The FED Pivot

Oct 10, 2022

Two weeks ago, I wrote in my newsletter about the currency crisis that several countries are facing (UK, Japan, EU). Only two days later the Bank of England (BoE) decided to pivot from quantitative tightening to quantitative easing. De declining Pound, but more important, the fast declining price of UK Treasury bills almost triggered a Lehman-moment, where 90% of UK’s pension funds could have gone bankrupt.

The Financial Times wrote:

“If there was no intervention today, gilt yields could have gone up to 7–8 per cent from 4.5 per cent this morning and in that situation around 90 per cent of UK pension funds would have run out of collateral,” said Kerrin Rosenberg, Cardano Investment chief executive. “They would have been wiped out.”

To prevent this from happening the Bank of England stepped in by turning on the money printer. A one eighty in their pursuit to kill inflation. The big question that remains is whether other central banks — and mainly the FED — will follow their course or not. More on that later.

Inflation

First some info on the inflation war that central banks are (or “were” in some cases) fighting.

Because of the high inflation, central banks around the globe have been tightening their monetary policy. Most of them have raised interest rates and have started to shrink their balance sheets, meaning that they dump treasury bills on the market. This tighter monetary policy should lead to a weaker economy and a weaker economy should slow down demand. Decreased demand on its turn should lead to a decline in prices and thus a decline in inflation.

Therefore it’s extra noteworthy that the Bank of England decided to make a one eighty and pivot from quantitative tightening to easing. To avoid a freefall in the prices of UK treasury bills, they decided to stop dumping treasury bills and start buying them.

It shows how quick the war on inflation becomes a secondary priority when the stability of the financial sector is at risk.

FED pivot

As a result of the BoE pivot, investors try to speculate on whether the FED will follow suit. My personal view is that it’s still too early for that. Powell has repeated many times that the FED has two main objectives:

Inflation back to 2%
A healthy job market

Last week the new job market numbers came out and it appears to be a lot stronger then some expected, with a decline in unemployment from 3,7% to 3,5%. As a result, there’s no reason for the FED to change course in their war on inflation. Yet.

Because the FED will act no different then the Bank of England if the financial stability of the US will be at stake. We have not reached that moment though, but it seems to be getting closer.

According to this Bloomberg article, the liquidity for US treasury bills is running dry as it lacks buyers for US bonds. On top of that, the FED is still dumping $60 billion worth of treasuries on the market every month. This deathly combination could lead to a similar freefall in bond prices as to what happened in the UK.

That could destabilize markets, as many insurers, pension funds and commercial banks hold large amounts of US treasuries on their balance sheets. To avoid that, eventually even the FED would pivot and step in as a “buyer of last resort”.

Negative real yield

If such a FED pivot would happen while inflation is still high, I presume there will be a large chance that real yields turn negative for a prolonged period. That means that the return on treasuries becomes smaller than the expected yearly inflation.

Example:
Interest on 10-year treasury bond = 1,75%
Expected average 10-year inflation = 2,25%
Real yield = 1,75 - 2,25= -0,5% (so negative real yield)

When you have negative real yields, it isn’t opportune to invest in bonds, after all this investment yields a negative return. Investors therefore start looking for alternatives and historically gold has performed well in periods with prolonged negative real yields. This study even concluded that there is a negative correlation of -0,82 (with -1 as the perfect negative correlation) between real yield and the price of gold. So when real yields drop, the gold price should go up.

But more interesting to me is that a similar negative correlation exists between real yields and Bitcoin. This correlation even seems to be stronger, as it reached -0,95 in July 2022. So just like gold, Bitcoin should go up if real yields turn negative.

I’m not expecting the FED to pivot tomorrow. But we do seem to be getting closer. And when the US financial sector really starts to crack, I expect the FED to shift their attention away from inflation real quick. And if that happens… I want to own Bitcoin.

Thanks for reading!