What can we learn from the changes in the dollar market over the past three years?

Original Author: Ben Lilly

Original Compilation: Shenchao TechFlow

If there is a fundamental question that affects how we design metrics, it is:

"What is money?"

Specifically, what makes people use, consume, or hold it. This is a thought exercise that helps us better grasp the dynamics of both conventional government-issued currency and cryptocurrency tokens.

Some may argue that these principles do not apply to the latter. But we prefer to view cryptocurrency tokens as native digital currencies. This means that many definitions and mental models of traditional currency can be applied to our field.

Instead of spending time providing you with the high-level overview we mentioned, let's get straight to the point.

Inflation is More Than Just a Supply Issue

Money has various uses.

We can burn it for warmth, use it for origami, buy candy, store wealth, use it as collateral, or purchase securities with it.

Each use is unique. And the popularity of each use conveys the value of money to the market.

If in some part of the world, money is primarily used as fuel for fire, then its value may be similar to the materials it is made of. Meanwhile, if in another part of the world, people use their money to gain returns… then there could be a significant difference in value between the two.

This perspective on money may seem strange. After all, we are talking about money. We mainly use it to buy things… right?

But the data tells us a different story… and these things change over time.

To help explain what we mean here, let's try to recall our mental state on March 16, 2020------during the COVID-19 pandemic.

The Dow Jones Industrial Average dropped by 12.9% that day.

The overall economy was in a similar situation. Businesses closed, employees were sent home, and uncertainty reached its peak. It was a moment when having dollars in hand meant more than anything else.

In fact, the U.S. savings rate skyrocketed from 7.2% at the beginning of the year to 32% in April… which is double the highest savings rate recorded by the Federal Reserve.

As we entered the summer of 2020, the primary use of dollars was to hold them.

In the crypto space, we refer to this as the hodl metric.

At that time, this level of holding currency represented a significant behavioral shift. Its effects are now very apparent.

Fewer dollars circulating in the economy and being used to purchase goods and services meant that inflation was negligible.

At the beginning of 2020, the inflation rate was 2.5%… by April, when behavior shifted from "normal" to "holding," the inflation rate dropped to 0.3%, and in May it even fell to 0.1%.

This change in the use of money directly affected inflation.

Meanwhile, the money supply measured by M2 increased from $15.4 trillion in early March to over $17 trillion within just a few weeks. When it comes to such a significant increase in the money supply, we often assume that inflation will follow immediately. But it did not.

If there is any difference, then this newly minted money acted more like a trigger for inflation. But it needed a match.

That match was the shift in how dollars were used.

In the world of economics, we express this change in mindset through a mental model called the Quantity Theory of Money, abbreviated as QTM. This perspective was popularized by economists Anna Schwartz and Milton Friedman in their work "A Monetary History of the United States, 1867-1960."

The title sounds like a textbook, but the concept is not difficult to understand. Simply put, it basically states that the amount of money in the economy multiplied by the frequency with which money is used (for example, velocity of circulation, which is the opposite of the savings rate) affects the value of money.

More money but less spending means no inflation.

More money but more spending… well, that's where we mentioned the match being lit.

This leads us to the next state of mindset.

The Summer Frenzy of 2021

After a year of COVID lockdowns in 2020, they ended in the summer of 2021. Economies around the world began to reopen. Plans for concerts… parades… it felt like "school's out for summer."

The notion that we no longer needed to hoard money out of fear of losing jobs or needing to survive had vanished. The mindset around money had shifted.

Previously, people were hoarding like in an arms race during the Cold War. Then suddenly, it was as if everyone discovered there was no need to worry about nuclear weapons.

This shift in mindset led to the savings rate plummeting from 26.1% to below 10% within two months. Below is the savings rate with May 2021 as a reference, marking the beginning of the summer frenzy…

Dollars were not for holding but for spending. In other words, dollars were more about being a means of payment rather than storing wealth.

