4th Finance Blog (FLOG) : May 2022 Finance and Economic Climate


For this month, I have decided to rant a bit (again based off my own opinion) on the current finance and economic climate.

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1. Persistent High Inflation

Let’s start off with how we ended up here. In 2020 COVID became a global pandemic and since then it has a material economic impact on, in particular, Western economies. As a result, a lot of Western governments such as the US under Biden administration, decided to literally print money through so called fiscal policy such as drastically increasing government spending to mitigate the undesirable economic impact. However bear in mind that the economic impact was not endogenous, meaning it was not because of weakness within the Western economies themselves rather than the exogenous factor, COVID pandemic, that weakened the Western economies through reduction in aggregate demand. As a result, once vaccination and herd immunity are roughly in place and COVID’s impact on livelihood has been eased, most Western economies experience rapid economic recovery accompanied by high inflation, not seen since 50 years ago because real output of developed economies remained roughly the same but money stock circulating in the economy has increased considerably! This coupled with the reduction in oil supply due to the military conflict in the Eastern Europe where most oil/gas pipelines are located, further boosted price level to a record high.

In a nutshell, mispolicy + supply shock = inflation > 8% per annum.

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2. Returned to normal?

Again, bear in mind most Western economies are developed economies and before COVID their GDP growth rate don’t usually exceed 3% per year. In fact, the UK’s GDP growth teetered between 0 to 2% since 2010 on average (excluding financial crisis and recovery), in the US it is a similar picture but slightly higher than that of the UK by about 0.3% on average. So by now you should get the idea that the economic growth experienced in the last 6 months in the Western economies was not real and sustainable. As stated above, slower economic growth than money stock growth, inflation would soar and when inflation rises large enough, certain economic inconvenience (economists dubbed it “Shoe and Leather Cost”) would appear. For instance, workers would demand higher wages due to higher cost of living and firms would see the profit cut unless they increased prices. More often than not, companies set prices based on forecast (and of course the need to maintain a decent chunk of profit margin) and therefore prices of goods and services increase rapidly (also taking into account of the increased cost of raw materials such as oil/gas/electricity). As inflation continues to rise, central banks are forced to take restrictive measure such as monetary/fiscal policies tightening (usually in the form of increased tax or increased interest/borrowing rate through open market operation such as selling bonds to reduce money stock) to combat inflation. With tightening monetary policy foreshadowed, investors would be more reluctant to borrow to invest (in fact a lot of large investors such as hedge funds use margin borrowing/leverage to increase yield as I used to work for hedge funds too). Panic sell-off to wind down leveraged position would sweep through the market once the sentiment is there and it’s literally a fused bomb ready to explode on impact.

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3. Disappointing economic data

“Oops I did it again”… the US returned higher than expected inflation rate again in April (CPI rise forecast to be 8.1% but turned out to be 8.3% though 0.2% less than March) or should we say “Not great not terrible” (Yup that’s from “Chernobyl” — touch wood). The weak economic growth or fear of economic recession in the UK where GDP fell by 0.1% as recession is defined as negative GDP growth successively in 2 quarters (fingers crossed) coupled with persistent high inflation sparked fear in the capital market in recent weeks with bearish sentiment felt across almost all asset classes (well the exception is FX where haven currencies seemed to have recovered from its recent lows). Sharp sell-off shook the market and as of “Black Friday”, 13 May, the market has still yet showed any proper sign of full recovery. Among the recent sell-off digital assets such as crypto-currencies, which has been traditionally the most volatile asset class, experienced “blood-bath” with some protocols native tokens fell to record low. Even digital gold, bitcoin, dropped to level not seen for a year and raising the liquidity risk treasuries faced relying on bitcoin to sustain its liquidity. (I guess the adage don’t put your eggs in one basket might need to be changed into don’t put your eggs in any correlated baskets).

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4. Luna-Terra death spiral

Yes you guessed it right, the above 1–3 was the backdrop to the recent Luna-Terra crash. For clarity, Terra is the supposedly USD-pegged stablecoin while Luna is the governance token issued by the protocol. The protocol operates an algorithmic stablecoin system where the issuance of Luna is based on the price of Terra so that Luna could absorb the price fluctuation of Terra and thus pegging Terra to US Dollar. In a good market where Luna has a decent price, the stablecoin pegging mechanism works well. However in a bearish market cased by inflation, fear of economic recession and monetary policy tightening, investors shorted (sold) both Luna and Terra massively causing the protocol having difficulty to sustain its US Dollar peg. To add insult to injury, LFG (Luna Foundation Guard) relies mainly on bitcoin to sustain its treasury but due to the recent crypto crash, bitcoin lost almost half of its value from its peak as at the end of 2021 and significantly reducing the financial liquidity and thus soundness of the Luna/Terra protocol. Then by aiming to sell bitcoin to support Luna/Terra (with some quipped it Qwon-titative easing), LFG further exacerbated the crypto market crash. From my experience working in a collateralized stablecoin protocol, investors usually dumped stablecoins in bearish market to redeem their collateral (such as bitcoin or ethereum) and I am not surprised Terra became stressed during last week. In fact, even Tether (USDT) also came under sell-off pressure and there is a slight bit of de-pegging to US Dollar at about 30–50 bps. However, unlike Terra, Tether has a large liquidity base and user acceptance and hence it has, so far, enough market cap to withstand the sell-off shock. Terra, unfortunately, has a much thinner liquidity base and as a result, Luna and Terra went down the “Death Spital” where Terra became de-pegged from the US Dollar and Luna crashed in vain to absorb the sell-off pressure.

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5. Sustainability of the ecosystem

Within the crypto community, I have long heard some critics claiming Luna Foundation resorted to using its treasuries funds (through Anchor) to provide high yield (about 20% APY) to attract staking users. Unless the financial incentive could be provided to users for eternity, the long-term sustainability of the Terra/Luna protocol is cast into doubt. Even if the protocol became sustainable in the long term, the short term financial incentive might not exist either. Therefore personally I did not invest in Terra/Luna because I doubted the sustainability of the ecosystem (not pretending to be smart with hindsight). However, Luna/Terra is surely not the only protocol paying users to stay in business. Another move-to-earn NFT protocol is also known to be doing something similar and I guess it’s a matter of time to find out whether the team behind the protocol could find their way out and gain mass adoption by revamping its ecosystem or it will blow up under stressed market condition. To wrap up, allow me to paraphrase from veteran traders “Remember, the market always test you”. I hope everyone learnt something and see you all next time!

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