By Arthur Hayes
Compilation | Wu Talks about Blockchain
The opinions expressed here are the author's personal opinions only and should not be used as a basis for investment decisions, nor should they be considered as advice or opinions on participating in investment transactions.
https://cryptohayes.substack.com/p/persistent-weak-layer
I spent the first two weeks of October skiing on New Zealand's South Island. My guide (who I skied with in Hokkaido last season) assured me that New Zealand was one of the best places in the world for off-piste skiing. I took his word for it and spent two weeks with him, chasing powder and big snow lines out of Wanaka. The weather was great and I was able to ski over some spectacular peaks and across huge glaciers. As an added bonus, I also improved my alpine climbing knowledge.
Storms in the South Island are very severe. When you have "weather," you are confined to your home or mountain lodge. To pass the time, my guide gave us an avalanche science class one afternoon. I have taken a number of avalanche training courses since I first went backcountry skiing in British Columbia as a teenager, but I have never taken a formal certification course.
This information is both interesting and sobering because the more you learn, the more you realize that you are always taking a risk when skiing in avalanche terrain. Therefore, the goal is to reduce the risk to an acceptable level.
The course teaches you about different types of snow layers and how they can trigger avalanches. One of the most terrifying is a persistent weak layer (PWL), which, when stressed, can trigger a persistent slab avalanche.
In avalanche science, a PWL refers to a specific layer in the snow that remains structurally weak for a long time, greatly increasing the risk of avalanches. These layers are particularly dangerous because they can be buried deep within the snow, lying dormant and unstable for weeks or even months until they are finally triggered by additional stress, such as skiers or new snowfall. Knowing that PWLs exist is critical to avalanche prediction, as these layers are often the culprits for large, deep, and deadly avalanches.
The geopolitical situation in the post-World War II Middle East is a PWL on the global modern order, and the trigger for this avalanche is usually related to Israel. The avalanche we care about in financial markets is the reaction of energy prices, the impact on global supply chains, and whether there will be an exchange of nuclear weapons if the conflict between Israel and another Middle Eastern country, especially Iran or its proxies, escalates.
As investors and traders, we are on a ramp that is both dangerous and exciting. On one hand, China has officially initiated monetary easing reflationary measures, and every major country or economy is reducing the price of its currency and increasing its money supply. Now is the time to take the biggest long-term risks, and obviously, I mean cryptocurrencies. But if the conflict between Israel and Iran escalates and results in the destruction of oil fields in the Persian Gulf, the blockade of the Strait of Hormuz, or the detonation of a nuclear bomb or device, then the crypto market could suffer a major decline. As they often say, you can't invest in war.
I face a choice: do I continue to sell fiat to buy crypto, or do I reduce my crypto holdings and hold cash or US Treasuries? If this is truly the start of the next phase of the crypto bull market, I don’t want to be underweight, but I also don’t want to see my capital evaporate if Bitcoin plummets 50% in a single day due to a lasting sectoral avalanche in financial markets caused by the Israel/Iran conflict. Don’t worry about Bitcoin, it will always rebound, I’m more worried about the completely worthless things in my portfolio… meme coins.
I would like to present to the reader the simple scenario analysis that I use when making investment allocations for the Maelstrom portfolio.
Scenario Analysis
Scenario 1: The Israel/Iran conflict de-escalates to a small-scale military retaliation. Israel continues assassinations and targeted strikes, and Iran responds with a pre-emptive, non-threatening missile attack. No critical infrastructure is destroyed, and no nuclear strike occurs.
Scenario 2: An escalation of the Israel/Iran conflict results in the destruction of some or all of the Middle East oil infrastructure, a blockade of the Strait of Hormuz, or a nuclear attack.
In scenario one, the persistent weak layer (PWL) remains stable, but in scenario two it fails, causing an avalanche in financial markets. Let’s focus on the second scenario, which threatens my portfolio.
I will evaluate the impact of the second scenario on the crypto market, especially on Bitcoin. Bitcoin is the reserve asset of the crypto market, and the entire crypto capital market will fluctuate accordingly.
