A 150 (degree) Pivot on Bitcoin

 Note: The following blog on Bitcoin was drafted in March 2024 with subsequent posting in September 2024.

At the start of this particular blog, I feel it necessary to devour some metaphorical crow. Not the entire bird, but a significant portion of Corvus corone. I believe I was premature in expressing extreme skepticism as concerns Bitcoin, and even relegating it to the dustbin of history. My initial error was a common one, especially among old coots like myself. I cast judgment on Bitcoin before taking the time and expending the energy to understand Bitcoin. In particular, I failed to research the pros and cons insofar as to whether or not it can be both a monetary vehicle and a long-term store of value. That was a mistake. It should be noted that my newfound positivity for Bitcoin does not extend to any of the other 13,217 cryptocurrencies currently in existence.

In 1984, Nobel laureate and Austrian School economist, Friedrich Hayek, was quoted as saying: "I don't believe that we shall ever have a good money again before we take the thing out of the hands of government. Since we can't take them violently out of the hands of government, all we can do is by some sly roundabout way introduce something they can't stop." Congress created the Federal Reserve Bank in 1913. Since that year (1913), we have experienced a cumulative rate of inflation of 3,035%. An item purchased in 1913 for $1.00 would cost $31.35 in 2024. The primary reason for this dramatic debasement of our currency and the subsequent loss of purchasing power has been a gross over-expansion of the country's base and broad money supplies. For this, we can place blame firmly on the shoulders of the Federal Reserve's consistently loose monetary policies and the total abdication of the U.S. Congress in performing their fiscal responsibilities.

The current global monetary system came into existence in 1971 when Tricky Dick Nixon brought an end to the Bretton Woods System and ended U.S. dollar convertibility to gold. In fairness to Nixon, he had no choice in the matter. Foreign nations and their central banks were rapidly draining America's gold reserves. From 1971 to date, our monetary system has been exclusively based on fiat money and a network of constantly increasing levels of debt. Fiat money is described as a government-issued currency that is not backed by a physical commodity. In other words, the U.S. dollar is only backed and supported by nothing more than the full faith, credit, and trust in the United States government. In my humble opinion, after a half-century of relentless currency debasement and accruing an unsustainable level of debt, the fiat system will soon (within a decade) be either replaced or reset in a dramatic fashion. And that is the main reason for me developing a certain fondness for Bitcoin. I simply no longer trust the government to do the right thing in terms of retaining long-term prosperity for the American public.

Unlike banks, central banks, and fiat currency financial systems, there is no entity that can unilaterally debase the Bitcoin ledger. Bitcoin is an open, decentralized, and widely distributed public ledger. Anyone with a basic laptop and internet connection can participate in the network as a node operator by running a free and open-source software application, and doing so allows them to send and receive transactions without the permission of any centralized entity. Bitcoin closes the speed gap between transactions and settlements. It represents the first significant way to settle scarce value at the speed of light. The number of bitcoins is capped at 21 million coins. As of now, about 95% of this total has already been created. Much like physical gold, Bitcoin is not someone else's liability. The ability to quickly move a non-liability asset over long distances is something the world has never had before.

Another similarity to gold is that Bitcoin can serve as "insurance" for an investment portfolio, Runaway inflation or a severe financial crisis will garner interest in these types of bearer assets. Bottom line is that Bitcoin represents a portable, self-custodial, supply-capped, censorship-resistant form of global money. Nobody knows for certain Bitcoin's long-term fate, in particular its pecuniary value, if any. Currently, there is approximately $500 trillion in global assets. Of this total, market capitalization for gold is about $10 trillion and Bitcoin comes in just over $1 trillion. Consider this possible scenario for a moment. Over the next few years, the Bitcoin network manages to capture 1% of the world's assets, which translates into a market cap of $5 trillion. Five trillion dollars divided by 21 million coins equals $238,000 per coin. Furthermore, at a mature stage for the Bitcoin network, people around the world might on average want multiple percentage points of their assets in that form of money.

