Since the end of last year, markets have been waiting for the Fed to shift its policy focus from curbing inflation to maintaining economic growth. On July 27, the Federal Reserve issued a statement saying that if economic growth falls short of expectations, they will shift their policy focus to supporting economic growth. This article argues for the need to resume monetary expansion by showing the rapidly deteriorating U.S. economy.
If you think my thesis is correct, the next step is to think about which assets are likely to perform best when the money supply expands again. The period of transition from monetary tightening to monetary easing is an excellent opportunity to significantly increase financial assets, and it would be irresponsible to waste such an opportunity, so we must be careful to choose the right assets.
Should I invest in stocks, bonds, real estate, commodities, gold, or crypto assets? Obviously, you all know that I advocate the use of encrypted assets as the protagonist of this game, so if we consider liquidity, which Token should we prefer? There is a premise here that during periods of monetary policy transition, we should prefer centralization over decentralization. And as a concentrated bet, ETH will bring the best returns in the second half of the year.
There are two potential events that could happen over the next 8 months or so, and whether it goes well is critical to my conclusion.
- Will the Fed change its policy focus and restart the money printing press for the economy?
- Will the ETH merger be a success?
Investing is a time-period job, so I had to set a time limit for the completion (or non-completion) of these events. This time limit is March 31, 2023.
Two events each have two outcomes, meaning there are four scenarios in the future.
Scenario 1: The Fed’s focus shift + ETH merger is successful (this is my favorite scenario).
Scenario 2: The Fed’s focus does not change + ETH merges successfully
Scenario 3: The Fed’s focus does not change + ETH merger is unsuccessful
Scenario 4: The Fed’s focus shift + ETH merger is unsuccessful
For each scenario, I provide a price target and assign a 25% probability. Then I’ll average all the results to come up with the expected value of the ETH/USD price on March 31, 2022. If this expected return is positive, then I will safely increase my long ETH position. If it is negative, I will not add ETH for the time being.
This analytical structure is demonstrated below.
Is the Fed’s policy changing?
Over the past few decades, banks have started financing more residential real estate as financial services have matured. Banks want to lend their excess reserve balances provided by the Fed to low-risk asset classes. The safest loans a bank can offer are for hard assets, and houses are at the top of this list. If you default on your mortgage, the bank can repossess your house and (hopefully) sell it for more than the remaining loan value. Over time, banks began pouring more and more free capital into home loans.
The breadth of housing finance and the willingness of banks to accept additional risk has made it possible for more and more people to take out a mortgage to buy a home. At some point, the price of a home becomes irrelevant. The only thing that matters is whether borrowers can use their disposable income to pay their monthly mortgage payments. As a result, the housing market has become completely dependent on financing costs, which are largely determined by central banks by setting short-term risk-free rates (more on how this works later).
U.S. National House Price Index (white) vs. U.S. CPI (yellow)
The chart above is from 1985 and has an index of 100 for each data series. As you can see, over the past four decades, housing prices have risen 75% faster than inflation as measured by the government. If everyone just bought a home with cash, house prices would be a lot lower. But if you can afford a monthly mortgage, you can afford to buy a more expensive home, and the willingness of banks to extend credit to home buyers drives prices up.
70% of US GDP is consumption. Beginning in the 1970s, the United States transitioned from a manufacturing powerhouse to a financialized service economy. Essentially, anything that can be used as collateral for a loan is eligible for financing. Most Americans live on paychecks, which means their entire lifestyle depends on monthly loans.
“PYMNTS research found that in April 2022, 61% of U.S. consumers were living on a wage, an increase of 9 percentage points from 52% in April 2021.”
The rate of return that banks earn when they release funds is called the Interest on Excess Reserves (IOER), and the IOER rate is between the lower and upper limits of the Federal Reserve’s funds rate (which the Fed sets at its meetings). This is one of the tools the Fed uses to translate its policy rate into the real rate observed in the market.
If a bank takes your deposit and pays you 0%, it can turn around and instantly earn 2.40% risk-free by lending to the Fed. Given that the market is competitive, if Bank A offers consumers a 0% deposit rate to earn a 2.40% spread, Bank B can offer a 1% deposit rate to steal business from Bank A and still earn 1.40% spread. So banks will compete by offering higher and higher deposit rates until they closely match the IOER offered by the Fed.
