# Annihilation

**Published by:** [Gallagher](https://paragraph.com/@gallagher/)
**Published on:** 2023-01-11
**URL:** https://paragraph.com/@gallagher/annihilation

## Content

Thankfully, unlike many others around the world, my experiences of war are sanitised and indirect. Two of my mother’s brothers were conscripted into the Vietnam War. One uncle decided fighting in the steamy hot Vietnamese jungles was not his idea of a good way to spend a portion of his youth, and was imprisoned for not fighting. Another went, and when I asked him what it was like, he said he felt like two angels were there protecting him from getting maimed or killed by enemy fire. My father fought in the Korean War, but he never talked much about his experiences, so I don’t have any idea on what he thought about the topic. As a child growing up, my knowledge of war came from the television. The video game of war played out on nightly news broadcasts. Americans fighting in Iraq, Bosnia, Afghanistan, Iraq again and various other proxy skirmishes dotted the news casts. Luckily I did not suffer rationing of food or consumer items, or experience the effect of crushing inflation during the times America was at war. Many in the world, likely including some of you readers, have experienced real hardship as a result of war. Family members you loved were injured or killed. You might be a refugee displaced by conflict. Or you have gone hungry because food was scarce or extremely expensive so that the soldiers could eat. When viewed from a macro humanist perspective, war is always destructive and energy wasteful. Human civilization converts the potential energy of the sun and the earth into food, shelter, and entertainment. War is the act of spending energy to destroy the fruits of human civilization. While one side “wins”, and achieves some political or resource-driven goal by defeating their enemy, humanity loses because the things destroyed by kinetic energy weapons must now be rebuilt using additional energy. The potential contributions of the humans slain on both sides are also lost forever. Because this is an essay that covers the crypto capital markets, we must consider humanity as a whole. Our currencies and assets are for the benefit of everyone, not just one particular imaginary construct that is a “nation”. There is no righteous war at a systemic level. Forget what the media on either side tells you about the justification for why this war is good for some nation state. Rather, consider that every life lost and structure damaged took energy to rear and construct. That energy is not inexhaustible, that is waste. The more we waste, the more negative consequences will be visited upon humanity as a whole. And the most obvious outcropping is inflation. The war effort always crowds out the ordinary consumer. In order to supply the armed forces, production must be shifted away from satisfying the needs of the ordinary consumer to satisfying the needs of the military. The side that musters the most resources and energy with the least impact to the everyday life of their citizens is the side that usually prevails. Many of you have probably studied various aspects of WWII in extreme detail. Your country may have even been created in the aftermath when the winning Allies carved up the world into spheres of influence that are still present today. Germany and Russia started as allies. Hitler needed the oil and grain of Stalin’s Soviet Union in order to power the war effort and feed ordinary Germans. However, Hitler needed more and more energy as the war went on, and he erroneously believed that if he invaded Russia he could easily capture Ukraine — the breadbasket of Europe — and the Caucasus oil fields. Obviously, like Napoleon, he failed; Hitler invaded Russia and total exports of grain and oil from the USSR plummeted. Hitler would have been better off continuing to trade on fair terms with the USSR than invading it. As the war dragged on, morale in Germany declined in the face of food rationing and crushing inflation. I only mention that vignette to illustrate that it usually is a net energy loss to take something via war, rather than trade. So anyone who believes war on a systemic macro level solves any of humanity’s problems, probably never watched their child go hungry so that a soldier in a far-off land can fight. As we enter a period where the global order of flag-waving nations shifts and the probability of possible conflagrations rise, the prospect of persistent global inflation caused by military needs crowding out civilian ones is here. Now, putting aside the misery and suffering that war visits upon humanity, what should we do with our portfolios? I don’t mean to diminish the sorrow of war by immediately switching to commercial concerns — but we must prepare ourselves and our financial assets in an attempt to maintain a certain lifestyle vis-à-vis our personal and familial energy consumption. The spectre of global conflict exists against a backdrop of the most accommodative monetary policy ever. I know that every major central bank talks about rising inflation and their commitment to dealing with it, but almost every major central bank is still printing money. Let’s observe some charts that depict policy rates vs. official measures of inflation. “Official” measures of inflation can never completely represent the prices an ordinary citizen faces. I believe these are massaged statistics that paint the best possible picture. Real consumer price inflation is acutely worse. But even the official statistics are a complete disaster. Fed Funds — US CPI = US Real Interest Rate (Currently Negative 7%) Euro Area Deposit Rate — Euro Area CPI = Euro Area Real Interest Rate (Currently Negative 5%) UK Bank Rate — UK CPI = UK Real Interest Rate (Currently Negative 5%) The three charts above display the [Policy Rate — Official Consumer Price Inflation]. As you can see, real rates have become deeply negative since the start of the pandemic. Imagine you hold one dollar, euro, or pound in your wallet. Next year, that piece of fiat is suddenly worth 5% to 7% less. If workers’ wages rose by that amount, then that wouldn’t be an issue. But for most salaried or hourly workers, their wages are not rising at the pace of the destruction of the currency in their physical or digital wallet. As you can imagine, the average Zhou, Jane, Johny, Jaewon, Jesus, et al. aren’t too happy that their wages are not keeping pace with prices of food, energy, and transportation. The politicians are now instructing their “independent” central banks to tame inflation. Central banks must now raise policy rates — that bit is not controversial. What is controversial is how much they decide to raise rates by and how quickly they want to accomplish it. The entire financial world paints an apocalyptic picture should the Fed raise rates six times this year. That is what the Fed funds futures markets predict. If they raise rates by 0.25% six times, that would leave them with a policy rate of 1.5%. Even if the 7%+ US CPI inflation rate halved by year end, that would still leave real rates at negative 2%. The above is a chart of the Eurodollar futures contract term structure. To arrive at the yield of US dollar deposits held outside of America, take 100 and subtract the futures price. For example, if the Eurodollar futures price is 98.00, then the yield is 2%. I could write many thousand word essays on the importance of the Eurodollar market, but the TL;DR is that it is the most important interest rate market globally. This market is heavily influenced by Fed policy. If we look at the Eurodollar futures curve, it tops out close to 2.5% in September of next year. The market expects the Fed to raise short-term rates, as the underlying for these futures are three-month USD deposit rates. 