The current world is in a period of turmoil, and uncertainty is flooding the entire market, so the rapid changes in the macro environment have highlighted the need for macro analysis at this time. To grasp the trend can better avoid risks and look for future opportunities. In this article, we will start from a macro perspective, starting with the game between the market and the Federal Reserve, to analyze the current high inflation situation the market is facing and the high probability of future crises and recessions.
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Macro Analysis Summary
The current world is in a period of turmoil, uncertainty is flooding the market, and risk factors are popping up everywhere. These include:
1) The monetary policy risk of the Federal Reserve and the European Central Bank.
2) The climate cycle of Europe and the United States has turned, and China’s economic recovery is sluggish.
3) Geopolitical turmoil continues, and the Russian-Ukrainian war continues to affect the macro market.
4) European and Japanese debt crisis worries.
5) The new crown epidemic continues to change the old economic cognition and form a new normal.
Therefore, the rapid changes in the macro environment further highlight the necessity of macro analysis of the market at this time. Only by grasping the trend can we better avoid risks and look for future opportunities. In this article, we will start from a macro perspective, starting with the game between the market and the Federal Reserve, to analyze the current high inflation situation the market is facing and the high probability of future crises and recessions.
1. Misjudgment of market policy
Since entering the tightening cycle, the Federal Reserve is one of the most important factors affecting the current market. It is often the most efficient option for markets to follow the Fed’s guidance and react. But since June 2022, the market and the Fed have entered a period of gaming under the influence of Fed policy uncertainty. During this process, the market has misjudged the Fed’s policy to a certain extent, and this misjudgment has an adverse impact on the future market trend. This article will start from the Fed’s policy goals, describe the market’s game strategy and the possible future policy changes of the Fed, as well as the corresponding market prospects.
The game between the market and the Fed is mainly manifested in changes in market interest rates. In the process of this game, the Federal Reserve, as the leader, controls the changes in the federal benchmark interest rate and has the first mover; the market, as a slave, responds to the policy interest rate and in turn affects the change of the market interest rate. The Fed’s federal funds rate usually leads and guides changes in market interest rates, but in some special cases, the purely following relationship between the two can change significantly.
Figure 1-1 Policy Rate and Market Rate 
From Figure 1-1, we can see that the Fed’s forward guidance is effective in most cases, and in the long run, the yield of US Treasury bonds will move in the direction expected by the Fed. However, due to the information gap between the market and the Fed, short-term games between the market and the Fed sometimes occur, and there are obvious misjudgments about policies during the game.
Figure 1-2 The performance of market policy misjudgments
Specifically, the market has misjudged policies and strategies because the Fed will make different policy orientations in different environments. According to the Federal Reserve Act, the U.S. monetary policy has two main goals: controlling inflation and promoting full employment . These two targets correspond to two important indicators that the Fed cares about, namely, the inflation rate and the unemployment rate. The inflation rate and the unemployment rate reflect the changes in the supply and demand of the commodity market and labor, respectively, indicating the level of the business cycle.
Changes in the inflation rate and unemployment rate are generally divided into the following four situations:
High Inflation, High Unemployment: Corresponds to the middle and end of stagnant inflation. The traditional economic view holds that the main reason for this situation is insufficient aggregate supply or excess aggregate demand. In this case, managing unemployment is more important and more feasible than inflation, because monetary policy will be ineffective at this stage, or will cause more serious unemployment problems. Therefore, fiscal policy should be the main policy to stimulate total social supply, bridge the gap between supply and demand, and at the same time increase employment.
High Inflation, Low Unemployment: Corresponds to the early stage of stagnant inflation, ordinary inflation or the high point of the business cycle. Generally speaking, at this stage, the direction of monetary policy is unclear, because not every high point of the business cycle will cause inflation, and not every inflation will evolve into stagnant inflation. This stage is often the main stage of the game between the market and the Fed.
