The impact of money supply on financial markets, the bitcoin trilemma and outlook, housing market in the U.S. signals a recession.
Chart of the week
The chart shows the M2 money supply in America (black line) and the price trend of the S&P 500.
Why this is important
Money supply trends have a big impact on financial markets. Research shows that about one-third of the newly created money supply does not end up in the industry for investment, but flows into the financial market. That is why it is essential for investors to monitor central banks and understand their actions.
Excursus: Money Supply and the Role of Central Banks
From 1880 to 1944, there was the gold standard. The gold standard is a monetary order in which money consists of gold coins or bills representing claims on gold that can be exchanged for gold. In the simplest case, minted gold acts directly as money. However, the gold standard also exists when the central bank guarantees a fixed exchange rate of its currency for gold in paper money and is able and willing to exchange the full amount at virtually any time. In 1944, a new system is introduced at a conference in Bretton Woods system of 44 countries. It is based on the following:
If the money supply and the number of all goods and services are equal, there is equilibrium. One monetary unit corresponds to one commodity.
However, as more and more commodities are extracted from the ground, the goods component rises steadily. If twice as many goods face the same remaining money supply, deflation occurs. One unit of goods now equals 0.5 units of money (example in the middle). Why should an entrepreneur build a new factory, if this leads to the fact that they get less and less for the manufactured product? In a deflation, the economy shrinks and there is high unemployment.
If, on the other hand, the money supply increases sharply but the quantity of goods remains the same, inflation occurs. One unit of goods now costs two units of money; which corresponds to an inflation of 100%.
The task of central banks is to ensure that the money supply and the quantity of all goods/services are equal. To achieve this, central banks need to know exactly how many goods and services are in the market at any given time. If the money supply is always slightly higher than the total of all goods and services, this leads to a steady growth of the economy.
The Bretton Woods Agreement laid the foundation for today's society and economic system. Constant innovation ensures progress and that our living conditions are constantly improving.
However, there are many who distrust central banks and would like to see a return to the gold standard with bitcoin as modern gold. From our point of view, this would be a step back to the time before 1944 and would bring all economic growth to a standstill. The consequences would be high unemployment and no more innovation.
The influence of central banks on financial markets
Central banks have two ways of intervening in the economy. With the key interest rate and the control of the money supply, they can promote or restrict the growth of the economy in order to achieve the goal of low inflation.
The biggest challenge is that both measures have a delayed effect. When the key interest rate is raised or the money supply is tightened, the effect is not felt in the economy until about 6 months later.
The chart shows the M2 money supply in the USA. It has been growing since 1970. This was also necessary to keep the economy in growth mode. Since 2020, however, it has increased disproportionately.
Managing the money supply is very complex. In addition to the amount of money, the turnover rate (velocity) is also an important factor. If I give my money to colleague A, she gives it to colleague B, and the latter gives it to colleague D in the same month, this would be a velocity of four.
The chart shows the annual change in the money supply. The increase in the money supply in 2020 is impressive to see.
However, the situation is now returning to normal. The economy is largely running normally again and there is a large pent-up demand for consumption, which is driving the economy. The turnover rate of the money supply is also rising again. So the central banks are now forced to reduce the money supply again.
Central banks can only set the rules of the game. They cannot determine what investors and consumers should do with the money. The idea, of course, is that investors invest in new factories and consumers spend the money. But about a third of the money goes into the financial markets. That then led to the sharp rise in financial markets after the COVID crash.
The strong tailwind for the financial markets is now turning into a headwind. This does not mean now that the financial markets have to collapse sharply. As long as the economy is doing well, companies can prevent prices from falling by making more profits. But a new equilibrium has to be found. There will be a strong shift in investor favor towards high quality and solid companies.
At the moment, it also looks like the central banks are overshooting the mark. They have raised interest rates too much and cut the money supply too much, and have not taken enough account of the delay with which the measures take effect. A recession no longer seems avertable. This is another reason to be more cautious and invest your money only in good quality and solidly financed companies.
