In Quest for Digital Gold

How did gold become gold? And, more importantly, why is gold staying gold?

Silver had its run during some periods and in some cultures, but silver has become “tarnished” as a store of value.

Gold meanwhile has survived the rise of fiat and major economies moving away from the gold standard. It has also survived the loss of its utility as a convenient medium of exchange.

Certainly, gold has demand from the jewelry industry and some industrial utility. But this “natural” demand is not even a close match for the existing above-ground supply. Imagine what would happen to the price of gold if all the metal in the vaults (owned by central banks or other hoarders) were to be sold.

And yet the value holds. Significant fluctuations for sure, but in the long run, it remains stable.

I am not an expert on the history of gold. To the best of my understanding, precious metals were chosen as a medium of exchange because they do not oxidize easily and remain in an uncorrupted form. They can also be traded purely by weight and are preferable to gems, which have value heavily dependent on their shape and quality.

Amidst precious metals, however, gold is neither the rarest (platinum and palladium are harder to come by) nor quite common, like silver. Gold has solid but by no means exclusive, industrial or jewelry related demand.

My guess is that over many centuries, the precious metal has hit it’s “golden” mean; it is common enough to be a worldwide currency, but not so common that mining can disrupt its price. It is useful and decorative enough to support some underlying value, but the supply is not so tight that marginal swings in demand would create wild price fluctuations.

My assumption is that through those subtle advantages, gold has simply outlasted its competition. And, as a result, it has gained so much credibility over millennia that its value can no longer be diluted or displaced.  Today, gold (XAU = $1,275) is more expensive than platinum (XPT = $915) which is much scarcer and as useful in an industrial sense.

That said, you may have guessed by the title that this post is really not about gold, but about digital assets. Until recently, I was thinking of the dichotomy between the precedence of bitcoin and the advantages of alternative protocols. I am realizing that this dichotomy may be false.

If a universal digital store of value (“digital gold”) is to be established, it doesn’t by any means have to be, and not even likely to be, the universal medium of transactions; a fortiori, it is not likely to be a universal conduit for transactions.

Bitcoin is battling to become digital gold, while ether, for example, is elbowing to become digital copper. If the analogy holds, the price of ether will be driven by technology demand, while the price of bitcoin by the need to store liquidity. Will bitcoin cash be digital silver?

As a corollary, the rise of altcoins geared towards specific purposes is not at all dilutive, but actually supportive of bitcoin. While diminishing its share of trading volume in actual transaction flows, it shields bitcoin from being demand driven and makes it a more attractive store of value.

Now, to assess the future value of bitcoin we need to answer three questions:

I.  Is there a need for digital gold?
II. Is bitcoin more like gold or more like fiat?
III. Why bitcoin specifically?

I am not going to spend time on question one; I assume that my readers appreciate the advantage of having digital value storage and I have nothing to add to the already existing discussion.

Regarding, question two, we need to address the issues of altcoins and forks. I have already explained why I think altcoins are no more dilutive to digital gold than platinum or palladium are dilutive to physical gold. And if physical mining for gold is alive and well, so will be the digital mining for digital gold.

Forks are a trickier issue because they cause many to liken a crypto-asset to fiat, and the community of miners to central bankers. So, are forks inflationary (and for the purposes of this post I use the example of recent bitcoin hard fork)?

One definition of inflation is “the tax on capital”. It describes what happens to the purchasing power of your asset if it just sits there doing nothing. Therein lies the distinction between bankers printing more money and the blockchain forking. New fiat does not go proportionately to the holders of existing money; rather it goes where the government directs it (some cynics seem to think it tends to end directed to the richest of us) via specific asset purchases such as QE or via targeted fiscal stimulus such as tax cuts or increased spending. While those things are happening, your savings may indeed be eroded.

But the hard fork gave each current holder an extra asset. Theoretically, it is a zero-sum game, but like just like stocks tend to react positively to a stock split, this particular fork went well for the asset owners. For what it’s worth, I think the fork was more like a dividend than like split, but this is not the most relevant debate here.

I think it is obvious that forks do not TAX the capital of current holders. A more interesting question, however, is posed by forward contracts. If I promised you delivery of a bitcoin on July 1st, 2017 or September 1st, 2017 this contract may have had a different value depending on how it was written.  Forward stock value, for example, dips down on the ex-dividend date. From my perspective, therefore, it is not so much an issue of forks being inflationary, but the necessity to program blockchain contracts carefully.

If the government one day announced that every dollar is to be exchanged overnight into ten dollars it would not be inflationary in itself because the purchasing power of existing money wouldn’t change. But it would be important to know what happens to existing contracts and liabilities. If you have a salary or pension guarantee, does it go up 10 times? What about debt payments? If it is all done proportionately, there is no economic impact. But if it’s done selectively a wealth redistribution could happen.

Lastly, why bitcoin specifically? It has been discussed ad nauseam why bitcoin mining qualities and limited supply gives it aspects similar to gold. But its unique advantage with respect to other crypto-assets is that was there first. And now it is in the process of outlasting the competition.

When bitcoin first started trading, I was mostly unaware and fairly agnostic of its value. As a trader, I became interested in its vertical rise in 2013 which was followed by a bear market in 2014. Notably, its drop found support; it didn’t continue to fall to permanent obscurity below the event horizon.  Instead, it stabilized, put a solid double-bottom in 2015, and started to creep up.