If a bank has to pay a deposit rate close to the IOER, then when making a loan, it has to charge a rate higher than the IOER. The higher the Fed’s risk-free rate, the higher your mortgage rate.
U.S. 30-year fixed mortgage rate (white), federal funds cap (yellow)
The chart above clearly shows that the higher the rate the Fed sets, the more Americans will pay to finance their homes. This is extremely important to the health of U.S. consumers, as monthly mortgage payments account for a large percentage of median household disposable income.
Mortgage rates, which were around 3% at the start of the year, are now slightly above 5%. As a result of this change, the median U.S. household balance sheet has deteriorated by more than 10%. The bigger problem is that loan amounts continue to grow faster than inflation. Looking back at the above graph of house prices versus inflation, imagine what it would look like if the median home price were reduced to match the 75% inflation rate since 1985? A household balance sheet would look like this.
In this case, households would have a larger percentage of their income set aside for other necessities. The more financially strained the median household is due to the cost of financing a mortgage, the more likely they are to turn to other consumer financial tools to pay for other necessities of life, such as credit cards.
U.S. household debt as a percentage of GDP
U.S. consumer credit outstanding
These charts above clearly show that households have increasingly resorted to using credit to finance their survival.
The Gross Merchandise (GMV) numbers in the chart above are basically the loan balances of customers of top BNPL (New Form of Credit) fintech companies. As you can see, almost $70 billion of GMV in 2020 was funded this way. Old people use credit cards, while young people use BNPL, in different forms and the same essence.
The U.S. is a car nation, and for Americans earning an average wage, owning a car is a must to get from home to work. The family car is another asset that must be financed due to its high price. According to the Kelly Blue Book, the current average car price is $48,043, an all-time high. If you make $50,000 a year and the average car price is $48,000, then you have to fund that mother car!
U.S. commercial bank auto loan
The above dataset from the Federal Reserve dates back to 2015. Over the past seven years, outstanding auto loans have jumped 44%.
Homes and cars are two examples of life-critical assets that American households must finance. Determining the interest rate Americans must pay each month for these necessities is directly affected by the federal funds rate. So when the Fed makes the currency more expensive by raising interest rates, it directly makes the vast majority of American households poorer.
The Fed’s impact on household balance sheets is directly related to the amount of loans these households hold. If the price of an average home or car suddenly drops by 50%, raising interest rates by a few percentage points from the Fed won’t have much impact on households, because while they will pay more for their home or car, they will pay more each month. The net payout may be lower. However, we are at the end of more than 50 years of intense financialization of the US economy, which has driven an exponential rise in the price of any asset that can be borrowed.
If you can’t pay your monthly payment, you can’t buy a house, car, or other durable items. If the buyer can only pay less, the seller must sell for less. Then at the margin, the entire stock of houses, cars, and other financing assets becomes even less valuable. Given that these assets are financed by debt, this becomes a problem for banks that lend on this type of collateral, because when their lenders fail to pay their loans, they will forfeit assets of lower value.
As asset prices have fallen, banks have become more conservative about who and what to lend to. At this point, the price of the asset must drop to a level where the buyer can afford the monthly payment with higher financing costs. While cautious, this actually reduces banks’ entire stock of loans to U.S. households. It’s a cyclical, reflexive process that leads to the dreaded deflation of debt-backed assets.
As I have said many times, the goal of central banks is to ensure that assets are not deflated because commercial banking systems cannot survive asset deflation. So the Fed, or any other central bank, if it thinks deflation is imminent, must act now, a lesson taught to anyone and everyone in an economics course. Most academics at the Fed (or any other central bank) who have written about and studied the Great Depression believe that the Fed’s mistake was not printing money, not supporting asset prices, not defending against the various advanced economies of the 1930s body deflation.
The takeaway from this entire section is that the health of the American consumer is directly related to the federal funds rate. If interest rates continue to rise, the economy will suffer. If interest rates fall, the economy will boom.
pick one of two
The phrase was famous in China, when e-commerce giant Alibaba was accused of forcing merchants to choose a platform between Alibaba or its competitors to sell their goods on, and not allow coexistence with other platforms.
