Bond Boom Bolsters Bitcoin’s Bottom Line

Portfolio construction has to do with opportunity cost and with bond yields plunging, Bitcoin is starting to look attractive.

For Ju Anh Kim, up to the time she left North Korea, the only face she hasd ever known was that of the Dear Leader.

She sees him in her sleep, he buzzes in her head like white noise throughout the course of the day, and everyday at 5 a.m. she wakes up with a jolt, expecting to hear the ominous tone of the “call to adoration,” that echo through the streets of Pyongyang.

Even after a decade having fled North Korea, Kim still has nightmares of the regime and when asked about her family that she left behind after defecting, she immediately turns quiet.

“It’s not as if I had a bad life in Pyongyang,” Kim recalls.

Kim’s father was a high-ranking official in then-leader Kim Jong-Il’s regime, which entitled her family to live in the capital and afforded them creature comforts, while millions of her countrymen in the surrounding countryside starved to death.

But Kim recalls her life changed when as a teenager she surreptitiously watched a Hollywood movie which her classmate had somehow managed to get ahold of.

“I saw well-dressed Americans eating more food than I had ever seen in my entire life and living in beautiful houses.”

“I was told that it was all propaganda, and after watching the movie, my classmate laughed and said that the ‘American bastards’ will stop at nothing to undermine our revolution with these lies.”

“Yet at the back of my mind, I couldn’t help but wonder, what if it wasn’t a lie, what if we had been lied to.”

That seed of doubt planted inside Kim’s young head eventually flowered and from that moment on she made plans to escape North Korea.

Now a decade later and living in South Korea’s capital Seoul, she says she has visited the United States many times and still can’t get over how much she had been lied to.

“I had a comfortable life in Pyongyang. When I gave up everything I didn’t know what I was going to give it up for, there was uncertainty and fear and it cost me a lot, my family, everything I had known.”

“But you never know until you give it up. Nobody can tell you, you just have to do it.”

Do You Take the Shot?

And while constructing an investment portfolio may not be as severe as choosing to flee an oppressive dictatorship, it still involves hard choices that require balancing off certainty and uncertainty.

Take for instance the typical 60/40 stock and bond portfolio.

Because equities come with risk, investors are rewarded with the potential for both capital gains and dividends, for their willingness to stomach that risk.

Conversely, the bond portion of a portfolio provides fixed coupons that guarantee a certain return, but that certainty comes at a cost of further upside and at the risk that inflation will eat away at the face value of those bonds.

But investors don’t have a static relationship with certainty, paying more for it during times of uncertainty, and valuing it less highly during periods of optimism.

When it comes to bonds, there’s no better benchmark of economic conditions quite like the U.S. 10-year Treasury yield.

In late March this year, the U.S. 10-year Treasury yield rattled as high as 1.77%, on concerns that inflation would skyrocket and that the U.S. Federal Reserve would do nothing about it.

Unlike the fixed interest rate that a Treasury pays out, the yield on a Treasury is what investors require for loaning money to the U.S. government and determined by market supply and demand.

While Treasuries are issued with a face value and a fixed interest rate, they are sold at initial auction or in the secondary market to the highest bidder.

When there’s a lot of demand for Treasuries, the price is bid up past its face value and trades at a premium, which lowers the yield that the investor will get since the U.S. government only repays the face value on the maturity date.

Conversely, if demand for Treasuries is low, the yield increases to compensate for lower demand, because investors are only willing to pay an amount below its face value.

The “yield” therefore is the calculated amount based on what investors are willing to pay for Treasuries and is dynamic — whether it’s over and above the face value, and not to be confused with the fixed interest rate that comes with the debt.

When the prospect of inflation is high (i.e. the future value of money is lower than the present value), bond investors will demand a higher yield on their Treasuries to compensate.

No Longer Correlating

So how is it that with U.S. Consumer Price Index data reflecting the sharpest rise in prices since 2008, Treasury yields are plummeting, meaning that investors are clamoring for these securities?

Key to understanding why Treasury yields are flagging is that these U.S. government securities represent safety and stability, and they do especially well in uncertain times.

So last year, when news that vaccines could potentially return life to normal, investors started dumping bonds and buying up stocks, on expectations that things would get better.

