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Good morning. The US Federal Trade Commission wants to block Microsoft’s purchase of Activision Blizzard, citing (among other concerns) fears that Activision’s Call of Duty will become exclusive to Microsoft’s Xbox. But the real problem with Call of Duty is that it sucks. Minimising its player base, in our opinion, is a social good. Regrettably, the FTC has accomplished just the opposite. Email us your gaming hate list: robert.armstrong and ethan.wu.
The crypto flame-out
Should regulators let crypto burn? Our view, crudely stated, is yes. These poorly understood tokens should not be legitimated by financial regulators. Unhedged readers tend to agree. Alas our line hasn’t been winning the day in Washington. From The Wall Street Journal yesterday:
Pressure is mounting on the Securities and Exchange Commission to step up enforcement of key hubs of the crypto industry after the collapse of FTX last month .
The SEC has investigations under way focusing on exchanges including Coinbase Global Inc. and the US businesses of Binance and FTX, according to people familiar with the matter and regulatory disclosures, and it has fined or sued dozens of token developers over the past six years.
The SEC has said many cryptocurrencies qualify as securities that should have been sold under rules for stocks and bonds. SEC Chair Gary Gensler has said exchanges are breaking the law by selling those unregistered securities and not following rules that the Nasdaq Stock Market and the New York Stock Exchange observe.
We think the SEC should stay away, but we were struck by a thoughtful Twitter thread by Todd Phillips, a policy consultant and former Federal Deposit Insurance Corporation lawyer, arguing the other way. We talked to him yesterday, and his case boils down to two points.
First, Phillips (who says he’s a “huge crypto sceptic”) is worried the “let crypto burn” argument is too callous to consumers:
The let crypto burn narrative I have heard is just don’t do anything, let it flame out. And I think that’s really the wrong way to think about it, because people are going to get hurt during that flame-out. Either we regulate it, so that we stop people from getting hurt now, or we shut it down entirely right now.
And second, existing finance law is largely sufficient for providing that consumer protection (with a few exceptions, such as the spot market for bitcoin). As Phillips wrote on Twitter:
There are a lot of bad products out there, but just because I don’t think they’re useful doesn’t mean that the people that do should go unprotected. The [US Federal Trade Commission], SEC, and other federal agencies exist to regulate bad products. This is what governments do.
We understand why this argument would fall on sympathetic ears at the SEC and US Commodity Futures Trading Commission (if you only have a hammer, everything looks like a nail, etc). Yet the fact crypto can be regulated under existing law doesn’t suggest it should be. The cost of doing so is conferring legitimacy on a poorly understood asset that generates little economic value and has inflicted losses on millions of investors.
But we do agree that consumer protection matters too. As Unhedged thought this over, we differed on just how to do this. Ethan thinks a customer protection regime similar to how the UK regulates contracts for differences could work: big honking warnings saying you will lose money buying this junk, mandatory stop-losses for customers, a ban on monetary inducements and so forth. Rob (who is Ethan’s boss, just to be clear) thinks that with the narrow exception of stablecoins, financial regulators should stay away. Crypto tokens are not securities any more than baseball cards or sports bets are. Prosecute fraud, maybe regulate crypto exchanges like casinos, and keep the SEC et al out of it.
This is a disagreement about how to cordon off crypto so that when crypto burns, it is controlled. But make no mistake: it should burn.
The big Treasury rally
A few months ago, we argued that “long bonds are looking interesting.” We presented two scenarios under which 10-year Treasuries could work:
If the Fed sees inflation starting to cool, and remembers that policy works with (all together now!) “long and variable lags”, it might pivot towards smaller hikes, with an eye to ending rate increases altogether .[Alternatively] the Fed overtightens badly and drives the US right into a proper recession. If that suddenly looks like the most likely outcome, 3.5 per cent on a 10-year Treasury is going to look pretty good, because the Fed will be in loosening mode soon enough.
We wrote too soon. That was September 21, when the 10-year yield stood at 3.5 per cent. Yields moved to 4.2 per cent over the next month, just to mock us. In the last month or so, however, the 10-year has staged a rousing rally, pushing yields back to 3.5 per cent (despite a bad day yesterday). What has happened, in broad outline, is a combination of the two scenarios we outlined.
The Fed has pivoted to smaller hikes, and the market has interpreted chair Jay Powell’s recent comment that “my colleagues and I do not want to overtighten” as a nod to the end of tightening. At the same time, the yield curve remains inverted and the shadow of recession hangs over every portfolio. Greg Obenshain of Verdad Capital sums up:
You have inverted yield curves, a Fed still tightening, the Fed Lending Survey indicating that lending standards are much tighter, all indicative of tight money and oncoming recession. Even in the 1970s, bonds rallied in recessions. Given that inverted yield curves are THE signal of recession and given that bonds have sold off so much and tend to do well in recessions, it would be surprising if people weren’t taking a hard look at Treasurys. Add in some slowing inflation, and [the Treasury rally] makes all kinds of sense.
Everyone I spoke to about the rally noted that the market has been heavily short the entire curve and particularly the long end, positions that are now reversing. Pension funds and insurance companies globally know that rates tend to hit cyclical peaks when the curve inverts, and now that the Fed is signalling it is nearly done, they are piling in to long duration.
Recession next year is Unhedged’s base case, so the Treasury rally makes sense to us. That said, we do not think (as many do) that Powell is a closet dove. The reputational risk to him loosening while inflation is still well above the 2 per cent target is immense. In the next 12 months, Powell will be writing the top paragraphs of his obituary, and he knows it. This suggests two risks.
The first is that Powell looks at the recent stock and bond rally and sees financial conditions loosening fast, putting their effort to depress demand at risk. They may also notice, with disapproval, that the futures market has priced in two rate cuts for the second half of next year.
“The Fed wants to and needs to create material slack in the economy and in labour markets before saying ‘job done’,” Calvin Tse of BNP Paribas told us. “We’ve seen a rapid unwinding of financial conditions over the past month, so the Fed may have to do something to tighten them again — perhaps by introducing the idea that rate hikes may continue for a while.”
We think that this (a) would be a smart thing for the Fed to do and (b) it would come as a shock, given how the market is positioned today. It could make the curve invert even farther, as the short end prices in more hikes and investors, worried about an even deeper recession, throw more money at long Treasuries.
What would be bad for long Treasuries would be a breakdown in the current trend towards lower inflation falters badly. The peak policy rate would then have to be significantly above the 4.75-5 per cent currently anticipated. If inflation is 3ish in six months’ time, and the direction of travel is down, the Fed could consider a cut. Not if it’s 4ish.
BlackRock is worried about this. From its 2023 global outlook:
Long-term government bonds . . . historically have shielded portfolios from recession. Not this time . . . Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting.
Taking the other side of this argument, here is our regular interlocutor James Athey of Abrdn:
Just looking at the base effects from energy there would need to be significant upside in key core components for there not to be some significant disinflation over the coming months. The market prices headline [inflation] at around 3 by June. The way oil trades currently there are downside risks to that. Real time rental data suggests [housing costs] peaked a few months ago. And for the labour market not to weaken after the tightening we’ve already seen would be unprecedented. Of course there are upside risks, there always are, but right now I feel pretty confident that the risks are skewed to the downside.
We hope James is right. And Treasuries still make sense to us.
One good read
The mad scramble to build natural gas terminals in Europe.