Lyn Alden Talks Bitcoin, Inflation And The Potential Coming Energy Shock

Lyn Alden, investment researcher and strategist with a keen eye on both crypto and traditional markets. Lyn Alden Talks Bitcoin, Inflation And The Potential Coming Energy Shock

Inflation at a high number, 5%, leaves investors and market observers jumpy. On top of that, many have a hard time believing the U.S. Federal Reserve’s narrative for inflation as outlined in the recent FOMC meeting. How is this inflation different from previous spikes?

The foreign sector has historically been a large buyer of Treasurys in structural trade deficits. In 2013, China stepped away from this practice and started investing in its own infrastructure and in other regions across the world. Even if other countries continue to invest in U.S. assets, it is increasingly in hard assets like stocks or real estate. Will the dollar weaken as the Fed is forced to be the primary buyer of U.S. Treasurys?

El Salvador’s commitment to bitcoin as legal tender is one thing, but what will the reality of this new currency look like? Bitcoin’s Lightning Network provides easy access and transaction speeds, so long as enough of the general population has access to smartphones.

Lastly, with the public’s attention captured by the current inflationary moment, what market features are getting underreported? Tune in to hear Alden’s perspective on what will have an unexpected impact in the upcoming cycles, including the potential for a significant energy shock in the years to come.

NLW

All right, Lyn, welcome back to The Breakdown. It’s great to have you back.

Lyn Alden

Thanks for having me back.

NLW

So, we were just talking about this a little bit, you know, what I really want to do on today’s show is just check in with you on a number of the different things going on right now. I think there’s a broad sense of shifting between phases or cycles, certainly within the Bitcoin, you know, market, but also just, I think that there’s maybe a larger shift going on as well in terms of how people are perceiving the macro landscape. And I think you’re uniquely suited to help us sort through that. And so I guess, as a way to start, let’s talk about inflation. Obviously, this has jumped onto people’s radars in a major way. And maybe just to start, you know, what’s your read on how much of what we’re seeing right now is so-called base effects? How much is transitory versus something that should be, you know, people should be paying more attention to?

Lyn Alden

Yeah, that’s a really good question. I think, you know, there are a few layers of inflation here, and some of those are more transitory where others are more sticky. And so, the base effects are a pretty big figure, like, for example, we saw roughly 5% year over year CPI print, this past month. And, you know, somewhere around 3% of that is, you know, if basically, if inflation did nothing abnormal over the past few months, and you just compared it to that May 2020 period, because that was a very low point for inflation, you’d have roughly a 3% year over year period, right, so, so maybe 3% of that is base effects. But that additional 2% was largely, you know, actual inflation. So that stimulus driven things that supply chain driven things, all sorts of problems like that. And so as we go into, you know, June, still has pretty low base effects, but as you go into July and August, especially, those base effects get harder. So the year over year numbers are likely to be lower than 5%. So 5% could be the peak for this particular, you know, kind of moment in time, and this is in year over year terms. Now, if you look longer term, I mean, the Fed’s long term target is about 2% average inflation the way they measure it, which is PCE. And, you know, right now, we’re above that. And if you even just say inflation indicators stop going up now, and they just kind of go flat, we would still be elevated by the end of the year. And so, by most metrics, we are running hot in many ways, but the rate of change is likely to cool off a little bit. Now, longer term, there are still multiple factors at play, they’re probably resulting in a more pro-inflationary environment. But they depend on a couple decision points. So, one big one, for example, is whether or not the U.S. continues to do more stimulus, like particularly in the form of infrastructure stimulus, right, so we’re past the fast-acting kind of adrenaline stimulus, we just kind of give out checks and stuff. But, a big question is whether now we’re going to have these kind of very large structural fiscal deficits, or where to go back to kind of a more baseline, you know, say 5% of GDP deficit, which is still huge, and in the kind of historical context, but it’s different than more of a, you know, kind of a multi trillion dollar infrastructure bill added on top of that, and so that’s kind of a big political question to watch over the next year or so. And then longer term, we’re also seeing a risk for potentially energy driven inflation. And so one of the areas that is still being sticky is higher energy prices. You know, ever since 2008, we’ve basically been in an oil and gas bear market, and especially the past five or six years. And so we’ve been in this period of oversupplied oil. And that’s because North American shale oil ramped up production faster than global demand kept going up. And so, we entered this period of structural oversupply. And, you know, basically oil drillers just kept drilling, even if they weren’t free cash flow positive, just low interest rates and new technologies came together, and they just, you know, they didn’t ask if they should, they asked if they could, and they could, and so they just kind of made a lot more oil. But now, due to just you know, 13 years of really bad returns for the oil sector, and then you know, you had the oil price crash in 2015, then we had the 2020 COVID. And then now you have ESG concern, so some pools of capital are just not putting into oil stocks at all. Now, CapEx is very, very low in the industry. And so you’re not really kind of, spending a lot of money to find new reserves or bring reserves up to supply. And so, you know, when you look at a few years, as global energy demand continues to grow and recover, especially from emerging markets. At this time, we’re CapEx is now very, very tight, we actually could see some kind of energy shortages in the years ahead, which would be the opposite type of regime that we’ve been in for the past decade. And so if that were to take place, that would give us another leg up in inflation. And so I think when you take into account, wage growth, some degree of reshoring, or kind of a flattening out of globalization and potentially slightly, you know, kind of a slight reversal of globalization. And then you include the possibility of energy shortages. I still think as we look out into the 2020s, we’re going to see more of these kinds of inflationary periods, most likely.

NLW

What it sounds like from your point of view on it is that a lot of that is sort of structural, and based on decisions that were made a while ago, right? You know, we talk a lot about the inflation conversation as it relates to what the latest FOMC meeting said, but it kind of think, the point that you’re making is that some of this is baked in, and it’s more just how it plays out.