More money meant more spending…

Inflation had arrived.

This is the inflation on the chart. I guess you can see which period the red arrow highlights------the summer of 2021.

At the beginning of 2021, the inflation rate was 1.4%… by May, it had reached 5%.

It was as if dollars were hot potatoes. No one wanted to hold onto them.

Looking back, you might remember buying things you really didn't need. It could have been a bigger TV, a computer monitor, some fancy home office chair, or even doing some renovations on your house. The frenzy was real.

No matter what you regretted buying in your childlike shopping spree…

Would you have preferred to keep that money in your pocket? I mean…

That dollar now gives you a 5% return. Imagine if you had converted your wealth into dollars at the beginning of 2022, now you could be getting a 5% return. I guess you'd be a bit more satisfied with yourself.

This brings us to the recent shift in mindset regarding usage…

The Dollar Became a Hodl Asset

If we look back at the previous inflation rate chart, we can see that inflation peaked at 9.1% in June 2022.

It is almost unimaginable how the economy allowed the inflation rate to grow from 0.1% to over 9% in just one year. The primary forms of money usage are crucial. And with our next shift in usage, you will see it again.

Below is the savings rate chart focusing more on the post-COVID period. We can see that the chart reached its lowest point in June 2022------the same month inflation peaked.

However, the supply of dollars changed little… it was not a sudden decrease in supply that caused the inflation reversal. So what exactly happened here?

The Federal Reserve changed market behavior.

In the first half of 2022, the central bank raised borrowing rates three times, with a slight increase in March. Then in May and June, we saw borrowing rates rise from about 0.25% to 1.5%. This was a significant change.

This major move led to sending dollars to the U.S. government for borrowing purposes (i.e., purchasing Treasury bonds) to obtain actual cash flow. Before 2022, lending those dollars could yield you 0.25%. That is, for every $100,000 borrowed, you could earn $250.

But by June of that year, the same $100,000 could earn over $3,100. Compared to six months ago, this was a 1,140% increase in cash flow. This is very significant.

So the market's preference for how to use dollars changed. Dollars became more about generating significant cash flow rather than spending them on goods and services. Of course, the strengthening of the dollar helped, but in any case, this is the primary use of dollars today.

People want returns on stable-priced assets------note this, token economists. We even saw several projects bringing this yield exposure to public blockchains. This is why it has become so popular.

Thus, we have roughly the same amount of dollar supply, but now they are being spent less… as I write this in October 2023, the inflation rate has been below 4% for four months. If anything, more people want to hold dollars now than ever before.

We can see this in the rising demand in the Treasury market. In the chart below, each colored line represents a U.S. Treasury maturity. The height of the line is the bid amount for each maturity per month. The shaded area of each bar is the number of bids awarded by the U.S. Treasury.

I mentioned earlier that the inflation rate has been below 4% for the past four months. Over the past six to eight months, the bid amounts at Treasury auctions have been increasing.

Here are the auctions for U.S. Treasuries with maturities of 52 weeks or shorter.

Here are the auction results for Treasuries with maturities longer than 52 weeks.

These two charts show that the demand for using dollars to obtain cash flow is increasing. This is essentially the ultimate form of "hodling."

In the summer of 2020, people held onto funds out of fear. By 2023, the group of dollar holders was holding to generate cash flow. This is a more productive use of money.

This is why I support a version of QTM for cryptocurrencies that focuses not on quantity but on quality. I call it "Token Quality Theory."

The Story is Not Over

This may seem like a lot of information.

But we can summarize things by looking back at the timeframe of March 2020 and reflecting on how the use of money has changed in the following years.

It evolved from a holding state to a spending state, and then to a state where money generates returns.

In this process, inflation shifted from very low to very high and then back down again.

Meanwhile, the amount of money in circulation had no direct impact on inflation. This means that the effect of the money supply on the price of dollars is not as significant as the effect of how dollars are used on prices.