“Printed money was the painkiller. Unfortunately, we are now addicted to the pain medicine.”

Maybe once a month, I read something that I feel is a sneak peek into the future.

Greg Foss’s pdf on CDS and bitcoin is such a thing.

If you are interested at all in: macro, stocks, crypto, bitcoin, sovereign individual, investing…then this paper is well worth your time. Some of the terminology and concepts are complex, but he does as good a job as anybody of explaining them in clear and simple terms.

Below are a few highlights to give you a taste (all copied verbatim):

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My experience with insolvent money centre banks in 1988 would be re-experienced in 2008/2009 when Libor rates and other counterparty risk measures shot through the roof PRIOR to equity markets smelling the rat.

Asymmetric trades define careers, and ABCP was the best asymmetric trade versus risk, I had seen up until that point in my career. But Bitcoin is a better trade than ABCP, in my opinion. Bitcoin is the best asymmetric trade I have ever seen.

The global response to the Covid pandemic has ensured that our kids’ futures are doomed to eternal Fiat currency debasing. Again, simple math.

Fiats are worthless, yet they have “subjective value” today. However, they are programmed to debase. Bond investors are really just a “derivative” to this reality. Choose your SoV wisely. Think physics and math and code.

Secondly, if the common equity pays a dividend, this dividend is NOT a FIXED income instrument. The dividend is NOT contractual,

The shape of the yield curve is a subject of great economic analysis, and in an era when rates were not manipulated by Central Bank interference, the yield curve was useful in predicting recessions, inflation, and growth cycles.

Almost all government debt, from the same borrower ranks parri passu, that is to say, there is no priority of claim within the debt structure of governments because there is no subordination and no equity.

Interest rate risk and inflation risk are synonymous. Both have been declining for my entire trading career. That is because over the last forty years, the general level of interest rates (YTMs) have declined globally, from a level in the early 1980s of 16% in the USA, to today’s rates of close to zero, or even negative in some countries.

When G-20 government balance sheets were in decent shape, and operating budgets were balanced, and accumulated deficits were reasonable, the implied risk of default by a government was almost zero. That is for two reasons. Firstly, their ability to tax to raise funds to pay their debts. Secondly, and more importantly, their ability to print Fiat money.

…the turmoil in the (Great Financial Crisis) essentially transferred excess leverage in the financial system to the balance sheets of Governments. The can was kicked to the Govies. Printed money was the painkiller. Unfortunately, we are now addicted to the pain medicine.

In many cases, if you were to line up the operating cash flows of the government and its leverage statistics compared to a BB corporate, the corporate would look better.

Contagion in the bond market is much more pronounced than in equities. For example, if provincial spreads are widening on Ontario bonds, most other Canadian provinces are widening in lockstep, and there is a trickle- down effect thru bank spreads, car paper spreads, high grade corporate spreads and even to junk spreads.

It was rumoured that one of the main reasons the Fed stepped into the credit markets to be able to buy HY debt in 2020, was due to the impending downgrades of four very large IG borrowers who are on the cusp of crossing over (to the dark side?). General Motors, Ford, AT&T and GE have cumulative debt that is larger than the entire HY market.

When Central Banks decide to intervene in the equity markets to stabilize prices and reduce vol, it is not because they care about equity holders, it is because they need to stop the negative feedback loop and its ultimate impact on widening spreads and the seizing of credit markets. Remember, Credit is a dog. Its tail is the equity markets.

“Communism only works until you run out of other people’s money” – Margaret Thatcher

Credit concerns will overwhelm inflationary concerns, particularly if the deflationary impact of technological advances continues. However, technology does NOT solve credit risk in sovereigns/Fiats.

“Fulcrum Index”, an index that calculates the cumulative value of CDS Insurance on a basket of G-20 Sovereign nations multiplied by their respective funded and unfunded obligations. This dynamic calculation could form the basis of a current valuation for bitcoin (the anti-Fiat).

I believe Bitcoin is the best asymmetric trade I have seen in my 32yrs of trading, and why I believe EVERY fixed- income investor needs exposure to Bitcoin in order to reduce portfolio risk.

Liquidity is best defined as the ability to sell in a bear market.

According to the Institute for International Finance, in 2017, Total global debt / global GDP was 3.3X. Global GDP (then US$67Trillion) has grown a little in the last three years, but Global debt has grown much faster. I now estimate that the debt/GDP ratio is over 4X. At this ratio, a dangerous mathematical certainty emerges. If we assume the average coupon on the debt is 3% (likely low), then the global economy needs to grow at a rate of 12% just to keep the tax base in line with the organically growing (the coupon obligation) debt balance. This does not include the increased deficits that are contemplated for battling the recessionary impacts of the covid crisis.