Lyn Alden

Yeah, I mean, basically, when it comes to overall policymaker decisions, you know, we made mistakes decades ago by encouraging debt to get as high as it has. And doing some of the fiscal, some of the monetary policy we’ve done, and now the debt is this high, they find themselves with very little choice other than to, essentially, you know, financial repression. So, maintain industries that are below the inflation rate, and that’s obviously easier to do when you have an inflation rate that is above 2%. So, they want to hold rates around zero, and they want to have inflation kind of, run hot for a little period of time. And of course, they are, you know, policymakers, they want things to be kind of smooth, so they don’t want 9% inflation, but they want positive inflation that is above the interest rates, if possible. And and, and they don’t really have much of a choice. And so, my base case for a while is that we’re gonna, you know, the 2020s will be a period of, you know, certain inflationary spikes, without corresponding increases in the industry to, you know, kind of keep up with that. So, for example, we’ve seen, if someone bought a five year Treasury, this time last year, all of their interest payments for the past for the next five years of that bond are already outpaced by inflation. So unless we encounter a period of outright deflation, you know, in the years ahead, that bond’s already underwater. We’re gonna be at the case soon where someone bought a 10-year Treasury in 2020, especially the middle of 2020, when when interest rates are like, you know, 0.6%, the entire 10 years worth of interest payments will be outpaced, as soon as essentially the CPI is 6% higher than it was back then, which is not that far from now, it’s only a couple quarters away. And so I think that’s going to probably continue for a good chunk of the decade, where cash and bonds are going to be yielding rate levels that are below the prevailing inflation rate. But that inflation rate will have periods of being elevated due to either shortages or fiscal stimulus. And then ahead of periods of kind of returning to normalcy until you have another catalyst which could be infrastructure spending, could be energy shortages, things like that.

NLW

So you’ve, you’ve identified some kind of fiscal spending, infrastructure spending as a possible catalyst for more of this, which is sort of one side of the money equation. The other side is, of course, monetary policy. I’m interested in your take on how the Fed’s discussion of inflation is starting to shift and change, especially as for last week’s FOMC meeting, and two just more broadly, how constrained you feel like their policy options are, at this stage?

Lyn Alden

Yeah, so the Fed has been focusing on the idea of inflation being transitory for a while, so they’ve had a couple goals. One is, you know, so they target 2% average PCE, which is their measure of inflation, and we can talk about all the different shortcomings of that, but that’s what they’re looking for. And over the past 10 years, nine years, really, because they kind of formalized that target back in 2012, but the past nine years, they’ve on average, undershot 2%. So, the way they measure it is average, more like 1.5% or so. And it only touched 2%. A couple times, mostly it’s been below that. And so, they want to go back and say, okay, we want inflation to run hot the way we measure it for a period of time, we want to run at 2.5%, or even 3%, for a little while, to kind of, you know, in hindsight, look back and see that we average 2%, based on the way we want to do it. And so they’re in that mode right now. But, when they start seeing, you know, 5% prints, and that’s not with PCE, but that’s the CPI. PCE is also elevated, when they start seeing that kind of print, and we when you kind of see inflation kind of get into the popular narrative, you know, they are a little bit concerned about that. And so they were kind of playing down how big inflation would rise. And they’re also kind of emphasizing to be transitory. But now they’re admitting that it’s probably a little stickier than they thought, right. So, some of the Fed officials are admitting that, you know, it might be less transient than they thought. And so, they got a very, very slight hawkish shift in the previous FOMC. Meeting. And so it’s kind of funny how small it was basically, they they tweak some of the near term rates, they didn’t actually raise interest rates, but they basically increased rates on on repos and interest on excess reserves, which is basically a way to try to make sure that that that T bill rates don’t go negative, right. So that was one thing they did, that’s really the only change they made, however, in their projections, different FOMC members have different projections for what they think interest rates are going to be in the next few years. And we saw that a couple of them, you know, starting to price in rate hikes a year earlier than previously thought. So those are still a couple years out. But they’re a little bit, you know, pulled forward more than the market was expecting. And compared to what FOMC members were previously forecasting. And so the market is now kind of pricing in, okay, when are they going to start tapering asset purchases, and then start kind of gradually raising interest rates. And so I do think at some point, they’re going to cut down on mortgage backed security purchases, that seems pretty unnecessary at this point. But it’s gonna be pretty tricky for the Fed to cut down on Treasury purchases, unless the Treasury, you know, unless we don’t get any more fiscal stimulus, if you don’t do any sort of infrastructure stimulus, and we lower the amount of treasuries that are issued, right, because, you know, right now, we’re just, we’re still issuing a regular rather large amount for this year, it’s very hard for the private sector to absorb that many that many treasuries. And so the Feds been a core buyer. And so basically, with debt levels as high as they are, and with Treasury instruments, as high as it is, it’s pretty challenging for the Fed to normalize interest rates without crashing the markets. And so they kind of find themselves where the trade stayed low, and that the spikes of inflation, you know, basically devalue cash and debt to a significant degree. Or, they can try to, you know, raise rates and taper to combat that, but then they risk pulling down asset valuations across the board. And because the market is so financialized, if asset price has a significant fall and stays there, that actually circles back and results in slower economic growth, like the tail wagging the dog, rather than the other way around.

NLW

It’s interesting, one of the things that you kind of brought up or alluded to, was the fact that there’s not the same sort of natural buyers for these Treasurys that there used to be, I noticed some that you’ve been paying attention to for a long time, the sort of larger secular shifts in how much of the Treasury market is being absorbed by, for example, foreign actors. I mean, what’s the story there? And maybe we can talk a little bit more about just kind of some of the emerging market stuff in general as well.

