By Arthur Hayes
Compiled by: TechFlow
(Any opinions expressed here are the author’s personal opinions and should not be used as the basis for investment decisions, nor should they be interpreted as recommendations or suggestions to participate in investment transactions.)
Water, water, water everywhere,
All the boards shrunk;
Water, water, water everywhere,
But there was not a drop to drink.
— Coleridge, The Rhyme of the Ancient Mariner
I love specialty coffee, but my home brews always failed. I spent a certain amount of money on coffee beans, but my coffee was always worse than that from a cafe. In order to improve my brew, I started paying more attention to details. One important detail I overlooked was the quality of my water.
Water is crucial to coffee quality. I was recently struck by an article in Standart issue 35.
I had a similar experience during my time as a barista, when I learned that over 98% of a cup of coffee and about 90% of espresso is water.
This realization often comes late, probably because it’s easier to invest in a new machine to improve your coffee. “Ah, you have a conical grinder! That’s why your brew is cloudy. Switch to a flat grind!” But what if the problem isn’t the ingredients? What if focusing on the solvent itself could solve our coffee problems? — Lance Hedrick, On the Chemistry of Water
My next step is to understand the author's advice and order a home water distiller. I know a local coffee shop that sells mineral concentrates that can be added to water that will provide the perfect base for my coffee to bring out the flavors of their roasted coffee. By this winter, my morning coffee will be delicious...I hope. I pray for my adventurous friends who will try my "black gold" coffee before climbing Mount Yotei.
Good quality water is essential for brewing delicious coffee. Turning to investments, water or liquidity is also important for accumulating Bitcoin (sats). This is a recurring theme in all my articles. But we often forget its importance and focus on the little things that we think affect our ability to make money.
If you can identify how, where, why and when fiat liquidity is created, it is hard to lose money when investing. Unless you are Sue Chu or Kyle Davis. If financial assets are priced in USD and US Treasuries (UST), then it can be inferred that the amount of global currency and USD debt is the most critical variable.
It is not the Federal Reserve (Fed) that we need to focus on, but the U.S. Treasury. This will help us determine the specific circumstances of the increase or decrease in fiat liquidity of Pax Americana.
We need to return to the concept of “fiscal dominance” to understand why US Treasury Secretary Janet Yellen made Fed Chairman Jerome Powell her “beta cuck towel bitch boy”. Please read my article entitled Kite or Board for a more in-depth discussion. During fiscal dominance, the need to finance the country outweighs any central bank concerns about inflation. This means that bank credit, and therefore nominal GDP growth, must remain high, even if this leads to inflation that is persistently above target.
Time and compounding determine when power shifts from the Central Bank to the Treasury. When the debt-to-GDP ratio exceeds 100%, the debt is mathematically growing much faster than the economy can grow. After this event horizon, the institution that controls the supply of debt is crowned Emperor. This is because the Treasury decides when, how much, and when debt will be issued. Furthermore, since the government is now dependent on debt-driven growth to maintain the status quo, it will eventually instruct the Central Bank to use its printing press to cash the Treasury's checks. Central Bank independence no longer matters!
The COVID outbreak and the U.S. government’s efforts to keep people home and hand out stimulus checks in exchange for their compliance caused the debt-to-GDP ratio to quickly exceed 100%. It was only a matter of time before Yellen went from “grandma” to “bad girl.”
Before the U.S. enters a full-blown hyperinflation scenario, Yellen has a simple way to create more credit and boost asset markets. There are two sanitized pools of money on the Fed's balance sheet that, if released to the market, would boost bank credit growth and drive up asset prices. The first pool is the reverse repo pool (RRP). I've discussed this pool in detail, where money market funds (MMFs) park cash overnight at the Fed and earn interest. The second pool is bank reserves, and the Fed's program on this pool pays interest in a similar manner.
When money is on the Fed’s balance sheet, it cannot be rehypothecated into financial markets to generate broad money or credit growth. By providing incentives to banks and money market funds to pay interest on reserves and reverse repo, respectively, the Fed’s quantitative easing (QE) program creates inflation in financial asset prices, rather than causing rapid growth in bank credit. If QE were not sterilized in this way, bank credit would flow into the real economy, increasing output and inflation in goods/services. Given Pax Americana’s current total debt, strong nominal GDP growth coupled with inflation in goods/services/wages is exactly what the government needs in order to raise tax revenues and reduce leverage. Hence, “bad girl” Yellen steps in to correct the situation.