The Federal government has over US$25Trillion in outstanding debt. According to Jeffry Gundlach, it also has US$157T of unfunded liabilities in Medicare and Medicaid obligations.

Others will argue that bitcoin is too volatile. I quote Bill Miller, “Volatility is the price of return”. No Vol, no return. And finally, given its asymmetric return distribution I believe “It is more risky to have zero exposure to bitcoin than it is to have a 5% portfolio weight. If you are not long bitcoin, you are irresponsibly short”.

The tipping point (or Fulcrum point) for that event is when bitcoin is adopted as a global unit of account for the trade of energy products. When oil, natural gas and electricity are priced in bitcoin, bitcoin will supplant the USD as world reserve

Secondly, sovereign credits do default even though they can print money. Remember the LDC crisis in 1988. Or Venezuela in 2020 where Fiat is shovelled to the curb as garbage.

A powerful description of America’s current economic dilemma

http://charleshughsmith.blogspot.com/2021/02/trapped.html

The first market shadow nationalized was the mortgage market, the foundation of the housing market. After Wall Street’s epic swindle (subprime mortgages) imploded in 2008, the Fed printed trillions of dollars out of thin air and bought hundreds of billions of dollars in mortgages. The federal government nationalized the quasi-governmental mortgage issuers Fannie Mae and Freddie Mac, and the net result was virtually the entire mortgage market was government guaranteed or owned.

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Since Wall Street’s fraud had nearly vaporized the entire global financial system, the Fed also shadow nationalized the stock market, which had imploded once the house of cards collapsed. Thus the S&P 500 has advanced from 667 to 3,850 with just enough brief wobbles to maintain the semblance of an organic market.

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Now the Fed is in the process of shadow nationalizing the entire bond market. It signaled its intent long ago with quantitative easing, i.e. strangling price discovery in the Treasury market, and recently it began buying corporate bonds (proxies come in handy here).

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But that will release rogue waves of unintended consequences that will sink the Fed and the economy. Kill authentic price discovery, you also kill markets, and in killing markets, you kill allocation of capital and risk management, and in killing those, you kill the economy.

“It poisoned the German people by spreading among all classes the spirit of speculation”

Thanks to @tuurdemeester, a quote from an analysis of the Weimar inflationary depression:

The inflation retarded the crisis for some time, but this broke out later, throwing millions out of employment. At first inflation stimulated production because of the divergence between the internal and external values of the mark, but later it exercised an increasingly disadvantageous influence, disorganizing and limiting production. It annihilated thrift; it made reform of the national budget impossible for years; it obstructed the solution of the Reparations question; it destroyed incalculable moral and intellectual values. It provoked a serious revolution in social classes, a few people accumulating wealth and forming a class of usurpers of national poverty, whilst millions of individuals were thrown into poverty. It was a distressing preoccupation and constant torment of innumerable families; it poisoned the German people by spreading among all classes the spirit of speculation and by diverting them from proper and regular work, and it was the cause of incessant political and moral disturbance. It is indeed easy enough to understand why the record of the sad years 1919-23 always weighs like a nightmare on the German people.

Highlights from Layered Money by Nik Bhatia

An easy to read tour through the history and evolution of money types (from gold coins to today’s fiat paper notes), presented through a useful framework of money layers (that together form a pyramid). Amazon Kindle.

Here are some of my favorite highlights (copied verbatim):

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In the second century under the rule of Marcus Aurelius, the denarius coin weighed about 3.4 grams and contained about 80% silver, which was already a reduction from its 98% purity when Augustus Caesar declared himself the first Emperor of Rome three centuries prior. […] By the end of the third century, the denarius had been devalued so frequently that its purity was down to only 5% silver

Historically, precious metal coins were durable, divisible, and portable, but with governments constantly reducing the purity of their coins, no coin existed with multigenerational credibility. The Florentine mint changed that. The florin maintained an unchanged weight and purity, about 3.5 grams of pure gold, spanning an astounding four centuries. By the time the florin denomination was one hundred years old, it had evolved into the international monetary standard for pan-European finance. High salaries, jewelry, real estate, and capital investment were all priced in florin.

Contractions can result in redemption requests, called bank runs, and eventually financial crises. These crises can be more easily thought of as attempts to climb the pyramid of money, as holders of lower-layer money scramble to secure a superior, higher-layer form of money.

The creation of the Antwerp Bourse in 1531 revolutionized money because it birthed the money market. At the time, the money market described the market for second-layer monetary instruments such as bills of exchange, gold deposits, and other promises to pay precious metal.