Lyn Alden

Yeah. So before it is neat, I mean, that, you know, most of the treasuries were purchased by various private sector actors, right. So, the Fed only bought a tiny amount for basically management purposes, they weren’t really significant buyers of treasuries. And so, you had a combination of U.S. households buying Treasurys, different types of funds, pensions, of course. And then, the foreign sector was a very large buyer of treasuries. And the way that worked was, because of the petrodollar system we’ve had in place since the 70s, the U.S. runs these structural trade deficits with the rest of the world. You know, those parties that get those dollars, those countries that get the dollars, they go ahead and reinvest those dollars back into U.S. Treasurys. And so, they build up their foreign exchange reserves, they hold a lot of treasuries, and so that’s been the cycle that has been in place for decades. But starting around 2013 or so, China said it was no longer in their interest to keep, you know, putting their surpluses back into Treasurys. And they said, instead of that, we’re going to go ahead with the Belt and Road Initiative. So we’re gonna start, you know, buying infrastructure, commodities and financing the growth of infrastructure across Eurasia, over into, you know, Latin America, even, basically a bunch of places around the world. And so, they started reinvesting those dollars into hard assets, rather than buying Treasurys. In addition, we’ve seen a general trend where even in other countries, they’ve been happy to put money into U.S. assets, but instead of buying treasuries, they’re buying equities, like Apple stock, for example, or they’re even buying single family homes and then renting those back to Americans. And so, we’ve seen this kind of, you know, continued asset purchase of American assets, but not necessarily the Treasury market, because, you know, these countries want to manage their reserves, some of them also have pension funds and things like that, like Japan has been a buyer of Treasurys. But, you know, they have to be careful about buying too many Treasurys, when the Treasury’s yielding below the inflation rate. So they’re, they’re basically parking money and assets that are no longer appreciating, and so there’s been less interest to do that. And so, basically, they find themselves now, where the Fed has been, you know, forced to become the primary buyer of U.S. Treasurys. And this is something that’s happening worldwide, so you know, you know, in Japan, the Bank of Japan is the biggest buyer of of JGBs. In Europe, the European Central Bank is the biggest buyer of most types of European sovereign debt, and so you have weird things happening, like five-year Greece bonds, you know, having negative yields, even though you know, they’re, they’re one of the higher default risks out there. I mean, just a few, just several years ago, we had the European sovereign debt crisis. And, you know, basically, that hasn’t really gone away, at least most of it. And so you know, Greece still has an extremely high debt to GDP ratio, and they don’t control their own money supply really, right, because they’re, they’re part of the European, you know, the currency. And so we’re in the situation where all around the world, countries are doing this. And the only difference for the United States is that, you know, we used to be different, we used to be the ones where other countries bought our debt. And now, we’re looking more and more like those other currencies, where we’re just kind of one among many, rather than having that special status of other countries happily buying our debt.

NLW

What are some of the implications of that, if this continues?

Lyn Alden

Basically, that it keeps the Fed as an active buyer of those Treasurys, and over time, that could result in a weaker dollar, which, ironically, can can, in some ways benefit the United States, right, because a strong dollar has been part of why we’ve had to export a large chunk of our manufacturing base at a faster rate than than Europe or Japan have, right. So it’s not just a developed market to emerging market phenomenon. It’s been specifically, you’re very much an American phenomenon as well, because we’re running this policy of having a currency that is kind of, you know, artificially propped up, that makes our exports less competitive, and our import power very strong. And so, that transition could be painful, but ultimately is more balanced if our currency becomes one among many, rather than this kind of central piece to the, you know, global financial system. So, I think over time, we’re probably looking towards, you know, a more diverse set of global reserves, right? So that’s already happening since you know, about the year 2000, where, you know, the dollar share reserves, even though we’re still by far the biggest currency in those reserves, our percentage is going down over time. And so they’re becoming a little bit more diversified and I think that trend is probably going to continue for the next, you know, 5, 10 years.

NLW

I want to come back to this question, I think it’s an interesting jumping off point for a discussion of CBDCs, and just sort of that interesting battle. one thing that I’ve had so many people ping me and asked me about, and I feel like it’s a perfect context to ask you is, one more dislocation or kind of, you know, interesting thing around the Fed, which is what’s going on in the repo markets. And so I know you spent a bunch of time over the last couple of weeks observing. And I think it’s at one point, you actually said that it was sort of the opposite of the problem that was happening in September 2019. So first, I guess, just a really brief, what, what are repo markets? What is their function? What do they tell us about the Fed kind of in general, or markets in general? And then what’s going on right now with them that’s starting to kind of crop back into headlines again?

Lyn Alden

Yeah, so the Fed operates these facilities to basically allow the private sector to convert cash and Treasurys back and forth. And those are the repos or reverse repos. And so if you look back and 2019, for example, when we had the repo spike, right, so that basically there’s an overnight lending rate between banks and institutions, and that spiked overnight, it was it was it went up to like, 7%, it was a complete, you know, basically micro disaster happening. It’s one of those things where the average person in the street wouldn’t know about it, but anybody working in financial markets was like watching, you know, the Titanic hit the iceberg. You’re like, what, what the heck was that? For over a year before then, the Fed was reducing their balance sheet, they were doing quantitative tightening. But then starting with that repo spike, the Fed had to come in and start supplying repos. And so basically, these institutions with T-Bills could give them to the Fed. And basically, you know, use those as collateral for liquidity. And so then there’s a bunch of analysts like myself saying, okay, you know, this is due to, you know, basically an oversupply of T-Bills compared to the amount of bank reserves in the system. And so basically, we ran out of buyers for those T-Bills. And so, the Fed is going to have to create new bank reserves to buy more T-Bills, essentially, they’re gonna have to start deficit monetization, even though that was late 2019. That was before the pandemic, that was before a recession. That was, you know, the economic growth rate was slowing, but we were still in an expansionary economy. And so it’s kind of awkward for the Fed to have to come in and essentially do quantitative easing, you know, when we were not in a recession. And so that was kind of a challenging narrative battle. For them, they call it not QE and said, we’re only buying T-Bills. And you know, so it depends how you kind of want to semantics, but basically, we had a problem: too many T-Bills, and not enough reserves. Now, what we’re seeing in 2021, is the opposite problems, where they’ve done so much quantitative easing, that banks are so stuffed with reserves, and the Fed has bought so many of the T-Bills, that there’s actually too many reserves relative to how many T-Bills there are. And T-Bills are an important part of the system, they use those as collateral. In many ways, they’re more valuable than cash for the financial system. And so basically, they’ve had to do reverse repos, where, you know, these institutions can put cash, with that institution, and they get T-Bills out of it. And so it’s kind of the exact opposite problem of 2019, we have too many reserves relative to T-Bills. And last time we saw this happen, was towards the end of quantitative easing three, the third QE program back in 2014. And that started to signal eventually, that the Fed would begin tapering and winding down that QE program, because they were already kind of, you know, effectively at the maximum amount of liquidity, right. So there’s so much liquid in the system, that some of that liquidity is actually being forced back into the Fed, because there’s nowhere else to put it. And so basically, any more liquidity at that point, doesn’t really kind of doesn’t really liquefy things anymore, it’s kind of like once you, if you’re already soaked, you’re standing out in the rain, you’ve been out there for an hour getting, you can’t get more wet than you already are. And so the system is kind of like that now, where there’s so much liquidity, it just, it just can’t hold any more liquid anymore, just flows back into the Fed. And so probably, what we’re gonna see, eventually, is reduction of mortgage-backed security purchases, and then we’ll see what happens with their Treasury purchases, that will largely depend on how much Treasury Department issues in the, you know, the years ahead, and part of why this has been happening in the past quarter in particular, you know, in addition to just, you know, just the amount of QE that’s happened over the past year, but it’s also because this past quarter, the Treasury drew down their Treasury general account. And so for people that are familiar with that, that the Treasury issues bonds, and they bring in cash, and they hold that cash at the Fed, and then as they spend over time they, they draw down that cash reserves. And so if they issue more bonds than they spend, that TGA goes up, and if they spend more than they issue bonds for, that goes down. And so normally, that’s a few 100 billion dollars. But in 2020, they brought that up to $1.8 trillion. And so it came time to normalize that, which means that they basically would have a period where they’re not issuing as many treasuries, but they’re still spending aggressively on all these fiscal programs. And so, that helped draw down the TGA. But basically, when that happens, means you’re not issuing a ton of T-Bills. And you’re putting all that TGA account essentially going back into bank reserves, right. So it was kind of held in this void on behalf of the Treasury. But now it’s actually going back into the commercial banking system reserves. And so that’s kind of you know, putting excess liquidity into the market. And so basically, as that process went underway, some of that spilled over into things like reverse repos.