The road to Bitcoin riches is obviously laden with myriad roadblocks, pot holes, and hurdles. There is probably a 55% probability that the valuation per coin will eventually go to zero, with an additional 25% probability that the value will never exceed what it is at the time of this writing ($64,000). People are bothered by Bitcoin's volatility, and that is understandable. Much of that volatility is due to the fact it monetized from zero to more than a $1 trillion market capitalization within its first 15 years of existence. Bitcoin is almost guaranteed to be very cyclical (high highs and low lows) along the way. Only once it is closer to its addressable market, with extremely high levels of liquidity and user adoption, can its notorious price volatility realistically diminish.

A couple of minor risks to Bitcoin's future would be software bugs and arbitrary changes to the rules of the network. For the most part, these two risks can be easily dismissed. Previous software issues have been competently and expeditiously resolved. Also, the extensive decentralization of the network precludes an individual or minority of participants from unilaterally making changes to the system. A more feasible threat in my opinion would be the saturation of different cryptocurrencies. Although there will only be 21 million bitcoins, the concept can experience supply inflation and dilution by the countless new blockchain monies. If the market share becomes and remains highly fragmented between an excessive number of blockchains, then perhaps none of them will persistently maintain any significant purchasing power, liquidity, or security. Bitcoin currently stands alone with over 90% of market value of all proof-of-work blockchains.

The biggest threat, the threat that would probably keep me up at night, would be the federal government imposing a ban on the ownership of Bitcoin. There is precedent for this action. Between the early 1930s and the early 1970s it was illegal for Americans to own gold. Fortunately, the law was not strictly enforced. The penalties were quite severe. As mentioned previously, I have little or no trust in our government as the powers that be slowly but surely increase government involvement in our respective lives at the expense of our individual freedoms. To make matters worse, as fiat currency loses value, expect blame to ultimately be placed on Bitcoin users, as though they somehow caused the existing monetary systems to become destabilized.

A legislative effort to ban Bitcoin would tell us a lot about the condition of our nation. A country with a robust currency, strong property rights, and where capital wants to be, is unlikely to ban Bitcoin. Whereas a country dealing with severe mismanagement of its public ledger is more likely to try to ban Bitcoin, or at least add a lot of friction to it. If Bitcoin ultimately ends up in the crosshairs of Congress or a government agency, I expect it to happen sooner rather than later. Young people look at Bitcoin more favorably than their parents and grandparents. As Baby Boomers exit the stage, in theory, Bitcoin should gain interest and strength. Even now it is estimated that 46 million Americans (roughly 22% of the adult population) own a share of Bitcoin. That figure was before the SEC approved Bitcoin spot ETFs a couple of months ago. The art of investing does not incorporate avoiding risk, it involves managing an acceptable risk/reward matrix. Perhaps I should join those American investors who have taken the Bitcoin plunge and put my money where my mouth is.

 

The Paramount Relevance of Liquidity

 Note: Although posted on or about 9/15/24, this blog was actually drafted in February 2024 before the blog originated. I thought the timeliness and relevancy of the subject matter were important enough to see the light of day on "Mark's Macro Musings."

Like many active investors who closely follow the capital markets, I fully expected the American economy to enter a recession in 2023 with a corresponding dive in the stock market. The most expected recession in history never arrived in 2023 and the S&P 500 Index appreciated by 24% last year (2023).What the heck happened? In my opinion, there were two primary reasons for this surprise. The first one, and by far the least important of the two, is the customary lag period (6mo.-18mo.) between interest rate changes and their impact on the economy. The Fed Funds rate went up by 5.00% between March 2022 and year-end 2023. A significant increase with seemingly little effect on the economy. There is another factor that trumps interest rates - liquidity. While interest rate levels capture most, if not all, of the attention, the real story of liquidity levels escaped the scrutiny of almost everybody. This is a mistake, a profound one.