Low inflation, low unemployment: Corresponding to the initial stage of deflation, the normal range of the business cycle. This stage corresponds to the economic normality faced by stable economies, especially those in developed countries. No special economic policy intervention is generally required at this stage.
Low Inflation , High Unemployment: Corresponds to the middle and end of deflation or the low point of the business cycle. The main problem at this stage is actually the lack of aggregate demand in the society, so both fiscal policy and monetary policy should exert force at this time to reverse the expectation of deflation.
From the above four situations, we can find that the Fed’s policy and its interaction with the market are determined in most cases. Only in an environment of high inflation and low unemployment will the two sides play a game, which is the current market situation.
In an environment of high inflation and low unemployment, “pre-stagflation” is far more likely than “normal inflation” and “cycle highs.” The “high point of the business cycle” and “ordinary inflation” are usually normal phenomena in economic fluctuations and will not have a lasting impact on the economy, so the Federal Reserve generally does not adopt aggressive tightening policies. Even if the tightening is carried out, the Fed will take into account the growth of the economy at any time during the process, and adjust or stop the tightening policy in a timely manner. In this case, then, the market’s best strategy is to hedge when tightening begins and dip when inflation peaks. Because according to the Philippe curve, peaking inflation will lead to an increase in unemployment, and the Fed is likely to ease tightening after seeing an increase in unemployment.
However, stagnant inflation will continue to induce self-fulfilling inflation expectations and form stubborn inflation, which will have a devastating blow to social production. As a result, the Fed tends to resort to aggressive tightening in the hopes of reversing inflation expectations. In this case , the Fed is unlikely to ease tightening until inflation expectations are completely reversed and back on target, and in the process there won’t be an expected point of the Fed’s policy shift. In this case, the market’s best strategy is to wait for inflation to fall back into inflation territory, or for the Fed to signal a clear policy change.
The current difference between the market and the Fed is that the market generally believes that the United States is now facing “the high point of the economic cycle ” or “ordinary inflation “. Previously, although the Federal Reserve insisted that the United States was facing “the high point of the economic cycle” or “ordinary inflation”, its actual practices and measures were more radical. The Fed’s disagreement caused the market to misjudge its strategy from June to August, thinking that the Fed’s rate hike cycle had reached its peak, so the risk market experienced a large rebound.
Figure 1-3 Market misjudgment in June-August 2022
Figure 1-4 Federal Reserve Balance Sheet 
Facing the optimism in the market, the Fed has continuously emphasized its policy objectives, raising interest rates three times at the interest rate decision-making meeting at the end of July, and accelerating the reduction of its balance sheet in August. Finally, after entering September, the market began to wake up to its misjudgment in strategy and began to re-price risks, which also opened the prelude to the second round of market correction. During the second round of correction, the discussion on the nature of this inflation began to re-enter the market’s field of vision. Whether and when inflation will fall this time, analyzing these two issues will help us make a reasonable judgment on the market outlook in the future.
2. Hyperinflation is on
The study of inflation is one of the prominent sciences of economics. There are countless theories and viewpoints trying to demonstrate the causes and effects of inflation. But in general, we still have to adhere to the principle of specific analysis of specific problems, and analyze the special points of this inflation from several logics, as well as our views on possible future crises.
Inflation is essentially a phenomenon of market supply and demand in the form of currency in a specific time and space context.
So there are three key points:
1) It has a specific space-time background. The occurrence of inflation tends to be limited to a country for a period of time, and generalized and permanent inflation does not exist, because inflation-induced crises will destroy production, suppress demand, and ultimately bring the economy into a new normal.
2) Expressed in monetary form. Inflation is a price indicator that is measured in currency, not the actual exchange value in the market. Therefore, the value of the currency itself is also an important consideration for inflation.
3) It is a phenomenon of market supply and demand. This is easier to understand, because the price itself is the result of the game of supply and demand.
Therefore, we will start from these three perspectives to disassemble the causes of this inflation.
