1937 and the Bullish Case for Bitcoin

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Cycles come in two forms: the short-term debt cycle and the long-term debt cycle. Based on Ray Dalio’s analysis, we are currently at the late stages of both the short-term and long-term debt cycles. This article explains these cycles and why it might be a bullish case for Bitcoin (and other cryptocurrencies).

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The Short-Term Debt Cycle

The short-term debt cycle lasts about 5-10 years, depending on how long it takes the economy to go from having a lot of slack to not having much, which depends on how much slack it starts off with and how fast demand grows.  In the cycle that we are now in, the expansion has been long because it started from a very depressed level (because the 2008 downturn was so deep) and because growth in demand has been relatively slow (because of the debt crisis hangover, because of the growing wealth gap and spending of those with a lot of wealth having a lower propensity to spend than those with little wealth, and because of other structural reasons).  When slack is reduced and credit-financed spending growth is faster than capacity growth early in the cycle, that leads to price increases until the rate of growth in spending is curtailed by central banks tightening credit, which happens late in the “late-cycle” phase of the short-term debt cycle (where we are now).  At that time, demand is strong, capacity is limited, and profit growth is strong.  Also at that time, the strong demand for credit, rising prices/inflation, and eventually central banks’ tightenings of monetary policy to put the brakes on growth and inflation, causes stock and other asset prices to fall. They fall because all investment assets are priced as the present value of their future cash flows and interest rates are the discount rate used to calculate present values, so higher interest rates lower these assets’ present values.  Also, tighter monetary policy slows prospective earnings growth, which makes most investment assets worth less.  For these reasons, it is common to see strong economies being accompanied by falling stock and other asset prices, which is curious to people who wonder why stocks go down when the economic and profit growth is strong (because they don’t understand how this dynamic works).  That is where we now are in this short-term debt cycle.

More particularly, during the expansion phase of the cycle that we are in, central banks created exceptionally low interest rates, which made it attractive for companies to borrow money to buy their own and other companies’ stocks, which boosted stock prices and has left corporate balance sheets much more indebted.  Additionally, the US corporate tax cuts boosted equity prices even more and increased the budget deficit, which will require the Treasury to borrow much more.  In addition to creating exceptionally low interest rates, central banks printed a lot of money and bought a lot of debt, which supported the markets.  These one-time boosts to the markets and economies—at first via the low interest rates and the central bank purchasing of debt and more recently in the form of corporate tax cuts (in the US economy)—coming in the late stage of this short-term debt cycle when the capacity to produce was constrained—led the Fed to raise interest rates.  Also contributing to the rate rise has been a) the Fed selling off some of the debt that it acquired through QE and b) big corporate borrowings.  As a result, we are now seeing this classic late-cycle strong profit growth and strong economic growth that is accompanied by falling stock prices due to the financial squeeze.  That’s when the cracks in the system begin to appear and what most people never expected to happen starts happening.

Typically at this phase of the short-term debt cycle (which is where we are now), the prices of the hottest stocks and other equity-like assets that do well when growth is strong (e.g., private equity and real estate) decline and corporate credit spreads and credit risks start to rise.  Typically, that happens in the areas that have had the biggest debt growth, especially if that happens in the largely unregulated shadow banking system (i.e., the non-bank lending system).  In the last cycle, it was in the mortgage debt market.  In this cycle, it has been in corporate and government debt markets.  

When the cracks start to appear, both those problems that one can anticipate and those that one can’t start to appear, so it is especially important to identify them quickly and stay one step ahead of them.

Of course psychology—most importantly fear and greed—plays an important role in driving the markets.  Most people greedily switch from buying when things are going up to fearfully selling when they are going down.  In the late-cycle stage of the short-term debt cycle, once the previously described tightening top is made, the cracks appear.  The market movements are like a punch in the face to investors, who never imagined the punch coming, and it changes psychology, which leads to a pulling back and higher risk premiums (i.e., cheaper prices).  Typically, the contraction in credit leads to a contraction in demand that is self-reinforcing until the pricing of asset classes and central banks’ policies change to reverse it.  That normally happens when demand growth falls to less than capacity growth and there is greater slack in the economy.  After central banks ease by several percent (typically about 5%), that changes the expected returns of stocks and bonds to make stocks cheap and it provides stimulation to the economy, which causes stock and other asset prices to rise.  For these reasons, it is classically best to buy stocks when the economy is very weak, there is a lot of excess capacity, and interest rates are falling, and to sell stocks when the reverse is the case.  Because these cycles happen relatively frequently (every 5-10 years or so), those people who have been around awhile have typically experienced a few of them, so this short-term debt cycle is reasonably well recognized.

The Long-Term Debt Cycle

The long-term debt cycle comes around approximately once every 50-75 years and happens because several short-term cycles add up to steadily higher debt and debt-service burdens, which the central banks try to more than neutralize by lowering interest rates and, when they can’t do that anymore, they try to do so by printing money and buying debt.  Because most everyone wants to get markets and economies to go up and because the best way to do that is to lower interest rates and make credit readily available, there is a bias among policy makers to do what is stimulative until they can’t do that anymore.  When the risk-free interest rate that they control hits 0% in a big debt crisis, central banks lowering interest rates doesn’t work.  That drives them to print money and buy financial assets.  That happened in 1929-33 and 2008-09.  That causes financial asset prices and economic activity to pick up as they did in 1933-37 and 2009-now.  In both the 1930s case and our most recent case, that led to a short-term debt cycle rebound, which eventually led to a tightening (in 1937 and over the last couple of years) for the reasons I previously described in explaining the short-term debt cycle.  This time around, the tightening is coming via both interest rate increases and the Federal Reserve reducing its holdings of the debt it had acquired.

For all of the previously described reasons, the period that we are now in looks a lot like 1937.

Tightenings never work perfectly, so downturns follow.  They are more difficult to reverse in the late stage of the long-term debt cycle because the abilities of central banks to lower interest rates and buy and push up financial assets are then limited.  When they can’t do that anymore, there is the end of the long-term debt cycle.  The proximity to the end can be measured by a) the proximity of interest rates to zero and b) the amount of remaining capacity of central banks to print money and buy assets and the capacity of these assets to rise in price.  

The limitation in the ability to print money and make purchases typically comes about when a) asset prices rise to levels that lower the expected returns of these assets relative to the expected return of cash, b) central banks have bought such a large percentage of what there was to sell that buying more is difficult, or c) political obstacles stand in the way of buying more. Right now, the world’s major central banks have the least fuel in their tanks since the late 1930s so are now in the later stages of the long-term debt cycle.  Because the key turning points in the long-term debt cycle come along so infrequently (once in a lifetime), they are typically not well understood and take people by surprise.  

So, it appears to me that we are in the late stages of both the short-term and long-term debt cycles.  We are in the late-cycle phase of the short-term debt cycle when profit and earnings growth are still strong and the tightening of credit is causing asset prices to decline, and we are in the late-cycle phase of the long-term debt cycle when asset prices and economies are sensitive to tightenings and when central banks don’t have much power to ease credit.

The bullish case for Bitcoin?

For large investors looking to store recent gains earned in their investment portfolios, Peter Thiel’s comment might come to mind

“I do think people are a little bit … underestimating bitcoin especially because ... it’s like a reserve form of money, it’s like gold, and it’s just a store of value. You don’t need to use it to make payments … and it’s a sort of hedge of sorts against the whole world going falling apart.”

In contrast with the US stock market, cryptocurrencies are down over 70% from their price last year. Now overlay that with Bullish Sentiment for Bitcoin being at a 5-Month High. Now might just be a good opportunity to buy low and HODL…

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Brendan Daly