As the Fed is slamming the breaks on inflation, and investors are dumping gold and crypto. Is that the right call?
In an effort to combat rampant inflation, the Fed is preparing for a reversal in monetary policy.
In its last December meeting, Fed officials revealed that they may increase interest rates “sooner and at a faster pace” than expected. Soon thereafter, the Fed may start dumping government and corporate bonds.
This information became public on Wednesday, with the release of the minutes from the Fed’s Open Market Committee meeting.
FOMC members expect that the outlook for the “economy, the labor market, and inflation” will allow the Fed to “increase the federal funds rate sooner or at a faster pace” than anticipated.
The Fed will also start unwinding its bloated Fed’s balance sheet, with trillions in corporate and government bonds. So far, it had accumulated some $8.7 trillion in debt.
— Holger Zschaepitz (@Schuldensuehner) December 15, 2021
“Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate,” they wrote.
Fed had been accumulating these bonds at a rate of $120 billion per month since the start of the pandemic. It had since reduced the pace of the purchases by $15 billion in November. In January, that number will be just $30 billion per month. Soon, the Fed may start selling bonds, instead of buying them.
Gold, Crypto And Interest Rates
That’s all bad news for gold and crypto. Right? After the release of the Fed minutes, gold lost 1%, dropping below $1,800. The precious metal is now trading at about $1,790.
Crypto, on the other hand, experienced a huge selloff. Bitcoin dipped below $43,000, and it was not even the worse performer. Most other major cryptos posted double-digit losses.
For comparison, gold reached its record high of $2,063 in August of 2020. Bitcoin, on the other hand, reached its all-time high of $68,000 in November 2021.
Why the drop? Firstly, most investors consider gold a hedge against inflation. That means that, when inflation is high, people flock to gold.
On the other hand, gold is a safe haven for investors. When the economy doesn’t perform, investors flock to gold. That means that gold is particularly strong in times of recessions.
Moreover, gold is hard money. That means that its value will keep rising in the long run – in dollar terms. That is, as long as the Fed keeps printing money – and we can basically count on that.
As the Fed is talking the talk on inflation, most investors think that inflation will not be a problem. That’s why they don’t think they need to hold gold.
Crypto And The Tech Bubble
Crypto is in the same boat, but for a somewhat different reason. On the one hand, some investors consider crypto as a hedge against inflation.
However, others also consider crypto as a risk asset. It’s an asset that relies on innovative tech, promises high returns with high risk and volatility. For that reason, some compare crypto with tech stocks.
However, risk assets don’t perform well when interest rates are high. The reason is that high interest rates make investors more risk-averse. Specifically, leveraging up and chasing high gains becomes less attractive when interest rates are high.
In fact, it is likely that the historically low pandemic interest rates inflated the boom in tech stocks – and possibly, in part – in crypto. That bubble may now be at risk of bursting.
Reality Check – Fed’s Track Record
So things would be looking really bad for crypto – if the Fed really did start fighting inflation. However, there are reasons to think that they won’t.
The main reason is that higher rates may crash the economy. Bubbles from easy money, as well as structural problems, make most western economies addicted to easy money. If the Fed starts raising rates and unwinding its balance sheet, it might crash the economy.
On the other hand, high interest rates don’t jive well with Joe Biden’s “infrastructure” plans. With $3 trillion in new debt from “Build Back Better” alone, the White House would prefer to keep rates low.
But let’s look at long-term trends, and see if they work with this explanation. Firstly, let’s look at the Fed’s Fed’s balance sheet. The Fed basically started its massive bond purchasing program during the financial crisis of 2008. Back then, they called it “quantitative easing” or QE.
The Fed's balance sheet hit another record this week at $8.79 trillion. It has more than doubled over the last 2 years.
— Charlie Bilello (@charliebilello) December 23, 2021
The Fed’s balance sheet did shrink slightly a few times in that period. However, it never came anywhere close to what it was before 2008.
Even in 2020, 12 years after the financial crisis of 08′, the Fed’s balance sheet was about twice as large as at the height of the crisis!
Are we really supposed to expect that the Fed will dump more bonds this time? It may sell some bonds, sure. But soon, it will find another excuse to start buying more.
The same goes for interest rates. The trend is clearly for lower interest rates for longer amounts of time.
The economy was struggling at 2.25% Fed Funds rate and 3% 10 year yield in 2019. That was with national debt at $22 trillion.
At $29.5 trillion now and estimated $32 trillion debt by the end of 2022, what Fed Funds rate and 10 year yield is the breaking point now ? pic.twitter.com/suiQ4ou62J
— Wall Street Silver (@WallStreetSilv) January 2, 2022
Given its historic track record, it’s safe to assume that the Fed will continue to pump more and more money into the economy. And that is good for gold – and crypto.