Part 2: A Tale of Tail Risks - The Fiat Prisoner’s Dilemma
Global central banks have manipulated the cost of risk in a competition of devaluation, leading to unsustainable debt and leverage. Is bitcoin the solution to the inevitability of fiat debasement?
The paper, “Volatility And The Allegory Of The Prisoner’s Dilemma,” goes into depth about how inflation volatility will lead to the 60/40 correlation crises, which investors in today's current market regime have just barely begun to grapple with.
“The $1.4 trillion dollar question is… what would cause the relationship between stocks and bonds to completely melt down?
“The volatility of inflation appears to be a core driver of higher correlation between stocks and bonds. When inflation, as gauged by the consumer price index, is more volatile we tend to experience higher levels of stock and bond correlation as evidenced by data from 1885 to 2015. The early part of the 20th century, which experienced the most debilitating periods of stock and bond underperformance, was a period of wild fluctuations between inflation and deflation. The last three decades of extraordinary anti-correlation has been an era of falling rates, globalization, accommodative monetary policy, and very low volatility of CPI. The global economy is now at the zero bound whereby the effectiveness of competitive devaluations is coming into question.
“It is not hard to imagine a regime whereby central banks lose credibility or are not capable of moderating swings in inflation in a way consistent with the past three decades. Any period of sustained correlation failure will result in rising volatility and selling pressure across bonds and stocks in a self-reflexive cycle.”
In case you missed it: Bitcoin Magazine PRO hosted Matthew Pines to discuss the current geopolitical landscape and how to think about the next decade with shifting power structures.
Here we find ourselves in 2022, with bonds down 45% in purchasing power since 2020, and the first period of positive stock/bond correlations to the downside in every investor’s memory.
“The global economy is suffering from a cancer of debt-deflation, income inequality, and low growth. Instead of treating the root cause, policy makers have treated the symptom of asset price declines. Whenever the patient feels weak an increasing amount of policy drugs are required to maintain the illusion of stability to the point where the patient is addicted to the painkillers. The root cause of the cancer is never confronted and as a result, the fundamental health of the patient does not improve. Neither the doctors nor the patient wish to face the reality that difficult and painful therapy is needed to destroy the cancerous leverage in the system. The inevitable result of this denial will be the death of the patient. In all instances, policy intervention has generated a short-term market fix at the expense of addressing the longer-term fundamental problems.”
As we continue to reference the bursting of the “global everything bubble,” this is what we are referring to. We are in the bursting process as inflation rears its ugly head, surging to the highest level since the ‘70s.
As investors grapple with hawkish central bank policy in the interim, the system is no closer to a return to sustainability. If anything, tightening interest rate policy with global debt burdens this high is going to result in a major economic shock for the global economy. The belt is tightening in a massive way and will ultimately result in the policy pendulum swinging back much harder in the opposite direction.
Now for a return to some of the recent market developments across the macro landscape. This week was one of the biggest weeks for economic data and new releases before the end of the year. In response, we’re seeing weakness in both equities and bitcoin headed into the weekend. After a ramp up in the bitcoin price leading up to the U.S. CPI data release and the December FOMC meeting, those gains are now turning over. Although not always the outliers, the days surrounding CPI releases and FOMC meetings have been some of the most volatile of the year.
A relationship that has held up well since March 2020 is the ratio of high beta versus low beta equities and bitcoin. They track nearly the same trajectory as this ratio reflects current weight and positioning of higher risk assets compared to lower risk (and lower volatility) assets in the market. Although decoupling some in the latest effects of the FTX contagion, this ratio is starting to turn over yet again as bitcoin looks to test below $17,000.
Is the top in sovereign debt yields in? It’s not looking that way as yield curve inversions and the spread in yields across EU countries start to widen further, especially the Italian-German yield spread that’s been closely monitored by the European Central Bank (ECB). Overall 10-year yields across the eurozone are on the rise and nearing recent October highs after ECB announcements of attempted quantitative tightening (QT) to kick-off in February 2022.
It’s the inflation picture that’s worsening — or at least the realization of entrenched inflation by central banks that’s worsening. Announced just this week, the ECB forecasts core inflation at 4.2% through 2023, the Bank of Italy forecasts inflation at 7.3% through 2023 and Germany’s Bundesbank forecasts 7.2% inflation through 2023. Those are just a few examples, but it’s the same story across every EU country. The EU picture may be a precursor for what could happen in the United States as risks of sustained inflation rise on the backs of China’s reopening policies and a resurgence in global energy prices.
We are still of the belief that the worst is to come for asset prices and the real economy. The lag response of monetary policy tightening is just beginning to be priced in. While the Fed attempts to jawbone markets lower to decrease inflationary pressures, conditions in the real economy continue to deteriorate under the surface.
In the short term, where the liquidity goes, bitcoin goes. Thus, we remain cautious on our short-term outlook for the bitcoin exchange rate. As described in the “Volatility And The Allegory Of The Prisoner’s Dilemma,” the unique dynamic of unserviceable debt burdens, falling financial asset prices and a debasing currency can lead to devastating societal outcomes. Our view over the long term is that bitcoin can serve as a solution to the inevitability of fiat debasement in the incumbent credit-based economy.
Central banks, in an attempt to ease economic conditions and financial markets, have embedded hidden tail risk at the societal level. The scary realization for many is that it just might mean that the tail risks are a deflationary bust and/or a hyperinflationary impulse; these might be the only two outcomes.
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