Before proceeding, it would be wise to establish a definition for liquidity when used in the context of the financial markets. Liquidity would be a combination of all liquid assets and the availability of credit to borrowers. Liquid assets are further defined as all such assets that can be exchanged for money, at any time, at short notice, and at a relatively small transaction cost. Obtaining credit or having debt is self-explanatory. It should be noted that the debt portion of the equation is probably more important in the determination of market liquidity. The credit availability factor is also more volatile and usually the source of financial crises.

We live in a credit-based world - leverage is what drives the boom-bust cycle and liquidity sets the stage for the debt cycle. When leverage is cheap (low interest rates), people borrow profusely and bid up riskier assets - pushing prices higher (the boom phase). Following the Great Financial Crisis in 2007-2009, the Federal Reserve Bank effectively adopted a program of keeping interest rates artificially low and flooded the system with monies via Quantitative Easing (QE). Those monetary stimulants went into hyperdrive when the Covid-19 pandemic hit in 2020. The result is that the Fed has managed to simultaneously drive debt (government, corporate, individual) levels to historic highs while creating a massive asset bubble, particularly in the equity and real estate markets.

The flip side of the boom phase is of course the bust phase. When leverage is expensive (higher interest rates), people borrow less - and even liquidate riskier assets to pay back debts - pushing asset values lower. As mentioned previously, the Fed started aggressively raising interest rates in March 2022. Late in 2023, they effectively pivoted with indications that either in the 1st Quarter or 2nd Quarter of 2024, they would begin reducing interest rates. Starting in June 2022, the Fed began gradually reducing its Balance Sheet via Quantitative Tightening (QT). This will no doubt come to an end at some point in 2024 since they have messaged rate cuts are coming in 2024.

Ironically, despite the Fed's rate hikes and Quantitative Tightening over practically two years, monetary conditions are still considered "loose." The reasons are multiple. Banks still had trillions worth of excess reserves from the Fed's QE years. Plus, slowing growth and calamity in Europe, Emerging Markets, and Asian economies have pushed investors to put cash in the United States. The U.S. and U.S. dollar is still considered a safe haven for parking money. This has given banks even more excess money.

By this point, the reader is probably thinking..."Now where can I find information and data concerning the present and past liquidity levels?" The ideal mechanism to track and measure liquidity in the financial system is the National Financial Conditions Index (NFCI). The NFCI tracks what is going on in money, debt, equity markets, and even the "shadow banking" system. This information and valuable tool is generated and posted by the Chicago Federal Reserve Bank. The index is neutral at zero. A number below zero is considered "loose" conditions. The more below zero, the "looser." A number above zero is considered "tight" conditions. The more above zero, the "tighter." When the NFCI has spiked dramatically above zero, harsh bear markets and economic recessions have occurred.

It is only a matter of time before another leak springs in the financial system due to unprecedented (500 basis points) interest rate increases in the past couple of years. A little under a year ago the Fed had to extinguish a fire when regional banks such as Silicon Valley Bank and First Republic Bank imploded. A strong candidate for the next potential crisis would be the corporate debt sector. Corporate debt as a share of GDP is now at an all-time high. Firms took advantage of the ample liquidity and low rates to bring on debt. Approximately 40% of the companies in the Russell 2000 are losing money. These are companies that rely on credit to stay afloat. Over the next 2-3 years, a whopping $3.5 trillion of corporate bonds are set to mature. Companies will be forced to roll over debt and add new debt when the cost to borrow will no doubt be much higher. Markets will be in a fragile position if liquidity dries up.

