More Catalyst than Cause: COVID-19 as the Pin that Pricked the Bubble
Yuriy Anosov, Anchorage Trading
A month ago, not many would have picked a virus to take the markets down.
Markets were hitting record highs. Unemployment rates in the United States were low. Companies had high levels of capital expenditures. Other general metrics of a healthy economy such as PMIs and consumer confidence were coming in on a regular basis. To the casual observer, the economy was as strong as it had ever been. Then, in the last seven days of February, the S&P 500 shed more in a one week period than it had since 2008.
In response, on March 3rd, the Federal Reserve cut interest rates by 50bps. And as I was writing this piece, they cut another 100bps, moving the target rate range to 0–0.25%. That’s 150bps in less than a week. There has not been a move of such magnitude since the mortgage-induced financial crisis more than a decade ago. This time, though, the cause is not subprime mortgage securitizations, but pandemic. Or at least that’s how the story has gone so far.
In the news media, coronavirus is the cause of current market woes. Investors are skittish and scared. It is unclear how bad the pandemic will grow to become — and to what extent industries, sectors, and specific companies will be affected. As such, the markets have become highly volatile.
To the extent that markets are, to quote Niall Ferguson, “mirrors of the human psyche,” prone to breakdowns and euphoria and everything in between, the wild market swings of recent days are mirroring virus-related fear and uncertainty. No matter what you track, be it energy, emerging markets, volatility, or the Fed, fear is palpable. And as COVID-19 affects more and more people around the world in the near term — and the 24/7 news cycle keeps it front of mind — everyday, investors are selling off, looking for liquidity anywhere they can find it. We can expect, at least in the immediate future, for these effects to linger, if not increase.
But COVID-19 is perhaps more catalyst than cause. A closer look at market vitals suggests that the economy may have been vulnerable from the start, making it more susceptible to the widespread effects of pandemic than a truly healthy market would be. What seemed to be good fortune in the recent past may have been artificial, propped up on cheap debt. Even so, the Fed and other bodies like it seem poised to use the same kinds of tools they used to shock the market in 2008. But the use of these kinds of tools intended for emergency use lose their effectiveness — or even cause more of the problems they aim to solve.
While Bitcoin and the broader crypto markets have not been wholly immune to sell offs in the midst of greater market turmoil — take, for instance, Thursday’s precipitous drop — it is remarkable that not only have these projects survived, but even stabilized to a degree, without any kind of external intervention.
It is also worth remembering, in this time of crisis, that Bitcoin literally has crisis written into its base code.¹ Bitcoin was born from and intended for times of crisis, and today’s pandemic — and the reactions of the central banks around it — may be the proving ground for one of its implicit theses: that Bitcoin is an inflation hedge.
In the years leading up to 2008,² the government and Wall Street banks, through various regulations and financial engineering tactics, enabled people to get mortgages on homes that they otherwise couldn’t afford (and for which lending standards deteriorated over time). In 2008, when interest rates on these mortgages adjusted upwards, people could no longer make their mortgage payments. As this dynamic quickly spread, the mortgage-backed securities that were sold to investors rapidly lost their value. This caused the broader credit markets to tighten, which, in turn, brought down stocks.
To address these tightening credit conditions and falling asset prices, the Fed brought rates from 5% to basically zero (see chart above) and implemented Quantitative Easing and mass asset purchases. As the Fed printed massive sums of money, those of us who were net savers saw our purchasing power dwindle. In response, Bitcoin was created with the idea of a finite pool built into it — the idea that no more than 21 million BTC will ever be minted, and no central authority will ever be able to change that fact.
At its core, Bitcoin was a response to the Fed loosening monetary policy during the credit crisis. And there are certain similarities between the mortgage crisis of a decade ago and the crisis we now face.
From its peak on February 19th to its steepest down-move on Thursday March 12th, the S&P 500 lost more than 25% of its value before a slight rebound. Such drawdowns have happened before, but never as quickly as this.
