How do U.S. Treasury yields affect the cryptocurrency market?

The author of this article is Junhaeng Lee, compiled by Echo.

On February 25, the yield on the U.S. 10-year Treasury bond suddenly surged to 1.6%, causing a simultaneous crash in both the Nasdaq market and the cryptocurrency market, shaking confidence in the future trend of Bitcoin prices.

Recently, Junhaeng Lee, the founder of the South Korean blockchain financial company Streami, wrote about this matter, deducing three different scenarios and outcomes based on changes in U.S. Treasury yields and the Federal Reserve's response policies, and analyzing the prospects of the cryptocurrency market. Chain Catcher has translated and edited the original text without altering its meaning. With the simultaneous decline of the Nasdaq market and Bitcoin prices, along with the rise in U.S. 10-year Treasury yields, many are concerned about the direction of Bitcoin's price. The fear stems from the rising market interest rates, which have caused Bitcoin prices to plummet over 20%, potentially shifting the market atmosphere towards a risk-averse mode.

We believe that on-chain indicators and macroeconomic indicators are the core driving forces behind Bitcoin prices. In fact, the recent rise in U.S. 10-year Treasury yields due to rising inflation expectations is the most likely scenario. Contrary to many people's concerns, although Bitcoin prices will experience short-term fluctuations, there is still greater upside potential in the long term.

In the second half of last year, I predicted that there would be two important variables in macroeconomics for 2021. First, will the post-pandemic economic recovery and inflation expectations lead to a rise in market interest rates? Second, how will the Federal Reserve set its response policies when market interest rates rise?

Using these two variables for deduction, three possible scenarios will emerge, starting with the one with the lowest probability.

1. Rising Market Interest Rates + Monetary Contraction

Market interest rates will rise as inflation rates soar. Suppose I purchase a 10-year long-term Treasury bond at a 1% interest rate. However, if the expected inflation rate this year is 3%, then long-term bonds will incur losses, leading to a large circulation of long-term bonds in the market, causing long-term bond prices to fall and relative interest rates to rise. Expected inflation raises market interest rates through this mechanism.

However, if long-term bond rates rise, short-term bond rates will also rise, as long-term and short-term bonds are issued by the same central bank and have the same credit rating, leading to a price recognition phenomenon.

Interest rates are a determining factor for the benchmark rate. Typically, central banks adjust the prices (i.e., interest rates) of short-term Treasury bonds by buying or selling them, thereby setting the benchmark rate (except in extreme cases like quantitative easing). In this case, if the Federal Reserve does not take any measures in response to the rise in long-term bond rates, the benchmark rate will also circulate through the following loop.

Moreover, if the benchmark rate rises, it will offset inflation, leading to a reduction in money circulation and employment opportunities in the market, causing the economy to stagnate.

Long-term bond prices fall (interest rates rise) → Short-term bond prices fall (interest rates rise) → Benchmark rate rises → Bank rates rise → Monetary contraction → Employment decreases (expected inflation falls) ⇒ Economic recession

Considering the fragile development trend of the real economy after the reduction of quality jobs, the Biden administration's expansionary fiscal policy stance, and the Federal Reserve's tolerance for inflation in its monetary policy tone, the likelihood of this scenario occurring is extremely low.

This situation could lead to an economic recession. In the case of monetary contraction, the prices of all risk assets are generally under downward pressure. Bitcoin is referred to as a "risk-on safe asset," but whether it is a risk asset is a very relative concept. In this scenario, long-term Treasury bonds are more worthy of investment than Bitcoin.

At this time, Bitcoin prices are under downward pressure, while long-term Treasury bonds are under upward pressure. However, considering the reduced BTC supply in 2020 and the still strong long-term investment demand from institutions, I believe a crash like that of 2018 will not occur.

2. Maintaining Low Market Interest Rates + Monetary Expansion

In a situation where market interest rates are zero, to prevent a substantial deflationary state and promote employment, the government must release money, leading to inflation. If explained from the Federal Reserve's perspective, providing more funds to the market when expected inflation rates are low is not a problem. In fact, this has been the case almost continuously since 2010.

After the financial crisis in 2008, we experienced unlimited expansion of liquidity and liabilities under a long-term negative interest rate environment. In the real economy, there was no consumption or investment, and the released liquidity only flowed into the asset market, raising asset prices, but the result was deflation. Former U.S. Treasury Secretary Larry Summers and many other economists predicted last year that this situation is unlikely to occur.