In the process of reading a book and various articles on the subject matter of this blog, I stumbled upon a statistic that switched on a light bulb in the cognitive portion of my brain. Per an economist and author named Michael Howell, over the past 40 years, new factors have evolved to displace earnings power as the main driver of stock prices. He goes on to postulate that only about 20% of equity gains can be attributed to increased corporate earnings. I assume that figure is net of inflation -which was up a little over 200% between 1982 and 2023. The S&P 500 Index, on the other hand, increased by a mind-boggling 3,300% (from 140.64 to 4,769.83) between 1982 and 2023. So why did investors move away from safe assets like bonds and seek riskier assets like equities? A strong argument can be made that enhanced and elevated global liquidity is the answer.

The Net National Savings Rate Takes A Swoon

The net national savings rate measures the amount of income that households, businesses, and governments save. It is an economic indicator tracked by the U.S. Commerce Department's Bureau of Economic Analysis (BEA). Although not considered one of the "prime time" leading economic indicators, the savings data is relevant and has implications for all businesses and investors. A disturbing fact is that the net savings as a percentage of gross national income has been negative since the first quarter of 2023 after starting a decline in the fourth quarter of 2020. The current period of negative net savings is only the third time that net savings slipped into negative territory in the last 75 years. The only other time net savings has gone negative is in the lead-up to the Great Recession (2007-2009) and during the brief Covid-19 recession (2020). A rapid drop in the net savings rate virtually always indicates the U.S. economy has either entered a recession or will soon enter one. It would not surprise me to ultimately learn that we are in recession as I write this blog. A lag for announcing a recession is not unusual. For example, the National Bureau of Economic Research (NBER) declared in December 2008 that the United States economy entered a recession in December 2007.

The primary culprit for the slide into negative territory in terms of the national savings rate would of course be Uncle Sam. The federal government has been operating at a fiscal deficit for over a quarter century now. The past few years have been particularly disconcerting as the government went on a spending binge while tax revenues remain weak. The Covid-19 pandemic and the development of the "green" economy serve as excuses for our government to accumulate limitless debt. The percent of disposable income saved by Americans has likewise reached disturbing levels. The personal saving rate in the U.S. averaged 8.45% between the years 1959 and 2024. The rate currently stands at 2.90%. Consumer spending has been robust and this has kept the economy plugging along. The American consumer is about to hit the wall, however.

Soaring inflation in the wake of the pandemic makes it harder for lower and middle-income earners to make ends meet. The cost of goods and services has increased a minimum of 25% since January 2020. Income has not kept pace. Everyday expenses are being funded by dwindling cash reserves and increased levels of personal debt. Credit card debt stands at an all-time high of $1.14 trillion (average interest rate of 21%) as individuals use cards to fill in budget gaps. Delinquencies and bankruptcies are steadily increasing. Due to reduced savings, most Americans won't have as much at their fingertips come a downturn or a shock that leaves them more financially vulnerable. Because of the precedent set by direct distribution of checks to most Americans during the early days of the pandemic, I expect they may be expecting and looking for a bailout when the economy tanks.

Next, we'll look at the long-term ramifications of a low or negative national saving rate. Spoiler alert - there is nothing positive about a scenario of that nature. The purpose of savings is to allow a country to finance its investment needs with its own resources. Investments are generated through savings. Household savings can be a source of borrowing for government to provide funds for public works and infrastructure improvements. Any deficiency in net national savings must be filled by foreign capital to make up the difference between net U.S. investment and net U.S. domestic savings. At negative net national savings, the United States is eating into its capital stock instead of adding to it. This cannot go on for long without putting the American economy at the mercy of the international capital markets. But here's the catch - where will all of the capital come from? Investors from China are no longer welcome on American soil. At present, Europe lacks sufficient savings to replace China as a source of capital.

Wrapping things up, it should be reiterated that an economy is dependent upon savings to grow, be vital, and provide prosperity for the participants of a nation's economy. Another financial crisis, perhaps equal or worse than the Great Recession (2007-2009) will eventually enfold on the U.S. economic landscape. History tells us that the countries with the highest savings rates before this nasty recession, were also the ones that were less affected by it. I anticipate this particular correlation will repeat.