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Good morning. We are delighted to have a third and final collaboration on the future of Europe with Adam Tuz in Chartbook tomorrow. Today, Brainard and Bitcoin. Email us: robert.armstrong and ethan.wu.

Brainard’s comments and yield curves

Lael Brainard, who has lined up to be the Fed’s vice-chair and has been adamant about monetary policy in the past, said Tuesday that a “rapid” decline in the Fed balance sheet could begin in May. He has made various other hawk sounds. It’s a big deal. Bond yields have risen and stocks have fallen.

Brainerd’s harsh words have reached a market that was already quite worried that the Fed was going to tighten the US economy into a major recession, as the 10-year / 2-year yield curve is about to reverse. Do we need to think more now?

Start with Brainard’s comments about the balance sheet loss. The traditional way of thinking about shrinking the Fed balance sheet is that it is almost equivalent to a rate hike, but targets a different part of the yield curve. When the Fed buys bonds (quantitative easing) that lowers interest rates, encourages lending and expands the economy. The opposite happens when it sells bonds (quantitative tightening). So moving from QE to QT should have the same economic-cooling effect of rate hikes and lead to long-term rate hikes.

But as we mentioned earlier in this space, we don’t know how it works. Since the Federal Open Market Committee reduced the point in minutes from its December meeting:

There is less uncertainty about the impact of a change in the Federal Reserve rate on the economy than there is about a change in the balance sheet of the Federal Reserve.

How much less certainty? Well, the last time the central bank tried to lower its balance sheet, in 2018-19, the 10-year yield fell, contrary to the traditional theory that would predict.

Which brings us to the unconventional way of thinking about QE and QT (which we’ve discussed several times before here). In this view, the main direct effect is on liquidity, not on rate. QE pushes money into the system, QT pulls it out. When there is more money slushing around the system, people prefer more speculative assets and less secure assets such as treasury. The opposite is true if there is less money in the system. The Fed, by contrast, sells treasuries, lowering rates and creating demand for them. Meanwhile, it is not clear what effect the liquidity change will have on the real economy.

All of this is strange, but most likely true. I’m repeating it all just to emphasize that we don’t really know the portion of the Fed Balance Sheet of Brainard’s comments – the part that led the headlines – portends. We know for a fact that the Fed repeatedly and more emphatically indicated that they would soon be tightening policy, using every tool at hand. And it should concern us that we are going to be stuck in a direct recession.

Those who think we shouldn’t think about the signal transmitted by the all-but-reversed 10-year / 2-year curve would like to mention that the 10-year / 3-month curve, which educators argue is more predictable. Wide Here again is a chart of two curves:

10/3 months wide. So any recession?

Consider why the 10 year / 3-month curve usually predicts a stronger recession. Probably because that curve is reversed only when the market expects the Fed to move at a faster pace – slowly putting a brake on the economy instead of leaving it on the accelerator. In other words, as Aberdeen’s James Athe pointed out to me, the difference between a 10-year / 2-year and a 10-year / 3-month reflects market expectations about how fast the central bank will raise rates. 10/3-months is now wide because the market thinks the Fed is going to raise rates slowly ৷

Yet the Fed has begun to indicate that in reality, There are slam on the brakes. The three-month yield is still not getting Brainard’s message, but it could only be a matter of time. You should be more concerned about the recession this morning than yesterday morning.

Freedom Money and Bitcoin Decoupling

Crypto is advancing towards the mainstream. At an industry conference in Boca Raton, Florida, last month, Sam Bankman-Fried, CEO of crypto exchange FTX, outlined his pitch for how his technology could reshape the U.S. futures market and repeat past calls for cooperation with regulators. From FT’s recently published report:

FTX regulators are taking matters into their own hands Bankman-Fried has already suggested to Congress that the CFTC should regulate all digital assets in the US spot and derivatives markets. With its proposal to the CFTC, FTX is leveraging its preferred regulator that can establish basic rules of the road for traders.

“We want to get more clarity on how to get a license and register for digital assets,” said Bankman-Fried.

Although many Bitcoins do not want a regulatory entity. They want war. I wrote earlier about the “Bitcoin as Freedom Meaning” view. The idea is that Bitcoin is fundamentally about security – in terms of personal control – and bypassing state power. Last Friday, Ethereum founder and early Bitcoin supporter Vitalik Buterin published a detailed post about the perspective on the meaning of independence. A stylized summary of his argument:

  • Governments and banks regulate access to the financial system, sometimes acting on arrogance, stupidity or indifference.

  • Technology should exist to allow people to send prices freely from these vain / stupid / indifferent doormen.

  • To that end, the technical designs of Bitcoin and Blockchain maximize personal control over the ease and cost of completing transactions.

  • The key to Bitcoin’s intolerant culture is to focus on Bitcoin’s security and prevent mainstream tensions.

  • Bitcoin’s limited usefulness and intolerant culture make it worthwhile.

For Bitcoin to be “a light in a dark place, when all other light goes out”, it must reject the mainstream and bear the cost of its persistence.

Liberal policies that first pushed Bitcoin out of an obscure computer-science project never give up, and even people like Bankman-Fried pushed crypto steadily into the mainstream. Now roaring again.

Myanmar’s rebels, refugees from Afghanistan and now Ukraine’s wartime government – Bitcoiners are seeing growing evidence that cryptocurrencies from the state could be used in practice. At the same time, events such as Canada’s harsh response to his truck blockade terrified liberals. (Fox News host Tucker Carlson’s recent crypto convert.)

This does not mean that Bitcoin has to be decoupled from crypto. The financial and social pressures that are pushing Bitcoin into the mainstream are strong. But it could. Buterin and his associates are influential, and they have the opposite view of Bankman-Fried. The future of crypto has been challenged, and most of its biggest fans have competed. (Ethan U.)

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