Pumping Iron

Arthur Hayes
31 min readMar 4, 2021

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

I used to be an amateur bodybuilder. Sometimes friends who haven’t seen me since university remark at how skinny I am. Twice a day workouts and protein shakes were my life during university. Bonus points for anyone who can locate photos from the annual Mr. and Mrs. Penn competitions from 2005 to 2008. The photos used to be on the internet but I can’t find them anymore.

The barbell investment strategy resonates uniquely with my past. It consists of constructing a portfolio comprised of beta to participate in the upside, and volatility hedges that compensate and eclipse losses on the downside. This strategy is the simple output of Nassim Nicholas Taleb’s musings about anti-fragility and engineering a life that exhibits positive convexity.

Managing to find cheap convexity is quite difficult. You might happen upon it by chance, only to have your vega disappear as time tiptoes forward. That is why entrusting a portion of your wealth to a skilled convexity fund manager is wise. I found such a fund, and the man in charge is a veteran OG trader. Every time I sit down for coffee with him, I feel like I’m getting bashed over the head with knowledge. I usually have to go home and brush up on my option Greeks to fully unpack the knowledge he dropped. Vanna and volga were the terms I recently googled after I got home from our latest meeting.

He is plugged into all the major dealing desks and sees structures that most retail and institutional investors will never witness. As he tells me, “we buy what the banks are selling.” The best part is, sell-side traders don’t really care about the long-term implications of the options structures they price because of an annual bonus cycle. If the bank blows up years down the line because of flawed pricing, it doesn’t matter since they got paid cash money years prior. This allows savvy vol funds to buy long-dated structures that are fundamentally mispriced. But everybody wins, so the dance continues.

In this world of central bank largess, all institutional money managers are grasping desperately for low risk yield. Therefore banks sell insurance and pension funds structured products with embedded options to enhance yield. The client is always selling volatility. The banks then have to recycle this, so they offload complex structures to sophisticated vol funds.

I routinely meet up with the fund manager to chat about his view on the markets. This sojourn to the financial fringes always leads to talk about the ways in which central bank policy is distorting the financial markets and society itself. He is steeped in our age’s economic cannon, as one of his university professors was the US Treasury Secretary Janet Yellen. He formally rejects most economic cannon as poppycock, but his understanding of how the plumbing works allows him to purchase the right long tail hedges.

Let Them Eat Cake

“In 2021, inflation is coming” — this statement is now common knowledge. Everybody knows, that everybody knows, that inflation will rise this year and into the future. As such, what will the market decide is the asset that everybody should buy to protect their portfolios from the ravages of inflation? I came into the meeting with the fund manager determined to find the answer.

After our hour-long conversation, it clicked when he said, “Arthur, you have the perfect barbell portfolio for this age — long crypto (via my interest in 100x), and long interest rate volatility via my fund. I wish I had met you 5 years ago.”

We talked about Bitcoin for half the meeting. I asked him if he owned any, and he said no, but he tells all his clients they should own it. To him it is the purest expression of inflation because it is the one asset class that central banks are not directly or indirectly managing through their policy mandate.

The next few thousand words will unpack our conversation, and at the end of this essay I hope you come away with the following:

  1. The cryptocurrency complex — led by Bitcoin — is the best hedge against hyperinflation because it resides outside of the mainstream financial system. Even the best performing traditional asset will never eclipse the returns of the crypto complex during a period of inflation, simply because all assets in the mainstream financial system are manipulated by central banks so that they do not output the correct inflationary warnings signals.
  2. If policymakers decide to try to avoid the end game of hyperinflation, which has historically always been war and/or revolution, they will raise policy rates to push real interest rates into positive territory. That will crush asset values, including crypto. In this scenario, you want to be long government bond interest rates — usually via interest rate swaptions.

Both scenarios are extreme, and the actions of global policy makers must be extreme due to the endogenous risk built up in the post WWII Bretton Woods / Petrodollar financial system. There will be no muddle through, it’s either or, and subsequently a violent whipsaw between the two modalities.

A Faustian Bargain

Our government fiat petrodollar system began in 1971 when Tricky Dick (aka President Nixon) ended the Bretton Woods system by removing the USD convertibility with gold. Then US and Saudi Arabia agreed that if Saudi priced all oil in dollars, the American military would protect the monarchy. Other OPEC nations followed suit, such that oil could only be bought and sold using USD — forcing all other nations to convert to USD on a massive scale in order to participate in what was arguably the most important market in the world at the time. The Petrodollar was born, allowing the US to retain its dominance as the world’s global reserve without having to be pegged to gold.

