Hello there,

A terrific Tuesday to you as markets continue to tank and with no end to the bleeding in sight.

In brief (TL:DR)

• U.S. stocks fell sharply Monday with the Dow Jones Industrial Average (-1.99%), S&P 500 (-3.20%) and the Nasdaq Composite (-4.29%) all continuing to add to losses and with no signs of reprieve.

• Asian stocks came under more pressure Tuesday as concerns about a darkening economic outlook hang over global markets and support the dollar.

• Benchmark U.S. 10-year Treasury yields declined five basis points to 2.99% (yields fall when bond prices rise), reflecting haven demand and uncertainty over how far the U.S. Federal Reserve will hike rates to stem inflation.

• The dollar is at the highest level since 2020.

• Oil slipped with June 2022 contracts for WTI Crude Oil (Nymex) (-1.77%) at US$101.27 as economic data out of China painted a bleak outlook.

• Gold edged lower with June 2022 contracts for Gold (Comex) (-0.15%) at US$1,855.90 as the greenback continued to strengthen.

• Bitcoin (-10.71%) fell to US$30,519 (at the time of writing), a retreat that’s become emblematic of the ebbing liquidity that’s curbing risk appetite. At one point, the benchmark cryptocurrency dipped below US$30,000 before retracing.

In today's issue...

1. Why is everything dropping?

2. A Reverse Currency War & Race to the Bottom (Top)

3. Bitcoin is Bombing at the Worst Time for Another Algo Stablecoin

Market Overview

China’s woes, a global wave of monetary tightening and the war in Ukraine are casting a pall over the world economy.

In a semi-annual report, the U.S. Federal Reserve warned of deteriorating liquidity conditions across key financial markets.

Investors are awaiting the April U.S. consumer-price index print on Wednesday to gauge whether inflation is peaking and if so, could provide enough for markets to cheer as the Fed may hold back on further tightening.

Asian markets continued to fall Tuesday with Tokyo's Nikkei 225 (-1.81%), Seoul's Kospi Index (1.81%) and Sydney’s ASX 200 (-2.22%) were all down, while Hong Kong is still closed.

1. Why is everything dropping?

• The 60/40 portfolio management theory has come under pressure as both stocks and bonds have been hammered in the wake of the U.S. Federal Reserve’s 50-basis-point rate hike and there appears to be no end in sight for swift market downturn.

• As bond yields soar, investors are disincentivized to take risks by buying stocks, leading to a self-fulfilling negative feedback spiral that is seeing stocks and bonds plummet back to earth.

The typical 60/40 stock and bond portfolio was intended to be the “free lunch” of investing.

According to the 60/40 portfolio management theory, because bonds and stocks are supposed to move in opposite directions to each other (negatively correlated), a portfolio that contains both assets ought to be less volatile.

But that theory has come under pressure as both stocks and bonds have been hammered in the wake of the U.S. Federal Reserve’s 50-basis-point rate hike and there appears to be no end in sight for swift market downturn.

Last week, stocks and bonds rallied momentarily when the Fed promised no jumbo-sized rate hikes, before that brief window provided an opportunity for investors to exit.

Since then, stocks and bonds have been in virtual freefall as rate rises against the prospect of a recession are seeing investors turn to cash (the dollar is at its highest in two decades), while no corner of the market has been spared.

But is this rout overdone?

To understand how we got here, we first have to examine what circumstances have caused a self-fulfilling feedback loop that has led to the stock-bond portfolio death spiral.

For the longest time, excess liquidity meant that there were few “safe” places to put money to work and institutional investors with relatively conservative mandates had to find places to plug their assets, one of which was corporate bonds and sovereign debt.

This kept yields on haven assets such as U.S. Treasuries very low, as more money was chasing these bonds (yields fall as bond prices rise) which pushed their prices higher.