Housing market in the USA signals recession
The market for houses in the USA is regarded as a good leading indicator of general economic development.
The chart shows an indicator calculated by the investment bank Goldman Sachs that shows how affordable it is for Americans to build or buy a new home. The value has plummeted more than it did during the financial crisis.
The graph shows how many existing homes are changing hands. The indicator has also plummeted and are now at the level last seen in 1982.
Both indicators suggest that a recession is inevitable.
The Bitcoin Trilemma and Outlook
If you want to create a new cryptocurrency, you have to decide where to position yourself in the blockchain trilemma. The three criteria of security, scalability and decentralization contradict each other. No one has yet succeeded in creating a cryptocurrency that meets all three criteria.
If the application is to be fast and scalable, then the best thing is for it to run on a fast server. But then this contradicts decentralization. If the application is decentralized, as with Bitcoin, each transaction must be completed on over 10,000 servers (nodes) to be confirmed. That takes time. For example, the Bitcoin network only manages to process 7 transactions per second (TPS). This makes Bitcoin simply unsuitable as a global currency. For comparison, the Mastercard network manages 5,000 TPS and the cryptocurrency Solana 65,000 TPS. However, Solana then has "only" 1900 nodes.
Challenge number 1: Regulation
Even the SEC (Federal Reserve) has recognized the special character of Bitcoin. It is currently in the process of suing many cryptocurrencies. They argue that the creation of cryptos is equivalent to issuing securities. The issuer creates them knowing and willing to sell them to investors at a higher price. Bitcoin recognizes it as a special case, due to its long history and the fact that with over 10,000 nodes, no one has any control.
This wave of lawsuits against cryptocurrency is unsettling many investors and causing lower prices. The issue is highly political in the US. The Democrats want more regulation or even a ban on cryptocurrencies, the Republicans see it as the technology of the future, in which the USA should take the leading role. The SEC currently argues that no new rules are needed because everything is already covered with the existing regulatory framework. To prove this, they are currently launching countless actions against the crypto industry.
The US is currently so important because 25% of all Bitcoin nodes are operated in the US. After the ban on Bitcoin in China, the USA has risen to become the market leader.
Clear regulation would be the basis for the future of cryptocurrencies and would lead to a rise in value that could catapult Bitcoin and cryptos in general to new highs.
Challenge number 2: Shakeout of the industry
Bad news comes one after the other in a daily or weekly rhythm. The wave of bankruptcies does not even stop at the very big names. Many thought that the collapse of FTX was the peak, but now the largest market maker Silvergate is under pressure.
First it was small companies that went bankrupt and small crypto projects that failed. But the casualties are getting bigger. FTX was one of the largest crypto trading platforms and Silvergate was one of the largest and most important market makers in crypto. After the collapse of Silvergate, volumes in crypto markets are decreasing massively. This makes the markets an easy target for manipulation. Volatility in the crypto space is likely to increase in the coming weeks and months.
On the one hand, this development is bad, as it leads to uncertainty and everyone wonders who will be the next to collapse. One then also often hears the comparison with the financial crisis, that FTX corresponds to Bear Sterns and Silvergate corresponds to Lehmann. It can't be ruled out, but in the "rage" and "depression" phase in the psychological market cycle (see next chart), such fears are normal.
On the other hand, the shakeout of the industry is also good. Only the strong and solid will survive and emerge stronger from the crisis.
Psychology of the markets
The formation of investment bubbles in the financial markets and the bursting of this bubble always follows a similar pattern:
The peak is reached when all investors are euphoric and invest much more than they should. Everyone has already invested, every newspaper reports on it and at every event it is the number one topic. Since everyone has already bought, there are no buyers left. In the wave of buying, companies are also flushed up that were of poor quality. Bad news proliferates; fraudulent bankruptcies or charges of disloyal management lead to a change in opinion. The bubble bursts and the market collapses.
If you compare the chart of bitcoin over 3 years, you can see great parallels to the picture above, with the psychological market cycle.
But where are we today? Are we at the "rage" and another downward wave is coming or have we already reached the "depression". The picture is not clear here.
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