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Three Things I Think I Think – When Things Break

Here are some things I think I am thinking about:

As a housekeeping note – check out my new YouTube channel. It’s short hits on money and finance so people who like the long form reading might not enjoy it as much, but I am giving it a try. Constructive criticism is extremely valuable as I want this to be valuable to people. 

1) Will interest rate risk transform to credit risk? 

One of the things I’ve been hammering on lately is that I think that Fed made a policy mistake by not being more proactive and then overreacting and raising rates very rapidly by essentially pricing in 12 rate hikes in a matter of months. I think all this stuff going on in financial markets is disinflationary at best and deflationary at worst. We’ve lost $35 TRILLION of total market value in the last 3 months. That’s 14% of all global wealth. In 2008 financial wealth fell 19%. The crazy thing is that a lot of this is a self inflicted wound from the Fed raising rates so late and so rapidly.

Exactly one year ago I wrote:

“Personally, if I ran the Fed I’d be changing the language and starting to talk about tapering the balance sheet. I think there’s a lot of weird stuff that kind of worries me. It’s not just consumer prices. The real estate market around the country is whackadoodle. People are buying meme crypto coins just for fun. The Gamestop stuff and the endless surge in stocks. There is speculative fervor all over the place. And while asset prices aren’t a major concern for the Fed I do think the total amount of weirdness in prices is alarming. Maybe it’s just the risk manager in me speaking, but I’d be hinting at rate hikes by now….”

I got the direction of inflation right, but the magnitude wrong (I expected core PCE to top out at 3-4% and it’s at 5%). But overall I am pretty proud of that statement and my overall analysis of the last few years. And yes, I was early about being worried, but now I wonder if the real turmoil is just beginning. After all, the Fed has now slammed on the brakes at the worst possible moment after it looks like inflation is already peaking. And now we have to start looking for where the bodies are buried. The big question now is how much of this interest rate hike is going to roll over into the real economy and exacerbate already fragile conditions? We haven’t even started to see real house price declines or other real asset price declines from refinancing hurdles. This is a disastrous scenario if you’re a Fed official and I say that as someone who is usually pretty sanguine on these matters.

Anyhow, as I said in my recent video – I think the next 18 months have the potential to be very challenging. Keep plenty of cash in reserves and don’t overreact. Stay disciplined to your long-term plan while making sure you can navigate your short-term liquidity needs.

2) The not so stable coin. 

The big story in crypto this week is the collapse of Terra, the third biggest stable coin. All stable coins are forms of a currency peg. The ones that are collateralized are a lot more like a money market fund than anything else and the one’s that aren’t collateralized are just fragile currency pegs without sufficient reserves. I’ve talked a lot about how maintaining a peg or a stable coin is very difficult. I actually worked on a few stable coin projects back in 2017 and I told the coin founders that their projects weren’t viable. I’ve seen how a lot of these things work at the ground level and they’re incredibly fragile if not reserved fully. But to put this in perspective – it’s very difficult for a government to maintain a currency peg without reserves so it’s not all that surprising that smaller entities would struggle with it.

I am a broken record on this point, but I don’t think a decentralized stablecoin can ever work. The coin has to be centralized and collateralized in order to maintain the peg because the peg is always contingent on a hierarchy and that peg has to be collateralized using the denomination of the thing you’re pegging to. In other words, if you want to peg to the USD you have to have assets that are somewhat stable denominated in USD that you can easily convert. This is why most money market funds are basically Treasury Bills. Bills are about as close to actual USD without being USD as it gets. Money market funds in the traditional finance space don’t break because regulators require them to be overly collateralized.

Anyhow, this collapse feels different in a lot of ways. This wasn’t a small coin. It was a $40B coin just a month ago. And it didn’t just “break the buck” like the famous Reserve Fund in 2008, which was a $60B fund that fell 3%. This thing folded like a lawn chair and was down 80% at points last night. A lot of hot money flowed into this space in the last year and we’re now seeing that a lot of the swimmers don’t have trunks on. I don’t know where or how deep the contagion is, but this is a disaster.

3) Not Your Keys, Not Your Coins. 

Here’s an alarming disclosure from CoinBase in which they explain that the Bitcoin they custody could be considered firm assets in case of bankruptcy. In other words, customers would be considered unsecured creditors and their crypto assets would not be considered theirs, but part of the firm’s assets. This seems to be a legal unknown at this point because there isn’t precedent for establishing how a BK court would treat the assets. This is essentially a version of the popular crypto mantra “not your keys, not your coins”. In other words, if you don’t personally custody your coins they’re not really yours.

This is wild. Imagine if Schwab came out one day and said “if we go bankrupt your personal assets will be subject to the bankruptcy settlement”. They’d lose all their assets overnight. I don’t know the legal aspects of this and so I am not in a position to have a strong opinion, but this seems like a very, very important matter that needs to be sorted and I certainly wouldn’t want to wait around for a bankruptcy court to settle it.

In any case, things are breaking all over the place. Have a nice day.