Arthur Hayes: Cryptocurrency may get rid of the downturn in September, and 2025 will be a brilliant crypto bull market

Original title: Water, Water, Every Where

Original author: ARTHUR HAYES, founder of BitMEX

Original translation: 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 planks have shrunk;

Water, water, water everywhere,

But there is not a drop to drink.

——Coleridge, "The Rhyme of the Ancient Mariner"

I love specialty coffee, but the coffee I brew at home always fails. I spent a fair amount of money on coffee beans, but my coffee was always worse than the coffee shops. In an effort to improve my brew, I started paying more attention to details. One important detail I overlooked was the quality of the water.

Water is critical 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 think about throwing money at 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 was to understand the author’s advice and order a home water distiller. I know of a local coffee shop that sells a mineral concentrate that can be added to water that will provide the perfect base for my coffee to bring out the flavors of their roasted coffee. My morning coffee will be delicious by this winter... I hope. I pray for my adventurous friends who will try my "black gold" coffee before climbing Mt. Yotei.

Good quality water is essential to brewing a delicious cup of coffee. Turning to investments, water or liquidity is also important for accumulating bitcoin (sats). This is a recurring theme in all of my articles. But we often forget its importance and focus on the little things that we think will affect our ability to make money.

If you can identify how, where, why, and when fiat liquidity is created, it is difficult to lose money when investing. Unless you are Sue Chu or Kyle Davis. If financial assets are priced in dollars and U.S. Treasuries (UST), then it can be inferred that the amount of global money and dollar 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 and decrease of fiat liquidity in Pax Americana.

We need to return to the concept of "fiscal dominance" to understand why U.S. Treasury Secretary Yellen made Fed Chairman Powell her "beta cuck towel bitch boy". Please read my article called Kite or Board for a deeper discussion. During fiscal dominance, the need to subsidize the country outweighs any concerns of the central bank about inflation. This means that bank credit, and therefore nominal GDP growth, must remain high, even if this leads to persistently above-target inflation.

Time and compounding determine when power shifts from the central bank to the Treasury. When the debt-to-GDP ratio exceeds 100%, debt is mathematically growing much faster than economic growth. 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. Moreover, 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 measures to keep people at home and give 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 "Granny" to "Bad Girl".

Before the U.S. enters a full-blown hyperinflationary scenario, Yellen has a simple way to create more credit and drive asset markets. There are two sanitized pools of money on the Fed's balance sheet that, if released to the market, would promote bank credit growth and push up asset prices. The first pool is the reverse repo pool (RRP). I have discussed this pool in detail, where money market funds (MMFs) park their 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 banks and money market funds with an incentive to pay interest on reserves and reverse repo interest, 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 sanitized 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 increase tax revenues and reduce leverage. So, "bad girl" Yellen stepped 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 political party or its supporters have committed to spending cuts, deficits will persist for the foreseeable future. Moreover, with the size of the federal deficit 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 off the Fed’s balance sheet and 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 and 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 T-bills? 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.

Yellen, however, or whoever replaces her in January 2025, does not necessarily have to issue Treasury bills to finance the government. She can sell longer-term Treasury securities that are less liquid and carry higher interest rate risk. These securities are not cash equivalents. Furthermore, due to the shape of the yield curve, longer-term debt securities yield less than Treasury bills. The profit motive of banks and money market funds makes it impossible for them to exchange the funds they hold at the Fed for anything other than Treasury bills.

So why should we crypto traders care about the flow of funds between the Fed's balance sheet and the broader financial system? Check out this beautiful chart.

As the Reverse Repurchase Program (RRP) (white line) has retreated from its highs, Bitcoin (gold) has rebounded from its lows. As you can see, it's a tight relationship. When money leaves the Fed’s balance sheet, it increases liquidity, which leads to higher prices for finite financial assets like Bitcoin.

Why does this happen? Let’s consult 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. Over the 2023-24 period, overnight reverse repo funds were transferred almost one-to-one to Treasury bills. This rotation facilitated the smooth absorption of record Treasury bill issuance. - Slide 17, TBAC July 31, 2024

As long as the yield on T-bills is slightly above the reverse repo rate, money market funds will move cash into T-bills - currently, the yield on 1-month T-bills 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 of funds from the RRP into T-bills. 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 Q3 2024 Quarterly Funding Announcement (QRA), the Treasury said it would issue $271 billion in T-bills by the end of the year. That's good, but there is still money in the RRP. Can she do more?

Let me quickly talk about the Treasury repo program. Through this program, the Treasury buys back illiquid non-Treasury debt securities. The Treasury can finance the purchases by drawing down its general account (TGA) or issuing Treasuries. If the Treasury increases the supply of Treasuries and decreases the supply of other types of debt, it will net increase liquidity. Money will leave the RRP, which is positive for dollar liquidity, and as the supply of other types of Treasuries decreases, holders will move across the risk curve to substitute these financial assets.

The latest repo program through November 2024 will total $30 billion worth of non-Treasury securities. This is equivalent to issuing another $30 billion in Treasuries, bringing the total outflow from the RRP to $301 billion.

This is a solid liquidity injection. But how bad-girl is Yellen? How badly does she want minority U.S. presidential candidate Momara Harris to win? I call her "minority" because Harris changes her phenotype attribution in different occasions depending on the audience. This is a unique ability she possesses. I support her!