Unconstrained by the straightjacket of the gold standard, all currencies were suddenly floating against one another with no hard money anchor. All types of monetary folly became possible at a scale unprecedented in the history of human civilisation. With a newfound ability to set short and long-term interest rates at the extremes, central bankers of the major economies embarked on a journey to artificially control business cycles. Every time the economy wobbled, the Fed and its peers cut rates. They never let the system completely reset by forcing losses on those who profited in the boom.

The long OECD government bond has been one of the best risk adjusted trades ever since the early 1980’s. Just about every financial titan we worship today enacted a strategy that essentially levered up on long government bonds and rode them onto a 100-meter mega yacht.

“Risk Parity” is a prime example. Every time equity vol spikes, I lever up on government bonds. You can call me Ray Dalio and I’ll see you at Burning Man at 10 and Esplanade. The 2019 Roots stage was LIT. Thank you Bridgewater.

Latin Debt Crisis — drop rates to save the western banks from dodgy loans made to Central and South America.

US Savings and Loans Crisis — drop rates and guarantee bank deposits in S&L institutions that committed fraud in some cases with how they managed company and depositor funds.

Russian Debt Crisis / Asia Financial Crisis — drop rates to save western banks and hedge funds from dollar loans made to Russia and South East Asia.

Subprime Mortgage Crisis — drop rates to save the financial system from over investment in US subprime mortgage credit.

2012 Euro Crisis — drop rates to save a politically created union with a common currency but not a common government. Super Mario said he “will do whatever it takes”, and he meant it. Corzine was a bit too early in the trade; SFYL MF Global investors.

2013 Taper Tantrum — the Fed Chairman Bernanke tried to take the punchbowl away via signaling that in the future the Fed would allow its balance sheet to naturally shrink as bonds matured. The lack of a constant flow of future wampum caused yields to spike, and the Fed subsequently walked back such inflammatory language.

COVID-19 — drop rates and monetise government deficits to fiscally support the economy which governments shutdown in an attempt to halt the spread of COVID.

In many cases, these frequent financial crises were themselves caused by central bankers raising rates to normalise or beat off uncomfortably high inflation or financial asset appreciation. Raising rates causes a crisis where the remedy is to drop rates lower than before. Therefore, while all of these crises were painful, they never drove any meaningful changes to how we approach the management of our economies — and the solution to each just sowed the seeds for the next financial flare up.

Policy makers oscillate between printing money, which causes inflation, and raising rates, which causes asset losses and/or a financial crisis. 40 years of this back and forth has resulted in almost $20 trillion in zero- or negative-yield government and corporate debt, the lowest interest rates in the last 5,000 years, and the most amount of global debt ever in human civilisation.

The Inflation Barbell

At one extreme: print money to lower rates, so that debt can be repaid with debased money. This supports asset prices, which supports a high debt load. Those with financial assets benefit.

At the other extreme: raise rates, which in turn depresses asset values, causing debtors to default and forcing them to hand their assets to creditors. These assets fall in value toward their fundamental ability to generate cash flow. Those earning wages benefit as their labour can buy more real and financial assets.

Previously, policy makers could operate in the belly of the barbell. They didn’t have to print excessive amounts of money, nor was the act of raising rates slightly so debilitating. However, the current situation does not afford our high clergy the luxury of being able to tweak around the edges.

Consider this — in order to stave off the economic ravages of COVID and bring USD borrowing costs lower, the US Federal Reserve has injected approximately 3 trillion dollars into the economy via quantitative easing. To fund this effort, it has expanded its fiscal deficit to levels not seen since WWI or WWII. And the big problem with using debt to stimulate the economy is you need ever-increasing amounts of it to generate the same level of output. It wouldn’t be so bad if the world entered COVID with a low debt load but heading into Q1 2020, global government debt to GDP was at its highest in human history.

If the Fed were to raise rates at all it would inflict staggering losses on bond portfolios worldwide. When real rates go from nothing to even 100bps higher, negative convexity destroys bond holders. That is why raising rates is the nuclear option. Instead they go with the palatable, feel good option, which is to continue pilling on debt in the hopes that some transformational technological breakthrough allows productivity and output to accelerate so quickly as to expunge the crushing debt load.

The stated policy goal of the Fed is to limit inflation to 2% annually. $1 loses half its value after only 35 years of 2% annual inflation. For a young entrant into the workforce, 2% inflation means your savings need to return 50% just to stand still over your working life. That’s not hard to do if a bank deposit or fiat government bond yields in excess of 2%, but they do not. You are now forced to speculate in the … “fair, free, and open” financial markets (cue everyone opening up their Robinhood / E-Trade / Schwab app). If this is considered “good” inflation, imagine how destructive even slightly higher levels are. When you buy a bond with a zero or negative yield to maturity, the only way you don’t blow up is if central banks take rates even more negative.

