Global markets, economy are collapsing – but it’s not all disaster

The Federal Reserve’s main mission is to ensure full employment and price stability. In the shadow of unprecedented inflation, Federal Reserve Chair Jerome Powell has a grim choice to make: let the economy slide into recession or restore price control.

At its last meeting on June 15, the Federal Reserve increased interest rates by 75 basis points to a range of 1.5%-1.75%, marking the most aggressive hike since 1994. The CME FedWatch Tool shows that Fed-funds futures traders see a 98.1% chance that the central bank will raise interest rates to 2.25%-2.50% at its July meeting. 

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Target Rate Probabilities for Fed 27 July Meeting

Source: the CME FedWatch Tool 

Though Powell recently acknowledged stabilizing price pressures could need “some pain” – and possibly higher unemployment – he remained silent about a recession. 

During the period from 2008 to 2021, the Fed’s aggressive monetary policy distorted economic expectations about the cost and availability of financial resources – a situation when businesses and individuals take disproportionately greater risks, increase their debt load and engage in risky financial projects and speculative bubbles. 

In a protracted and aggressive monetary policy, the psychological vulnerability is the conditional belief in an inexhaustible money supply and ultra-soft financial conditions. Investors in these conditions are influenced by the illusion of a safe investment environment. This leads to a critical overhang of institutional participation in speculative hype, which inevitably creates a dependency on artificial liquidity, leaving regulators in a bind.

Trillion dollar bubbles, coupled with the extreme involvement of businesses and retail investors, shackle regulators with regard to monetary policy. Therefore, regulators are directly involved in creating these bubbles when they intervene verbally in the market and pump money into it.

In addition to speculative hype, ultra-soft monetary policy conditions generate a critical mass of “bad” non-performing debts for businesses that cannot be covered by real cash flows. These 

zombie companies drain the corporate soil, diverting the resources of the economy to inefficient, economically unviable projects.

When monetary policy tightens, excessive cheap liquidity, blind faith in a bright future, and distorted expectations interfere with the market, causing intractable problems and contradictions. While macroeconomic indicators may seem to show a good picture, they are misleading in a world where unlimited money printing exists.

Reserve currency status allows the regulator to keep rates low over a long period and bail out bankrupts through asset purchases. Zombie corporations expand because unprofitable businesses are not burned out. Due to negative economic returns, it is necessary to keep real interest rates negative for the foreseeable future, thus eroding the currency’s reserve status. As a result, debt markets explode and bubbles that have inflated at real negative interest rates collapse. A zombified economy does not have the resources to quickly revive and compete globally.

We are currently experiencing the beginning of the collapse of the debt and equity markets, as well as the loss of reserve currency status. Stock markets worldwide are experiencing their worst quarter on record.

However, it is likely that the selloff is still in its infancy. Stock prices bottom out when the Fed eases. Since World War II, the S&P 500 has dropped by a median of 24% during recessions. This makes the current stock declines – happening without a recession – look particularly sharp.

Source: Deutsche Bank 

A Recession Offers a Way Out 

It is blindingly obvious that the only way in response to hyperconcentration of financial market participants in speculative excitement and avalanche to multi-level margin positions is to let a recession happen, triggering an uncontrolled collapse of assets. This is what the great inflation fighter – former Federal Reserve Chair Paul Volcker – did four decades ago. 

The Federal Reserve cannot achieve its goals without a contraction of the economy, according to economists including ex-Fed Vice Chair Alan Blinder.

Recessions bring pain, fear, and uncertainty, but the economic landscape is replete with them. They may end the misallocation of capital in which a handful of companies account for a quarter of the S&P 500, which includes 500 companies. It may also clean up the market of dead wood – weak companies – allowing stronger ones to rise. Ultimately, this would lead to a stronger economy. 

Why Is This Relevant to Crypto?

There has been much discussion that Bitcoin and stock markets are correlated. The crypto market is no different from traditional markets – it’s not independent, despite how we would like it to be. Specifically, the participation of institutional investors in the above-described type of speculation has exacerbated this dependence. 

This is a decisive moment – whether Bitcoin will finally decouple from equities and act as a standalone asset with its own value proposition – or will sink with the stock market.

Source: CoinMetrics 

Bitcoin’s 60-day correlation with the S&P index reached its all-time high of 0.74 on May 25, 2022, but currently lowered to 0.64 – still a very high level.

However, the 20-day correlation between Bitcoin and the Nasdaq 100 has dropped from about 0.88 in early May to just 0.30 currently.

Source: Bloomberg 

This is a positive sign indicating that Bitcoin could regain its independence with the long-term view that blockchain holds economic value.

Even so, some pain will be inevitable, such as in the stock market. The crypto market will benefit if the card house of risky, inflated tokens collapses. The collapse of the Terra stablecoin and Luna token teaches investors caution and contributes to the advancement of digital asset technology. Their stablecoin was built in a wrong way, and the market could not mature until it knew that.

Bottom Line

World markets and the global economy are definitely experiencing hard times. While a recession may seem doom and gloom, instead of pulling our hair out in frustration, we can accept it as a necessary reality and understand that it’s not necessarily a bad thing – just like medicine, which isn’t pleasant but is necessary for health. It will heal the economy, wipe out artificial liquidity, bring adequacy back to the markets, including the cryptocurrency market, bringing them to a mature and stronger state, creating a truly safe investment environment, not an illusion.