When the risk-free rate of return from Treasuries is so low, the other excess money has to find an outlet somewhere, and that place was in all manner of risk assets, from high-yield corporate debt to unprofitable tech stocks.

But, when the Fed calls an end to the party, for instance by throttling back bond purchases and raising interest rates, demand for U.S. Treasuries reverts to the mean and yields start to rise – in recent times benchmark U.S. 10-year Treasury yields have blasted past 3%.

Even though yields are well below the rate of inflation, which in the U.S. has been 8.5%, it provides less of an incentive for investors to start hunting for yields in all the riskier places, like the stock market.

Ordinarily, as more investors pour into Treasuries, this should theoretically bring yields back to earth, enticing yet other investors back into the stock market – but these are not ordinary times because the 400-pound gorilla that is the Fed, is also no longer buying Treasuries.

And to make matters worse, the Fed is also letting its balance sheet runoff, meaning that near-term Treasuries that are expired aren’t being replaced, increasing the supply of Treasuries in the market.

Recent changes to banking regulation has also meant that financial institutions, which could typically be counted on to soak up the excess government bonds, no longer have the capacity to act as buyers of last resort for Treasuries, because of stricter capital reserve requirements.

As bond yields soar, investors are disincentivized to take risks by buying stocks, leading to a self-fulfilling negative feedback spiral that is seeing stocks and bonds plummet back to earth.

And that, is why everything is dropping.

2. A Reverse Currency War & Race to the Bottom (Top)

• While there aren’t (yet) signs that the world is plunging headfirst into another global conflict, there are signs that another type of war may be in the offing – a reverse currency war.

• For central banks playing this high-stakes game of chicken, the risks of tightening may far outweigh maintaining the status quo.

Outside of historians, few will recall that the precursor to the Second World War was a far more innocuous one – a currency war.

Countries in the 1930s abandoned the gold standard and used currency devaluation as a means to stimulate their moribund economies in the wake of the Great Depression.

A cheaper currency means that a country’s goods and services cost less in a foreign country’s money and should stimulate exports and production.

But this race to the bottom stoked already simmering national rivalries and bitterness between the victors and the vanquished from the First World War, laying the foundation for another bout of destructive global conflict.

And while there aren’t (yet) signs that the world is plunging headfirst into another global conflict, there are signs that another type of war may be in the offing – a reverse currency war.

As central banks struggle with soaring inflation, many are starting to abandon a longstanding preference for a weaker exchange rate that would typically assist exports, marking a departure from the period following the 2008 Global Financial Crisis.

Part of the reason of course that central banks can tolerate stronger currencies is a focus on combating inflation, as opposed to spurring growth.

The dollar has already hit a 20-year high against major currencies as the Fed became the first major central bank to raise rates, while the euro and the yen have lagged as their central banks have yet to move on policy.

And that could spur a “reverse currency war” because a stronger currency actually helps to combat inflation by reducing the cost of imports.

While the European Central Bank is said to be monitoring the situation closely when it comes to imported inflation, the Bank of Japan has made clear it has no intention to tighten, with the yen in near freefall against the dollar.

Yet raising rates is no guarantee that a national currency can fend off the strengthening of other currencies like the greenback, a fact that the Bank of England learned painfully last week.

As the Bank of England raised rates for its fourth meeting in a row, the pound slumped to a 2-year low against the greenback and policymakers are warning that the United Kingdom is headed for a recession later this year.

Against this backdrop, policymakers in developed economies are left with few good choices – raise interest rates, potentially tipping the economy into a recession, or keep rates low but continue to battle the ill-effects of inflation.

For central banks playing this high-stakes game of chicken, the risks of tightening may far outweigh maintaining the status quo.

With Europe on the doorstep of Russia’s invasion of Ukraine, the European Central Bank which was on a shaky recovery out of the pandemic anyway, will all but certainly plunge into a recession if policymakers raise rates, and there’s no guarantee that the euro will rise anyway.