As I mentioned earlier, the end game of rampant inflation is always war and/or revolution. Show me a regime change, and I will show you inflation. When you work your ass off only to stand still or get poorer, any “ism” that promises affordable food and shelter for the unwashed masses will reign supreme. If you are starving to death, nothing else matters except feeding your family. The symptoms of inflation are populism, social strife, food riots, high and rising financial asset prices, and income inequality.

Policy makers know that if they engineer inflation that is too rapid, they will find themselves underneath the guillotine. So, their only hope is to move back to the other side of the barbell (i.e., raising rates) before bloodshed begins.

Fighting Inflation

Our masters at the Marriner Eccles building told the world in no uncertain terms they are willing for inflation to run “hot” in order to, in their minds, rebuild the American economy. (I focus exclusively on the Fed because every other central bank is subservient to them, since the Fed controls the global reserve currency.) As a simple heuristic in this time of monetary inflation, did your portfolio appreciate at or above the increase in the broad money supply, M2? If not, you underperformed. US M2 expanded 25% in 2020. Take a hard look at your portfolio. Did you, or the fee-charging flunky managing your money, generate a return greater than 25%?

With the threat of hyperinflation on the horizon, your job as a steward of your own and other’s capital is very simple: find a way to store financial wealth today, that will allow you to outpace inflation and purchase energy tomorrow. Radigan Carter, a new favourite financial blogger of mine, wrote an excellent essay “Ample Liquidity and Productive Assets” which expounds on money’s energy purchasing power.

The First Law of Thermodynamics is not a suggestion. Energy is not created nor is it destroyed. It only changes shape.

Our entire civilisation is built upon the use of dense sources of potential energy to create goods and services. We take this energy and turn it into food, shelter, transportation, and entertainment. On a universal scale, all energy that ever was or will be is already in existence. As we move from potential (stored) to kinetic (energy in action), there is exhaust. The lesser the waste, the more productive our civilisation becomes.

Burning wood is less efficient than burning hydrocarbons, which is less efficient than nuclear energy. As a steward of personal capital, we must save in financial terms in order to exchange for real goods. Saving real goods cannot be done at the personal level, and it is extremely risky.

A thought experiment:

It’s 1900, and coal is the densest form of energy known for industrial applications. Coal powers all the amazing inventions of this current industrial revolution. You decide to take all of your savings and own coal directly. In the shed out back, you have a pit filled with coal. You now believe your energy needs are secure. In the future, you believe regardless of any monetary inflation, your coal holdings will allow you and your family to experience a constant quality of life vis-à-vis your energy consumption.

Then oil is discovered in quantities that allow it to be used industrially. Coal’s societal value declines — it’s still useful, but it’s way less efficient than oil. Therefore its price vs. financial assets declines. You are now actually poorer because while you are long a form of potential energy, you are short human technological innovation.

It is suboptimal to attempt to pick a winner amongst physical potential stores of energy. Potential energy is also expensive and difficult to store in non-industrial quantities. It is better to accumulate a financial asset or monetary instrument that will stay constant or rise in its value vs. the dominant form of potential energy. Gold has been “money” for almost the entirety of human civilisation. And while the most important current exchange rate may be a financial asset or monetary instrument’s value vs. a barrel of oil, over the 10,000 years of human civilisation, we have moved from animal, to wood, to coal, to oil, to nuclear and renewable forms of energy. Historically, saving in gold vs. saving in physical raw energy is a safer bet.

But, that doesn’t mean gold is necessarily the best bet. As investors, our goal is very simple, but difficult to achieve: Construct a portfolio of assets that will benefit disproportionately as global fiat liquidity, created by central bank money printing, washes into them. This is a common knowledge game — what does everyone else believe everyone else believes retains value? The degree to which an asset class captures the narrative is based on liquidity, scarcity, and transaction costs.

Invest wisely and you can maintain or increase your standard of life against the rising fiat cost of energy. Invest poorly and the road to serfdom is real. You will find yourself working harder for a declining standard of living, and your fiat earnings and assets will not be able to keep up with the rising fiat cost of energy.

Which Asset?

Let’s do a quick tour around the major asset classes. I will evaluate them on liquidity, scarcity, and transaction costs.

Stonks for the Long Run

I didn’t have a high enough GPA to attend Jeremy Seigel’s class at Wharton. However, his fame lives on in my memory.

Liquidity — A-

Stocks are liquid. Each major economy has a domestic stock market, and the US market can be accessed by most retail investors in some way.

Scarcity — B

Stocks are semi-scarce. While there is only one Tesla, Elon can and does routinely decide to increase the float and dump shares on the market as the stock price rises. This continuous dilution at the discretion of management presents a risk to investors.