First, this inflation starts in the first quarter of 2021. At this time, at the time of the handover of the American regime, there are several special time and space backgrounds in specific policies:
1) One year after the implementation of strict epidemic control, states in the United States began to comprehensively relax epidemic control measures.
2) After the Democratic Party came to power, Biden signed the $1.9 trillion economic rescue plan and the new crown relief bill in March.
Changes in epidemic prevention policies and economic policies ignited the fire of inflation, and then the over-issue of currency added fuel to the fire of inflation.
Figure 2-1 Federal Reserve Balance Sheet 
At the beginning of 2020, the economic downturn in the United States was superimposed on the new crown epidemic, which caused a large-scale dollar liquidity crisis. Therefore, the Federal Reserve took unprecedented measures such as “zero interest rate + unlimited QE” to try to restore market confidence. The balance sheet has doubled from around 41 trillion to a peak of 89 trillion, pouring a huge amount of liquidity into the market.
Figure 2-2 U.S. Treasury bond issuance 
The issuance scale of U.S. Treasury bonds has almost doubled to three times that before the epidemic. The leverage ratio of government departments has soared. The over-issued treasury bonds were finally converted into currency and entered the market through the QE policy.
Figure 2-3 U.S. government debt as a percentage of GDP 
Figure 2-4 US money supply M2 
Figure 2-5 US money supply M1
During the epidemic, the broad money supply M2 in the United States increased by about 44%, and the narrow money supply M1 increased by 311%. The scissors difference between M2 and M1 quickly converged to an unprecedented level, which injected a large dose of booster into the crisis-ridden US economy at that time, and provided assistance for economic recovery. However, at the same time, a large amount of currency over-issuance has seriously damaged the actual purchasing power of currency. In particular, the universal “helicopter money” makes the financial market, which could have been a currency reservoir, unable to carry such a large amount of currency over-issuance and inflation. The fire started to burn more and more intensely.
The most basic logic of supply and demand in the market began to slowly change, so that the energy of inflation was completely released.
We divide supply and demand logic into production side and demand side:
On the production side, two trends, the ebb of globalization and the supply chain crisis, have begun to accelerate:
1) The ebb of globalization is accelerating:
From the World Bank’s ratio of global trade to GDP, we can see that since the outbreak of the global financial crisis in 2008, the proportion of trade has continued to decline, and deglobalization is led by developed countries whose interests have been damaged by most people. Contrary to common sense, the leaders of this wave of globalization ebb are China and the United States.
Figure 2-6 The ratio of world trade to GDP 
Figure 2-7 Trade Dependence of the World’s Major Economies (1970=100)
It can be seen from 2006 that China’s trade dependence has dropped significantly. Although the absolute value of China’s foreign trade is still rising, the relative proportion has peaked. This led to the first wave of globalization ebb after 2008.
Figure 2-8 The trade dependence of the world’s major economies except China (1970=100)
It can be seen that the trade dependence of the United States has also dropped significantly since 2011, but the trade dependence of the EU and Japan is still in a spiraling stage. The decline in U.S. trade dependence confirms the trend of ebbing globalization.
2. Supply chain crisis:
Strictly speaking, the supply chain crisis is inevitable for the ebb of globalization, but the epidemic and the Russian-Ukrainian war have exacerbated this situation.
The Russian-Ukrainian war caused a chain break between upstream raw materials and midstream processing and manufacturing, and the epidemic caused a chain break between midstream processing and manufacturing and downstream commodity retailing. At the same time, the soaring sea freight price caused by poor logistics has further aggravated the situation of the supply chain crisis.
Figure 2-9 Baltic Dry Index 
On the one hand, the supply chain crisis has resulted in the accumulation of inventory in the middle and upper reaches, and the shortage of downstream supply, which has exacerbated the shortage of supply; at the same time, some production capacity that relies on supply chain management has been eliminated in the market competition because of the loss of economy. The loss caused a decline in the total output of society.
There are also two obvious trends on the demand side: 1. Comprehensive inflation is taking shape very quickly.