I am even more concerned that now that the United States has committed to deploying the THAAD missile defense system to Israel, Israel may escalate further. Israel must be planning a massive strike and anticipating a strong Iranian response. So they are calling in Big Brother — U.S. President “Slow Joe” Biden, to send reinforcements. Also, the more Israel publicly states that it will not strike Iran’s oil or nuclear facilities, the more I believe this is exactly what they are planning.
The United States said on Sunday it would send U.S. troops and advanced U.S. anti-missile systems to Israel, a rare deployment aimed at bolstering the country's air defenses following an Iranian missile attack. Source: Reuters
Risk 1: Physical destruction of Bitcoin mining machines
War is physically destructive. Bitcoin miners are the most important physical assets in the cryptocurrency space. What happens if they are destroyed?
A key assumption in the analysis is where the conflict would expand to. While an Israel/Iran war is really a proxy war between the US/EU and China/Russia, I am assuming that neither side would want to attack the other directly. A better option would be to confine the conflict to relatively chaotic areas like the Middle East. Furthermore, both sides in the eventual engagement are nuclear powers. The US is the most aggressive military force in the world and (knock on wood) has never directly attacked another nuclear power. This is saying something, as the US is the only country to have ever deployed nuclear weapons (when they bombed two Japanese cities to intimidate them into surrender in order to end WWII). Therefore, it is reasonable to assume that the physical conflict would be confined to the Middle East.
The next question is, is there a significant amount of Bitcoin mining activity in Middle Eastern countries? According to some media reports, Iran is the only country where Bitcoin mining is thriving. According to different sources, Iranian Bitcoin miners account for about 7% of the global hashrate. What would happen if Iran's hashrate dropped to 0% due to internal energy shortages or missile attacks on facilities? The answer is: nothing would happen.
This is a chart of the Bitcoin network hashrate from January 2021 to March 2022.
Remember when China “banned” Bitcoin mining in mid-2021? Hashrate quickly dropped by 63%. However, hashrate recovered to its May 2021 high in just eight months. Miners moved out of China, or other global miners quickly increased hashrate due to more favorable economic conditions. On top of that, Bitcoin hit a new all-time high in November 2021. The dramatic drop in hashrate had no discernible effect on the price of Bitcoin. So even if Iran was completely destroyed by an Israeli or American strike, causing a 7% drop in global hashrate, this would have no impact on Bitcoin.
Risk 2: Sharp rise in energy prices
The next consideration is what happens if Iran destroys major oil and gas fields in retaliation? The Achilles heel of the West’s over-leveraged financial system is the lack of cheap hydrocarbons. Even if Iran could destroy the Israeli state, it would not stop the war. Israel is just a disposable pawn in Pax Americana. If Iran wants to inflict heavy damage on the West, it must destroy hydrocarbon production and prevent tankers loaded with oil from passing through the Strait of Hormuz.
The price of oil will soar, driving up other energy prices as oil-starved countries turn to alternative energy sources to keep their economies going. So what will happen to the fiat price of Bitcoin? It will go up.
Bitcoin is energy stored in digital form. So if energy prices rise, the value of Bitcoin in fiat currency will also increase. The profitability of Bitcoin mining will not change, because all miners face a simultaneous rise in energy prices. It may be more difficult for some large industrial miners to obtain energy, because governments may cancel contracts through force majeure clauses. But if the hash rate drops, the mining difficulty will also drop, allowing new entrants to mine Bitcoin profitably even at higher energy prices. The beauty of Satoshi's creation will be fully revealed here.
If you want a historical example of the resilience of hard currencies to energy shocks, consider gold trading from 1973 to 1982. In October 1973, the Arab oil embargo began in retaliation for U.S. support for Israel in the Yom Kippur War. In 1979, the Iranian revolution overthrew the Western-backed shah and established the current theocratic regime, resulting in the exclusion of Iranian oil supplies from global markets.
Spot oil (white line) and gold (yellow line) price performance relative to the U.S. dollar, both based on 100. Oil prices have risen 412%, while gold has risen almost as much at 380%.