NLW

One of the things that I’ve been thinking about a lot and observing is the extent to which the market seems not to be buying the narrative that the Fed is selling. And I wonder to what extent that is just my perception, because I’m paying much more attention to it than I have in the past. Because I have a daily podcast now, versus there is actually sort of a narrative loss, a loss of control around the narrative. And you know, I started to especially notice this a couple of months ago, when it felt like every time Powell said anything about, you know, “not even thinking about thinking about raising rates,” the market was just basically not buying it and was convinced that he was going to have to, and now, we sort of have this moment of them acknowledging that some aspects of inflation maybe not as transitory as they hoped, which is effectively acknowledging the narrative loss because of inflation, sort of self-fulfilling prophecy impacts. So I’m interested in your take, as someone who’s watched this for, you know, a longer period of time on whether this is sort of just part and parcel of the sort of normal ongoing Fed battles, or whether it does feel like there’s a loss of control of the PR tools that they have to keep the markets in line with what they want them to be.

Lyn Alden

So overall, I think they’ve actually been moderately effective at getting their message across and the inherent problem is how challenging their message is, because their message is that we want bond yields below the inflation rate for quite a while, and we don’t necessarily want you to sell your bonds. Right. So that’s a hard message to get across. And basically, you know, from a wall street perspective, you know, they’re trained so that if interest rates go up, we expect interest rates to go up. That’s how it’s worked for decades where the Fed, you know, if inflation goes above a certain threshold, they raise rates to help contain that inflation. That’s how it’s been working for decades and you have to go all the way back to like the, you know, the 1940s and 50s, to find a period where inflation ran very, very hot. And the Fed said, “Nope, we’re gonna hold rates near zero anyway.” And so, but that was the last time, for example, that we had debt as a percentage of GDP as high as we have now and the last time we ran deficits as a percentage of GDP as high as we are now. And of course, that was related to World War Two. What people don’t realize is, basically, the world war two spending, you know, large part of that ended up being stimulus, essentially, we basically stimulated the local, you know, the domestic economy to build all this stuff. And after the war, we transitioned it towards, you know, refactoring, towards domestic stuff, right? So instead of you made a ton of cars, and we said, “Okay, now we’re gonna make a ton of tanks and planes. Now we’re going to go back to making cars again, but now your industrial base is two and a half times bigger than it was.” So that was essentially kind of almost like an MMT program, then, of course, you had the GI Bill, you got millions of people trained and educated and given sort of mortgage assistance, all sorts of stuff like that. So it’s a very large domestic spending program in the grand scheme of things. Back then, they had very, very high federal debt to GDP. And they basically just had this decade where you’d get these, you get these big spikes in inflation, and the Fed would say, “Oh, well, we’re gonna hold in trade zero.” Because this is not bank loan driven inflation, we’re not trying to curtail bank lending. It’s just that all the inflation is coming from fiscal spending. And so rather than the Fed fight that, they’re just kind of let that run hot. And so we’re in this period now, where, you know, the types of inflation that we’re experiencing in the 2020s looks a lot more like that 1940 style inflation rather than the 70s inflation. So 70s inflation was driven primarily by increased bank lending on top of some fiscal deficit spending. But it’s really that combination that is very large. In large part it was bank lending driven and so the Fed would try to raise rates to curtail the growth of the money supply, whereas now because it’s very fiscal driven, the Fed can’t really push back on that. It doesn’t really have a good incentive to. And so their messaging is, inflation’s gonna run hot, we’re still gonna hold rates at zero, and you’re gonna have negative real rates. And you have to deal with that. And so they have to kind of spin that message and say, Oh, it’s inflationary, we’re going to let things run a little bit hot for a period of time. But we also, you know, in their FOMC meeting minutes, know, when they’re talking about why they’re purchasing bonds, they explicitly say they want to keep yields low, they want, including on the long end of the curve, if possible. And so we’ve had periods of time where you know, certain months where the Fed is really buying more treasuries that are being issued on net from the Treasury. And so they’re basically soaking up excess Treasurys. And so, they’re basically holding short rates at zero. And then they’re buying, they’re by far the biggest buyer of Treasurys. And that helps keep interest rates relatively low. It’s very challenging messaging environment for the Fed, they kind of ran into that same sort of message environment in late 2019, where, you know, they couldn’t say, “there’s just too many T-Bills, so we have to buy some of them.” Instead, they had to say, “oh, there’s like plumbing issues, there’s these technical matters that are happening,” you had to kind of, you know, put it in language, where you don’t just say we’re doing deficit monetization, you just have to kind of, you know, kind of soften that blow a little bit. And so that’s kind of what the Fed has been doing. And it is a really tough thing for them to be in. Right. So I think a lot of the mistakes were laid decades ago. And for example, I wouldn’t envy being in Jerome Powell’s position right now.