While the S&P 500 was in a downward plunge, Bitcoin also experienced a historic drop — one that saw it drop from around $8,000 to about $4,000 before bouncing back to $5,000 where it is currently oscillating. While Bitcoin maximalists will tell you that they’ve seen these drops before and that this is a great opportunity to buy more, the bears will see this as evidence — evidence that Bitcoin has lost its luster as a safe haven, macro hedge, or whatever else it was “supposed” to be.
It is important to note that, on Thursday, blocks were still being produced, onchain transactions were still taking place, and the network was fully functional. With no need for circuit breakers or market halts, the network was working. The market did not close, while futures gave investors — who could only wait for a violent move at the open — the shakes. And it did not have to bet on when a central bank might come in to “rescue” the markets, or what shape that rescue might take. The BTC network just kept producing blocks. All price action aside, it worked like it was supposed to, and that is a huge win for Bitcoin. While the traditional markets figure out how to de-lever, and governments choose which industries and companies to bail out, Bitcoin, it seems, will continue operating as it was originally coded, block after block after block.
While the coronavirus is, without a doubt, grinding the economy to a halt, erasing the revenues of many different business lines, and disrupting life the world over, for the markets as a whole, it’s the pin that pricked the bubble. The reason the markets are reacting in such a dramatic fashion is, in a word, over-leverage.
Like the mortgage borrowers of the 2000s — borrowers who should have never been given low rate mortgages that would eventually adjust upwards — over the last decade, companies from all different industries have taken advantage of low rates to borrow money, via bank loans and high yield bonds, to invest in projects that likely would not survive in a true free market. Low rates have meant that projects did not necessarily need to provide high returns. As long as returns were just above the artificially low rates, things were good.
But when the Fed began to steadily raise rates from 2016 to 2018 — and the bond and bank loan maturities were on the horizon — these over-leveraged companies were exposed and had their credit ratings downgraded (I wrote a piece last year highlighting this phenomenon). They simply could not afford rolling their debt at the higher rates, and their business models would fall apart without the new funding. Because of this dynamic, which is negative for the companies’ equity prices, the Fed had “no choice” but to put a halt to the tightening and begin the easing soon after.
And it’s not just companies who have become over-leveraged. At the level of the treasury markets, the government has consistently issued so much debt that if the average rates on the treasuries were 4.3% (given $23.3 trillion of outstanding debt), the interest payments would be $1 trillion — or about the same as the 2020 military budget. In short, it has become next to impossible to raise rates and still be able to afford the interest payments.
Current U.S. monetary policy has, in effect, created and continues to perpetuate this problem. By loosening monetary conditions in response to the 2008 crisis, the Fed made it easy for companies and the government to borrow cheaply — and asset prices to rise. In times of market stress, the Fed simply injects more money into the system, or uses various other monetary policy tools to keep rates low.
Now, companies and the treasury have grown accustomed to operating at low rates. They have structured their balance sheets around emergency financing. All of this means that, every time the Fed attempts to tighten — to raise rates, even a small amount — the markets contract, and the Fed turns again to the same solutions that caused the problem: printing more money and keeping rates low.
Last week felt like the economy is finally starting to realize that an endless cycle of low rates and emergency cash infusions is simply not sustainable. Despite the Fed taking rates to zero on Sunday (among other stimulative measures), the markets have reacted quite negatively (SPX futures were limit down). It seems that the economy may be in need of a new kind of cure — perhaps one in finite supply.
Over the next year or two, after the COVID-19 pandemic is hopefully a distant memory, Bitcoin will be truly tested. Only time will tell if market participants are ready for a currency guaranteed to be finite in supply, with no central authority able to alter this policy in order to manipulate markets. But right now, one thing is for certain: BTC markets, although down, have more than survived recent market turmoil — they have stabilized on their own, without the kind of historic intervention traditional markets require.
[1]: The Times 03/Jan/2009 Chancellor on brink of second bailout for banks
[2]: This is the tl;dr. There are many in-depth writings on what happened to the markets in 2008. My favorite is one of the chapters from Ray Dalio’s Principles for Navigating Big Debt Crises, which describes the day-by-day thinking at Bridgewater as the crisis unfolded. If you are a visual learner, The Big Short does a good job going over what happened as well.
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