Here is a chart of the price of gold (yellow line) divided by the S&P 500 (red line) and then compared to the price of oil, again with a base of 100. Gold only buys 7% of oil, while stocks have lost 80% of their purchasing power.
Assuming that either party removed Middle Eastern hydrocarbons from the market, the Bitcoin blockchain would continue to function normally and the price of Bitcoin would at least maintain its value relative to energy and would certainly rise in fiat currency.
I have discussed physical risk and energy risk, and now let’s move on to the last one: currency risk.
Risk 3: Currency Risk
The key question is how the United States will respond to this conflict. Both major political parties are staunch supporters of Israel. No matter how many innocent men, women, and children the Israeli military kills in its campaign to destroy Iran and its proxies, the American elite political class will continue to support Israel. The United States supports Israel by providing weapons. Since Israel cannot afford to buy the weapons it needs to fight Iran and its proxies, the U.S. government borrows to pay for weapons from American arms dealers such as Lockheed Martin, which are provided to Israel free of charge. Since October 7, 2023, Israel has received $17.9 billion in military aid.
The US government buys goods by borrowing, not saving. That’s the message of the chart above. To provide Israel with free weapons, the US must borrow more, and the already bankrupt US government needs to pay for this by borrowing further. The question is, who will buy this debt when national savings are negative? The green arrows in the chart mark the periods when US national net saving was negative. Luke Gromen correctly points out that these arrows correspond to the sharp increase in the size of the Federal Reserve’s balance sheet.
The arrows in the chart correspond to the dramatic expansion of the Fed’s balance sheet. When the US plays the role of “lord of war” by supporting Israel’s military actions, it necessarily needs to borrow more money. As seen during the 2008 Global Financial Crisis (GFC) and the COVID-19 lockdown, the balance sheet of the Fed or the commercial banking system will grow exponentially to purchase this increased debt issuance.
So, how will Bitcoin respond to another dramatic expansion of the Fed’s balance sheet?
This is the performance of the Bitcoin price divided by the Fed’s balance sheet, with a base value of 100. Since Bitcoin’s inception, it has outperformed the Fed’s balance sheet expansion by 25,000%.
We know that war causes inflation. We know that the U.S. government must borrow money to sell weapons to Israel. We also know that the Federal Reserve and the U.S. commercial banking system will expand their balance sheets by printing money to buy this debt. Therefore, as the war intensifies, the fiat price of Bitcoin will rise significantly.
Intensifying conflict in the Middle East will not destroy any of the critical infrastructure that supports cryptocurrencies. As energy prices rise, Bitcoin and cryptocurrencies will rise with them. Tens or trillions of new money printing will reignite the Bitcoin bull market.
Trade with caution
Even though Bitcoin will continue to rise in the long term, that doesn’t mean there won’t be wild price swings, or that every “shitcoin” will share in the glory. The key is to properly size your positions.
I’m prepared to take crazy paper losses on any position I hold. As some readers know, I’m invested in several meme coins. When Iran launched its latest missile strike at Israel, I cut those positions significantly. Because crypto assets are unpredictable in the short term in response to escalating conflicts, my positions were too large. I know I’m over-sized because I’d be really annoyed if I lost 100% of my investment in a bunch of joke cryptocurrencies. Currently, the only meme coin I hold is Church of Smoking Chicken Fish (ticker: SCF). R’amen.
I have not yet instructed Akshat, Maelstrom's head of investment, to slow down or stop our participation in pre-sale token trading. For the idle fiat currency held by Maelstrom, I stake it on Ethena to earn high yields while waiting for good entry points into various liquid shitcoins.
The last thing I should do as a trader is to trade based on who I think is on the "right" side of this war. This will only lead you to destruction, as war will be accompanied by financial oppression, asset confiscation, and destruction on both sides. The best thing to do is to ensure that you and your family are safe from danger, and then direct capital into instruments that can outperform the depreciation of fiat currencies and maintain their purchasing power for energy.