Transaction Costs — A-

Trading stocks is “free” in some cases, and in others carries low transaction costs. If the product is free, you are the product. That’s neither good nor bad, just the truth. At a macro level, trading stocks is cheap and will get cheaper with the explosion of digital finance.

Verdict — B+

Stocks tick all the boxes, so the question then becomes — which ones to buy?

Every era has a sector that is hot. Being hot means that investors suspend fundamental cash flow analysis and buy into the story. Tesla is the epitome of this in our current era. Tesla is worth more than all other auto companies combined, even though it produces an extremely small fraction of global cars each year. It does not have positive unit cost economics on cars it produces when government subsidies are stripped away. A company that makes no money and depends on government largesse to continue its operation has made its founder one of the richest men in the world. This is a story stock — investors believe in some future that is so amazing it renders cash flow analysis moot.

All stocks trade on a multiple to something the market cares about. Sometimes it’s sales, cash flow, active users, etc. Each industry has its defining multiple that the market expects management to deliver on. Multiple expansion is when belief trumps reality. If my results are constant, but my stock price against those results increases, equity holders benefit. If my results are constant, but my value against those results decreases, equity holders suffer.

Back to Tesla. If Tesla starts making money, but its multiple to EBITDA declines, stockholders lose money. Therefore, as stocks or a sector switches from story-driven to being judged on their fundamental cash flows, multiples compress, and equity holders are punished.

For the inflation-minded investor, this is suboptimal. You want to invest in one or a few assets that just go up based on liquidity, scarcity, and transaction cost terms. Worrying about the price to value metric is hard to do over a long period of time. You can entrust your money to successful stock pickers, but not everyone is DeepFuckingValue. The name of the game is beta to inflation. Why pay 2 and 20 for beta? Stocks are a very narrative sensitive asset class where the narrative is not constant across the entire universe of securities.

I would put stocks as a top choice to hold value in a very inflationary environment, but buyer beware — not all stocks can withstand the ravages of inflation. In fact, a recent piece by Charles Gave and Didier Darcet called “Inflation and the Stock Market” called into question the belief that any stocks perform well in inflationary environments. I haven’t had a chance to fully digest this piece, but at first glance the authors provide compelling statistics that point to the total amount of excess returns for the S&P 500 was driven by appreciation in dis-inflationary periods rather than inflationary or deflationary periods. I highlight to show that even my view that the broad index can perform well during inflationary periods might be erroneous.

You can do better.

Real Estate Never Goes Down

Every time I hear this, I cringe inside. But it is to be expected. Shelter is an essential human need. As long as there are humans, there will be a need for shelter. That is why intrinsically everyone gets why real estate holds value.

Liquidity — C

Real estate is not liquid. Buying a property in most jurisdictions takes between 1 to 3 months to close. Every property is different. There is no standardisation or homogeneity outside of apartments in the same development. Therefore, everyone can’t own the same type of unit which destroys fungibility.

Scarcity — A+

Real estate is scarce. They ain’t making more land. This is especially true if you focus on urban areas. Zoning laws restrict what can be developed and how. This creates scarcity at a local level.

Transaction Costs — D

It is extremely expensive to trade real estate. Property agents in most markets earn percentage points of commissions. Once you factor in taxes, commissions, and legal fees it can cost 10% — 30% round trip to buy and sell a piece of property. We are trying to preserve wealth for energy consumption in the future, not pay economic rent to the government, lawyers, and agents.

Verdict — C+

The good thing about real estate is that it has real cash flow. Either someone in theory could pay you rent, or you use it yourself.

The bad thing is that it is really hard to put a lot of money to work in real estate quickly. At the small investment scale, you don’t get much diversification. If you can only afford to invest in one piece of property, you have to stomach a lot of local idiosyncratic risk endemic to its physical location that may or may not correlate to global liquidity conditions. Energy is priced on a global scale at the margin, not local.

Fixed Income

The problem with fixed income is in the name itself. “Fixed”, the returns are predetermined. What is not known is the level of inflation that should be used to discount future cash flows. A bond that trades at 50 with 100 par offers way more convexity than a bond that trades at 100 with 100 par.

Liquidity — A+

Bonds are extremely liquid. Government bonds are the most liquid financial assets globally. They trade trillions of dollars per day. It is so easy to deploy capital into bonds, and that is why it is hard for large asset managers to stray too far away from some fixed income allocation.

Scarcity — F

Bonds are not scarce. Well, highly-positively yielding ones are scarce. But debt levels are at the highest level in history. The more debt a government or company issues, the harder it is to pay back that debt unless cash flows accelerate quickly.