NLW

It’s super interesting point, I wonder to what extent you’re going to see then some of the narrative battles shift to other parts of the political sphere, where it’s sort of like the Stephanie Calkins of the world who are creating the narrative fodder, because in some ways, it feels like you’ve got two camps, broadly speaking, the batsh*t crazy, you know, to use the phrase that Paul Tudor Jones used on CNBC a couple of weeks ago, looking at markets, you know, where he said that he’s just waiting to see what what they do next, because that’s going to shape everything, versus sort of the, you know, a newer school of thinking that says this new normal isn’t something to be concerned about, you know, is that I mean, is that, is that how you’re seeing it play out? Or, are people still in more traditional camps than that?

Lyn Alden

Yeah, I do think that inflation is becoming a political tool that the different sides will use, and it makes it you know, if you’re looking at purely a kind of an effectiveness tool, it makes sense for them to use it, right, because you use whatever tools, you have to try to win over the other other side. And so, you know, for example, whenever you have a period of inflation there are going to be winners and losers. So for people that are receiving a lot of the aid, that is that is helping to contribute to inflation, they generally benefit from that. Whereas if you were a person or an institution, you structurally overweight bonds, or cash, you’re the one essentially paying for it, you’re essentially being the one taxed for that, right, because you’re being diluted. It’s like, you know, if a company issues equity, to fund something, and you’re a shareholder, but say the things that they’re funding are not necessary things, they’re going to benefit the earnings of the company, well, you’re just getting the dilution without the earnings. If you’re another party, if you’re an employee, maybe you’re benefiting from it. And so it kind of varies based on where you are in that ownership structure. And so we’re seeing now that, you know, you know, for parties that are in favor of another round of stimulus, they naturally want to play down inflation, they want to say it’s transitory, there’s, you know, supply issues that are temporary, is not due to the increase the money supply. And so there’s no problem doing another round. On the other hand, if you’re a party that wants to, you know, kind of push back on that right, say, for example, you know, the right now Democrats have, you know, they control the House, Presidency, they have a very, very tight Senate control, that they’re worried about losing and in 2022. On the other hand, Republicans are the out of favor party that you know, the ones that are kind of, you know, want to get back in control. And so there’s a natural thing where they want to say, No, no, this is inflationary, we need to stop the spending. And then they can hope, you know, from their perspective, they can, they can hopefully get back in 2022, and start that cycle anew. And so there’s naturally going to be the different parties using this, you know, how the public perceives inflation as part of either justifying certain programs or to push back on certain programs.

NLW

Yeah, it’s interesting, too. One of the things that I’m just kind of watching it, I don’t necessarily have strong feelings yet about how it plays out. But, the number of, I feel like there’s a corresponding growth in the people who pay attention to these types of issues as political issues that coincides with the number of people who are trading based on memes, like “Money Printer Go Brr,” right? I mean, it sounds sort of silly, but like, when you have, I don’t know a 10% increase in the number of people who consider themselves investors or who actually are allocated in equities markets and things like that, you probably have a corresponding increase in people who pay attention to these arguments which makes it more public salient, rather than sort of just some abstract Washington DC, you know, infighting right.

Lyn Alden

Yeah, I mean, I’ve been describing it there, we’re in a macro-heavy decade. And last decade was a macro-heavy decade and this decade’s, another macro-heavy decade. And what that means, essentially, is that, you know, the government’s in a position of choosing winners and losers. And so, you know, basically, you know, when you’re looking at Central Bank activities, or what sort of stimulus Congress is passing, you know, basically what investments you make will largely depend on what you think Congress is going to do, right? So if you didn’t have multiple trillions of dollars of stimulus, then the correct investments last year, it’ll be very, very different than the ones that ended up being the best investments, right. So maybe instead of being in some of these more inflationary assets, you would have stuck to more deflationary assets. But then the trap there is that, you know, a lot of people are coming in, but it is inherently a very challenging space. And it’s something that is particularly very sensitive to rate of change. And so for example, right when the inflation chorus reaches its peak, right, so right when we’re getting these 5% inflation prints, is right, also when we’re kind of a peak base effects, and we’re kind of starting to roll over a little bit. That’s when I think, you know, a lot of people that are kind of new to the space are then at that point really offsides? Because they’re in like the hyperinflation camp, right? And that’s not happening this year. And so then they’re like, Well, what do you mean Dogecoin is going down, right? So that’s where you get into these traps, right? Where people kind of pile in for the wrong reasons and the wrong asset at the wrong time, and the wrong everything. Then they get punished for that. So, it is a really challenging environment where I think it’s important for people to be aware of macro factors. But also, you know, make sure they really understand them before using them to justify investments that might not otherwise make sense.

NLW

Yeah, I think that’s a super selling point, and maybe a good shift over into Bitcoin and crypto markets. I guess I’d love your take on you know, how you see where Bitcoin is right now from more of a kind of an asset trading perspective, as well as I mean, a subset of that question, but to what extent, you know, Bitcoin or crypto markets in general, are subject to the same forces impacting equities and everything else right now.

