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Good morning. No one wrote in to tell us that Monday’s selection of wildly speculative short bets were pure insanity, which is evidence that either market sentiment among Unhedged readers is pretty negative, or that no one reads to the bottom of the letter. We don’t know which of those to prefer. If you have a wild bet or two on, email it to us: robert.armstrong@ft.com and ethan.wu@ft.com.
Zero is not the important number right now
When negative-yielding sovereign debt first became a significant slice of the global bond market a decade or so ago, people got worked up about it. There is, admittedly, something very odd about paying someone to borrow your money. Negative-yield buyers were not in it to make borrowers richer, of course. They were either buying it because they had to have risk-free assets, whatever the yield, or because they thought that rates would fall more, leaving them with a capital gain. Negative yielding debt is not insane, and the move into negative territory, while psychologically important, was just another move along a financial continuum.
Now the same thing is happening in reverse. The financial punditocracy is excited about to charts like this one, from Chris Verrone of Strategas, showing a fast decline in the volume of negative-yielding debt around the world. Note the log scale:
But the zero barrier doesn’t tell us much. It is not a magical threshold, beyond which investors will come rushing back to risk-free debt, having been forced into riskier assets by the presence of a minus sign.
What is important is just the plain fact that rates are rising, and why. My excellent colleagues Kate Duguid and Eric Platt made an important point about this on Sunday. What has been driving rates up in the past month or so is not higher expected inflation, but higher real rates. Here is their chart of inflation break-evens — nominal US bond yields minus the yields on inflation-protected bonds, which renders a market estimate of future inflation:
People expect less inflation now than they did a month ago — not surprising, given that the Federal Reserve’s posture (or the consensus interpretation of it) is more hawkish now. What is rising is the rate of interest after inflation:
Real rates are not just rising, but rising fast. Duguid and Platt report one common interpretation of this, linking higher real yields to higher growth expectations. In combination with lower break-evens, they anticipate a Fed that will kill inflation without killing the economy:
Analysts say this increase in so-called real yields indicates traders are expecting the US economy to continue expanding in the years to come even as policymakers withdraw stimulus measures to slow intense price growth.
This is not the only interpretation available, however. Another was offered to me by Unhedged’s friend Edward Al-Hussainy of Columbia Threadneedle. He rejects the notion that real rates are an indicator of growth expectations, citing several examples.
In May 2013, when Ben Bernanke announced that the Fed would start tapering asset purchases at some point in the future, real rates rose 130 basis points almost immediately. Presumably this was not because of a sudden increase in growth expectations. Similarly, growth went gangbusters for all of 2021, but real rates went nowhere until December. Looking over longer periods, we know that real rates have been falling rapidly across developing economies — the US, Europe, Asia — for years, even though growth has not been declining in all of those regions.
What real rates are telling you, Al-Hussainy argues, is how close monetary policy is to the neutral rate of interest, which economists call R*. It is the rate of interest in an economy that is consistent with full employment and stable inflation. This, not zero, is the number that matters. Unfortunately, we don’t know exactly what R* is, and there is not much consensus about what determines it.
What we are pretty sure about is that R* has been declining, and at a pretty good clip. Consider just one very imperfect proxy for it: the Federal Open Market Committee’s estimate of the appropriate long-term policy rate, as expressed in the famous “dot plots”. In 2012, it was over 4 per cent. Now it’s under 2.5 per cent.
What are the mechanics by which a tightening policy stance drives real rates up? The Fed says “we are going to raise rates and stop buying bonds”. All else being equal, such an announcement drives nominal rates up, and inflation expectations down. Higher real rates result, just by arithmetic.
So how do we know that monetary policy has hit or even exceed R*, given that we can’t observe R* directly? When the risk-seeking behaviour that is enabled by holding interest rates below the neutral rate comes screeching to a halt. “We know we’ve hit R*,” Al-Hussainy says, “when risk assets puke all over themselves. It’s the only way. Otherwise we are just feeling around in the dark.”
If you buy Al-Hussainy’s interpretation, you might look at the nausea gripping riskier assets right now, and conclude the R* has come down even lower than the Fed currently believes.
