets, leading to potential financial crises
Pension funds and banks, as large institutional investors, have a natural inclination towards buying bonds due to their role in managing fixed liabilities and regulator requirements for liquid assets, respectively. However, when the bond market, the foundation of their investment portfolios, becomes volatile, these institutions are forced to reduce their risk exposure by selling off their riskier investments, triggering a cascade of events that can lead to economic contraction or deflation. This is because the most vulnerable parts of the financial system, such as highly leveraged companies and emerging markets, are hit first when instability spreads from the base. The conversation about a pyramid's foundations shaking and the resulting contraction or deflation is the same as the economic terms of the same name. The bond market's volatility can lead to these institutions selling off their riskier investments, putting downward pressure on prices and potentially causing a wider financial crisis.
Fed's balance sheet reduction causing less liquidity for banks: The Fed's balance sheet reduction is reducing bank reserves, making the financial system less lubricated and more volatile, potentially leading to market instability
The current economic situation, with the shaky bond market and decreasing bank reserves, is making the financial system more volatile and less lubricated. The Federal Reserve's balance sheet reduction is leading to a shrinkage of bank reserves, which are essential for banks to settle transactions and engage in liquidity providing activities. With less liquidity, banks become more risk-averse and less willing to provide liquidity to the markets. This can lead to a drying up of markets from liquidity, increasing systemic risks, and potentially causing market instability. On a positive note, the advancements in web 3 technology, such as Arbitrum, are providing faster and cheaper transaction solutions, making web 3 development more accessible and easier to navigate for a wider audience. Additionally, the Brave Wallet offers a secure, multi-chain solution for managing crypto assets, simplifying the process for users and reducing the risk of managing multiple wallets and extensions.
Exploring the future of web browsing and blockchain technology: Brave's web 3 ready browser and Fuel's modular execution layer are steps towards decentralization and faster, more efficient execution in web browsing and blockchain technology. However, the adoption of decentralized assets as alternatives to traditional financial assets faces regulatory challenges.
The future of web browsing and blockchain technology is moving towards decentralization and faster, more efficient execution layers. Brave's web 3 ready browser is a step in this direction, providing a seamless experience without the clutter of traditional web extensions. Fuel, a modular execution layer, supports parallel transaction execution and goes beyond the limitations of the Ethereum Virtual Machine (EVM) with its own FuelVM and Sway programming language. However, the adoption of decentralized assets like Bitcoin and Ethereum as alternatives to traditional financial assets, such as bonds, is currently just a fantasy. Regulators treat these assets unfavorably due to their volatility and lack of concrete regulatory frameworks. Gold, which is familiar to regulators and treated as a reserve asset, faces similar regulatory challenges, despite its long-standing use as a store of value. The shift towards decentralized assets as a viable alternative to traditional financial assets may not happen anytime soon.
The Dollar's Dominance in the Global Financial System: The dollar's dominance in global finance makes it a risky investment for cryptocurrencies, as regulators prioritize control over disruption. Emerging markets' reliance on the dollar for transactions and borrowing can create vulnerabilities during economic shifts.
Despite the potential of cryptocurrencies like Bitcoin and Ethereum to become new foundations or bases of the financial system, they currently occupy the riskiest part of the pyramid due to the prevailing financial system being built around traditional financial instruments like bonds and the US dollar. The incentive scheme for regulators to disrupt this system is minimal, as they prefer controllable outcomes and the status quo. The dollar, being the base of the global financial pyramid, accounts for only a small percentage of global GDP and world trade but a significant percentage of cross-border payments, FX transactions, and bonds issued by non-US jurisdictions. As a result, many emerging markets have adopted the dollar as the denominator of their transactions and borrowing, leading to a significant increase in dollar-denominated emerging market debt. This reliance on the dollar can create vulnerabilities when economic conditions change and developed markets reduce their demand for exports from these countries.
Dollar's value surges amid deleveraging episode: The dollar's value is increasing due to a deleveraging episode, making it harder for riskier assets like crypto to reach new highs. Bond market volatility continues, potentially leading to increased unemployment and slower inflation, but a more favorable setup for risk assets around late 2023 or early 2024.