Figure 2-10 Energy inflation 
Energy inflation kicked off in the first quarter of 2021, quickly climbing above 20%.
Figure 2-10 Service inflation 
Figure 2-11 Rent inflation 
Figure 2-12 Food inflation 
The spike in food inflation in the second quarter of 2021 marks the official start of full-blown inflation.
Figure 2-13 Retail Sales (Historical) 
The retaliatory consumption after the release of epidemic control and the huge amount of cheap funds provided by the New Crown Relief Act have become the main engine for the rapid start of comprehensive inflation.
Figure 2-13 Retail sales (5 years) 
From the data point of view, this comprehensive inflation even skipped the stage of structural inflation and took shape in a short period of time. Starting from the first quarter of 2021, with the Democratic Party coming to power, the loosening of epidemic control measures, coupled with the massive monetary easing, and the recovery of the economy, the above factors have caused energy prices, service prices, rental costs and food prices to continue to rise, fermenting More than a year later, under the catalyst of the Russian-Ukrainian war in the first quarter of 2022, generalized inflation is completely out of control.
2. This inflation is stubborn and self-fulfilling.
The stubbornness is reflected in two characteristics of this inflation:
Widespread coverage: involving commodity trade, service trade, capital market,
Large margins: well above the acceptable 2% range for the inflation target.
Self-fulfillment is simply the self-fulfillment of inflation expectations. When prices are expected to rise in the future, consumers will tend to buy more goods in the current season in an attempt to avoid the impact of inflation in the future. The generation and fermentation of sticky inflation, and the passive increase of wages along with prices will undoubtedly accelerate and solidify consumers’ inflation expectations, thus causing inflation to fall into a vicious circle of self-fulfillment.
Figure 2-14 Sticky Inflation Data 
Sticky prices The Consumer Price Index (CPI) is calculated from the subset of goods and services included in the CPI whose prices change relatively infrequently. Because the prices of these goods and services change relatively infrequently, they are thought to be more indicative of future inflation expectations than prices that change more frequently. One possible explanation for sticky prices might be the costs companies incur when changing prices. A rise in the sticky price index means that inflation itself will become more stubborn.
In addition to the stickiness of inflation, we can also look at the stubbornness and self-fulfillment of inflation from the perspective of wages.
Figure 2-14 Average hourly wages in the U.S. private sector 
It’s hard to see how fast wages are rising from the picture.
But if you look at the data, it takes less and less time for each $2.50 increase in average hourly wages in the United States, which means that wages are rising faster and more rapidly.
Table 2-1 Time spent per $2.50 increase in average hourly wages in the United States
There are two main reasons for the rise in wages since the epidemic:
Supply side: The COVID-19 pandemic has disrupted the U.S. job market, resulting in a mismatch between the supply and demand of human resources. At the same time, due to the impact of the disease itself, a large number of laborers have lost their ability to work or cannot participate in labor, widening the output gap.
Demand side: On the one hand, the rapid release of epidemic prevention and control has made the demand in the service industry recover rapidly, on the other hand, rising inflation has forced business owners to give workers higher wages to attract workers.
Under the double blow, the contradiction between supply and demand in the labor market has rapidly intensified, and it is manifested in the form of a rapid rise in wages.
According to Keynesian theory, wages will become rigid for a short period of time, so once production starts to fall, unemployment will arise. But at the same time, the rigidity of wages also means that the level of wages pushed up by inflation will not decline in a short period of time. According to the definition of the demand curve, an increase in wages will cause the entire labor demand curve to shift to the right. Under the condition that the supply curve remains unchanged, prices will naturally rise, thus forming a constant “inflation-wage-inflation” situation. It is the self-fulfilling nature of this inflation.
The stubbornness and self-fulfilling nature of inflation on labor demand also means that all demand control without the help of external forces may not be able to effectively bridge the supply and demand gap. The market may face a fundamental demand-side clearing to balance the total social supply and total demand.