Transaction Costs — B

Trading bonds is free or very expensive depending on the issuer. If you are trading government bonds the transaction costs are very low. If you are trading corporate bonds, the spreads are wide and markets opaque. Just how the banks want it to be.

Verdict — C

Bonds hate inflation, so owning them is suicide at this end of the barbell.

All That Glitters

Now we move into the forms of money that may or may not stand the test of time.

In my 2020 piece “Choose Your Fiction” I laid out my view of the three types of money.

Fiction + Physical Violence (Government Fiat)

Fiction + Physical Scarcity (Gold)

Fiction + Digital Scarcity (Bitcoin / Cryptocurrencies)

Debasing the domestic currency is the easiest option for a government that cannot deliver productivity and economic growth to its subjects. That is the implicit assumption throughout this essay. Therefore, I will not give a grade to any fiat currency. They all trade relative to each government’s willingness and ability to debase its currency to achieve mercantilist outcomes. That is, namely, I want to devalue my currency so my export sector achieves global prominence. That way my domestic industry is competitive, profitable, and hopefully wages at the lower end are sufficient to engender the middle class to my form of government.

We humans believe in the fiction of gold. It is shiny, beautiful when handled by skilled craftspeople, and holds its value vs. the dominant form of energy. Full disclosure: I myself am a gold bug. I own the barbaric relic in the physical form, and shares of gold miners.

Liquidity — B

I have travelled to many cities worldwide, and there is always a section of a city where gold is traded. There is always someone willing to exchange something of value for gold.

The problem with gold is that it is heavy. In small quantities, this weight is immaterial. But as you start to hold large quantities of gold it becomes unwieldy to transport. It also attracts a lot of attention. How funny is it that we spend energy to dig it out of the ground, energy to lock it up safely, and energy to transport it to market?

The paper markets are quite liquid, but paper gold is just a trading vehicle. ETFs, futures, bank passbooks etc. are gold derivatives. They are not the metal itself. If you really believe gold is money you must own the physical. Every other trading product is some financial actor’s liability, and if the system is inherently unstable their promises will be found null and void in a time of crisis.

Scarcity — A-

A geologist can give an approximate figure for the total amount of gold contained in the Earth’s crust. We know how much is on Earth, but what about in the cosmos? At the rate space travel is being commercialised, it is not ridiculous to imagine a gold discovery on the moon or some stable asteroid in Earth’s orbit. That would dramatically change the supply.

Barring extraterrestrial discoveries, gold is sufficiently scarce to earn it a high grade. Many have tried to create the philosopher’s stone — none have yet succeeded.

Transaction Costs — B

If you own a few coins, bars, or pieces of jewelry, it is quite expensive to buy and sell gold. You could pay up to 10% in terms of buy / sell spread to acquire and dispose of your gold. That is not ideal if the goal is to one day exchange gold for energy.

In larger sizes, gold spreads are tight. But what will cost you is transport. Depending on where the gold comes from and goes to, it is not a trivial cost. That is the reason why central banks have historically stored their gold in one or more trusted money centers. London, New York, Shanghai, Hong Kong, and Singapore are some of the large trading hubs.

Verdict — B+

Gold has history on its side. However, its physical weight is a drag on its usefulness.

“Rat Poison Squared”

Warren Buffet is an excellent trader so I won’t hold his comments about Bitcoin against him. He is a pro at saying one thing but investing in another. Give him time, he will see the light. He used WMD’s, also known as derivatives, adeptly when he bailed out Goldman Sachs in the 2008 Great Financial Crisis and took his pound of flesh in the form of warrants. Hypocrite is too harsh a term for such a smooth market operator.

Bitcoin is Fiction + Digital Scarcity. The supply is fixed via open-source code. With prominent hedge fund managers, corporate chieftains, and pension fund administrators beginning to dip their toes into the market, the narrative surrounding it has shifted massively.

Find me a client willing to pay commissions to trade Bitcoin, and I will find you an investment bank with a Bitcoin BUY rating. People think banks hate Bitcoin; no, they hate when a form of money or financial asset escapes their ability to rehypothecate it and/or charge commissions to trade it. It is also likely not the existential threat to banks that some people think it is. The extinction level event for commercial banks is not Bitcoin or any other private digital asset, it is their domestic government allowing the populace to hold accounts directly with the central bank using a Central Bank Digital Currency (CBDC). Stay tuned for my essay on this topic.

Now that commercial banks’ clients believe Bitcoin will protect their wealth from inflation, every major sell-side macro research analyst has a piece on it. Spoiler alert, they all think the price will appreciate markedly. Their arguments allow more beta-chasing institutional money managers to justify purchasing it.

