Greg Foss takes a deep look at the conditions surrounding the global credit market in this executive summary.
It is often said that equities are about emotion, whereas bonds are about reason. Equity investors tend to ask, “How much can I make?” whereas bond investors tend to ask, ”How much can I lose?” Are these types of investors optimists vs. pessimists? No, but bonds tend to have asymmetric return distributions (to the downside), and equities have a much more symmetric return distribution.
Credit markets are far larger than equity markets, and in the case of corporate credit, they also have priority of claim versus equity. If debt is not worth 100% of its parity, then the underlying equity can be worthless. Accordingly, credit markets frequently dictate whether it is safe and/or wise to be investing in equities. When the credit markets sneeze, the equity markets can quickly catch a cold.
Capital markets are built on leverage, and the banking system is reliant on confidence that this leverage is sustainable and that the system is functioning smoothly. When the financial system’s plumbing starts to gurgle, equity markets are frequently unaware of the pending leverage “unwinds” and predictable selling pressures that arise due to these regularly occurring events.
I have traded credit for over 30 years, and I have seen my share of crises in the financial markets. The Lesser Developed Country (LDC) debt crisis in the late 80’s, Long Term Capital Management in 1998, the Great Financial Crisis (GFC) in 2008/09, and the most recent COVID pandemic-related financial crisis in 2020. Each episode shared some very similar traits that have made our financial system increasingly precarious. We have continued to kick the can down the road by shifting the financial system’s risks towards the ultimate backstops, the central banks (CBs). Unsurprisingly, the CBs have responded by using the tools at their disposal, which manipulate open market pricing mechanisms and distort the risk/return characteristics of the capitalist system.
CBs’ ultimate weapon is the ability to print money. It is this ability that backstops the global banking system and the confidence of the populace to deposit their hard-earned savings in the system. However, the ability to print money generally reaches a tipping point when the populace realizes that the ultimate debasing of the currency renders it worth less (and potentially worthless) over time.
I believe that we are currently close to this tipping point. This opinion comes from my experience in the credit market, where I have witnessed how quickly the system can grind to a halt and how quickly contagions engulf all corners of the market. This leads to leverage unwinds in which cash needs require managers to sell not just what they want to, but whatever they can. Markets become dysfunctional, and it is often too late to properly hedge. You need to buy insurance before the calamity hits, while insurance premiums are low and affordable.
I divided my paper into four parts. In Part 1, I detail my experience and state that I believe bitcoin is the best asymmetric trade I have ever seen in my career. Parts 2–4 aim to reinforce this claim. Part 2 delves into some credit market technicalities as well as some bond math. Part 3 focuses on the GFC and introduces my belief that Bitcoin can be viewed as default insurance on a basket of fiat currencies. As such, I calculate an “Intrinsic Value of Bitcoin” based on sovereign credit default spreads (the premium on the insurance contracts). Part 4 was written after I had received some feedback about the prior installments and thus addresses some questions about the methodology.
I am flattered to have been invited to share my publication with Bitcoin Magazine. I hope that my work will be viewed as one piece of the building block that our current fiat-based system desperately needs. It is said that math is the base layer of language. Because Bitcoin is math plus code, I believe that Bitcoin is the base layer of money.
Money has always been a technology for storing the value of presently expended time/energy/work for future consumption. (h/t Ross Stevens, NYDIG). In that light, I believe that Bitcoin offers my generation, as well as my children’s generation, the best opportunity to escape the certainty of fiat currency debasing.
The reasons are only mathematical. Every fixed income investor needs to own bitcoin to hedge against the inherent risks of the current credit environment. Many investors are still focused on the threats of inflation. I believe that credit concerns are likely to overwhelm inflation concerns in this next cycle and that Bitcoin offers the best insurance against this impending risk.
Choose your store of value wisely.
This is a guest post by Greg Foss. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.