Looking at today’s inflation from these three perspectives, we can draw the following conclusions:
1) The current inflation occurs around the time when the European and American sentiment caused by the new crown epidemic quickly bottomed out and then quickly pulled back. The main places of occurrence are the European regions that are still at the peak of the boom and the United States, which has seen the peak of the boom.
2) The over-issue of currency in Europe and the United States during the epidemic is one of the most important causes of this inflation.
3) According to general experience, this inflation cannot be limited on the production side, that is, the output gap cannot be narrowed by expanding production capacity. At the same time, at the monetary level, there is no precedent in history that can eliminate the impact of such a large-scale release of water. Therefore, the inflation problem can only be solved from the demand side in the future.
From the above specific time and space, capital and supply and demand, we can clearly find that this inflation has some very unusual characteristics compared with inflation in the past 40 years. As for the warning signs of the impending recession risk and crisis, we will describe in the third part.
3. Crisis warning sounded
Generally speaking, economic crises are mainly manifested in two forms, deflationary economic crises and inflationary economic crises. Before the Second Industrial Revolution, the economic crisis in the time frame was mainly manifested as an inflationary economic crisis. But after World War II, with the progress of productivity and the progress of globalization, the inflationary economic crisis has almost disappeared. It has been 40 years since the last classic inflationary economic crisis, the capitalist world economic crisis of 1979-1982. It can be said that governments and central banks have forgotten the horror of releasing the devil from the cage of inflationary crises.
Given that the speed and intensity of this inflation are far beyond normal, we believe that this inflation will likely evolve into an inflationary recession.
We briefly describe the difference between inflationary and deflationary recessions using a table and four dimensions
Figure 3-1 US inflation rate 
From the figure, we can find that the development of this comprehensive inflation has broken through the range of the past 40 years, and it already has the necessary conditions to develop into an inflationary recession. Beyond the data level, in the larger context, there are similarities between today and the inflationary recession that happened 40 years ago. For example, the second oil crisis corresponds to the Russian-Ukrainian war. Fed’s Paul Volcker’s aggressive rate hike corresponds to Powell’s aggressive rate hike.
Now that the economic and policy trends are becoming clearer, we can already be sure that the next recession will most likely be an inflationary recession. And on the question of when the crisis and recession will come, the U.S. long- and short-term Treasury bond yield spread is an important leading indicator of recession and gives a warning signal.
Figure 3-2 US long- and short-term Treasury bond spreads 
The U.S. long- and short-term interest rate spread is a warning light for a crisis. Since the establishment of this indicator, every inversion of the long- and short-term interest rate spread will correspond to a large-scale recession, and there has been no exception so far.
There are many perspectives to understand why the long-term and short-term interest rate gap in the United States causes recession. Here we only analyze it from three perspectives: policy guidance, interest rate pricing, and the underlying logic of the financial market.
1. The inversion of long-term and short-term interest rate spreads means the failure between policy guidance and market adjustment. Generally speaking, we regard the 2-year treasury bond rate as the policy rate expected by the market, that is, the market’s expectation of the Fed’s future adjustment range of the federal funds rate. The 10-year Treasury bond rate represents the nominal rate the market is facing. When the difference between these two interest rates decreases, it means that the Fed has entered a tightening cycle. Generally speaking, the Federal Reserve will gradually raise the federal funds rate to the upper limit of the interest rate acceptable to the market, but there will also be special circumstances. Almost upside down. That is to say, under normal circumstances, the market has been unable to accept the Fed’s interest rate guidance, so there will be a large-scale market clearing, that is, a recession.
2. The interest rate is the cost of capital. A very important point in interest rate pricing is the risk premium. The higher the risk, the higher the relative required interest rate. This part of the interest rate that increases due to the increased risk is called the risk premium. Generally speaking, the risk will increase with the extension of the payment time, so the long-end interest rate must be higher than the short-end interest rate under normal circumstances. The narrowing of the long-term and short-term interest rate difference means that the short-term risk increases rapidly, and the inversion means that the risk is imminent. The inverted range can directly reflect the time period in which the crisis may occur. At present, among the time-term structure of U.S. Treasury bonds, the 1-year and 2-year Treasury bonds have been inverted, which means that the market believes that a crisis is very likely to occur within one year.
