The last time the Fed lifted its cash rate to 2.5% in 2018, Bitcoin fell 83% to US$3,416

In the AFR I write that according to banks, Aussies shifted $20 billion out of risk-free deposits into cryptocurrencies last year, which have since more than halved in value. This massive wealth destruction is being amplified by large losses in stocks and superannuation as all asset-classes tumble. The housing market is also rolling-over as the Reserve Bank of Australia raises interest rates, with the pace of these losses accelerating in Sydney and Melbourne.

The past week has highlighted a further degradation in the durability of the buy-the-dip reflex that is prevalent amongst retail and institutional investors. Global equities have been pummelled after seemingly robust rallies, which have ended up as dead-cat-bounces. As of Thursday, the S&P500 and NASDAQ indices were 19 per cent and 29 per cent below their late 2021 peaks, respectively. Larger losses loom with our modelling pointing to the spectre of a US recession next year.

For the global equities market to mean-revert back to its pre-pandemic peak, the S&P500 and NASDAQ will have to shave another 14 percentage points off current valuations. Goldman Sachs estimates that the total value of the global crypto ponzi has shrunk 43 per cent (or US$1 trillion) since its 2021 peak. The question is how much lower can crypto go...

The good news is we know what happened the last time the US Federal Reserve normalised its overnight cash rate from 0.25 per cent to a more neutral 2.5 per cent level in 2018. Financial markets are currently pricing-in a very similar path for US rates. The difference this time around is that core inflation and wages growth are much higher than they were in 2018, implying that the Fed could, in theory, lift its cash rate well beyond 2.5 per cent.

A key driver of the crypto ponzi has been the advent of near-zero interest rates on conventional cash deposits. As global central banks floored their policy rates to zero in response to the pandemic, they destroyed the value of deposits as viable investments. This forced punters to look for returns in other higher-risk asset-classes, such as equities, property and crypto, in the famed “search for yield”.

All these assets benefited from a surge in capital gains as desperate investors bid up their prices, forcing yields down. The reversal of this dynamic will inevitably drive substantial payback. This is precisely what we have seen play-out since late last year.

The last time the Fed’s cash rate was near-zero in 2015, Bitcoin was worth US$250. By December 2017, it had soared to over US$19,000 in what was its first mega-bubble. This peak broadly coincided with the Fed ramping-up its hiking cycle that culminated in the current chair, Jay Powell, pushing his cash rate to 2.5 per cent in December 2018.

Notwithstanding some sharp bear market rallies, Bitcoin steadily lost a total of 83 per cent by the time it hit its nadir of US$3,416 in December 2018 at the same time as the Fed completed its final rate hike. This also coincided with the US equity market’s lows in a pattern that is reminiscent of current market dynamics: the NASDAQ Index lost 44 per cent 2018, troughing days after Bitcoin in December of that year.

If Bitcoin follows a similar trajectory to its 2018 experience, it should bottom-out around US$11,000. Yet this time is different. Back in 2018 there was no inflation shock and burgeoning wage-price spiral. The Fed put option was alive and kicking, as evidenced by the Fed halting its hikes after the equity market crashed.

In 2022-23, the Fed has no choice but to keep raising rates until it crushes inflation, even if that means tipping the US economy into recession. And it appears completely undeterred despite the 20-30 per cent drawdown in US stocks thus far.

This suggests that there may be bigger downside risks for crypto investors. If, for example, Bitcoin is to return to its pre-pandemic level, it could trade below US$8,000. In contrast to stocks, bonds, and property, the existential risk for cryptocurrencies is that it is impossible to value assets that have no intrinsic worth. The crypto ponzi relies on the greater-fool-theory: with no income generating capacity and de minimus practical uses aside from money laundering and tax evasion, Bitcoin is only worth more than $0 if you can convince another person that it will one day trade at a higher value. Hence the hyperbolic crypto-to-the-moon memes.

A crypto trader worth US$24 billion on paper, Sam Bankman-Fried (founder of crypto exchange FTX), told the Financial Times last week that Bitcoin has no real value as a medium of exchange or payment mechanism. Instead, he claimed it should be considered a form of "digital gold".

“He likens to gold as “an asset, a commodity, and a store of value”, but says it will never work for day-to-day payments,” the Financial Times reported. “The system used to validate bitcoin transactions isn’t capable of operating at the scale required, and the environmental costs would be unacceptable. Using bitcoin for daily payments would be akin to paying for purchases with gold bars, he says.”