The Treasury can 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 inject at least $301 billion and up to $1.05 trillion by year end. Bang! This will create a brilliant 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 this superpower within her/his reach.

Hand Grenade

The injection of $2.5 trillion into financial markets over the past 18 months through the pumping of the reverse repo program (RRP) is very impressive. But there is a whole lot of dormant liquidity that is eager to be released. Can Yellen's successor create a situation after 2025 where money is pumped out of bank reserves held by the Fed and injected into the broader economy?

In a fiscally dominated period, everything is possible. But how?

For-profit banks will swap one yielding cash instrument for another in terms of capital adequacy, as long as regulators treat them the same and the latter has a higher yield. Currently, Treasuries yield less than the reserve balances held by the Fed, so banks will not buy Treasuries.

But what happens next year when reverse repos are almost zero and the Treasury continues to dump large amounts of Treasuries into the market? Ample supply and the inability of money market funds (MMFs) to buy T-bills with the money parked in reverse repos means prices must fall and yields will rise. Once T-bills yield a few basis points above the excess reserve rate, banks will use their reserves to buy T-bills en masse.

Yellen’s successor – I’d be willing to bet it’s Jamie Dimon – will not be able to resist the ability to continue dumping T-bills on 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: T-bills, baby, T-bills!

I believe TBAC is quietly hinting at this possibility. Here is another excerpt from a previous presentation, with my comments in [bold]:

Looking forward, a number of factors may warrant further examination in considering the share of future Treasury issuance:

[TBAC wants Treasury to consider the future and how large Treasury issuance should be. Throughout the presentation, they advocate that Treasury issuance should remain around 20% of total net debt. I believe they are trying to make the case for what would cause that share to increase and why banks would be the primary buyers of these Treasury securities.]—TBAC July 31, 2024, Slide 26

The evolution and ongoing assessment of the regulatory environment for banks (including liquidity and capital reforms, among others), and the implications for banks and dealers to meaningfully participate in the primary Treasury market to intermediate and warehouse (expected) future 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’re not going to 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 impact on the Treasury Market Resilience Initiative, including,

· The SEC’s central clearing rule, which will require large margin posts at covered clearing agencies

· [If the Treasury market moves to exchanges, this will require dealers to post billions of dollars in additional collateral. They can’t bear the cost and the result will be reduced participation. ]

· Future (expected) Treasury auction sizes and predictability in cash management and benchmark Treasury issuance

· [If deficits continue to remain so large, debt issuance could increase significantly. Therefore, the role of Treasury bills as a “buffer” will become increasingly important. This implies the need for higher Treasury bill issuance. ]

Future MMF reform and potential structural demand for Treasury bills

· [If money market funds return to the market after reverse repos are completely withdrawn, Treasury bill issuance could exceed 20%. ] - TBAC July 31, 2024, Slide 26

Banks have effectively gone on strike and are no longer buying long-term Treasury bonds. Bad girls Yellen and Powell nearly caused the banking system to collapse by flooding the banks with Treasuries and then raising rates from 2022 to 2023… RIP Silvergate, Silicon Valley Bank, and Signature Bank. The remaining banks don’t want to take any more chances and see what happens if they get greedy and buy high-priced Treasuries again.

Case in point: US commercial banks have only bought 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 a similar risk profile to bank reserves but with a higher yield.

The Widow Maker

The move from 160 to 142 in the USD-JPY currency pair 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 Bank of Japan 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 once again in the spotlight.

Dehydration

Without water, you die. Without liquidity, you face collapse.

Why have crypto risk markets been trading sideways or down since April this year? Most tax revenues are generated in April, which results in the need for the Treasury to borrow less. We can see a reduction in the number of Treasury bills issued between April and June.

Liquidity is removed from the market due to a net reduction in Treasury bills. Even if overall government borrowing increases, a net reduction in cash-like instruments provided by the Treasury results in a reduction in liquidity. As a result, cash remains trapped on the Fed’s balance sheet, in the Reverse Repo Program (RRP), 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 issued, 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 USD-JPY retreat from 162 to 142, which led to a broad sell-off in risk assets.

So, in the words of 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, Bitcoin will quickly cover the sell-off caused by the appreciation of the yen. Bitcoin’s next target is $100,000.

When is altcoin season?

Altcoins are crypto plays on high-beta Bitcoin. But in this cycle, Bitcoin and Ethereum now have structural buying in U.S.-listed exchange-traded funds (ETFs). Although Bitcoin and Ethereum have pulled back since April, they have escaped the altcoin market’s fiasco. Altcoin season will only come back after Bitcoin and Ethereum break through $70,000 and $4,000, respectively. Solana will also exceed $250, but given the relative market cap, Solana’s rise will have far less impact on the wealth effect of the entire crypto market than Bitcoin and Ethereum. By year-end, a rally in Bitcoin and Ethereum driven by USD liquidity will lay a solid foundation for the return of the sexy altcoin party.

Trade Setup

With Treasury issuance and repo 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). Crypto markets are rising, improving the odds of a Trump victory. Trump's chances of winning are at their peak after the assassination attempt and Slow Joe's disastrous debate performance. Kamala Harris is a top-notch political puppet, but she's not an octogenarian vegetable. That's all she needs to beat Trump. The election is a coin toss, and I'd rather watch the chaos from the sidelines and re-enter the market after the US debt ceiling is raised. I expect that 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 run will be brilliant.

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