Lyn Alden

Yeah, so basically, Bitcoin for the most part in its history has behaved like a risk on asset. And so when there’s liquidity in the system, when stocks are doing well, generally Bitcoin’s doing even better. Now, because it’s a smaller asset, and because it, you know, it’s only a 12 year old asset, it has been heavily correlated to its own adoption cycle, right? So kind of like how, you know, say, in its early days, Google could be immune to the economic cycle, because no matter what the economy was doing, Google was growing its market share, and it still is, in large part. And so Bitcoin has been like that for a while where you know, Bitcoin’s growing, but the price can obviously fluctuate substantially based on if there’s a liquidity event, right? So if the dollar spikes if liquidity is tight, Bitcoin is likely to sell off. On the other hand, if liquidity is very abundant, then Bitcoin can do very well. And of course, when Bitcoin’s doing well, people want to go out on the risk curve and buy like, you know, silly coins, and those kind of, you know, temporarily outperformed Bitcoin, but then when it when the, you know, come when the music stops, and there’s less liquidity and everything kind of corrects, those things go down a lot more, and not to hold their value for multiple cycles. And so, basically, Bitcoin’s benefiting from the long term adoption cycle, while still being generally a risk on liquidity driven asset, that is prone to sell offs when it’s not going in this direction. You know, another thing that I think is really kind of understated over the past few months, is how important Grayscale has been for bitcoin’s price action and the tactical sense. And so, for example, you know, the second half of last year, Grayscale was by far the biggest buyer of bitcoin. And so some of that was natural demand. But another part of it was that arbitrage trade, right, so Grayscale had a premium over Nav, and investors could buy in at Nav, so they could create new units of it, and they could short bitcoin elsewhere. And so, basically, that served as this program that kind of kept converting liquid bitcoins into illiquid bitcoins. And so even when that trade ended every six months, those bitcoins would stay in there and just be permanently illiquid now, and then traders could go and do it again and put another batch of bitcoin in there. And because we’ve had a rise in competition, right, so we have a Canadian Bitcoin ETF, we have other ways to access Bitcoin exchanges have gotten more and more usable. We have all sorts of ways to access Bitcoin now for institutions and individuals. So that Grayscale bitcoin trust went to having a discount to Nav and so that kind of closed that, you know, very aggressive kind of neutral risk free arbitrage trade. And so, Grayscale is no longer a buyer of bitcoin like they were. So essentially, the biggest buyer went away. As we started to see Bitcoin consolidating and kind of you know, not really making higher highs and then when you get the Ilan five when you get all the other fun now, we have now They’ve kind of tried trying to hash rate moving around. And so, you know, we’re seeing kind of a period of Bitcoin weakness. And I think in some ways this was due given how much euphoria there was, in things like Dogecoin, you know, things like Ethereum Classic, like, basically every every token under the sun was having these crazy vertical price action in 2021. And so now reality is kind of setting in, some of these tokens are crashing, Bitcoin that actually has the fundamentals is correcting, but it’s holding up better than, than those meme tokens and things like that. And so, overall, I don’t have a firm say, three to six month outlook, I’m kind of watching certain risk levels, right. So I was kind of watching to see if it breaks, you know, we started to have some rising action in recent, you know, weeks, as I was trying to see, if we break over, say, 42,000. So far, it’s kind of gone the other direction, kind of settled in the lower 30s for now. And so I don’t have any near term price action. But overall, what I’m doing is kind of watching the fundamentals of the space. So, watching development continue to happen on the Lightning Network, watching what’s happening with, you know, say El Salvador, watching what’s happening with some of the Layer 3 now stuff that’s out, watching what’s happening with this with this Bitcoin, you know, mining, migration, that’s, you know, potentially underway here. And so I think it’s a kind of a time to focus on the fundamentals and make sure they remain favorable, as for the price action, I think has, you know, it definitely has to start, you know, it has start proving itself to the upside in order to kind of regain that momentum right now, it’s kind of in that big consolatory phase.

NLW

I think one of the really interesting points that your Grayscale point, kind of reifies is, how much we’re either learning or being reminded, depending on who you are, that things that we attribute, largely to narrative are actually more about market structure, on both the way up and the way down, you know, where, where big run ups come from, in our brains, as well as institutions buying, you know, spot, but that’s not actually, you know, it’s these specific trades, like you mentioned, same way on the way down when I think the second round of the 18, China FUDs that we’ve had this year, whatever happened, and we’ve dropped from, like, 41, to 32, you know, to listen to people who are at trading desks and on exchanges and things like that talk about it, no one actually wanted to sell much below 39 or 40. It’s just they were liquidated, right. And so this move that was meaningful, but not devastating, became a, you know, a 30% move instead of a 7% move. And I think it’s an important reminder, I think, to not get too euphoric on the way up or too depressed on the way down. Speaking of the sort of El Salvador and lightning network, I noticed something you’ve been paying attention to, one, I would love your kind of impressions about El Salvador, and you know, what that might mean for for Bitcoin, but then two, you know, I’d love to get your take on how it could be, or whether it will be a force for really putting some momentum and excitement back in kind of lightning network development, which is, it’s been comparatively quiet to some other parts or aspects of the industry over the last year.

Lyn Alden

Yeah, I think overall, it’s good news. Right. So you know, basically, you know, we’ve had the whole story of expensive remittances to El Salvador is very reliant on remittances. And so anything that can lower that cost is helpful. And anything that can give people you know, banking when they don’t have banking and so there’s still challenges there to get more people to smartphones for example, because you know, the, the the population is under banked, but also under penetrated in terms of smartphones. But you know, potentially smartphones are a quicker thing to fix than than banking issues right? So if you get more people’s smartphoned-up, they can access things like you know, a Lightning wallet, they can now have kind of you know, basic banking services and so overall, I think that’s a good thing. And by making it legal tender, it decrease the friction for things that they can do, you know, when they get when they get the Bitcoin and they don’t have to rely on stable coins as much as they can interface the banking system with that in a better way, that can be a smoother process for them. And so it kind of enables that technology. I also think that you know, the potential for El Salvador looking into Bitcoin mining as a revenue source is interesting, right. So as part of the diversifies hash rate, if they can make it work financially, then that’s good. That’s good for them. You know, I think at the same time, Bitcoin should be careful about hero worship and always kind of wanting the next narrative, right. So I think they learned that lesson with Elon Musk, where they were super happy when Elon, you know, finally bought into Bitcoin. But then it turned out his narrative is kind of all over the place. He might have been pressured by, you know, outside entities, or his board, or whatever the case may be about, say some of the ESG narratives around it. And so, now he kind of backpedaled on, you know, Tesla’s support for Bitcoin. He’s also that he was out there pumping Dogecoin and other kinds of meme coins. And so they kind of, I think, regretted some of the status they gave him in the space. And so I think people have to think the same way that when they’re giving, you know, the president of El Salvador that kind of same treatment, where, you know, you have to realize El Salvador is still a very troubled country. You know, there’s, there’s, there’s questions about the way that they run the government, you know, to put it lightly. And so I think I think people have to be careful about saying, you can recognize a good thing. But you don’t want to get into the next trap of always kind of, you know, feeling you’re relying on one person to kind of drive the Bitcoin narrative. I do think overall, I think one of the stories of the Bitcoin conference, followed up by this El Salvador news, is that Lightning is starting to reach critical mass. And so you know, if you kind of look back in history there, I mean, it was it started, you know, it hasn’t exploded the same way that say DeFi has on Ethereum, right, because it’s inherently different purpose, Lightning doesn’t have that inbuilt incentive for using it as like a gamified token, you know, casino, right. So it’s basically this slower, more structural build out. And so it started as a white paper in 2015, then they had to do some standards, right. So the different companies could start kind of implementing Lightning, they were interoperable. And then, you know, the Segway update, they could start actually building Lightning on top of Bitcoin. But they’re, you know, the limitation of Lightning is that there’s, it’s all reliant on liquidity. And so there’s only a handful of nodes. It’s not a broadcast network. It’s like a channel network. And so that took a long time to build out, both the tools to allow that to make it easier, and for just more and more people to use it, more and more kinds of channels and nodes on the network. And so we’ve really kind of reached critical mass, starting late 2020, where it’s a pretty usable network for small transactions, and it’s kind of sufficiently liquid now. So we’re starting to see some killer apps come that actually kind of put that network to use and start to use that technology. This is one of those things where, you know, it can happen slowly, and then all at once, where you had a couple years of really building it out ever since it’s been, it’s been possible. But I think, you know, now I think we’re in a more exponential growth phase, most likely, where are the apps and the end users really starting to onboard on that. So exchanges are starting to use Lightning, because it’s cheaper. And we’re also seeing that, you know, it can be used for places like El Salvador and remittances. It can be used in, for example, games that are streaming lightning, you know, streaming stats, you know, based on rewards in the game. I think that’s kind of one of the takeaways of the conference overall, is that lightning is now, you know, pretty well developed, there’s still a lot to go. But it has come pretty far. And it’s really a usable network now.