Yellen doesn’t care about inflation. Her goal is to create nominal economic growth so that tax revenues can rise, lowering the U.S. debt-to-GDP ratio. Given that no party or its supporters have committed to spending cuts, deficits will persist for the foreseeable future. Moreover, since the size of the federal deficit is the largest in peacetime history, she must use all the tools at her disposal to finance the government. Specifically, that means moving as much money as possible from the Fed’s balance sheet into the real economy.
Yellen needs to give banks and money market funds what they want. They want a yielding cash-like instrument with no credit and minimal interest rate risk to replace the yielding cash they hold at the Fed. Treasury bills (T-bills) with a maturity of less than one year, with a yield slightly above the interest on reserve balances (IORB) or the reverse repo rate (RRP), are the perfect substitute. T-bills are an asset that can be leveraged in the market and will generate credit and asset price growth.
Can Yellen afford to issue $3.6 trillion worth of Treasury securities? Of course she can. The federal government is running a $2 trillion annual deficit that must be financed through debt securities issued by the Treasury.
Yet Yellen or whoever replaces her in January 2025 doesn’t have to issue Treasury bills to finance the government. She could sell longer-term Treasury securities, which are less liquid and carry higher interest rate risk. These securities are not cash equivalents. Moreover, because of the shape of the yield curve, longer-term debt securities yield less than Treasury bills. The profit motives of banks and money market funds make it impossible for them to exchange the money they hold at the Fed for anything other than Treasury bills.
So why should we crypto traders care about the flow of money between the Fed’s balance sheet and the broader financial system? Check out this beautiful chart.
As the Reverse Repurchase Program (RRP) (white line) fell from its highs, Bitcoin (gold) rebounded from its lows. As you can see, it is a tight relationship. When money leaves the Fed's balance sheet, it increases liquidity, which causes the price of finite financial assets such as Bitcoin to rise.
Why is this happening? Let’s ask the Treasury Borrowing Advisory Committee (TBAC). In its latest report, TBAC clearly illustrates the relationship between increased Treasury bill issuance and the funds held by money market funds (MMFs) in RRPs.
Large overnight reverse repo balances may indicate strong demand for Treasury bills. Overnight reverse repo funds were transferred almost one-to-one to Treasury bills during 2023-24. This rotation facilitated the smooth absorption of record Treasury bill issuance. - Slide 17, TBAC July 31, 2024
Money market funds will move cash into Treasuries as long as the yield on Treasuries is slightly above the reverse repo rate — currently, the yield on a 1-month Treasuries bill is about 0.05% higher than the money in the RRP.
The next question is whether bad girl Yellen can direct the remaining $300 billion to $400 billion from RRP into Treasuries. If you doubt bad girl Yellen, you may face sanctions! Ask those poor souls from developing countries what happens when you lose access to dollars to buy basic necessities like food, energy and medicine.
In its recent Quarterly Funding Announcement (QRA) for the third quarter of 2024, the Treasury said it would issue $271 billion in Treasury bills by the end of the year. That’s good, but there’s still money in the RRP. Can she do more?
Let me quickly talk about the Treasury repo program. Through this program, the Treasury repurchases illiquid non-Treasury debt securities. The Treasury can fund the purchases by drawing down its general account (TGA) or issuing Treasury bills. If the Treasury increases the supply of Treasury bills and decreases the supply of other types of debt, it will be a net increase in liquidity. Funds will leave the RRP, which is positive for USD liquidity, and as the supply of other types of Treasury securities decreases, holders will move across the risk curve to substitute these financial assets.
The latest repo program will see a total of $30 billion worth of non-Treasury securities purchased through November 2024. This is equivalent to an additional $30 billion in Treasury securities issuance, bringing total outflows from the RRP to $301 billion.
This is a solid liquidity injection. But how good is bad girl Yellen? How much does she want minority US presidential candidate Momala Harris to win? I call her "minority" because Harris changes her phenotype in different occasions depending on the audience. This is a unique ability she possesses. I support her!
