This letter intends to convey our “base case” in regards to monetary policy enacted by the Federal Reserve, and how that relates to the crypto markets in the short and medium term. As many of you are aware, the crypto markets have recently shown a high correlation to the broader macro markets. Markets go down, crypto goes down more. This intuitively makes sense given the fact that institutional capital is now intimately involved in the crypto ecosystem. That won’t change in the short term. In fact, we will only see more and more institutional players move into digital assets as the industry matures. However, in the medium to long term, we do expect the long tail of digital assets to slowly decouple from the broader macro markets as crypto networks begin to see real adoption and provide utility to users and businesses.
It really is all one trade at this point. The Fed is in the driver seat.
Markets are inherently inefficient, especially the crypto markets. This is a well known concept in behavioral finance, articulated exceptionally well by Robert Shiller in his book, “Irrational Exuberance.” This means that markets tend to overshoot in either direction, because investors are irrational and driven by fear and greed. We have seen this play out time and time again; 2022 will be no exception.
Crypto markets are at the bleeding edge of technology innovation. Another concept worth exploring is that technology innovation is intrinsically deflationary. Why? Simply put, new technology allows the production of goods and services to scale more efficiently.
1) Technology reduces the demand for labor, which puts downward pressure on wages and employment levels, which in turn reduces demand for goods and services because workers have less money to spend. This innovation leads to more automation and tools that make workers more efficient.
2) Innovative technology is allowing more businesses and industries to cross an important inflection point; the point at which the production of goods and services can scale faster than the consumer demand for them. As technological improvements lower production costs and increase the speed at which goods and services can be produced, it becomes easier to satisfy market demand for particular goods. If the supply of goods can always meet demand, then there is no room for price increases, generally speaking.
Let’s look at 2 examples to see how this works.
During the pandemic, thousands of companies around the world all moved to remote work in less than a month and, after ironing out some small glitches and capacity issues, Zoom was able to handle the increased demand for their product without needing to double or triple the price of their service. This is a great business model for Zoom and other teleconferencing companies, but it is also highly deflationary because the entirety of the market’s sudden demand for remote conferencing tools was met nearly overnight without the need for price increases.
Physical products are less impacted by this, but are not immune to this concept. Things start to get really interesting when the scaling gets efficient enough that it can accommodate the entirety of consumer demand. Let’s look at cheese as an example.
As mentioned above, technological improvements in the dairy industry mean that more cheese can be produced more cheaply than ever before and it is relatively easy to add additional capacity. At the same time, there is a clear upper bound to how much cheese a person can eat in a given day or year.
There are still limits to cheese production; even with robotic milking we will never be able to produce enough cheese to allow the average person to eat a million pounds of cheese a year, but the demand for cheese is never going to be that high; there is a physical limitation (not to mention a preference limitation) to how much cheese can be consumed in a given year.
The same goes for some SaaS and entertainment companies; there are only 24 hours in a day to consume media or participate in a Zoom call, so while production of these goods and services isn’t truly infinite, demand cannot be infinite either and there are now more limitations on the demand side for these goods than on the supply side. It is hard to see a way for there to be meaningful inflation in sectors like these, as supply will always be able to meet or exceed demand, even if demand were to increase due to short-term factors or fiscal stimulus.
Technology improvements have continued to make just about every industry more efficient. The pace of technology innovation is ever increasing, especially in the crypto markets, which will continue to be an impactful force to fight inflation.
The Bottom Line
The Fed seems to have “horse blinders” on right now, and is solely focused on taming inflation, even if that means driving asset prices off a cliff. This bear market is a necessary cleansing of the crypto assets with weak fundamentals, which is healthy for the ecosystem long term. We continue to see low quality crypto projects go to near zero, and quality will prove to be king in this market environment. This could set up a once in a generation buying opportunity in the crypto markets, but only for projects with clearly defined use cases and traction. Crypto investors are getting smarter and more sophisticated everyday, which is why we are laser focused on the fundamentals.
Given all the information at hand, we expect a bottom to form in the crypto markets at some point in the back half of 2022, as monetary policy hawkishness begins to fade into the background as inflation metrics surprise to the downside. It is possible the Fed may overshoot this..
In a subsequent post, I’ll continue to explore this idea of irrational exuberance in the crypto markets by taking a deeper look at reflexivity.
Feel free to contact us at any time.
Founder & CEO