Meme stocks are deflating, but crypto is doing its own thing
Are crypto and meme stocks connected? You might believe, for instance, that both are speculative manias downstream of loose monetary and fiscal policy. The government spent and the central bank printed and so the market rotated into insanity.
Well, now monetary policy is tightening, the fiscal impulse is negative and the savings rate is back to normal. So you might expect all that speculative junk to collapse. If that’s your view, the past few months have delivered some vindication:
The fallout is hitting meme-stock land hard, with true believers holding out hope that GameStop shares will skyrocket once more. They pray for the “mother of all short squeezes”, or MOASS — a deus ex machina by forced hedging. A recent Wall Street Journal story interviewed some of the hangers-on:
The MOASS adherents say GameStop shares will soar to unprecedented highs — thousands or perhaps even millions of dollars per share. The theory goes that legions of small investors will hit the jackpot while losses cripple the financial elite.
[Tesla salesman Ben] Wehrman, who said he has 80% of his investment portfolio in GameStop, plans to quit his job once the squeeze occurs — to travel the world and work on his blog.
We’ll leave the final verdict to the historians. But it looks to us like the pandemic created a meme-asset moment that is now passing. AMC and GameStop execs knew this, and used their inflated valuations to issue shares and refinance debt. We never got a dramatic freefall, but now the air is seeping out. The diehards are probably right: an apocalyptic short squeeze is the only way to restore the glory days.
Something broadly similar is happening in crypto. Retail investors are finding other things to do. Robinhood’s crypto trading revenue has fallen 79 per cent from its quarterly high in mid-2021, including a 5 per cent slump in the most recent quarter. That’s in line with a broad volume drop in crypto, which has been declining since last January and fell further in December:
But unlike the meme stocks, in crypto, retail is only half the story. Crypto firms are swimming in institutional money, mostly provided by VCs. On Monday, Polygon raised $450mn from funders including Sequoia Capital and SoftBank’s Vision Fund 2. Or consider this scoop in the FT last week:
The start-up behind Bored Ape Yacht Club, the non-fungible token collection that counts celebrities such as Gwyneth Paltrow and Snoop Dogg as owners, is discussing a financing with Andreessen Horowitz that would value it at between $4bn and $5bn.
According to people with knowledge of the discussions, NFTs pioneer Yuga Labs is seeking to sell a multimillion-dollar stake in a new funding round . . .
People familiar with the talks said Yuga could even issue crypto tokens to investors and existing Bored Ape holders, which could then prove valuable on the resale market.
Ebbing retail interest and falling prices have not deterred VCs, who smell huge profits if crypto becomes critical financial infrastructure. So with peak speculation behind us, meme stocks are listless while crypto has the funding to push on.
And crypto has recovered from enough slumps to assure some commentators that the revolution is coming. Here’s historian Niall Ferguson writing in Bloomberg over the weekend:
Bitcoin today is seen primarily as “digital gold” . . . As my Hoover Institution colleague Manny Rincon-Cruz argued in a brilliant essay last month, “Bitcoin’s core value proposition, and technological innovation, is digital scarcity via a public, decentralised ledger that tracks a fixed supply of 21 million bitcoins.” It’s that scarcity that investors like, compared with — as the pandemic made clear — the potentially unlimited supply of fiat currencies . . .
Applying financial history to the future, I expect this crypto winter soon to pass. It will be followed by a spring in which bitcoin continues its steady advance toward being not just a volatile option on digital gold, but dependable digital gold itself; and [decentralised finance] defies the sceptics to unleash a financial revolution as transformative as the ecommerce revolution of Web 2.0.
Unhedged is wary of making predictions, but we do like thinking about the range of other people’s guesses. The “crypto revolution” trade is a crowded one, as is the “crypto is going to zero” trade. The middle range is neglected. What if crypto just turns out to be a medium-sized technical innovation that improves the delivery of certain services? Not a thrilling bet, but the cost of carry sure is cheap. (Ethan Wu)
One good read
Half of Unhedged went to college with US Olympic figure skater Karen Chen, who has just won silver in Beijing. On campus, Chen’s name was spoken in awestruck tones. “How the hell is she also a pre-med?” was asked more than once. Jerry Brewer brings that same feeling to the pages of The Washington Post.
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