This situation could lead to inflation. Risk assets roam in an inflationary market, with assets that have higher growth potential receiving more attention. Bitcoin will also show strong upward momentum, but this momentum will weaken over time, while projects like Gamestop will divert investment demand. In other words, in this scenario, Bitcoin's price does not fundamentally differ from trends in the 2010s.

3. Rising Market Interest Rates + Monetary Expansion

In this case, although market interest rates rise, the standard interest rate remains at zero due to monetary expansion. In fact, Australia has artificially lowered the 3-year Treasury bond yield through YCC (Yield Curve Control).

As inflation rates rise, long-term Treasury bond yields also rise, leading to cash depreciation and a decline in short-term Treasury bond yields, making expected inflation no longer "anticipated," but "real." This situation, where inflation is ignored and continues to worsen, is referred to as "hyperinflation."

In an inflationary environment, the value of money declines, and citizens' purchasing power decreases. This is a reverse trend. From the perspective of those in power, this is a better choice than deflation leading to economic depression, so the likelihood of this occurring is very high. The key question is whether market interest rates will really rise. I stand on the side of an impending inflation environment. In fact, as commodity prices rise, market interest rates are also increasing.

This situation could lead to hyperinflation. As mentioned earlier, the rise in expected inflation is reflected in the rise in market interest rates. The rise in U.S. 10-year Treasury yields (i.e., the risk-free rate) driven by expected inflation rather than economic fundamentals reduces the present value of stocks (i.e., the sum of future cash flows).

Moreover, as the central bank's uncertainty regarding monetary policy increases, there will also be temporary downward pressure on risk assets. Bitcoin will undergo adjustments in the short term.

However, due to inflation leading to a decline in the real purchasing power of money and long-term Treasury bond prices, a fundamental question arises: "How do I protect my wealth?" This applies to both individuals and institutions.

Ultimately, all economic participants will actively seek new safe assets that can protect wealth. In the past, gold was almost the only refuge, but I believe that Bitcoin, which has recently gained nearly $1 trillion in stability, will become a much-discussed alternative to gold.

If Bitcoin wins in the competition with gold as a safe asset, the liquidity released in the market will be absorbed into the Bitcoin black hole. In that case, the price discovery mechanism for all assets in the world may center around Bitcoin.

4. Insights

When the aforementioned hyperinflation scenario becomes a reality, the market will validate whether Bitcoin truly acts as an inflation-hedging asset like gold. So, what world changes would it mean if Bitcoin suppresses gold under hyperinflation?

In the financial market, the phenomenon of preferring Bitcoin over U.S. long-term Treasury bonds does not signify the end of the dollar. The dollar is a currency, while long-term Treasury bonds or gold are merely "stores of value" that support it. Even with the rise of Bitcoin, the U.S. will still collect taxes in dollars, just as Bitcoin mined will be settled in dollars like oil.

However, this changes the composition of dollar-backed assets, meaning that a portion of the current 100% U.S. Treasury bonds will transform into Bitcoin. The language of developers will change existing infrastructure protocols.

Changes in monetary infrastructure mean changes in the rules of the economic activity game. In 2010, due to the excessive issuance of Treasury bonds, the allocation of funds was based on political logic rather than market logic. Furthermore, funds were mainly concentrated in companies like WeWork, which were chosen by large funds and could provide unlimited liquidity through blueprints, rather than in highly profitable companies.

However, this paradigm cannot be fully maintained in the financial system. In this financial system, Bitcoin, which has "scarcity," will at some point anchor the value of money, rather than government bonds that can be printed infinitely.

Ultimately, this signifies a generational shift. The younger generation, who have recognized Bitcoin's potential and invested in it, and who largely do not own real estate, will have significant economic dominance. Additionally, the new generation creating a digital economy based on Bitcoin and virtual assets will have more opportunities.

Seeing the massive fiscal deficit in the U.S., the decline in national education levels, and the increasing inequality, countless people are anticipating the decline of this empire. Meanwhile, China has become a major trading power with strong industrial competitiveness, and many believe that the economic dominance of the 21st century will shift from the U.S. to China (just as it shifted from the UK to the U.S. in the early to mid-20th century). However, I believe that the "new empire" is "digital space," and the "new sovereignty" is "Bitcoin."

We need to continue to closely monitor the shifts in market interest rates in 2021, the U.S. response strategies, and the changes in Bitcoin prices.

Note: This article is for reference only and does not constitute any investment advice.