2.5% is not enough to combat the current levels of inflation, and that’s without factoring in various medium- or large-sized conflicts that will completely distort energy usage globally over the next 12 months. The politicians gave a directive– “fix inflation”. The central bankers will comply, but only to a certain degree. Why? Because the level of nominal policy rates that is likely to cause a financial crisis creeps lower and lower each recession. The above is a chart of the lower bound of the Fed funds rate since 1990. Every major global financial hiccup or crisis occurs because leverage and debt builds up in some area of the financial market. When the Fed raises rates, it pricks the bubble, as it becomes more expensive to finance folly. Coming off of the low rates that followed the first Gulf War with Iraq, the Fed raised rates roughly 5% to 6% by the end of 1994. That resulted in the Mexican Peso crisis,and the US Treasury stepped in to bail out American lenders in Mexico. The Fed also pitched in by lowering rates a tad. A few years later, when rates rose to nearly 6%, the Asia financial crisis occurred. Various “Asian Tigers” came to the IMF and World Bank cap in hand asking for bailouts of their economies due to increased dollar funding costs. We all know what happened to tech in 2000. The chart clearly shows that the Fed raised rates again after dropping them slightly in the aftermath of the Asian financial crisis. Higher funding costs diminished the hopes and dreams of a techno utopia, and a general equity market crash ensued. Then the 9/11 attacks occurred and the Fed dropped rates and blew a housing bubble. Rates sky-rocketed by a massive 5% subsequently, and that ended up being the top of the US housing market in 2006. Voila– by 2008, losses stemming from toxic subprime mortgage derivatives infected the entire global financial system and bing bada boom! After another seven years of 0% interest rates the Fed got the religion again, and started raising rates to slightly over 2% up until late 2018/early 2019. After rates went up, a general recession began in late 2019 plus the addition of the global pandemic, metastasized into one of the sharpest contractions of economic activity ever. 6%, then 5%, then 2% — every decade, the level at which the financial markets buckle under positive and rising nominal rates declines. Given that systemic debt and leverage exploded globally after COVID due to low to negative rates and a need to generate yield, I don’t think the global financial markets can handle nominal rates even at 2%. Looking at the charts above, the major central banks are so far behind inflation that at a policy rate of 2%, rates are still negative. And unless workers start getting larger pay raises, they will still lose out month after month to the pernicious effects of consumer price inflation. That is a recipe for “social re-organisation”, let’s resurrect the Jacobins. Every asset class has an ever-shifting narrative around whether or not it will make a good hedge against inflation. Instinctively, many believe that as a scarce asset, Bitcoin and other cryptos are great inflation hedges. And over a multi-year time horizon, they are likely right. However, lately, Bitcoin has behaved in a more “risk-on / risk-off” fashion rather than an asset that always appreciates if real rates are negative. Bitcoin obviously benefited to a large degree from the COVID-inspired global central bank money-printing bacchanal. It still needs to digest that massive move higher, and it doesn’t help that liquidity conditions are tightening. But, let’s remove negative rates from the picture for a moment. Bitcoin rose from $4,500 in March 2020 to close to $70,000 in November of 2021. But then central banks changed their tune — saying that they would do the right thang and tame inflation. Just those comments were enough to pump short-end rates, and the crypto bull market stalled. The chart above shows Bitcoin (the yellow line) vs. the 2-year US Treasury note (the white line) since September of 2021. In my view, the Bitcoin bull market stalled because liquidity conditions tightened globally. The market repriced fiat credit due to the expectation that central banks would raise nominal rates in the future, and it caused the 2-year yield to pamp 8x — sending Bitcoin sideways to slightly lower. Gold, however, finally began stirring in its grave. It began marching higher towards $2,000 as rates persisted in negative territory. Short-end nominal rates rose, and gold still rose because real rates were still negative. As a result, gold’s historic tendency to hold value against a depreciating fiat regime has recently regained mindshare with investors. I expect Bitcoin will experience a similar narrative rediscovery eventually. Eventually is the key word, though — patience and the ability to tame your itchy buy-button finger is required to properly time a re-entry into or re-allocation of assets in the space. The global citizenry now possesses smartphones that fit inside their pocket, which are a tool of mass communication to share knowledge instantaneously. We can show each other the depravity and destruction war ravages upon our respective societies. Hopefully the knowledge of what bombs and bullets can do, in real time and in colour, tempers the collective from going along with wars put in front of them by the political elite. But while we can all be idealistic and hope that the proliferation of information can change humanity’s proclivity for waging war on itself, we must prepare our finances to survive the scourge of inflation. That isn’t to say we should disregard the short-term price action, which I believe is negative for risk assets. The trick is to recognize when it’s time to pay the offer, at whatever the price — because he who sells fiat first, sells fiat best.

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