Since lockdowns began, there have been higher and higher expectations of inflation from financial communities. However, as time goes on DEFLATION becomes more and more likely.

Time for a thread on banks and inflation, and what it means for equities, gold, and bitcoin

Let’s start with what inflation is, and how it occurs.
Inflation is a general rise in prices caused by an expansion of the money supply. We will be focusing primarily on inflation in US dollar terms, and therefore the Fed as our central bank.

Under a central banking system, inflation occurs primarily as a result of lending. Remember, the Fed cannot print money themselves; all they can do is supply money to banks and purchase some financial products like Treasuries, MSBs, and more recently corporate bonds.

So, when the Fed wants 3% inflation, as they stated recently, there’s not a ton they can really do to make it happen. They can supply banks with tons of reserves, and they can hold down interest rates (making borrowing more attractive), but they can’t force the banks to lend.

Now, you make remember hearing about bank stress tests back in July. These tests are performed to see how a bank will fare during an economic downturn, when their reserves may be stressed. Despite knowing exactly what the test would entail, the banks did TERRIBLE.

In response to this, the Fed told the banks that they were no longer allowed to buy back their own stock until they perform better. As you can probably guess, the banks didn’t like this. I’ll get back to this.

There is another way the Fed can create inflation, and that is by monetizing government debt. This money goes into the real economy and can be inflationary. However, this depends on Congress passing another stimulus bill, which they’ve been unable to do thus far.

Now, we’ve already been in a somewhat deflationary environment for some time. @RayDalio calls it the de-leveraging at the end of the long-term debt cycle, and its likely been occurring since the Great Financial Crisis of 2008.

You’ll notice that people like @PeterSchiff have been calling for rampant inflation for years due to QE and low interest rates, but it has never really materialized beyond some bubbling in financial markets. How could that be?

First, QE does not create inflation because it doesn’t create new money. Yes, it expands the Fed’s balance sheet, but each dollar “created” is matched by a liability, and the money rarely leaves the financial ecosystem. QE merely provides ample liquidity for markets to function.

In terms of low interest rates, the economy has hit a point of leverage that they no longer spur lending growth, they merely support existing debts. There is so much debt that rates must stay low so people can pay interest, but that doesn’t mean they’re going to borrow more.

Now, inflation concerns have been kicked into overdrive, but let’s look at what’s actually happening in the economy. Small businesses are going under in droves; this has been delayed by stimulus measures like PPP, but that money has dried up and now they’re dying off.

SME’s provide 50% of the jobs in the US, so when these businesses go under, people’s incomes dry up too. This has been offset by generous unemployment, but that too has decreased significantly with no foreseeable increase to come.

Let’s go back to the banks. In response to the stress test (and the new inability to buy back stock), bank lending requirements have increased significantly. This makes it harder to borrow money and, you guessed it, contributes to a deflationary environment.

Why would the banks do this? Well, I see two reasons. First, the Fed has made it very clear that they will do whatever it takes to create inflation. They’ve played all their cards. That gives banks an opportunity to take advantage of.

One holdout Powell has had is negative interest rates. If you’re a bank, you really want negative rates because it means the Fed is PAYING you to loan money. Sounds pretty great from the POV of a banker. How long do you think he’ll hold out once deflation starts to manifest?

Second, the market is heavily positioned in anticipation of inflation. Now, traditional market wisdom will tell you that whenever everyone is positioned for one thing, the opposite will happen. And who is taking the other side of all these trades? You guessed it, the banks.

We can already see deflation start to kick in through foreign central banks selling their treasuries. For example, there was news yesterday of China planning to decrease treasury holdings by 20% in the coming months. This might sound bad for the dollar, but it’s far from it.

When the US buys goods from Chinese companies, they pay in dollars. When those companies want Yuan, they exchange them with their central bank. When the central banks have too many dollars, they exchange them for US treasuries.

Now, the reverse is occurring. Companies aren’t getting paid because consumers don’t have money. However, they still need dollars for their operations with other foreign companies since the dollar is the world reserve currency.

So, central banks are selling their treasuries to get back dollars. This is the cornerstone of a deflationary environment; more demand for dollars than there are dollars in circulation.

Now, what does all this mean for YOU, the investor. Well, depending on how you’re positioned, it’s probably not great.

Equities, gold, and Bitcoin have all likely benefitted from these inflation concerns. If you’re expecting inflation, it is unpalatable to hold dollars, so you seek somewhere where your purchasing power is protected.

Traditionally, you would go to bonds and treasuries, the least risky investments out there. However, since the Fed is artificially suppressing interest rates, yields are not enough to make bonds a viable strategy.

So, you move to equities and store of values. These are higher risk, but are the only thing that can offer you protection. This is likely the reason stocks have rallied so hard in recent months, as well as gold and Bitcoin. They’re the only place where inflation can’t get you.

But what happens if deflation starts to rear its ugly head? Well, it becomes less risky to hold dollars. So, there’s no longer a need to be hedged against inflation. You can see where this is going.

Money will likely start to flow out of at least equities and gold, and likely Bitcoin as well. This becomes a self-fulfilling prophecy because as more people want to sell, more dollars are needed, dollar demand rises creating more deflation, making more people want to sell.

This may lead to a market crash of epic proportions (it’s scary, I know).

Now, I am a Bitcoin holder with more than significant exposure. This may be stupid, but for the time being I will maintain it. This is because Bitcoin may be the one asset that can escape this crash.

Deflation means there is too much demand for dollars. Now, it’s not even dollars per se, but currency that people want. Unlike equities or gold, Bitcoin can be used as a currency.

So, it’s possible that in this deflationary spiral, Bitcoin actually increases in value to be used as an alternative money. People can’t get enough dollars, so they use Bitcoin instead.

This is highly speculative, and may be wishful thinking. The more likely outcome is that Bitcoin crashes along with everything else, leading to a lot of very unhappy hodlers.

Now, what could change this outlook? A few things, although most are pretty unlikely at this point. First, and most likely, governments can pass another stimulus bill and allow the Fed to monetize their debt to do it.

Remember, government spending translates to real money in the economy, so large government programs could create the inflation that we’re all expecting and likely want.

Second, Congress could amend the Federal Reserve Act to allow the Fed to directly print and distribute money. This is unlikely to occur, but it would allow them to create the inflation that they want to see. This would be easiest with a USD CBDC.

Finally, the economy could start to recover and monetary velocity could pick up. The M2 money supply is currently at an all-time high, so if that money starts to move around faster, inflation will manifest.

The issue is that all these SME’s are going under and people have no income. So, they’re unlikely to get ahold of those dollars to be able to spend them and increase velocity.

Now, it’s certainly possible that my conclusions here are wrong. You may have noticed that the market’s don’t really make sense anymore, so really anything can happen. However, this is a real concern that you should be aware of.

That’s all for today. If you found this interesting, follow me because I’ll likely follow up as the situation develops. Other than that, stay safe out there and try to position yourself so you’ll be ok no matter what happens!

Let me know what you think of all this @hodl_american @SahilBloom @thetaseek @aantonop @AltcoinPsycho @TopRolling @pierre_rochard @loomdart @bitcoinandboyz @multibitcoiner @stephanlivera @BTCization @realmaxkeiser @knutsvanholm @mjdsouza2 @breedlove22 @johnkvallis @TomerFederman