How Rising Inflation and Interest Rates Led to the Crypto Crash
Cryptocurrency is experiencing another moment of meltdown, and the reasons why it shines a light on how our new environment of higher inflation and higher interest rates will change the world.
Bitcoin has fallen dramatically, dropping 26% in the past month. But the well-known cryptocurrency is a relative rock of Gibraltar compared to many other lesser-known coins crashing around it. The second-largest cryptocurrency, Ethereum, is down 34% over the same period and the “joke” cryptocurrency Dogecoin is down 38%. A coin called Orion is down 85%. It’s a bloodbath.
The following chart shows the changes in Bitcoin and Ethereum, measured against the US dollar, over the past year. For the last six months of 2021, they were a good bet. Recently, they have again become a very bad bet.
The financial markets have a saying: you find out who’s been swimming naked when the tide goes out. The past decade of ever-lower inflation and ever-lower interest rates has been a historic royal tide. With the water so deep and high, skinny swimming has become almost mandatory.
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Practices that in historic times would have been counted as Ponzi schemes and fraud have become widespread. They worked because they were profitable.
They were profitable as money kept flowing into the cryptocurrency. Money kept flowing into cryptocurrency because it was profitable.
But what happens when the tide goes out? All those people who never bothered to bring a bathing suit to the beach are exposed.
Assets that are making strong profits are now winners. Assets that traded on excitement, momentum and a sense that the world had fundamentally changed? They are now losers.
People buying NFTs (non-fungible tokens) had to believe that the world had fundamentally changed to justify spending hundreds of thousands of dollars on so-called proprietary rights to mere cartoon images. (In a way, the world had changed! But not in a way that kept him from going back!)
Some are now losing hundreds of thousands of dollars when they sell the property rights to these cartoons.
Many cryptocurrencies offered no fundamental value other than the idea that everyone believed they offered value. Admittedly, the same type of belief is part of why gold is a store of value, so we can’t be too harsh on the concept that the collective illusion can be a source of value. But when it comes to collective delusions, it is important to distinguish between those with a history and those that are fashionable!
What caused the tides
The moon raises and lowers the tides in the real world. What causes our metaphorical tides that drive up and down the price of new assets? There is a debate on the subject, but the most plausible answer is monetary policy.
Over the past decade and a half, central banks around the world have engaged in extraordinary monetary policy. They injected liquidity into global financial systems via a policy called quantitative easing and, at the same time, cut interest rates to zero and below. The rise in asset purchases has been extraordinarily strong over the past two years.
When central banks buy assets, they can do so with money they just printed out of thin air. This has the effect of reducing the number of assets in circulation while increasing the amount of cash in circulation. The asset-to-cash ratio decreases, which means that anyone who wants an asset is competing against other people who also have a lot of money. This drives up the prices.
It also encourages people to invent new assets. It is difficult to create new lands; it is easier to create new start-ups and a lot easier to invent new cryptocurrencies and NFTs. So there have been a lot of innovations in these latter areas.
It’s not just the US Federal Reserve that does this. Everywhere, central banks are buying up assets and injecting liquidity.
At the same time, low interest rates and low inflation meant that people were happy with assets that paid far into the future. So it didn’t matter if your tech start-up lost money in 2020, what mattered was that it could become profitable in 2025.
Low interest rates meant you didn’t make good returns on safe investments anyway, and low inflation meant the purchasing power of a dollar next year would be about the same as the purchasing power of a dollar today, so it was a good time to invest in assets that did not pay off quickly. The abundance of liquidity and the scarcity of good alternatives made unprofitable assets attractive.
Today, central banks are shrinking their asset bases, selling assets in exchange for cash. The Reserve Bank of Australia (RBA), which increased its holding of assets from 5% of GDP to almost 30% of GDP, now plans to reduce its holding.
Here is how the Governor of the RBA put it the other day: “Our balance sheet will also shrink significantly in 2023 and 2024 as banks repay funding made available under the Term Funding Facility. This contraction in our balance sheet will contribute to some tightening of financial conditions in Australia.
This makes money less available. And at the same time, inflation means that people place a higher value on assets that pay off now rather than in the future. All of this is causing a pivot away from speculative tech assets and bitcoin.
The fall of Bitcoin is associated with the fall of tech stocks, as both rose in this environment where people thought the world was different and were happy with possible gains in the distant future. People bought shares of Netflix, for example, not for its pitiful returns in 2021, but because they believed it might one day dominate the global entertainment landscape and reward them handsomely.
As the following chart shows, it is now falling alongside Bitcoin. Its profitability here and now becomes more important and is lacking. Tech stocks like Apple and Google, however, are holding up relatively well because they are established profit behemoths.
If inflation continues to rise, interest rates continue to rise and central bank assets continue to fall, then the future of asset markets will be in profitable businesses selling things that people have need right now.
Crescat Capital, an investment fund that has long been very upsetting, believes that now is the time to buy commodities. They predict a “major shift in market leadership from technology to natural resource-related companies,” illustrating the opportunity with the following chart showing commodity prices at record highs relative to stock prices.
They make the case for investing in assets that don’t need you to believe a story to be impressed. Companies that sell things people need, not things they hope to resell later. Food companies and energy companies, for example. Not cryptocurrencies, not early-stage tech start-ups, and certainly not NFTs.
This article was first published by Crikey.