Fools’ gold and gold

Credit is beginning to implode, starting with equities. Investors are wavering, not knowing where to go for safety. Bitcoin? It corelates with tech stocks. The public have been fooled.

Introduction

Last weekend, I put out a note to my Substack paying subscribers detailing the differences in valuation between bonds and equities, and that by this measure, equities are more overvalued than they ever have been before. The timing of my article was prompted by developments in Japan, leading to a substantial recovery in the yen, imposing huge losses on Japan’s institutional investments in US and other equities, which in response to the Bank of Japan’s negative interest rate policy had led them to seek better returns abroad. 

A sharp recovery in the yen was the set-up for a massive bear squeeze on the carry trade, which had become an important element in financing the US Government’s borrowing requirement, principally through the buying of short-term debt in the form of Treasury bills. It was to be the trigger for beginning the unwinding of the valuation disparity between bonds and equities.

When that trigger was pulled, equities came tumbling down. If they continue to fall, there is likely to be an emergency meeting at the Fed to reduce interest rates in an attempt to save the stock market from total meltdown. It is this possibility which has driven US Treasury bond yields lower — still not enough to close the valuation gap. 

The Fed’s actions are set to repeat its interventions of late-1929. The New York Fed purchased government securities on the open market and lowered the discount rate. It supplied the extra reserves to keep commercial banks open and to satisfy demand for deposits, while keeping short-term interest rates from rising due to credit shortages.

To repeat those actions today, the Fed will set up an aggressive programme of quantitative easing while reducing interest rates. In the absence of a gold standard, it is not expected to do much else in order to stabilise the stock market. In its own historical record upon which the above paragraph was based, the Fed’s analysts stated that “…when stock market crashes occur, their damage can be contained by following the playbook developed by the Federal Reserve Bank of New York in the fall of 1929”.

Those actions stabilised the market, which recovered almost half its losses from the previous September before a far more pernicious and continual slide in stock prices set in, taking the Dow down for an eventual loss of nearly 90% by mid-1932.

For now, the stock market panic appears to be in its early stages. For desperate investors the sources of funds to cover losses are by selling previously high-flying stocks and cryptocurrencies led by bitcoin and ether. These two asset classes appear to corelate closely, as the chart below illustrates.

We can draw two conclusions from the relationship. The first is that far from behaving like a new form of money as bitcoin enthusiasts claim, bitcoin is behaving like a volatile technology stock. And the second is that technology stock and bitcoin prices are being set by the same cohort of investors. Therefore, given the price increases of the last two years, both NASDAQ stocks and cryptocurrencies will be sources of funds to cover other losses in a developing bear market. 

In the context of a widening credit meltdown, this relationship has important implications for bitcoin’s supposed status as the future counterparty-free role as money. Does it replace gold, or is it just the fool’s version?

The rest of this article is for paid subscribers to MacleodFinance Substack