They likely aren’t wrong, either. With bond yields at the zero-bound, fixed income is the worst thing money managers can own. So they will have to rotate out of fixed income, where market to market losses are assured, into something else. This will be the most important source of flows and commissions this decade. Watch out for academic papers deriding the balanced 60 / 40 equity vs. bond balanced portfolio. That fixed income slice will get pushed lower, and that will unlock trillions of dollars of fiat that needs to find a home in one or more of the financial and monetary instruments described in this essay.

And the last important fact about Bitcoin and the crypto ecosystem is that the vast majority of it is owned by individuals, not central or commercial banks. To my knowledge, no government treasury, central or commercial bank holds Bitcoin on its balance sheet. That means it cannot be sacrificed on the altar of credit, which subsumes an asset into the financial firmament in which we operate.

Liquidity — B

Some friends of mine who work for major crypto OTC desks talk about the scarcity of physical. The largest net sellers right now are miners. Everyone else is hodl’ing. This is the moment the ecosystem has been waiting for since 2017 — those who had to sell, sold already. A good metric to monitor is the number of wallets from which nothing has moved in the last year, and their percentage ownership of the total Bitcoin float. If that percentage is increasing, it means less supply is available for sale, and if it is falling, more supply is available for sale. Another similarly interesting metric reported by glassnode is the amount of Bitcoin leaving exchanges (ostensibly to private wallets to be hodl’d).

All of this hoarding is great for your mark to market fiat value. More fiat chasing a dwindling supply leads to PUMP CITY. But for those looking to put billions to work, it will be expensive. There is simply not enough supply, at this market cap, to accommodate the trillions that will be printed in the coming decade.

Either you believe the price appreciating creates a positive feedback loop that encourages money managers to disregard the difficulty in putting on size, and just YOLO, or you believe this will dissuade money managers from allocating a sufficient amount of capital — forcing them to continue acting as marginal buyers that push up the last traded price. Remember, it’s about the flow, not the stock. The marginal buyer sets the last price, not those who bought before.

I firmly believe liquidity will expand as interest in the space increases. While crypto on a macro level is the least liquid of the assets described in this essay, the market is 10+ years old and billions of USD per day already trade across the various major exchanges and over the counter.

Scarcity — A+

There is no way to change the supply cap unless the network — which now spans millions of self-interested participants — decides amongst itself to alter it. The beauty of Bitcoin is that if you bought it for its 21 million supply cap, why would you vote to debase yourself? Could it happen? Technically. Would it be economic suicide for all participants in the ecosystem? YEP.

Transaction Costs — B+

At a retail level, trading Bitcoin is cheap, but still more expensive than trading stocks or government bonds. However, it more than compensates for the higher cost by removing the need for relying on intermediaries to move value. You simply pay the prevailing Satoshi per byte, and no matter the day, time, or year, you can transfer value from A to B. There are no centralised gatekeepers.

Trading or transferring any of the items described above require the friendly assistance of banks, brokers, lawyers, and or security guards. They don’t dance no more, they make money move.

As the Ojay’s said:

All the time they want to take your place

The back stabbers (back stabbers)

(They smilin’ in your face)

All the time, they want to take your place

The back stabbers (back stabbers)

Verdict — A-

Bitcoin is the only monetary instrument that trades in a completely free market. Even if you nuke all the exchanges, Bitcoin can still be traded and transferred amongst global citizens. Its price is the market’s true reflection of the inflationary nature of the policies enacted at this end of the inflation barbell.

Rising Rates

What happens if inflation gets too hot, and central banks must raise rates to a territory where real interest rates are positive? FINANCIAL ARMAGEDDON.

If it’s so bad, why would they inflict pain upon wealthy financial asset holders? Because the alternative is that the rabble rise up, and align themselves with a leader or system that will forcibly remove wealth from those who prospered in the ancient régime. Therefore, in the best interest of maintaining the social order, some losses must be inflicted upon those who hold financial assets.

The Fed’s stated goal is 2% inflation. Let’s assume they achieve that, and they hold the ten-year bond at 1% interest. That means real rates are -1%. At that point, bondholders are essentially paying the government for the privilege of lending it money — which, naturally, no one wants to do. One way to monitor current real rates — which are absolutely essential to charting out your investment strategy — is to compare government bond yields against nominal GDP growth.

Currently, nominal USD government bond yields are rising. But if nominal GDP is growing at a pace greater than the interest rate of the ten-year bond, real rates are still negative. If nominal GDP growth is lower than the ten-year, real rates are positive. As of market open today, the yield for the US 10-year treasury is 1.47%, and given reflation expectations on the back of the COVID vaccine rollout, 2021 nominal GDP is expected to be well in excess of 1.5%. So, real rates are currently negative.