NLW

Slight, slight detour, but I want to make sure to get your take on it before we wrap. I’m interested in your take on what’s different this time with China’s sort of anti Bitcoin, anti crypto actions, how much do you think it has to do with their CBDC? And just in general, how much you’re watching what’s going on with, you know, China’s CBDC Digital dollar, and that sort of emerging topic of conversation?

Lyn Alden

Yeah, so there are certainly people better than me that follow Chinese law closer than I do, and kind of understand the nuances more than I do. My interpretation, from people, they’re more knowledgeable than me in the space, is that this one came from, you know, the premier came from a higher source. This one is so far held more weight than than previous, you know, quote, unquote, China bans for mining. And so this one, as far as I can tell, seems to be actually resulting in hashrate shifting, which I think is in the long run good. It’s probably not ideal to have, you know, estimates of over 50% of a hashrate in any one country, right? You want it to be as decentralized as possible. At the very least it takes away one of the the the narratives that that bears would have the network that that China somehow controls it, it’s much harder to make that argument, if they have 40% or less of the hashrate, they’re right, or even, you know, if it goes down much lower than that, it’s even better. And so, there’s that kind of characteristic. Now, China, you know, there’s a couple factors at play. One is, you know, they, you know, I think they are somewhat concerned about, say commodity inflation, and some of the issues there, right. So, but I think that’s the smaller factor, I think the bigger factor is that they are pretty far along here on their central bank digital currency. And they don’t don’t really want to have competitors to that. And they don’t, you know, they want to have that kind of be as much used as possible in the years ahead. And so they’d rather have that surveillance token than a programmable token, rather than a decentralized token. And, you know, for the first in some ways it makes sense, because for example, China wants to go around the dollar based system, they want to be able to buy commodities without having to rely on dollars. And so we’ve been in this kind of weird situation for a while, where, you know, you know, structurally for decades, the dollar has been the only currency worldwide you can buy oil in and to a lesser extent, it’s mostly the only currency you can use to buy commodities in general. And for a while that sort of made sense. I mean, the United States was the biggest commodity importer. But once China surpassed the U.S. and became the biggest commodity importer, it’s awkward that they’re using this other currency to buy their own commodities, when in many ways, in many times, they were the biggest customer of whatever entity they were doing business with. And so they have a pretty strong incentive to want to be able to have a currency that is more efficient and can, you know, form their own roots, rather than relying on another country that could sanction them, they could cut off their circulation to access those payment channels. And so that part makes sense. The part of course, that people that value freedom are, I think rightly concerned about, is that all the other attributes that come with that currency. So, the ability to surveil it, the ability to shut off someone’s access to it, if they’re if for whatever reason, they’re not on the on the right side of the government, the ability to automatically deduct money from it, for example, like automatic taxation, or automatic fines or things like that. And so, yeah, I do think that’s a pretty big factor. And I think it’s, you know, sometimes it’s hard to read exactly what Chinese officials are thinking. And so again, I’m not the I’m not the most optimum person to kind of give insights into what China is thinking at any one time. There are people, you know, much closer to source, or that devote more of their time to follow in that market than I do.

NLW

know for sure. I think it’s just kind of one of these things where even if you’re not, it is forced itself to be in the list of things that we all have to pay attention to, at least a little bit, you know, because it’s sort of just becoming a bigger factor. It’s always awesome talking to you. I guess I just have kind of one more broad question as we wrap up, you know, is there anything that you’re watching that you think people are under indexing for, not really paying enough attention to, you know, housing prices? You know, I mean, it seems like everyone’s paying attention to that, you know, that we’ve had so many conversations this year about commodity prices, lumber supply, things like that, is there anything that people are sort of paying too much attention to or not enough attention to that that you think are interesting right now?