The Treasury could inject a massive liquidity injection by reducing the TGA from about $750 billion to zero. They can do this because the debt ceiling goes into effect on January 1, 2025, and by law the Treasury can spend the TGA to avoid or delay a shutdown.
Bad girl Yellen will pump in at least $301 billion and up to $1.05 trillion by year end. Boom! That will create a glorious bull market in all types of risk assets, including crypto, just in time for the election. If Harris still can't beat the orange guy, then I guess she needs to become a white male. I believe she has that superpower within her/his reach.
Grenade
The injection of $2.5 trillion into financial markets over the past 18 months through the reverse repurchase program (RRP) is very impressive. But there is a lot of dormant liquidity that is eager to be released. Can Yellen's successor create a situation after 2025 where money can be drawn out of bank reserves held by the Fed and injected into the broader economy?
In times of fiscal dominance, everything is possible. But how?
For-profit banks will swap one yielding cash instrument for another for capital adequacy, as long as regulators treat them the same and the latter offers a higher yield. Currently, Treasury bills offer a lower yield than the reserve balances held by the Fed, so banks won’t buy them.
But what happens next year when reverse repo is almost zero and the Treasury continues to dump a lot of Treasury bills into the market? Ample supply and the inability of money market funds (MMFs) to buy Treasury bills with the funds parked in reverse repo means that prices must fall and yields will rise. Once the yield on Treasury bills is a few basis points higher than the excess reserve rate, banks will use their reserves to buy Treasury bills in large quantities.
Yellen's successor - I'm willing to bet it's Jamie Dimon - will not be able to resist the ability to continue dumping Treasury bills into the market for the political benefit of the ruling party. There is another $3.3 trillion of bank reserve liquidity waiting to be injected into financial markets. Shout with me: Treasury bills, baby, Treasury bills!
I believe TBAC is quietly hinting at this possibility. Here is another snippet from a previous report, with my comments in [bold]:
Looking ahead, a number of factors may warrant further examination to consider in the share of future Treasury issuance:
[TBAC wants the Treasury to think about the future and how large the issuance of Treasury bills should be. Throughout the report, they advocate that the issuance of Treasury bills should be kept at around 20% of total net debt. I believe they are trying to explain what would cause this ratio to increase and why banks would be the main buyers of these Treasury bills.] — TBAC July 31, 2024, Slide 26
The evolution and ongoing assessment of the regulatory environment for banks (including, among other things, liquidity and capital reforms) and the impact on banks and dealers’ meaningful participation in primary Treasury markets to intermediate and warehouse (expected) future U.S. Treasury maturities and supply
[Banks don’t want to hold more long-term notes or bonds that attract tighter collateral requirements. They are quietly saying we won’t buy any more long-term debt because it hurts their profitability and is too risky. If the primary dealers go on strike, the Treasury is in trouble because who else has the balance sheet to absorb the huge debt auctions.]
The evolution of market structure and its implications for the Treasury Market Resilience Initiative, including:
The SEC’s central clearing rule, which would require posting of substantial margin deposits at covered clearing organizations
[If the Treasury market moved to exchanges, it would require dealers to post billions of dollars in additional collateral. They would not be able to bear the cost, and the result would be a drop in participation.]
Future (expected) U.S. Treasury auction sizes and their predictability in cash management and benchmark Treasury issuance
[If the deficit continues to remain so large, the debt issued could increase substantially. Therefore, the role of Treasury bills as a "buffer" will become increasingly important. This means that higher Treasury bill issuance will be needed.]
Future monetary fund reform and potential structural demand for treasury bonds
[If money market funds return to the market after reverse repos are completely withdrawn, Treasury issuance will exceed 20%.] - TBAC July 31, 2024, Slide 26
The banks have effectively gone on strike and are no longer buying long term Treasuries. Bad girls Yellen and Powell nearly caused the banking system to collapse by filling the banks with Treasuries and then raising rates from 2022 to 2023… R.I.P. Silvergate, Silicon Valley Bank, and Signature Bank. The remaining banks don’t want to take any more chances and see what happens if they greedily buy high priced Treasuries again.
Case in point: US commercial banks have bought only 15% of non-Treasury Treasury securities since October 2023. This is very bad for Yellen because she needs the banks to step up when the Fed and foreign countries pull back. I think as long as banks buy Treasuries, they will be happy to fulfill their responsibilities because Treasuries have similar risk characteristics to bank reserves but with higher yields.
