The advent of the Kevin Warsh Federal Reserve with its first meeting last Wednesday, very likely heralds a new departure in American central banking. The Warsh Fed will likely be less effusive in its communication (notably there will be less public defending why the Fed doesn’t hit its forecast levels of rates and inflation), will be more closely coordinated with the Treasury, and if the track record of the new governor is to be believed, will be much more reluctant to use the balance sheet of the central bank to support markets and the animal spirits of the economy. The real test of this will be next economic crisis, potentially a public debt crisis that starts in the next couple of years.

In the medium term, the backdrop to the Warsh Fed will likely be characterised by tighter liquidity conditions. Warsh will likely slow the Fed’s reserve accumulation program, equity issuance by tech firms, IPOs, new bond issuance (again, for AI infrastructure) will also mop up market liquidity and following a bout of bond retirement in the second quarter owing to a bumper tax take, the US Treasury will increase debt issuance from the end of June onwards (up to USD 600bn in Q3).

So broadly speaking from a ‘plumbing’ view of markets, there will be less liquidity shooting around the pipelines of markets. Ordinarily, this is not great news for risky assets like equities, especially with valuations at the very top of 100-year ranges. However, the asset class that intrigues me, is bitcoin, already a significant underperformer this year. The mystery being that bitcoin has yet to reveal its true identity as an asset class, let alone a money.

Bitcoin was established in the aftermath of the global financial crisis, as an alternative to paper money and the institutional framework around that money (i.e. the Fed and the ECB), but has failed in this aim. Bitcoin is not a money. It is simply far too volatile to act as a reliable store of value or basis for payment. Also, the technology associated with cryptocurrencies is also complex enough to dissuade most households from using them.

As a case in point, I can recall that in bitcoin’s early days (2016), train stations in Switzerland’s ‘Crypto Valley’ had a facility to exchange swiss francs for bitcoin, and the canton accepted bitcoin as payment for taxes and services. But transaction fees were very high, and this experiment hasn’t caught on. In fact, only some 0.1% of tax settlements in the canton of Zug were paid in bitcoin.

While the Swiss authorities were happy to give bitcoin the benefit of the doubt, most institutions in the old-finance world, primarily central banks who plan their own digital currencies, have an incentive for it not to succeed, and famously in 2021 Christine Lagarde referred to bitcoin’s ‘funny business’.

Reflecting this, the weakness of bitcoin has not been the technology, but rather the infrastructure around it, and the people who have used it as a means of payment. In the past five years, a good number of exchanges (in Asia) and brokers have collapsed or been shut down, and the entry and exit points to the crypto world are under examination from tax authorities. Also the anthropology and sociology of those who populate the crypto world is crucial to how these assets behave and subsequently to their risk characteristics. In this light the, fact that the biggest holder of bitcoins is apparently the FBI says a lot.

Bitcoin, and the broader crypto world, now face two new competitors of sorts. One is the growth of stablecoins (which are based on the Ethereum blockchain), which may facilitate ‘grey’ economy transactions far more efficiently than bitcoin. The other is AI, whose claim on the electricity and energy sources of the world, makes the production of bitcoin more expensive. Lurking in the future is quantum technology, which some fear could break the bitcoin protocol.

So, bitcoin is far away from meeting the objectives of a ‘money’, and in my view is a ‘tulip’, a speculative, trading asset. It also seems to me that many people are increasingly happy with bitcoin being assigned this role, and much of the interest and eco-system that is developing around it underpins the role of bitcoin as a speculative asset rather than as a bona fide currency.

As such, this points to bitcoin and crypto currencies being ushered into the corner of eclectic trading assets – though less of an experience than horse racing, with none of the aesthetic bonus of art and not quite the fun of collecting wine.

These assets tend, in my experience, to be driven by waves of liquidity, and surges in wealth, as opposed to more fundamental factors. Thus, with the prospect of weaker liquidity ahead, bitcoin is in for a test. It has been claimed that bitcoin is a safe haven, or digital gold, but in general its tendency is to weaken as macro uncertainty rises. It might be the first victim of the Warsh era.

Have a great week ahead, Mike