The current economic environment is causing a "dash to the dollar" due to the dollar being the denominator of many debts and liabilities. This deleveraging episode is leading to an increase in the value of the dollar and making it more difficult for those holding riskier assets, like crypto, to reach new highs. The bond market's volatility is expected to continue for at least another year, with potential for another leg of weakness before stabilizing. This cycle, which can last 1.5 to 2 years, will likely result in increased unemployment and slower inflation, allowing the Federal Reserve to be more accommodative and leading to a more favorable setup for risk assets, including digital assets, around late 2023 or early 2024. However, those investing in risk assets for momentum rather than understanding or comfort may be "flushed out" during this time.
Fed may pivot from hawkish to dovish stance due to economic damage: The Fed is expected to wait until significant economic damage occurs before pivoting from its hawkish stance to a more dovish approach, focusing on controlling inflation even if it means causing economic pain.
The Federal Reserve is expected to pivot from its current hawkish stance towards a more dovish approach, but this pivot may not come until significant economic damage has been inflicted. The potential triggers for this pivot are a systemic liquidity crisis or a severe downturn in the labor market. The Fed's focus on controlling inflation, even if it means causing economic pain, suggests that they will only pivot at the last possible moment. The ongoing debate about the sources of future economic growth, particularly in the context of declining productivity, adds another layer of complexity to this situation.
Understanding economic cycles and their impact on growth and inflation: Long-term economic trends follow cycles of growth and inflation, but flatlining trends can lead to instability and potential social unrest
The economy follows long-term growth trends with inflation, represented by a line with an angle that can change over decades. These trends are marked by cycles that last around 12 to 18 months. The current trend shows a flatlining growth and inflation rate, which can lead to economic instability and potential social unrest if not addressed. The example given was Japan's prolonged period of printing money and credit after their bubble burst in the late 1980s and early 1990s, which resulted in a culturally fragile situation in Western economies. The potential for social unrest indicates the need for restructuring when long-term growth trends become flat, but the cultural differences between countries make the prediction of such an event challenging.
Late stage of economic cycle with challenges ahead: Recognize we're in a pivotal economic moment, prepare for challenges due to interest rates, social unrest, wealth inequality, and lack of peaceful transitions of power.
We are currently in a late stage of a long economic cycle, and the next few decades may prove to be more challenging to sustain the same level of growth as the last 40 years. This is due to several factors, including the fact that interest rates are no longer able to be lowered to fuel new credit iterations, and social unrest and wealth inequality are becoming more prevalent. The promise of technology may offer some potential solutions, but peaceful transitions of power and new economic orders have historically been rare. The clock is ticking, and the signs of instability are becoming more evident. It's important to recognize that we are in a pivotal moment and prepare for the challenges that lie ahead.
Maintaining economic growth through technology and productivity: In a world with declining demographics, technology and productivity are key to economic growth. While significant innovations have occurred, more needs to be done to fully utilize their potential. Stay informed and prepared for the challenges ahead.
Economic growth is crucial for societal stability and productivity. With declining demographics in many parts of the world, increasing productivity through technology is essential to offset the population decline and maintain economic growth. While there have been significant technological innovations, such as the Internet, more needs to be done to fully utilize their potential for productivity growth. The ongoing conversation and education about these topics are vital for investors and individuals to stay informed and prepared for the challenges ahead. Macro economics, though complex and often intimidating, plays a significant role in understanding asset classes and navigating the global economy.
Understanding Macro Economics is crucial for investors: Macro economics knowledge helps investors make informed decisions and gain an edge in various asset classes, including digital assets. Check out Macro Elf's blog for continuous learning.
Having a solid understanding of macroeconomics is essential for investors, especially in today's volatile market. Macro economics is a complex and ongoing puzzle that requires continuous learning and discovery. It's not just about understanding how money works or how economies interact, but also gaining insights into the thinking of world leaders and financial experts. By delving deeper into macro, investors can make informed decisions and gain an edge in various asset classes, including digital assets. To help you get started, check out Macro Elf's blog at macrocompass.substack.com. Remember, both macro and crypto markets come with risks, so always proceed with caution. This discussion is not financial advice, but rather an encouragement to expand your knowledge and skills in the world of finance. So, join the Bankless community on this exciting journey of discovery and learning.