While digital gold sounds amazing, Bitcoin is actually nothing like gold. Whereas gold is a physical commodity that has numerous important practical uses (60 per cent of its use is in jewellery and industry), it is difficult, as Bankman-Fried concedes, to use Bitcoin for anything other than speculation.

If you cannot use Bitcoin like real money to pay for things, its only value proposition is as a store of wealth, inflation hedge, and portfolio diversifier. The problem with these arguments, which crypto spruikers have relentlessly peddled, is that they are untrue.

In the biggest inflation crisis since the 1980s, Bitcoin has more than halved in value. It is not remotely stable or secure, displaying 4-5 times the volatility of equities. And it is not a portfolio diversifier, exhibiting an extremely strong correlation to stocks. Put simply, cryptocurrencies are just a leveraged play on equities.

What is more worrying is that there are subsidiary ponzi schemes embedded within the overall crypto craze as borne out by the recent collapse of the oxymoronically named “stablecoins”.

Stablecoins are similar to cash funds (or money market funds) that purport to always be worth US$1. One difference to a money market fund is they pay no income. To maintain the coin’s valuation at US$1, stablecoins should be backed by cash or riskless assets.

Yet one of the more popular stablecoins, Terra’s UST, was backed by Bitcoin and consequently collapsed in value - “breaking its buck” - as its price plunged from US$1 to just US7c in May. In the process, investors lost US$17 billion in just a few days. The operators of UST allegedly allowed selected insiders, or whales, to transfer US$2.7 billion of their money out at a full US$1 price while UST was actually trading at US60c. This de facto robbed the poor to protect the rich.

The most heavily traded cryptocurrency in the world is another (un)stablecoin, Tether’s USDT, which like UST claims to be worth US$1 for every USDT coin. Until recently, USDT has an extraordinary US$83 billion of money invested in it (investors pulled US$10 billion in the last two weeks). Just as remarkably, crypto punters have almost zero visibility on who really manages Tether, USDT, or the integrity of the assets backing it.

USDT is controlled by a Hong Kong registered company, Tether Limited, which refuses to provide detailed information on USDT's reserves. (Tether Limited also controls a crypto exchange called Bitfinex.) It also refuses to have these assets audited by a major global accounting firm. Instead, it simply produces a short letter from a Cayman Island accounting firm claiming the assets are worth what Tether say they are worth.

According to New Republic, “high-powered lawyers, jaundiced traders, rogue economists, industry whistleblowers, crypto gadflies, and several U.S. law enforcement agencies claim that Tether is part of an elaborate scam that essentially boils down to using the company’s in-house currency to buy Bitcoin, which has the intended side effect of juicing the price of Bitcoin, and to otherwise manipulate cryptocurrency markets”.

In 2021, Tether was fined US$18.5 by million by the New York Attorney General's Office (AGO) over misrepresentations regarding the “cash” assets backing USDT. The New York AGO stated: “Tether represented that each of its stablecoins were backed one-to-one by U.S. dollars in reserve. However, an investigation by the AGO found that iFinex — the operator of Bitfinex — and Tether made false statements about the backing of the “tether” stablecoin, and about the movement of hundreds of millions of dollars between the two companies to cover up the truth about massive losses by Bitfinex”.

“Bitfinex and Tether recklessly and unlawfully covered-up massive financial losses to keep their scheme going and protect their bottom lines,” Attorney General Letitia James said. “Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie.”

Tether does now provide limited information on USDT’s reserves. For example, Tether discloses that USDT is 6.4 per cent backed by "other investments", which could be anything, noting this includes cryptocurrencies (presumably these have recently halved in value). There is 5.3 per cent in "secured loans" but zero detail on the credit rating, liquidity or maturity of these loans, which some allege may involve lending to dodgy businesses.

Then there is 4.6 per cent allocated to "corporate bonds, funds and precious metals", which spans a vast spectrum of potentially high risk exposures. Finally, about one-quarter of USDT is in “commercial paper”, which would make it one of the larger investors globally in this space. But banks claim they have never seen Tether in the commercial paper market.

The history of financial crises teaches us that all entities outside of the regulated banking system tend to fail without the backing of government guarantees. It is likely many crypto concerns will face a similar fate. 

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