Turning back to our example scenario of 2% inflation and 1% ten-year bond yields, let’s assume that the Fed recognises the danger posed by negative real rates of -1% and freaks out — engineering the interest rate of ten-year bonds from 1% to 2% to match inflation and push real rates back to 0%. Now, let’s evaluate what happens to the assets and forms of money described above following that rate hike.


I know funderrrrmentals don’t matter, but they do (eventually). The reason why investors can buy big tech even with anemic or negative EBITDA is because money is cheap. If you can crystalise gains in a story stock, and then plow money into positively real yielding government bonds, that’s a slam dunk. The rotation out of growth into real yielding fixed income securities will be frenetic if the Fed ever raises real rates above zero.

If you ever studied corporate finance or worked as an investment banking analyst, you should be able to build a Discounted Cash Flow (DCF) model. A stock should eventually pay a dividend, therefore you can discount dividend payouts to the present and arrive at the value for a stock.

In any DCF model, you forecast earnings out to a point, then you assume a terminal value.

Terminal FCF * (1 + Terminal FCF Growth Rate) / (WACC — Terminal FCF Growth Rate) = Terminal Value

FCF = Free Cash Flow

WACC = Weighted Average Cost of Capital

Let’s just look at the terminal value of a stock that has $100 of earnings that will grow at 2% per year forever, with a WACC of 5%.

$100 * (1 + .02) / (.05 — .02) =$3,400

Remember that a company’s WACC is a calculation of its cost of capital across all of its sources of capital, including debt — which has its interest rate dictated by the interest rate of government bonds. So if this company’s WACC was 5% prior to the Fed’s 1% rate hike, it is now 6%. Let’s see what happens to the terminal value of a stock.

$100 * (1 + .02) / (.06 — .02) =$2,550

The stock that was worth $3,400 is now worth $2,550- a 25% drop caused by just a 1% rise in WACC. That is negative convexity as the stock price fell faster than the rise in the WACC. Bad News Bears. And it gets worse. If the WACC started at a lower level, meaning the spread to growth was tighter, your initial value is higher, but your % losses are greater. Let’s plug in an initial 3% WACC to the same stock:

Before 1% rate hike:

$100 * (1 + .02) / (.03- .02) =$10,200

After 1% rate hike:

$100 * (1 + .02) / (.04- .02) =$5,100

At a 3% WACC, the terminal stock price is $10,200; at a 4% WACC (driven by the rate hike) the stock price falls to $5,100. Stock price -50%, WACC +1%. Wah, such returns. You deserve that 2% management fee.

If you buy an asset where funding costs are already depressed, the negative convexity that results from a modest 1% rate hike is massive. Buying overvalued stocks because of a depressed discount rate is great as long as more liquidity follows your purchase to keep the price high and rising. That will persist as long as rates are low. But if interest rates rise even modestly, your losses will be magnificent.

Real Estate

The biggest real estate sector is residential. Most people buy their home with government- or bank-provided leverage. The US has the largest mortgage market in the world. Let’s look at a standard 30-year fixed rate amortising mortgage. You have a constant payment that over the next 30 years will pay off the principal plus interest.

I will not go into the math, but if you use the amortisation functions on excel you can replicate my figures.

The price a person can pay for a house depends on the affordability of the mortgage payment. Assume the median family can afford to pay $422 per month on a mortgage. Assume they take out a 30-year mortgage with monthly payments at a fixed interest rate of 3%. That means they can afford to buy a $100,000 house.

Now the rate rises to 4%. The median family can still afford to pay $422 per month, but the rate increase means they can only afford to buy a house worth $88,309. The rate rose 1%, and now they can afford 12% less house.

Given that the notional value of property is so large relative to wages, real estate is very sensitive to financing. If an asset cannot be financed, the price of the asset must be lowered so that the monthly payment is affordable. In the simple market illustrated above, the price of the median house must fall 12% in unlevered terms so that the median family can still afford it. Given that most deals are done with some sort of financing, levered losses on real estate portfolios will be substantial should interest rates rise.

Fixed Income

As with most things in life, bond returns are path dependent. If you buy a bond in a low-rate regime (where we currently find ourselves), your losses will be exponentially greater for any small move higher in interest rates. This is why any asset manager with a fixed income allocation experiences night tremors. The mandate says take new capital and purchase currently low-yielding bonds. If rates rise, they are doomed.

Allow me to illustrate. Keeping it simple, let’s value the fair price of a ten-year bond issued before the rate hike. The face value of the bond is $1,000, the coupon is 2% per annum, and the risk-free rate is 1%. The present value as a percentage of face value is 109.47%. The Fed raises the rate by 1% to 2%, now this ten-year bond’s price drops to 100.00%. Rates rose by 1%, but the bond price dropped by ~10%. NEGATIVE CONVEXITY strikes again.

