Markets unprepared for a new era
The era of financial repression after the GFC that has seen rapidly inflated asset values and rate expectations of 0 has unraveled since the pandemic ended. Since the Second World War, the most significant fiscal stimulus package has contributed to supply chain failures and surges in goods and services. This has unleashed a wave of demand for services with labor that remains in short supply. Fixed income yields have surged to multi-year highs, and investors continue to flock to the dollar.
The old era has ended; central banks have kept interest rates at all-time lows for the past two decades and have been extremely slow to hike. However, since 1999, the combined moves from the FOMC, ECB, and BOE have had a combined rate change of 2% for September and 3.75% over the quarter. The most since the establishment of the ECB.
Combined FOMC, ECB, and BOE rate change: (Source: Macroscope) Is Credit Suisse the Lehman Brothers of this cycle?
Credit default swaps (CDS) may seem complicated and heard during the GFC back in 2008, but the CDS market is telling us something similar may be occurring in 2022.
History doesn’t repeat, but it often rhymes.
What are CDS? In layman’s terms, a swap is a contract between two parties agreeing to swap one risk for another. One party purchases protection from another party against losses from a borrower’s default.
With every swap, there is a ‘counterparty risk.’ During the housing crisis in 2008, Lehman Brothers went bankrupt and could not pay back the insurance they sold to investors. The owners of the CDS suffered a loss on the bonds that defaulted.
CDS is a good indicator of potential defaults; when the price of the CDS rises, the insurance becomes more expensive (higher elevated chance of default).
In recent times it hasn’t been so good for Credit Suisse (CS), a record
trading loss, shuttered investment funds, multiple lawsuits, corporate scandal, and a new CEO. Poor performances have seen more than 10% of its 45,000 workforce fired while leaving the US market and splitting up its investment bank.
Default insurance on Credit Suisse is approaching the same level as during Lehman Brothers’ collapse.
As a result of the above, the share price has tanked from $14.90 in February 2021 to $3.90 currently and is avoiding going to the market for funding due to its tumbling share price. CS has dropped below a quarter of its book value while its market cap is below its revenue.
Should you be concerned about your CS pension? Holding USD doesn’t mean a lot because all you have is an IOU from the bank if they go insolvent.
Many Bitcoiners believe BTC is the best protection against fiat failure due to the lack of counterparty risk. As long as you custody and store Bitcoin correctly, the Bitcoin is yours, and there is no default risk on the insurance you own. Unlike CDS, Bitcoin has no expiry option. In addition, it is also protected against hyperinflation due to its finite supply.
Credit Default Swaps: (Source: Zerohedge)
Credit Suisse Share Price: (Source: Trading View) Correlations
DXY wrecking ball
The DXY has been devastating in 2022; it is up almost 20%, leaving all major currencies in trouble. Canadian and Australian dollars are down 8% and 11%, respectively, the Euro down 18%, while the British Pound and the Japanese Yen are down over 20% each.
However, one currency has emerged victorious over the US dollar, the Russian Ruble, which is almost up a whopping 30% on the DXY.
Spot Returns vs. dxy: (Source: Zerohedge) DXY milkshake theory
As the DXY strengthens, this puts pressure on emerging market currencies with US dollar-denominated liabilities. While their currency weakens comparatively against the US dollar, it makes it harder to meet the obligations of their payments in USD.
This ultimately leads to these markets printing more of their currency, most likely leading to hyperinflation (every fiat currency that has ever existed has failed with an average life expectancy of 27 years) or adoption of a US dollar standard, which we can see in El Salvador is trying to move away from by adopting Bitcoin.
CEO Santiago Capital Brent Johnson explains the failure of fiat currencies with a theory called the dollar milkshake theory; the loss of fiat currencies will be due to an ever-increasing demand for US dollars, encompassed with a short supply of dollars, when the Fed stops making new dollars, demand for existing dollars goes up.
Major Currencies: (Source: TradingView) Equities & Volatility Gauge
S&P 500 3,586 -2.41% (5D)
NASDAQ 10,971 -3.05% (5D)
VIX 32 -0.91% (5D) The 2020s will be filled with volatility; fasten your seatbelts
On Sept. 27, The Move index (the “VIX of the bond market”) closed at 158.12. This is the second-highest print in 13 years. Since the GFC, the only higher score was the height of the pandemic on March 9, 2020.
Bond Market “Move” Volatility: (Source: Bloomberg)
When the Move index exceeds 155, the Fed discusses the possibility of cutting interest rates to 0 or starting their quantitative easing program. However, this is not the case, the fed is in the midst of its quantitative tightening program, and the market is still pricing 4.25 – 4.5% interest rates for the end of 2022.
How bad is it out there?
report discussed the the 60/40 portfolio, which had been at its worst performance since 1937. Below are the top 20 peak-to-trough drawdowns for the S&P 500 going back to 1961. Never, in history, when witnessing an extreme drawdown of stocks, have US treasuries (the risk off asset) plunged more than stocks. If alarm bells aren’t ringing, they should now.
To reinforce the point above, almost $60 trillion has been wiped out in US stocks and the fixed income market.
20-year treasury bond and S&P 500: (Source: Bloomberg)
Drawdown in us equity and fixed income: (Source: Bloomberg) Commodities
Rates & Currency
10Y Treasury Yield 3.8% 3.85% (5D)
DXY 112.17 -0.72% (5D) The United Kingdom is in turmoil
On Sept. 26, the British pound collapsed against the US dollar to 1.03, sinking to an all-time low. This was on the back of the chancellor unveiling a fresh fiscal stimulus that will increase the UK’s estimated deficit by £72 billion, adding fuel to the inflation fire. The poor performance of the sterling was also coupled with a mere 50 bps hike by the BOE. Since then, the sterling has continued its collapse along with gilts and FTSE 100.
As the days continued, rumblings were heard of emergency rate hikes from the BOE to contain sky-high inflation. However, on Sept 28, the BOE carried out the temporary purchases of long-dated UK bonds doing the inverse of controlling inflation. This was a pivot from the BOE; for yields to be contained, quantitative easing had to continue, which would only devalue the pound further. The BOE is trapped, and all other major central banks may likely follow suit.
GBP/USD: (Source: TradingView) Did UK investors hedge sterling collapse with Bitcoin?
With the pound plummeting to its 30-year low, people flocked to hard assets to avoid major losses. On Sept. 26, the BTC/GBP trading volume soared over 1,200% as British pound holders began aggressively purchasing Bitcoin. This stands in sharp contrast to the BTC/USD pair, which has seen a relatively flat trading volume on centralized exchanges throughout the summer.
British chancellor Kwasi Kwarteng’s newly imposed tax cuts and borrowing plans further debased the pound and led to a sharp decrease in U.K. government bonds. To protect their holdings from risks associated with inflation and rising interest rates, most pension funds invest heavily in long-term government bonds. The Bank of England’s emergency measures are an attempt to provide support to thousands of
cash-strapped pension funds that are in danger of failing to meet margin calls. 24-hour Volume BTC/GBP: (Source: TradingView)