The Fed is facing a similar “choose one” dilemma. They can choose to fight inflation, or support America’s financialized economy, they can’t do both. Fighting inflation requires raising the price of money and reducing the quantity of money, but a “healthy” American economy requires the exact opposite.
In March 2022, as inflation began to surge, the Fed decided to take on higher interest rates, raising the federal funds rate by a quarter for the first time since 2018. However, the chart below shows that the US economy is in recession.
U.S. real GDP growth percentage
Remember, it’s a coincidence that the first rate hike by the Fed happened in March of this year, and the first negative GDP growth also happened in the first quarter of this year.
Americans are more pessimistic about the economy today than at the peak of COVID, and millions of people in the U.S. have died from COVID, but people are more desperate today.
Consumer Sentiment at the University of Michigan
Even so, however, inflation shows no sign of abating. By this standard, the Fed is a failure.
At home, the Fed is crashing the economy (it’s in recession), but inflation is still grabbing more and more purchasing power from the common people who are heading to the ballot box in a few months. How to do? What variable should the Fed optimize?
If the Fed wants to keep lowering inflation, then it must keep raising its policy rate. You could argue that the Fed needs to get more aggressive as its policy rate is capped at 2.5%, still 6.6% below the latest inflation reading of 9.1%.
If the Fed wants to grow the economy, it has to buy bonds again, which would reduce monthly payments for homes, cars and other durable goods by 90% of American households.
Market expectations for policy
A sharp rate hike is sure to come at the September meeting. The market is currently pricing in a 50bps rate hike in September. What is at work now is the follow-up suspension of the November meeting. That’s what the market cares about. With short-term interest rates at 3% by the end of September, these monthly payments will be very unaffordable for the American public.
The Fed raised rates by 0.75% at its June and July meetings, while expectations for a rate hike at the Fed’s September meeting were little changed. The September 30, 2022 fed funds futures contract was at 97.53 and 97.495 on June 17 and July 27, respectively.
The expected interest rate is 100 minus the futures price, and if the curve moves up, it means that the market expects the interest rate to fall, and vice versa. The market clearly expects the Fed to raise interest rates in the next six months.
However, after the Fed meeting, my macro risk asset measures all bounced back and held gains through Friday’s close. Risk markets continued their post-Fed gains, but forward-looking money market derivatives showed no change. who is right? I believe the story of negative growth will trump persistently high inflation as economic data continues to deteriorate and higher credit prices further constrain financial activity. Powell said the Fed has reached neutral and now they need to watch the impact on the broader economy.
Market expectations for a change in policy rates at the September meeting have taken hold. However, between now and then, the Fed will have two additional CPI data points (July CPI, released Aug. 10, August CPI, Sept. 13). I’m not a data sleuth, but the pace of price gains is likely to slow, which would give Powell the reason he needs to backtrack to easing monetary conditions.
Given the data, we are almost certain the Fed will raise rates by 0.5% to 0.75% at its September meeting. That makes the December meeting the defining meeting for the rest of 2022. I predict that between now and the December meeting, the steadily climbing federal funds rate will do absolute harm to the average American.
With the election over, the Fed will be back in business — reducing what Americans pay each month by easing monetary policy. While the top 10% benefit disproportionately from the rise in financial asset prices, given that every aspect of American life is financed and the common people need low interest rates to afford their way of life, everyone is hooked on what the Fed has to offer. cheap funds.
We should prepare now that forward expectations for Fed policy point to easing. Therefore, the risk asset market is likely to have bottomed out and will now trade.
Will the ETH merger succeed?
Will the ETH network be updated to Proof of Stake (PoS) as planned? This is the question you have to ask yourself. Before I give a reason why the ETH merger is extremely bullish on the price of ETH, let me explain why I am more confident today than ever that the merger will actually happen.
In 2018, I wrote an article titled “ETH, a double-digit junk coin” where I predicted that the price of ETH would fall below $100. I was wrong!
I started believing in 2020 when I saw a graph somewhere that depicted how the ETH market cap is lower than the total market cap of all the dApps it supports. I am a firm believer that DeFi offers a solid alternative to the current financial system – and right now, ETH is poised to power the world’s financial computer.