As a general rule, investors tend to bet on equities when they thing things are going to get better and they bet on bonds when they feel uncertain.

Things got worse for bonds when the Democrats clinched all the levers of power in Washington, with expectations of profligate fiscal spending, surging growth and a reticent Fed adding to a belief that prices would start rising fast.

By February, a shaky auction of 7-year U.S. government debt, typically a pedestrian affair that would only catch the attention of a handful of purists, sparked a sharp drop that rippled through U.S. Treasuries of longer tenures.

And that served as a reminder to investors that even the typically sedate U.S. debt markets, which underpin the price of pretty much all risky asset classes around the world, have their moments of instability under pressure.

With the belief that it was off to the races on risk, all manner of risk asset saw a huge spike, from equities to cryptocurrencies, with Bitcoin hitting an all-time-high of around US$64,000 by April.

But the risk party seems to be winding down and the partygoers appear to be getting ready to leave the burned out husk of a frat house.

After several defeats to the Biden administration’s most generous fiscal spending plans, expectations of government profligacy are now more measured.

Inflation has picked up, but the Fed has maintained a stance that it can and will intervene if necessary.

All of which have resulted in a sharp drop off in benchmark U.S. 10-year Treasury yields.

And this is where risk assets and Bitcoin started to diverge from the narrative.

Time to Count Costs

The reflation trade — investors betting on stocks more closely linked to the reopening of the economy — started to get overcrowded at a time when growth stocks looked exceedingly expensive.

As investors started to shift back into Treasuries, traders that were short government debt fell to a classic “short squeeze” of the sort that has the potential to be self-reinforcing, which it became.

So why are investors still betting on government debt in a time when there seems to be no shortage of it?

For one, government debt is as good as cash, except that unlike cash, it yields something.

Treasuries are also highly liquid instruments, to such extent that it doesn’t even matter how much an individual investor sells, it won’t even affect the price — after all, the U.S. Federal Reserve is the 400-pound gorilla in the Treasury market that will soak it up.

And at a time when there is growing uncertainty over the trajectory of the economic recovery, with China lowering the reserve requirement ratio for its banks and the U.S. seeing a massive 70% surge in infections last week alone, investors are understandably bullish on bonds.

But that also provides an opportunity for another instrument — Bitcoin.

To be sure, Bitcoin is neither bond nor equity, a chimera that yields nothing, but has the potential to deliver upside at the price of substantial risk.

And from that perspective, Bitcoin’s role in a portfolio needs to be viewed from its cost to such portfolio, and that’s where the argument for an allocation starts to really come into its own.

Betting on Bitcoin?

Because demand for U.S. Treasuries has been so high of late, the yield generated from their addition to a portfolio has plummeted, which makes the holding cost of non-yielding assets such as Bitcoin lower.

And with equities starting to falter, the opportunity to get in on an asset that represents the best of both worlds becomes apparent.

Consider this — the addition of any asset into a portfolio is the product of (hopefully) decisions based on opportunity cost.

For those who are more algorithmically inclined, a portfolio allocation process is the end result of a series of “if, and, or” branches.

So when the opportunity cost for one asset type increases, investors should start to whittle down the holdings of that asset class and move to another, and vice versa.

This is known as the “Opportunity Cost” theory of portfolio allocation:

Opportunity Cost = FO − CO

where:

FO = Return on best foregone option

CO = Return on chosen option​

So where does Bitcoin go in all of this?

When Treasury yields are high, as was the case in February this year, the opportunity cost for holding Bitcoin increases, because Bitcoin doesn’t generate any yield, and it has substantial risk.

But in February, investors were gorging on risk, and so Bitcoin was behaving as a risk asset, which saw it rally to a fresh all-time-high.

Now that Treasury yields are low, the opportunity cost for holding Bitcoin decreases — it doesn’t generate a yield and represents potential upside at a time when equities are starting to look shaky as well.

Viewed purely from an opportunity cost perspective, a bet on Bitcoin (at this moment) looks to have relatively low opportunity cost, but low opportunity cost should not be equated with low risk.

“You miss 100% of the shots you don’t take.”

— Wayne Gretsky