Fed is on the Verge of Repeating History
Writer: @qiuyue_analyst; WeChat official account: worldeye2020
Shocking CPI Statistics
On Mar.17th, 2022, The Federal Reserve of the U.S. announced raising the interest rate between 0.25%-0.5%. The news wasn’t a shock to the market as it’s already priced in with similar expectations. After that, commodities such as gold, silver, crude oil, BTC, and other crypto-assets bounced back in varying degrees.
However, this is largely an initial test carried out by the Fed. The following rise in interest rate would be hard to imagine.
Since the epidemic, Fed issued unlimited Q.E., pushing up the price of commodities. CPI inflation rate rose 0.8 month-over-month in February of 2022 (Reference: https://tradingeconomics.com/united-states/inflation-rate-mom ).
However, CPI didn’t show a sign of declining since Mar.17th. On the contrary, the war between Ukraine and Russia triggered the sanction from the West, driving up CPI and rising energy prices such as crude oil and natural gas. Brent crude oil reached as high as $140, and WTI crude oil, $130.5.
Brent crude oil movement
WTI crude oil movement
In modern society, expensive energy price means high cost in transportation and chemical industries, which press up the price of raw materials and then the price of overall goods and inflation.
As long as the energy price keeps high, CPI won’t drop quickly. Now US CPI is close to the figure in the 1970s-1980s when the U.S. entered a terrible prolonged recession.
The 1970s-1980s recession was caused by several factors:
- The U.S. suffered from a severe deficit and insufficient gold reserves due to the Vietnam and North Korea war. In August 1971, President Nixon announced the abolition of the Bretton Woods system, an act that was essentially a breakdown of the international agreement. This decision led to a credibility crisis of U.S. dollars. Then dollar continued falling while the price of raw materials in international trade kept rising. The U.S. then was trapped in high inflation.
- In 1972, the global food harvest was affected by El Niño. Suddenly, the food supply plummeted, and food costs skyrocketed. In October 1973, the fourth middle east war broke out, and Saudi Arabia and other countries reduced crude oil production. The U.S. was pro-Israel; later Arab countries used a crude oil embargo against the U.S. Since OPEC, including Arab nations, was the foremost global oil exporter, the move against the U.S. brought an oil price surge.
- Mandatory wage and price control policies strongly limited personal income and greatly hampered consumption. Supply was distorted by hoarding and speculation. Lifting the control resulted in market failure. Loose monetary policy, aggressive fiscal policies, extreme weather, wars, energy crisis, and food crisis brought the U.S. to stagnation. U.S. economy fell into recession in the next ten years, leaving a generation in a helpless maze.
On the Verge of Stagflation
Now we come to a situation quite similar to the 1970s-1980s, including monetary policies, wars, food crisis, etc.
First, the root cause of the clash between Ukraine and Russia is a contest between U.S. and Russia. Though not a belligerent country, the U.S. provided weapons to Ukraine and issued sanctions on Russia. The U.S., in essence, is in the war against Russia.
This state of the situation is not predictable, as it will escalate and drag the U.S. into war at any time.
Second, the U.S. kicked Russia out of SWIFT and imposed a sanction of over 1.2 trillion dollars, freezing about 300 billion gold and reserves of Russian oversea assets, 50% of Russian international reserve (almost 640 billion).
In the short term, the U.S. won by wielding its financial power. The act, however, will do more harm than good to the credibility of the U.S. and its dollar system. Other countries begin to worry if their foreign reserve is safe and consequently reduce the allocation of dollar assets.
Third, Russia and Ukraine are both major exporters of wheat. Their annual export amount to a quarter of the total wheat production worldwide. War inevitably delayed the spring sow.
Before the war, Ukraine had a sowing field of 15 million hectares. After Mar.23rd, the area was reduced to merely 7 million hectares. The wheat harvest will be reduced by half or even more. World agriculture supply will see a huge gap. The food crisis usually follows the war, pushing up food prices.
