Dialogue with Arthur Hayes: Where will Bitcoin go after the sovereign debt bubble bursts?

Host: Michael, Blockworks Macro

Speaker: Arthur Hayes, CIO of Maelstrom Fund

Compiled & Edited by: Deep Tide TechFlow

In today's program, Arthur Hayes, the Chief Information Officer of Maelstrom Fund, discusses the bursting of the sovereign debt bubble as bonds continue to experience one of the largest sell-offs in U.S. history, the steepening of a terrifying bear market, and its impact on bank balance sheets and market liquidity.

How can cryptocurrencies serve as a safe haven during financial crises?

Impact of High Global Debt

Nature of Debt: Arthur likens debt to time travel, borrowing from the future to fund today's activities, based on an expectation that the output of these activities will exceed the cost of the debt. This approach theoretically leverages potential future growth to drive current economic development.

Arthur points out that the structure of debt is typically based on the assumption that more people will engage in economic activities in the future, thereby creating wealth and income to repay this debt. If population growth declines, this fundamental assumption is challenged. In scenarios of slowing or negative population growth, there are fewer participants in economic activities, yet the debt burden remains, forcing the remaining individuals to bear more repayment responsibility, a situation particularly pronounced in developed countries.

Arthur criticizes the practice since the end of World War II that has attempted to eliminate business cycles. He believes this approach tries to smooth out the natural fluctuations of the economy through debt financing to avoid recessions and promote stable growth, leading to an unsustainable situation where the global debt-to-GDP ratio is around 360%, making the management of the interest on this debt a significant challenge.

Arthur emphasizes that when debt grows to such high levels, merely servicing the interest requires the economy to allocate substantial resources, reducing the funds available for other productive investments. This high debt burden limits the fiscal space of governments, which must allocate large portions of their budgets to debt repayment rather than investing in education, infrastructure, or other growth-promoting measures.

Steepening Bear Market, Are U.S. Treasuries Still Attractive?

Definition: A steepening bear market refers to the situation where long-term interest rates rise relative to short-term rates, which is seen as a negative signal in the bond market.

Arthur compares the performance of the long-term U.S. Treasury ETF (TLT) with Bitcoin. Since Russia's invasion of Ukraine on February 24, 2022, Bitcoin has risen by about 50%, while TLT has fallen by about 17%. From October 7, 2022, to now, Bitcoin has increased by about 24-25%, while Treasuries have dropped by 3%.

Arthur notes that traditional investment strategies involve investing in U.S. assets during market instability. However, investors are now beginning to seek global assets like Bitcoin, as it is not directly controlled by any national government and is virtual, unlike physical assets that can be seen and touched. Investors are starting to lose interest in U.S. Treasuries, fearing that the U.S. government may not be able to sustain its economic commitments to retirees due to its involvement in global military actions.

Arthur mocks those investors who continue to buy Treasuries, despite the fact that the performance of U.S. 30-year Treasuries has dropped by 50% over the past three years. He predicts that when these investors realize that bonds can no longer reduce the overall volatility of their portfolios, they will have to seek other investment avenues.

Arthur believes that as investors gradually recognize the changing dynamics of the market, they will seek assets with fixed supply, such as Bitcoin and gold. This shift will drive up the prices of these assets, given the vast size of the global bond market. If investors begin to question the ability of bonds to reduce portfolio volatility and whether the government can maintain the purchasing power of the bond market in terms of energy, demand for Bitcoin, tech stocks, and other assets could surge.

Dilemma for Policymakers

Arthur mentions that the MOVE Index, which measures bond market volatility, typically reflects increased market tension when it rises. To alleviate market anxiety and prevent further turmoil, the Federal Reserve or the U.S. Treasury may intervene in the market to stabilize the situation.

He points out that while rising long-term interest rates are generally seen as beneficial for banks, in reality, banks were induced to purchase large amounts of U.S. Treasuries between 2020 and 2022, and now the value of these bonds has declined, leaving banks effectively insolvent and unable to engage in lending activities, thus unable to make profits.

Arthur recalls a conversation he had with a volatility fund manager, who mentioned that U.S. banks disclosed significant unrealized losses on held-to-maturity securities in their quarterly reports. Although these losses do not appear on the income statement, they have already impacted the banks' capital adequacy ratios.

Arthur emphasizes that there are problems within the U.S. banking system, and market signals indicate that if the bank stock index falls below March levels, it means more banks are facing similar issues. As the interest rate curve accelerates upward, we may see more pressure.

Arthur poses a hypothesis about whether there will come a moment when market participants or investors choose a particular bank and discover it holds a large amount of depreciated commercial real estate and unrealized losses. When this happens, it could lead to banks being forced to sell these assets to balance their books, and if banks cannot resolve this on their own, they may require the FDIC and U.S. taxpayer funds to help them overcome their financial difficulties.

Arthur raises a critical decision point about whether a comprehensive guarantee mechanism will emerge, one that not only protects bank depositors' funds, ensuring they do not lose their deposits due to bank issues, but also potentially extends support to various types of debt.