For the Bank of Japan, raising interest rates and tightening policy will be the equivalent of cutting one’s nose off to spite one’s face, especially as inflation has been far more muted in that country, despite the soaring cost of oil.

Looking at the experience of the pound, there’s no guarantee that any country can win in a currency war against the United States.

Because of the dollar’s unique role at the center of the global financial system, its position as the de facto unit of measurement for practically everything from bullion to Bitcoin means that economies outside the U.S. will find it tougher to access dollar-denominated finance.

Other countries may attempt allowing their currencies to appreciate, but what history has demonstrated is that the value of a country’s currency isn’t purely about interest rates alone, but also has to do with the strength and resilience of its economy.

The dollar is soaring now because in a world devoid of good choices, America has emerged as the least-worst among a sea of poor options.

3. Bitcoin is Bombing at the Worst Time for Another Algo Stablecoin

• Over the weekend, a swift selloff in both UST and Bitcoin saw the UST’s peg slip to its lowest level in almost a year, with observers speculating that the peg is being actively attacked by another cryptocurrency “whale.”

• Even in the best of times, algorithmic stablecoins are an exercise in financial engineering that’s not for the faint-hearted.

Algorithmic stablecoins are a technological attempt to do something that the economic stock of entire nations have struggled to achieve – maintain a fixed peg with another currency through a combination of variable assets and financial alchemy.

But that hasn’t stopped entrepreneurs from trying to spin digital copper into gold and the latest and most well-known of these attempts has been TerraUSD or UST, an algorithmic stablecoin that aims to maintain a 1-to-1 peg to the dollar.

Over the weekend, a swift selloff in both UST and Bitcoin saw the UST’s peg slip to its lowest level in almost a year, with observers speculating that the peg is being actively attacked by another cryptocurrency “whale.”

According to social media posts, a single user dumped US$285 million UST on decentralized finance platform Curve as well as cryptocurrency exchange Binance.

Attempts to destabilize fixed pegs are not new, George Soros rose to notoriety as he bet against Southeast Asian central banks during the 1997 Asian Financial Crisis, which saw the Thai baht slip its supported peg with the U.S. dollar.

UST’s backers had earlier beefed up their coffers with Bitcoin, in an attempt to shore up the value of the stablecoin, but that did little to help over the weekend as Luna, which is designed to help UST maintain its dollar peg slipped by 14% on Sunday, after falling over 12% on Saturday.

Even in the best of times, algorithmic stablecoins are an exercise in financial engineering that’s not for the faint-hearted.

Last year, the highly-publicized failure of TITAN, cast a spotlight on algorithmic stablecoins as Dallas Cowboys owner Mark Cuban admitted that he lost a substantial amount through his investment in the ultimately failed algorithmic stablecoin.

In the case of TITAN, its peg to the U.S. dollar was backed by $0.75 worth of USDC (another stablecoin that is backed by bank deposits) and $0.25 worth of IRON tokens, whose supply and demand is algorithmically managed based on demand.

As TITAN slipped its peg, arbitrageurs found that they could literally make risk-free money by swapping less than $1 worth of TITAN for $0.75 worth of USDC and $0.25 worth of IRON and sell the IRON, leading to a self-fulfilling feedback loop that sent the value of IRON literally to zero.

UST may be different, but the flawed economics behind the algorithmic stablecoin are similar and the Luna Foundation Guard, or LFG, had to buy Bitcoin as a sort of backstop to help underpin UST.

The only problem of course is that much of the Bitcoin acquired by LFG in April, is now worth substantially less given the slipping price of Bitcoin and a trader or traders may be using this as an opportunity to take down UST for profit, by attacking both the price of Bitcoin and UST’s peg.

And far from providing an opportunity for LFG to buy more Bitcoin, which it says it has plans to buy as much as US$10 billion worth to prop up UST, it may actually force LFG to sell Bitcoin to keep the UST peg, leading to a debilitating self-destructive feedback loop.