The global economic shutdown caused by COVID-19 in Q1 and Q2 of this year was met by an onslaught of monetary and fiscal policy with no regard for national deficit or potential medium term consequences. The US economic machine could not be allowed to stop, forcing the federal government to backstop the US economy. The short term emergency actions outlined below will certainly have consequences - the biggest amongst them being reflation and then inflation of the dollar.
COVID Stimulus Results in Too Much Money & Not Enough Goods
Reflation is the act of stimulating the economy by increasing the money supply. The reaction by the federal government and Federal Reserve (the Fed) in response to government-ordered shutdowns appears in both the monetary supply (M1 and M2) and the Fed’s balance sheet.
M1 money supply (which includes funds that are readily accessible for spending) increased ~30%, while M2 money supply (which includes M1 and broader monetary assets) increased ~20% in response to COVID-related shutdowns and ensuing stimuli.
Much of that freshly created capital found its way into the hands of individuals and corporations, moving through the economy in the form of unemployment, payroll protection, small business loans, and the one-time $1,200 stimulus checks.
The result was a glut of money entering both the US stock market and individuals' savings accounts, with personal savings hitting a record all-time high.
The massive increase in liquidity was met by a drastic slowdown in production, resulting in too many dollars chasing too few goods - quite literally the recipe for inflation once consumer demand returns to pre-COVID levels.
You might be asking yourself why we’re not seeing inflation just yet, and you’d be smart to ask. In addition to a temporary decrease in consumer demand there is also deflationary pressure on the dollar because of foreign debtors' need to service their USD denominated debt obligations and potential looming debt defaults domestically (a topic we will dive further into in our next email). For now, it’s important to understand that inflation is highly likely to take place in the near future.
The US Fed Continues to Manipulate Natural Market Prices
The Fed has committed to backstopping much of the activities on the open market through ‘asset purchases’ in an effort to prop up asset prices. In this case, they are purchasing treasuries and corporate bonds on the open market. The effect of these purchases are reflected in the Fed’s balance sheet which has doubled since the beginning of this year, increasing by nearly $4 trillion.
A secondary effect of these aggressive treasury bond purchases is to drive interest rates toward zero (and potentially into negative territory). Further, by focusing purchases on various terms/maturities, the Fed can control the yield curve. For example, by driving down rates on longer term debt (10-30 year), they can encourage/stimulate longer term borrowing and investment (again, all in an effort to further stimulate the economy).
The combined effect of these monetary policies (driving down borrowing rates and driving down yield on debt) has forced investors to seek yield further down the risk curve (e.g. in equities). So while the Fed is taking disproportionate risk and acting as the buyer of last resort, traditional investors are making larger allocations into riskier investments in an effort to meet investment benchmarks and keep up with anticipated inflationary pressures.
We’re Seeing Early Defensive Buying of Gold & Commodities
With the bond market poised to underperform, capital is flowing out of bonds and into hard assets: primarily metals and commodities as a way to protect purchasing power.
The resulting capital flight out of the bond market will force the Fed to further increase purchases of these assets, creating a cyclical effect where it’s unclear when and how the Fed might ever be able to taper its purchasing rate - adding tailwinds to the likelihood of inflation.
So What Does This All Mean?
Just like in the 70’s, savvy investors are positioning their portfolios to protect their purchasing power from inflation. While in the 70’s the only decent inflation hedge was gold, bitcoin now exists. Bitcoin’s extreme scarcity and hard-money attributes, it’s digital nature (which makes it extremely popular with Millennial and Gen-Z investors), and its smaller market cap (currentrly equal to 2% of gold’s) positions it to be the best performing inflationary hedge of the foreseeable future. The trend toward holding bitcoin as an inflationary hedge is only in its beginning. Institutional investors have only just begun to take positions in the assets in size and will only accelerate as additional institutional name brand investment firms announce their investments in the asset.
Inflation is not a matter of if, but when. Bitcoin has weathered the past decade and emerged as the best performing investment of the time. However this story was nothing more than the prelude of bitcoin as a macro asset. The real story for bitcoin's surge is beginning now, and at under $10,000 USD it is severely under priced.