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What I Care About This Week | 2022 June 27

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Photo by Harrison Haines on Pexels.com

by Franklin J. Parker, CFA

The Summary

The Details

Let’s talk about what is going on with cryptocurrencies.

Bitcoin, a good proxy for the crypto market as a whole, is down almost 70% from last year’s high. Using traditional lines of thinking, this should not be the market reaction to higher inflation. Inflation is, at heart, a loss of value in your domestic currency. Meaning other currencies should gain in value. Were bitcoin a traditional currency, this line of thinking might apply.

However, bitcoin (and other crypto assets) are not traditional currencies. Rather, as their recent price action has shown, they are very risky assets. As such, they are governed more by liquidity flows than traditional valuation models. Let’s dig into that a bit.

Cash flows across markets in fairly predictable ways. During times of cash inflows, investors allocate to safer assets first, then they allocate cash to risky assets (like stocks or high yield bonds), then they allocate to more speculative markets (like angel investments, hedge funds, or cryptocurrencies). When cash flows away from investors, it is pulled from the last market first. So, speculative investments get liquidated first, then risky investments, then safer investments.

In many ways, this makes crypto a sort of “canary in the coal mine.” The selloff began there first because it is a liquid and speculative investment. As cash flowed away from investors, they began to re-allocate away from these markets and into others (pushing stocks higher and crypto down). Of course, cash kept flowing away from investors (in the form of quantitative tightening and inflation) so that selloff continued into risky markets. Now with less cash available to it than before, prices in this market may struggle to regain their previous levels (at least until cash begins to move back toward investors).

And, of course, as good times turn to bad times, we find out which organizations have the fortitude and foresight to survive. This is a good thing, long term, for that marketplace. After this, the crypto market should be a somewhat less speculative place to be.

Chart of the Week

The Federal Reserve has repeatedly talked about inflation expectations as a source of policy frustration. Along with very real policy tools, the Fed actively attempts to influence sentiment among both market participants and the general public. A public that believes inflation will continue marching higher is a public that will actively push inflation higher through the aggregation of their individual actions.

So, charts like this week’s are not good news to the Fed. As consumer sentiment has plunged, expectations for inflation—across both 1-year and 5-year windows—have increased substantially. As a keen observer will note, as inflation expectations increase, the general mood among consumers tends to decrease.

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