Governments and currencies are inextricably linked today because governments established a monopoly on second-layer money and used it to their own benefit, starting with the Bank of Amsterdam in 1609.

Up to a thousand different types of coinage circulated in the new international trade hub of Amsterdam, a monetary situation too cumbersome for a city with the world’s first stock market.

By suspending convertibility to first-layer money, the Bank of Amsterdam proved that precious metal wasn’t necessarily required to operate a monetary and financial system. It depended on its own disciplinary constraint to stay sufficiently reserved, and more importantly it depended on the peoples’ trust in that discipline.

Gold is money. Everything else is credit. —J.P. Morgan to United States Congress in 1912

In Virginia, tobacco became a first-layer monetary asset and the basis of its own money pyramid due to the global popularity of the crop. The pound-of-tobacco unit became an accounting standard, and notes promising the delivery of pounds of tobacco were issued by Virginia as second-layer money that circulated among the public as cash.

the second Congress of the United States of America finally passed the Coinage Act in 1792 to establish the United States dollar as the country’s official unit of account, defining one dollar as both 1.6 grams of gold and 24 grams of silver.

Finally, the Act decreed that the Fed maintain a gold-coverage ratio of at least 35% against the liabilities it issued on the second layer, meaning at least 35% of the Fed’s assets must be held in gold. In actuality, gold represented 84% of the Federal Reserve’s assets upon its founding, a number that would dramatically fall over time. Today, for reference, gold represents less than 1% of the Fed’s assets.

Gold’s disciplinary constraint received an outcry of blame for the economy’s inability to recover and led to dramatic and sweeping changes to the dollar pyramid during the 1930s.

FDIC insurance is a federally guaranteed insurance policy on all third-layer bank deposits.

In 1944, world leaders gathered at a hotel in Bretton Woods, New Hampshire and formalized that all currencies besides the dollar were forms of third-layer money within the dollar pyramid. The Bretton Woods agreement would come to be known as the dollar’s world reserve currency coronation.

Nobody could have ever conceived of a more absurd waste of human resources than to dig gold in distant corners of the Earth for the sole purpose of transporting it and reburying it immediately afterward in other deep holes, especially excavated to receive it and heavily guarded to protect it. The history of human intuitions, however, has a logic of its own.

The dollar had become deeply entrenched as the world economy’s denomination: barrels of oil were priced in dollars, trade agreements were struck in dollars, and international bank balances settled in dollars.

In 1971, the United States suspended gold convertibility for the dollar; the suspension initially was supposed to be temporary, but the dollar never returned to any linkage with the commodity. Two years later, the modern era of free-floating currencies began, officially ending the Bretton Woods agreement.

From a layered-money perspective, there aren’t a lot of places in the dollar pyramid that don’t have an explicit or implicit guarantee of liquidity backstop from the Federal Reserve today.

In gold’s absence, the Fed’s balance sheet used U.S. Treasuries as its dominant asset, and the private sector used them as the omnipotent form of monetary collateral. For banks, ownership of these government bonds wielded the power to create yet another type of dollar called Treasury Repo dollars.

By 1979, the Federal Reserve concluded in a study that the explosion in Treasury Repo transactions was in fact causing an overall increase in the measurable supply of dollars and admitted not being able to make that measurement with exact precision. By 1982, the Federal Reserve fully gave up on managing the supply of dollars because they had veritably lost the ability to keep track of it;

When the prestigious investment bank Lehman Brothers failed on September 15, 2008, a money market fund called Reserve Primary Fund famously “broke the buck” when it posted a share price of $0.97 because it owned a fair amount of newly defaulted Lehman Brothers commercial paper. This drop of a mere three cents from par triggered an all-out financial panic that elicited unprecedented emergency actions from central banks and governments around the world. The reason for the panic wasn’t necessarily the three-cent drop, but the fear that if Lehman Brothers commercial paper could fail, and Reserve Primary Fund’s shares weren’t worth a whole dollar, nothing could be trusted. All forms of bank liabilities lost liquidity, and the financial system froze.

A return to peaceful money markets was unattainable, as the Fed had removed price discovery from the system by disallowing so many third-layer money-types from realizing their ultimate fate.

The most fascinating component of Satoshi’s design of Bitcoin was his intention for it to mimic gold as a first-layer, counterparty-free money. And that meant a supply that does not originate from a balance sheet.

Gold is considered an insurance on monetary disorder and disarray, one that tends to work best during earthquakes in the dollar pyramid. But gold’s physicality falls short in a digital world where Bitcoin thrives. Eventually, Bitcoin will likely replace gold as the most desired neutral money and exceed it in total market value.

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All of the above highlights are copied verbatim from the book.