The Widowmaker
The move from 160 to 142 USD-JPY sent shockwaves through global financial markets. Many were reminded last week to sell what they could. That moment was a textbook correlation. USD-JPY will hit 100, but the next wave will be driven by foreign capital repatriation to Japan Inc., not just hedge fund investors unwinding their yen carry trades. They will sell US Treasuries and US stocks (mostly big tech stocks like NVIDIA, Microsoft, Google, etc.).
The BoJ tried to raise rates and global markets reacted violently. They relented and announced that rate hikes were off the table. The worst-case scenario from a fiat liquidity perspective is that the yen trades sideways and no new low-cost yen positions are established. As the threat of the yen carry trade recedes, bad girl Yellen’s market interventions are back in the spotlight.
Dehydration
Without water, you die. Without liquidity, you collapse.
Why have the crypto risk markets been moving sideways or down since April this year? Most tax revenues are generated in April, which leads to the need for the Treasury to borrow less. We can see a decrease in the number of Treasury bills issued between April and June.
Liquidity is removed from the market due to the net reduction in Treasury bills. The net reduction in cash-like instruments provided by the Treasury results in less liquidity even if overall government borrowing increases. As a result, cash remains trapped on the Fed's balance sheet, in the reverse repo program (RRP), and is unable to drive growth in financial asset prices.
This chart of Bitcoin (gold) vs. RRP (white) clearly shows that from January to April, when Treasuries were net issuing, RRP fell and Bitcoin rose. From April to July, when Treasuries were net withdrawn from the market, RRP rose and Bitcoin traded sideways, with a few sharp declines. I stopped on July 1st because I wanted to show the interaction before the strong pullback of USD-JPY from 162 to 142, which led to a broad sell-off in risk assets.
So, going by bad girl Yellen, we know that $301 billion of net Treasury bills will be issued between now and the end of the year. If this relationship holds true, Bitcoin will quickly make up for the sell-off caused by the appreciation of the yen. The next target for Bitcoin is $100,000.
When is the altcoin season?
Altcoins are the crypto play on high-beta Bitcoin. But in this cycle, Bitcoin and Ethereum now have structural buys in U.S.-listed exchange-traded funds (ETFs). Although Bitcoin and Ethereum have pulled back since April, they have escaped the altcoin market fiasco. The altcoin season will only come back after Bitcoin and Ethereum break through $70,000 and $4,000, respectively. Solana will also exceed $250, but considering the relative market capitalization, Solana's rise will have a far less impact on the wealth effect of the entire crypto market than Bitcoin and Ethereum. By the end of the year, a rebound in Bitcoin and Ethereum driven by US dollar liquidity will lay a solid foundation for the return of the sexy altcoin party.
Trading Setup
With Treasury issuance and repurchase programs running in the background, liquidity conditions will improve. If Harris falters and more firepower is needed to drive stocks higher, Yellen will reduce TGA funding. Regardless, I expect cryptocurrencies to begin to break out of their sideways to downward trajectory in September. Therefore, I will use this late northern hemisphere summer weakness to increase my exposure to crypto risk.
The US election will be held in early November. Yellen will be at the peak of her manipulation in October. There is no better time to get liquidity this year. Therefore, I will take advantage of the momentum. I will not liquidate my entire crypto portfolio, but will take profits on more speculative momentum trades and park capital in staked Ethena USD (sUSDe). The crypto market is rising, improving the odds of a Trump victory. Trump's odds peaked after the assassination attempt and Slow Joe's disastrous debate performance. Kamala Harris is a first-rate political puppet, but she is not an octogenarian vegetable. That is all she needs to beat Trump. The election is a coin toss, and I would rather watch the chaos from the sidelines and re-enter the market after the US debt ceiling is raised. I expect this to happen between January or February.
Once the US debt ceiling farce is over, liquidity will pour out from the Treasury and the Fed to get the market back to normal. Then, the real bull run will begin. $1 million Bitcoin remains my base case.
P.S.: Once bad girl Yellen and towel man Powell join forces, China will finally unleash its long-awaited fiscal stimulus. The 2025 US-China crypto bull market will be brilliant.