Let’s use the same numbers but instead the starting discount rate is 5% and rates rise 1% to 6%. The bond price drops from 76.83% to 70.56% for a loss of approx. 6.3% for a 1% raise in interest rates. The convexity is still negative, but less so.

As I said earlier, large asset managers with a large fixed income allocation will take profit after a 40-year bull market, and deploy those trillions of fiat dollars, pounds, euros, francs etc. into equities, real estate, precious metals, crypto or anything else the establishment believes performs well in an inflationary environment. The math couldn’t illustrate the ruin of fixed income investing at the zero-bound of risk-free rates any more clearly.


“Gold has no income” is the common refrain from haters. And while it’s true, the price of gold also tracks nicely against the ebb and flow of real rates of the global reserve currency.

Simply put, gold is a good hedge when real rates are negative — but when they turn positive, gold gets the stick. If I can easily earn a positive real return on my fiat, I don’t need to save in gold. My income from investing in low-risk positively-yielding fixed income assets covers the rising fiat cost of energy.

The last mega gold bubble was during the 1970’s stagflationary period where the cost of energy (oil) in real terms skyrocketed. Fed Chairman Volker came in with the inflation hammer and raised short-term rates well above 10% to depress inflation expectations. Gold subsequently crashed and is still below its inflation adjusted peak in the late 1970’s.


The value of Bitcoin is digital hard money that rides on its own transmission network. It has value both from fiat liquidity escaping inflation, and the market’s imputed value of the non-aligned decentralised payments / communications network.

Bitcoin Value = Liquidity Preference + Perceived Technological Value

I do not have a model for an estimate of the ratio between the two, but at a high level if global fiat liquidity can earn a real return again in government bonds, it will exit Bitcoin / crypto. The whole point of this exercise is to preserve / grow purchasing power against energy. If that can be done in the most liquid asset, government bonds, then liquidity will take the easy option.

The amount of remaining technological value is beyond my skills to estimate. However, it is much lower than the current fiat price of Bitcoin today.

Go Long Interest Rates

It sounds so easy, but is so difficult. As outlined above, the majority of financial and monetary instruments respond positively to falling interest rates, not rising ones.

Who is a price insensitive seller of interest rate volatility? By law, many supra-national pension and insurance funds must invest in fixed income. The yields are low, so the funds sell interest rate options to banks to enhance the yield. The banks then turn around and sell these options to sophisticated vol funds.

Because the distortions in the interest rate markets are so large, since every central bank’s stated policy is yield compression in the search for inflation, these interest rate options (swaptions) trade extremely cheaply. The PM told me about a large bond deal that was sold entirely to Taiwanese insurance companies. The embedded Bermudan options allowed him to buy 1-year by 30-year swaptions for a basis point on a hundred million of USD notional. A few percentage points rise in rates yields several million-dollar payouts. Ship Them In!

Also, the value-at-risk models are based on a flawed Gaussian normal distribution, which underestimates the tails and thus underprices risk. Therefore, if you can stomach small consistent losses, massive payouts are possible when the system adjusts to a rising rate environment. Again, this is Taleb 101. All his books are a must read.

Great, conceptually it makes sense. However, as a retail or even high net worth individual you cannot buy these exotic options. I have an ISDA with a major dealer, I get face-ripped on OTC options. However, there are many instances where the bank will refuse to show me a price even if I’m willing to cross the spread.

This is why, if you are able to invest in vol funds that explicitly invest in tail risks, do it. It solves neatly for this side of the inflation barbell. If you can’t, options on Eurodollar interest rate futures,or put options on government bond ETFs might be another way to benefit YUGELY if /when policy makers decide to raise rates.

It’s Really Quite Simple

The imbalances inherent in the post WWII USD Bretton Woods / Petrodollar regime can only be fixed at the extremes.

The easy option is to keep real rates negative and inflate the debt away. But for how long can this be done before those who do not hold enough financial assets revolt in the face of high and rising energy costs?

If the societal discount crescendos to an unbearable level, policy makers must change course. That change will be to raise rates so that real rates are positive. Given the market believes that central bankers have solved the business cycle, a rate hike will be cataclysmic in terms of losses across the financial system. Is it better to have your head on your shoulders, or another 1,000 points higher on the S&P 500?

Build a portfolio of long crypto plus long interest rate volatility. Walk away and watch the fireworks.



Arthur Hayes

Co-Founder of 100x. Trading and crypto enthusiast. Focused on helping spread financial literacy and educate investors.