Lyn Alden

I think on one hand, people are starting to pay a little bit too much attention to this, this current inflationary moment, right, the current few months. I mean, it is kind of a notable moment, because for example, core inflation is the highest it’s been since 1972. So it’s certainly worthwhile to make headlines. I think people have to be aware of the base effects. And we’re, you know, kind of following that rate of change of terms a little bit. So I think it’s a little bit overplayed, even though it is a really real phenomenon. I think I then ironically, was, but a lot of you know, markets are underplaying the potential for energy shortages in the year ahead, years ahead. And, you know, this whole kind of period of ever since 2008, has mostly been an environment of oil oversupply. And then especially the past five, six years. And so that’s a pretty disinflationary force. Because if you look at commodity markets, now oil is, is by far the most critical commodity for the world in terms of how much money goes into oil, how much that to use compared to, you know, compared to the more niche things like even lumber and copper are big, and then you get down into others. But oil is really kind of the big one, especially because oil is used for getting those other commodities out of the ground as well. And so when oil goes up, it impacts other commodities. And so because you’ve been, you know, even in this past period, oil has gone up in the past year. But you know, compared to some of these other commodities that hit all time highs or tested previous highs, oil still is nowhere near its highs. And that’s because it has more structural oversupply that some of these others like because like, say lumber and copper and things like that. And so, you know, in the years ahead, because we have low CapEx, because we have ESG mandates and things like that, I do think we’re likely setting ourselves up for, you know, some degree of oil and gas shortage, when we look out a couple years. You know, we could get a taste of that, you know, later into the summer, I think, but then whether or not that materializes, you know, because at a parsh depend on lockdown decisions and variants of the of the virus and all sorts, you know, basically what, how much demand comes from emerging markets. But as we look out 2, 3, 4 years, I think that that becomes an increasingly probable period, where we’re going to get another inflation spike from oil. And that can be a lot rougher because it’s just, it’s a larger market than these other commodities.

NLW

Super interesting. Something to watch for sure. Lyn, like I said, always great to have you here. Can’t wait till the next time and really looking forward to seeing how these things play out.

Lyn Alden

Yep. Thanks for having me. And it’s you know, it’s always a challenging market, but we do our best to interpret what’s happening.

NLW

This is why we have a daily podcast. There is so much interest in that conversation, but I think the thing that strikes me most is the need to expand our horizons when we talk about things like inflation and market cycles. Part of the reason that I think Lyn is so even-keeled even in the gladiatorial ring that is Twitter, is that when she’s looking at these phenomena, she’s not thinking about just the latest headline. She’s thinking with decades and even a century or more of historical context, she can situate what’s happening now in much bigger and broader patterns. And I think that’s incredibly valuable. We heard about that today in the context of inflation and whether we should be really talking about these 5% numbers from just recently, or whether we should be looking at phenomena that are more likely to be problematic in the future, such as what seems to be the potential for upcoming energy shortage. I think especially in a world where we live headline to headline, tweet to tweet, that sort of analysis is absolutely invaluable. So I hope you enjoyed this show. I hope you enjoyed hearing from Lyn, she’s always a great guest. Until tomorrow guys, be safe and take care of each other, peace!

7-22-2021

Bitcoin Is Failing Its First Inflation Test As Selloff Deepens

Original cryptocurrency has lost about half of its value since mid-April.

Bitcoin’s steep selloff is undercutting the argument made by the digital currency’s proponents that it’s an inflation hedge.

The original cryptocurrency has lost about half of its value since mid-April, fizzling after a spectacular rally that saw it surge above $60,000 from around $7,000 at the start of 2020. It traded Wednesday afternoon at $31,864, and got a small boost after Tesla Inc. boss Elon Musk said he has personal holdings of the cryptocurrency, as does his space company SpaceX.

The timing is ironic.

Bitcoin’s supporters for years have touted it as an inflation hedge like gold, mainly because the bitcoin network has a set limit on the number of units that can be created: 21 million. Their argument hadn’t previously been tested, however, because inflation has largely been under the Federal Reserve’s 2% target since bitcoin’s 2009 launch.

Now for the first time in years, shortages of semiconductors, lumber and workers are putting pressure on consumer prices, sparking worries about inflation. At the same time, governments and central banks have been forced to spend trillions to prop up their economies, potentially sapping the purchasing power of their currencies.

The consumer-price index rose to 5.4% in June, its fastest pace in 13 years. And inflation measures in 49 countries have all been rising since the beginning of the year, according to the Center for Financial Stability, a New York-based nonprofit think tank.

Bitcoin is going in the other direction. The digital currency has fallen in five of the past seven days and is down 7.9% in July, extending its monthslong selloff. It is now up 10% in 2021.

“Bitcoin’s price swings seem to be largely disconnected from macroeconomic fundamentals, including inflation,” said Eswar Prasad, a professor of trade policy at Cornell University who has written extensively about currencies. “At the moment it is hard to see people buying bitcoin as an inflation hedge.”

Other markets are also bucking traditional patterns during inflationary periods. Gold is down 4.8% this year and 12% from August’s record. Government-bond yields have declined in recent weeks as well, suggesting investors are more concerned about slowing economic growth prospects than a surge in inflation.

Many investors have largely dismissed the gains in inflation, seeing them as skewed by short-term supply disruptions related to the reopening of the economy. Federal Reserve Chairman Jerome Powell and other policy makers have also maintained that they expect such gains to be transitory.

In bitcoin’s case, scarcity itself isn’t a stable source of value, Mr. Prasad said. Bitcoin, in fact, is more sensitive to regulatory changes and tweets from influential users than it is from inflation, he said.

“It’s a good asset if gotten at the right time as with any speculative boom,” Mr. Prasad said.

Many investors agree that speculation still appears to be the main driver of bitcoin’s price—people buy cryptocurrency because they believe they can sell it at a higher price in dollars later.

“It’s just like buying a lottery ticket,” said Leonard Kostovetsky, an assistant professor of economics at Boston College Carroll School of Management, of bitcoin. “Inflation is probably there for some people, but it’s way down the list” of reasons to buy.

The speculative drive can be seen in the volume of derivatives trading, in which traders aren’t taking physical possession of the underlying asset but are instead just betting on price.

The volume of trading in the crypto derivatives market is anywhere from five to 20 times higher than the volume of spot trading on a given day, a study from Carnegie Mellon University’s CyLab research group said.

The volumes are so large that the moves in the derivatives market to a large extent have driven the overall price action, the study concluded.

“It’s very, very significant,” Kyle Soska, a postdoctoral researcher and the lead writer on the CyLab report, said of the derivatives market. The liquidation of derivatives contracts alone can determine the price, he said, as happened in April when $10 billion of liquidations in a single day accelerated bitcoin’s selloff.

To be sure, the recent moves of both bitcoin and inflation are too brief to draw any conclusions, Mr. Kostovetsky said.

“It may be an inflation hedge some day, but not right now,” he said.

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