3. The basic logic of the operation of the underlying financial market, especially the banking industry and the insurance industry, is to use the interest rate difference between long and short bonds to make profits while ensuring liquidity, and the reduction of the long and short-term interest rate spreads will make room for profit. Narrowing, once it goes upside down, it means that the arbitrage space not only disappears, but also banks and insurance companies have to subsidize short-term capital costs. At the same time, due to the particularity of government bonds, the rapid rise in the interest rate of government bonds also means that the price of government bonds falls rapidly, which is reflected in the balance sheet. Banks and insurance companies will have to recognize a large amount of asset losses, so they must sell some of their assets to make up for it. capital, thus forming a passive shrinking balance sheet. Therefore, the inversion of long-term and short-term interest rate spreads will shake the cornerstone of the financial market from multiple levels, resulting in the bursting of the asset-side bubble and the liquidation of the debt-side.
When we look back and substitute the difference between inflationary recession and deflationary recession into the long-term and short-term interest rate spread chart, we can clearly see that the two inflationary recessions in 1980 and 1982 occurred at the turning point of the long-term and short-term interest rate spread. At the moment when the Federal Reserve stated that it may adjust its monetary policy, a large-scale economic recession occurred in the negative range. The four subsequent deflationary recessions all occurred after the long-term and short-term interest rate spreads turned for a period of time, that is, after the Fed just entered the easing cycle from the tightening cycle for a period of time, and after the long-term and short-term interest rate gaps turned positive. The reason is that the crisis induced by a deflationary recession comes from the slow clearing of the debt side, which is a natural formation, while the crisis induced by an inflationary recession often comes from the collapse of the asset side, which is deliberately guided by the Federal Reserve. Therefore, deflationary recession-induced crises tend to occur some time after the end of the contractionary cycle, while inflationary recessions tend to occur at the peak of the contractionary cycle.
From this observation of inflation, we can draw the following conclusions:
1. There is a high probability that this inflation will induce an inflationary recession, and the elements of crisis and recession are already available.
2. The timing of the crisis is judged based on the spread between long- and short-term government bond interest rates. In about half a year, the recession will last as long as one to two years.
3. There are two observation indicators to judge the specific time of the crisis: the unemployment rate rises and leaves the economic range; the Federal Reserve releases a policy turning signal, and the long-term and short-term interest rates stop inverting.
The crisis we face today bears broad similarities to the crisis of the 1980s. Stagnant inflation, oil crisis, US-Japan trade war/China-US trade war. Behind the multiple coincidences is the stagnation of the development of human productivity. After more than 30 years of development, the information technology revolution has to re-find the direction of productivity growth. The bad news is that an era is over, winter is coming, and the cold is about to hit each of us; the good news is that the next era of technological revolution may be represented by blockchain technology. The downturn in the economy and the collapse in asset prices did not actually affect the development of technology too much. Most of the greatest Internet companies we are familiar with today have grown steadily after the bubble burst in the early 2000s. For value investors, now is the best time to watch teams grow and get involved in early-stage projects. And for broad price speculators, there should also be optimism about the future: the recovery of the cryptocurrency world is likely to be well ahead of the recovery of the world economy. Since last year, BTC has retreated 70%+, and the leverage level of the cryptocurrency market has completed a preliminary clearing after the LUNA rout. For the foreseeable future, accelerated Fed tightening and the resulting asset price crisis is a sine qua non for the next bigger bull market. There is no doubt that we are standing at a watershed of our times, and opportunities lie ahead for those who are most prepared.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/first-class-warehouse-research-report-macro-analysis-of-economic-policy-and-crypto-market/
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