Since 2015, Vitalik has been talking about the need to eventually move to a PoS consensus mechanism. I don’t have the technical skills to assess whether ETH core developers can succeed, but having a group of ETH network stakeholders definitely hinders the likelihood of success. This is the current ETH miner.
Miners who spend billions of dollars on GPU graphics cards and related capital expenditures can only earn income under a proof-of-work (PoW) system. Kraken wrote a great blog post explaining the difference between PoW and PoS systems. When the merger happens and ETH transitions from PoW to PoS, miners’ income will drop to zero and their equipment and facilities will become almost worthless unless they can find another valuable chain that provides the same marginal income as mining . I highly doubt this possibility since ETH is the second largest cryptocurrency by market cap and there is no other PoW blockchain with a market cap of hundreds of billions of dollars that can be mined using GPUs. Therefore, when miners start to voice their opinions on the negative impact of mergers, it is fair to speculate that mergers are an actual possibility.
Bao Erye is aligned with the Chinese ETH mining community. I’ve known him for years and I don’t doubt his determination to do so.
After reading this tweet, I reached out to some of my other contacts in the Chinese mining community. I asked them if there was a real incentive behind a potential airdrop or hard fork to form a PoW-based ETH chain. One person said “absolutely” and added me to a WeChat group where serious people were discussing the best way to achieve this reality. Another friend said it was an absolute failure, and Bao Er Ye had already extended a helping hand to him.
Also, after the merger, ETH miners’ machines will become worthless overnight unless they can mine on another chain of value. I seriously doubt the ETH PoW chain will have long-term viability, but for now let’s assume it will exist with a significantly non-zero market cap in a few months. More importantly, if miners don’t believe the merger will go ahead as planned, they won’t make the journey and spend valuable political capital within the community.
So if the merger is likely to happen sometime in Q3 of this year, or Q4 at the latest, then the question is – has the market already priced in the merger ahead of time?
Amber Group published a great article discussing all things merging. Here are the relevant points:
- The market expects the merger to take place on or around September 19, 2022.
- The ETH issuance per block will be reduced by 90% after the merger, making ETH a deflationary currency.
- ETH staked on the beacon chain will be locked for an additional 6 to 12 months.
Amber believes the merger will be similar to a “triple halving”:
On the supply side, ETH is currently incentivizing miners (under PoW) and validators (under PoS). Seigniorage is paid to miners for generating new blocks at 2ETH per block, and rewards are also distributed to validators on the beacon chain. After the merger, the rewards for miners will stop, reducing the issuance rate of ETH by about 90%. This is why the merger is also colloquially known as the “triple halving” – a nod to Bitcoin’s halving cycle.
Demand for ETH is also expected to increase after the merger due to a number of factors. First, staking rewards for validators will increase immediately. Validators will receive transaction alerts that PoW miners currently get, potentially increasing APR by about 2-4%. Also, since they are able to reorder transactions, they will also start earning MEV (Maximum Extractable Value). According to researchers at Flashbots, an R&D group that studies MEV’s emergent behavior, validator yields could increase by an additional 60% due to MEV (assuming 8 million staked ETH). So, if a merger happens today, validators are expected to get around 8-12% APR due to all the factors above.
Most, if not all, of the information has not changed in many months, what has changed is the credit-driven plunge in cryptocurrency prices. The market dislocation caused by Luna/TerraUSD and Three Arrows has caused many to be forced to sell, and many hedge funds that have entered DeFi aggressively have been hit.
Given all the forced sell-offs that occurred during the market downturn and the poor financial health of most crypto investors, the consolidation doesn’t seem to be priced in – we have an excellent opportunity to increase ETH positions at very attractive levels.
So now that the dust has settled, the remaining faithful among us — whether holding ETH or fiat — must determine how much we think the merger will affect price based on expected market conditions and/or other contributions .
Let me share a simple example of why I think the merger will have an incredibly powerful effect on the price of ETH.
Many of you trade stocks and understand at a fundamental level that stocks are a claim on a company’s future profits. However, a company does not pay you dividends in additional shares – it pays you in fiat currency. Also, to use a given company’s services, you don’t need to pay with the company’s own stock, but with fiat currency.