XBT, Oct 2012-Oct 2016


This trading pattern is consistent with precious metal behavior, only compressed to a shorter horizon.  For example, look at the slow consolidation in gold after the spike of 1980.

XAU, 1975 – Present


Or, more recently palladium after the spike of 2001.

XPD, 1995 – Present


Given the historical trading pattern in precious metals, the buy of bitcoin in 2015 was relatively easy.  But now, at 20X (including fork) the early prices, it is a more complicated trading dilemma. Bitcoin may or may not be a “bubble”, but it is important to remember that it did have a major “burst” in 2014 and, even this year, the market has witnessed bitcoin endure two meaningful corrections.

XBT, 2017 (Actual price swings were even wider than BBG-sourced data below)


And every time it survives and stabilizes, it gets extra “gold cred”.

In summary, despite the rise and fall of various alt coins and fork considerations, “time” works FOR bitcoin, not AGAINST it.  Every day it doesn’t disappear, it gets one step closer to a permanent status of digital gold.

Good luck!

Entering the Kyle Bass US Yield Curve discussion…

I greatly enjoyed watching Raoul Pal’s latest interview with Kyle Bass, entitled “Tipping Point for China” on RealVisionTV. While my eagerness to hear the discussion was rooted in hearing Kyle’s current views on China, many other ideas and subjects surfaced as always happens during such talks.

In particular, the shape of yield curves in the developed markets caught my attention. Kyle was concerned about the supply shock of bonds which would be caused by the Fed unwinding its balance sheet and by the ECB tapering. This led him to expect higher long-dated interest rates and a curve steepening. Interestingly; Raoul emphatically agreed with the steepening bias, but his motivation was that he expected a deflationary rollover of the economy and an imminent easing in the front end.

I find myself unable to resist the temptation to wade into this debate. First and foremost, the US yield curve has been flattening, flattening, and then some more flattening. Why? Well, there are a few completely unambiguous lessons I have learned over my 20 years in the market, and one of them is that the hiking cycle equates to a flattening curve. Flattening starts before the market anticipates it; and flattening goes on for longer and deeper than one would expect. Flattening in every portion of the curve even where economically it doesn’t make sense. Flattening, period.

US 2s-10s vs FF, Jan 1999-Present


Raoul’s point is exactly the opposite side of this coin; easing means steepening. And you can easily see it on the charts above immediately after the orange-shaded boxes. I don’t have any proprietary way of estimating how soon the easing may come, but it tends to arrive sooner than expected, in fact, on average only a few months after the final hike of a cycle.

I am tempted to argue “this time is different”; current front-end rates are low enough that scope of a steepening rally may be limited by the zero rate (or small negative) bound. But this seems intellectually inconsistent after my flattening spiel.

Even assuming I accept that easing equates with steepening, until proven otherwise, I am left with the dichotomy between the observable fact of the current hiking cycle and the speculation about the future easing cycle.  

An even more complex dilemma that bond bulls, like myself, have to face is the specter of the QE/balance sheet unwind. Kyle brought up the supply shock worry that is expressed by many. In fact, there is an opinion out there that developed market sovereign debt is a huge bubble propped up by Central Bank purchases and is bound to implode in the near future. And while I generally disagree, I can’t deny the risk is real and material.

As I speak of the reasons why I hold a different conviction, I want to point out my arguments mostly pertain US Treasuries (“USTs”) and, to some extent, Japanese Government Bonds (“JGBs”), but probably less so to European sovereigns, which are idiosyncratic.

I. The secular total return bull market in USTs started decades ago and has not changed its shape, pattern, or velocity with the advent of QE and tapering.

US Long-Bond Futures (Total Return Chart)


II.The demand for USTs appear to be extremely elastic, making a supply shock unlikely. Furthermore, USTs are an asset and they don’t dictate the overall level of interest rates. At most, supply/demand can push swap spreads up and down. To illustrate the point, remember “the vanishing Treasury supply” in the Clinton Era.

Well, in the middle of all the repurchases, the 10 year rate peaked at 6.78% in 2000. Swap rates were even higher on a relative basis with the 10 year swap spread blowing out to 138bp four months later during the same year.

US 10yr Yields vs US 10yr Swap Spreads, January 1999 to December 2000


Meanwhile, all the debt expansion of the recent decade along with the tapering of QE didn’t stop rates from falling to the lows of 1.35% in 2016.  And swap rates overshot the downside with the spread touching -0.18% (negative!) in November, 2016.

Of course, there were other forces involved including an obvious negative correlation between economic growth and Treasury supply (Keynesian fiscal policy). Still, it is very hard to argue that UST supply drives US rates.

III. From an economic perspective, balance sheet (“B/S”) unwind is unequivocally bullish for USTs. A similar argument can be applied to a hawkish short-term rate policy; it achieves economic slowdown and lowers inflation expectations.  However, B/S unwind is even more positive because it accomplishes a tighter money supply without actually increasing the cost of carry for long-dated bonds. One could argue that the economic argument may not matter if there is simply more sellers than buyers, but for this, I would refer again to point II. Short-cycle gyration of the long bond prices can be quite vicious, but the economic gravity tends to win.

To summarize, a new easing cycle is something to deal with when it arrives and the supply shock is something worth fading, but not without peril.

Good luck,

Alex Gurevich