Arthur points out that the owners of financial assets are primarily the top 1% of society, who benefit from them while the costs are borne by the entire society. This leads to class division and social injustice, as well as inflation issues that may manifest differently in various places.

Arthur mentions that governments and central banks may continue to print money and intervene in markets, especially when financial institutions face difficulties. He notes that while money can be printed, energy cannot, which could lead to rising energy prices and become a persistent factor in inflation.

Arthur believes that inflation statistics are manipulated by governments, as everyone's consumption basket is different, leading to varying inflation rates for individuals. The method of determining real interest rates should involve subtracting government bond yields from nominal GDP growth rates, as this would reflect the actual level of economic activity.

Arthur points out that the successful implementation of financial repression strategies in the U.S. during the 1940s and 1950s was possible because the U.S. was the only major producer in the world at that time. However, in the current globalized economic environment, such strategies may no longer be applicable.

Debt, Global Competition, and Asset Market Performance

Arthur notes that in 2023, every country is producing goods, with workers needing jobs, and these workers expect the government to fulfill its promise of employment. He mentions the current global trade imbalance, particularly the U.S. as a net debtor country, while Germany, China, and Japan are net creditor countries, and this extreme relationship is unsustainable.

Arthur points out that U.S. government monetary policies, such as the CHIPS Act and the Inflation Reduction Act, aim to encourage domestic production of goods through money printing, posing a direct threat to China, the EU, and Japan. He quotes, "Trade Wars Are The Mirror Image Of Currency Wars," suggesting that trade wars could lead to currency wars, ultimately resulting in real conflict.

Arthur emphasizes that the military interventions and actions undertaken by the U.S. government in Afghanistan, Iraq, and Syria over the past twenty years have been enormously costly, totaling trillions of dollars, and these massive military expenditures have impacted the current economic situation in the U.S.

Arthur points out that central banks around the world need to issue debt, but the question is who will buy this debt, and ultimately, the "burden" may fall on ordinary global citizens. He predicts a potential market scenario: rising yields on long-term bonds, increasing prices for gold and Bitcoin, and a downward trend in the stock market.

Arthur believes that ETFs could elevate the fiat currency price of Bitcoin but may also concentrate Bitcoin ownership, which contradicts its decentralized spirit. He emphasizes that cryptocurrencies provide a way to escape the unsustainable traditional financial system. As more fiat currency flows into the market while the supply of Bitcoin and other major cryptocurrencies remains constant or becomes deflationary, this scarcity will lead to an increase in the value of cryptocurrencies relative to fiat currencies.

Arthur argues that the value of money lies not in its quantity but in how much energy it can purchase. He stresses that regardless of the type of currency, even Bitcoin, what matters is how much energy it can buy. Energy is a resource that cannot be printed; if we continue to print everything else but energy, energy prices will keep rising and become a persistent sticky component of inflation.

The Script for BTC in the Current Economic Environment

Arthur mentions that in 2021, Bitcoin's performance was similar to that of tech stocks, both responding similarly to market volatility and macroeconomic factors.

However, in recent months, Bitcoin's behavior has diverged, beginning to resemble gold rather than tech stocks. This shift indicates that Bitcoin is starting to be viewed as a more stable store of value, rather than being linked to high-risk tech stocks as before.

Arthur sees Bitcoin's price as a combination of fiat currency liquidity and technology. When the focus is on Bitcoin as a decentralized peer-to-peer currency, combined with the liquidity of fiat currencies, it can lead to a massive bull market.

Arthur further points out that when global fiat currency liquidity increases (for example, through central bank quantitative easing), this extra liquidity often seeks investment channels, and Bitcoin, due to its limited supply and decentralized nature, becomes an attractive investment target.

Arthur mentions that when the market's focus is on Bitcoin's technological advantages, coupled with an increase in fiat currency liquidity, this combination can trigger a significant bull market.

Arthur discusses the potential impact of large institutional investors like BlackRock on the Bitcoin market. If these institutions control a significant amount of Bitcoin and mining operations, it could have a substantial impact on Bitcoin's future. He presents a scenario where institutions like BlackRock absorb a large amount of circulating Bitcoin through ETFs, which could make Bitcoin less liquid as these Bitcoins would be locked in ETFs rather than freely traded.

Arthur worries that if these institutions become major shareholders in Bitcoin mining operations, they may not support upgrades to the Bitcoin network, which could include enhancements for privacy or encryption to ensure Bitcoin remains a robust cryptocurrency asset.

He believes that the participation of institutional investors is a double-edged sword. On one hand, they can bring significant capital and credibility to the Bitcoin market, but on the other hand, they may negatively impact Bitcoin's decentralization and free liquidity. Arthur points out that if a large portion of Bitcoin's supply is controlled by these institutions, the essence of Bitcoin as a decentralized, freely tradable asset may be threatened.

Regarding market cycles, Arthur believes the usual sequence starts with Bitcoin, then shifts to major other cryptocurrencies like Ethereum, and finally to higher-risk assets. He notes that each cycle brings new "novelties" to capture the market's attention, and although the Maelstrom Fund has participated in these cycles, getting consumers to accept new things and change their long-standing behavioral patterns is very challenging.