In the case of ETH, the income the stakers get – paid in ETH, and you have to pay in ETH to use the service. Stakers also have to stake their ETH to earn income, which requires them to lock up their funds and effectively remove them from the market. The more ETH staked by stakers, the more income they earn. Therefore, it is safe to assume that most stakers will take the ETH they earn and lock it up. Add to that the impact of users needing to pay ETH fees to use ETH (which has been removed from circulation), and the fact that ETH will be issued about 90% slower per year under the new PoS model, and we’ll quickly look at the reduction of ETH supply. The more the network is used, the more of the network’s own currency must be used to use it – so as the network becomes more popular (assuming it provides a useful service), the ETH out of circulation will only increase. Of course, it’s important to note that the per-transaction fees paid by users are expected to drop under the new PoS model, but even then, when you combine all of these factors, they should still drive the price of ETH exponentially rise.
A good usage metric is Total Value Locked (TVL) in DeFi applications (i.e. the amount of money users deposit or “stake” on DeFi platforms from which they earn revenue). I believe DeFi will provide a reliable alternative to the financial cards we currently pay trillions of dollars in economic rent each year. As you can see, TVL skyrocketed after 2020, with applications using this locked collateral to pay the network ETH. The bigger the DeFi scale, the more deflationary ETH. This becomes an extreme problem, but we are not close to that.
Before continuing, let’s review my assumptions again.
- I believe the merger will happen by the end of the year due to the increased noise from ETH miners who may lose a significant portion of their revenue in the PoS world.
- The recent market plunge has shattered the soul of the bulls who have been thriving on ETH and DeFi this cycle, turning them into a bunch of indiscriminate sellers.
- There will be no post-merger “buy rumors, sell news” phenomenon. Anyone who might have sold has probably already sold, as prices have fallen sharply over the past month.
- The merger means ETH becomes a deflationary currency, and usage is expected to continue to grow as DeFi gains popularity – which increases the rate of deflation.
- Although there are other L1 smart contract network competitors, many of them already have some version of the PoS consensus algorithm. ETH is the only major cryptocurrency currently transitioning from PoW to PoS.
Expected value calculation
This is the most important part of this article, because even if my arguments are sound and you believe them, there is a good chance that I will be wrong. With that in mind, let’s take a quick look at price predictions for all potential outcome combinations.
Unless otherwise stated, the prices I quote in this section are from Bloomberg.
Scenario 1: Fed focus shift + ETH merger successful (i.e. what I speculate will happen, and best case for ETH)
In November 2021, the Fed started printing money, altcoins surged, and attention began to turn to the bullish narrative surrounding the impending ETH merger in 2022. Therefore, I will use $5,000 as my price target in this case. I believe this is a conservative estimate as structural changes in supply and demand dynamics are never fully priced in a priori – like how Bitcoin halvings continue to generate positive returns, even if we know well ahead of time when they will happen .
Scenario 2: The Fed’s focus does not change + ETH merges successfully
From the dark beginnings of Three Arrows, where many prominent crypto lenders and hedge funds were forced into liquidation, ETH has rallied from lows around $1,081 to $1,380 — a return of nearly 30% in a matter of weeks. From the Fed meeting on July 27 to the close on Friday, July 29, ETH rose 25% in absolute terms, compared to Bitcoin’s 9% gain.
If the Fed doesn’t turn the money printing press back on, the base case is to go back to where it was before the market started considering the Fed’s turn. To be conservative, let’s assume ETH prices return to the market low on June 17 ($1,081), but also retain any experience from the low on June 17 to July 26 (the day before the Fed pivot was proposed) Price movements, which we can strictly attribute to expectations for a successful merger. In order to isolate ETH price movement in this time frame driven solely by merger expectations, let us assume that any near-term performance of ETH vs. BTC is driven entirely by expectations of the impact of the merger. This will allow me to separate the speculative impact on the timing and outcome of the merger from the impact of dollar liquidity on the broader market.
From June 17th to July 26th, the value of ETH increased by 25.46% relative to BTC – so if the Fed pivot is removed, we can assume the price will drop to $1,081 (June 17th low) * 1.2546, which results in $1,356.
Now, we need to add the expected price impact of a successful merger. As I mentioned earlier, the merger is expected to drive a “triple halving” event due to the structural impact it will have on the ETH network. To predict how this might affect the price of ETH, we can look at how Bitcoin performs between halving dates. The table below shows the price appreciation that occurs between each Bitcoin halving date.