As a ”copy” of the inflation rate and background of the 1970s-1980s, U.S. economic growth is nearly halted. If it enters stagflation, the U.S. is not far from another recession.
A More Radical Approach
Now the US is confronted with 2 problems: near-stagflation and Midterm Election in 2022.
The Midterm Election will be held on Nov.8th. 435 seats of the Senate and 34 seats from the house of representatives will be up for election. 39 governors’ positions will be refilled.
This election is crucial for Biden. If inflation could not be contained before the election, then Biden’s popularity will decline, though the disapproval rate has already been over 50% (Reference: https://projects.fivethirtyeight.com/biden-approval-rating/).
Biden won the most votes in US history, but he also ranks high on a list of the presidents who lost approvals at a fast speed. Inflation and material shortage reduced the approval rate to merely 41%.
Against the Ukraine-Russia conflict, there are only 2 choices left to control inflation and reduce CPI.
- Biden and the EU lift sanctions on Russia and allied with OPEC countries to increase oil production. In this way, CPI and energy prices will fall instantly.
- Another option is a mad increase of the interest rate by at least 7 times. This will drain hot money from the market and squeeze bubbles so that price of goods and commodities will fall and so do CPI. As this method cannot reduce inflation and resolve material shortages instantly, putting sanctions on Russia appears to be a fast-acting remedy to win more votes. Biden wouldn’t be willing to lift sanctions. He could resort to pumping interest rates plus shrinking the balance sheet to get liquidity out of the market.
To prepare for the next election while keeping the US from stagnation and recession, the Biden government is likely to use more radical means to contain or delay stagnation.
Raising the interest rate on Mar.17th, 2022 is just an appetizer used to test the market and the impact on CPI. Through my tabletop exercise, the next interest rate rise is likely to start with at least 50 bp. In addition, Fed could start reducing its balance sheet very soon, probably using a combination of both.
Many people noticed the impact on the financial market by adding more interest rates but ignored the likelihood of shrinking the balance sheet. According to Bernanke, Fed is going to reduce 1trillion this year and 3 trillion within 3 years from the balance sheet. This could be massive liquidity drainage from the market, equivalent to an additional 3-4 times interest rate hikes.
The impact on the financial market is severe, the crypto market in particular. On Mar.23rd, 2020, Fed announced unlimited QE, buying 75 billion bonds and 50 billion MBS daily and setting the daily and fixed repo rate at 0. Hot money rushed into the financial market, including crypto. BTC was pumped to a new high.
Before unlimited QE, BTC price was on a downward track. When hot money flows into crypto, BTC began to consolidate and then take off. The highest price came to $6,9000.
Hence, the deep reason for this BTC bull market is not self-driven, rather it is pushed up by speculative capital.
Raising 25 bp this time had a little bearish effect on crypto. Instead, the market took it as the last negative news and began to bounce back.
However, to increase the interest rate of 50bp every time for 7 times plus shrinking the balance sheet is like interest rate hikes 11-12 times. It will be no other than a siphon effect on the liquidity of crypto, forcing the price to plummet.
The next FOMC meeting is going to be held on May 5, 2022. Before that, BTC has a window of a bull run. Most of the bulls pump the price in this period before the storm, starting from Mar.16th.
If you invest in crypto, I hope what I learned from the market would help you grasp as many opportunities within this interval.
What should be taken more seriously is the fact that Fed’s tightening monetary policy led to stagflation in the last 70s-80s, the situation we are now facing is even worse.
As the US imposes sanctions on Russia’s gold and foreign exchange reserves, other countries are proactive in diversifying their basket and signing bilateral swap agreements (BSAs). Fed’s decision might not take up as much liquidity as before. Much more liquidity will spread into relatively more reliable asset types, and most of them will choose non-sovereign financial assets, such as gold. BTC is of this kind. So I keep an optimistic view of the cryptos.
There will be pumps and drops in 1-2 years. In the longer term, BTC will get stronger as the real-world financial market gets worse. (This graph is only for illustration, not prediction of any kind. Arrows are drawn randomly with no implication.)