Bitcoin is a decentralized currency. ETH is decentralized computing power. If Bitcoin keeps rising after the halving, it is reasonable to assume that ETH will rise as well. So if we apply the minimal 163% post-halving price increase to $1,356, we arrive at an expected value of $3,562.
Please note: The combined 163% price performance is very conservative, as the total supply of Bitcoin continues to increase with each block after each halving, while the supply of ETH in the combined supply, given current usage trends, should be reduced.
Scenario 3: The Fed’s focus does not change + ETH merger is unsuccessful
Let’s go back to the dark ages and that would be the recent low of $1,081 – here’s my price prediction for this scenario.
Scenario 4: The Fed’s focus shift + ETH merger is unsuccessful
If the merger fails or is delayed, the ETH network will still work as it does today. Many people may be very disappointed, but the value of ETH will not drop to zero. Solana, the ninth-largest altcoin — with a market cap of $13.5 billion — has stopped working for hours multiple times over the past 12 months, but its value remains well above zero. Even if the merger doesn’t go as planned, ETH will still be fine.
To calculate the impact of this situation on the price of ETH, let’s use the price performance of BTC/USD between June 17th and July 26th as a liquidity beta to determine what the price of ETH will be before a possible Fed pivot occurs. And there is no consolidation-related upside driving the price higher — while still including any price movement that we believe is strictly driven by recent dollar liquidity conditions.
From June 17th to July 26th, BTC rose 1.72% against the US dollar. Therefore, we can estimate that in the absence of the excitement associated with the merger, the price of ETH would also have risen by 1.72% over that time period – as we again assume that the merger is the only thing driving ETH over BTC. So a failed or delayed merger would bring us back to $1,081 (ETH low on July 17) * Liquidity Beta (1.0172), which is $1,099. But in this case, we can also experience the ecstasy of printing more money. DeFi will continue to make progress on TradFi. If the past is any indicator, ETH will suck fiat into its orbit as the Fed expands the money supply again. ETH has rallied nearly 10x from its March 2020 lows, when the Federal Reserve expanded dollar global liquidity by 25% in a year. To be conservative, I predict ETH will only recover to its current level of $1,600.
I assigned an even probability to the four outcomes. (Obviously, you can use this base model at your own discretion, but it’s an easy starting point). I then calculated the returns from the current level to the expected price in each case, weighted these expected returns by probability, and averaged them together – to get the expected value.
With an expected future value that is 76% higher than today, our March 31 ETH/USD forward price is $1,600 (current spot price) * 1.7595, or $2,815.
I believe I am very cautious with the results for Scenario 3, so this is a very conservative estimate. Given that the expected return is well above 0%, I can confidently add to ETH.
Let’s evaluate our options for participating in this opportunity.
This is the most straightforward option. ETH is currently trading at 76% cheaper than my model and I am willing to buy ETH now. And I get extra rewards because I’ll get the same amount of ETH from the PoW ETH fork. Once ETH_PoW is listed on the centralized spot exchange, I can sell these forked ETH_PoW.
Today (August 4), Deribit’s March 31, 2023 ETH/USD futures contract is trading at $1,587. My model futures price is $2,815, so the futures market appears to be 44% undervalued. Therefore, I will do more.
Given that our model indicates a fair value of $2,815 for the March 31 futures contract, I should buy a call option with a strike price of $2,800.
On Aug. 4, Deribit’s March 31 strike price of $2,800 ETH/USD call option was priced at 0.141 ETH. Each contract is worth 1 ETH. Using their option pricing model, the important parameters are as follows:
Delta: 0.37. Implied volatility: 98.3%.
I wanted to take more risk on the timing and potential upside of the merger, so I bought the December 2022 options contract with a $3,000 strike. Shorter expirations mean less time value for me to pay, which is expensive given the high level of implied volatility. My strike price is far from the current market price, which lowers the price of the option, but on the other hand, I will pay more for volatility due to the term structure showing a smile.
As I develop a trading strategy to deal with the merger, I will most likely buy more spot ETH and participate in other funding deals to maximize the chance of market mispricing. Such opportunities are numerous, as during the 2017 Bitcoin fork.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/arthur-hayes-blog-post-my-highest-bid-for-ethereum/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.