The Breakdown - Slightly Hot Inflation Print Probably Won’t Change the Fed’s Perspective

Starting point is 00:00:00 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDesk. What's going on, guys? It is Tuesday, February 14th, and it is CPI Day. Before we get into that, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod.

Starting point is 00:00:39 All right, guys, well, first of all, happy Valentine's Day. Hope you are spending it with someone you love, even if that's just yourself. Today is the much-watched, always important reminder of just how weird our financial markets are. I'm referring, of course, to today's inflation announcement. This morning we got January's inflation numbers, which matter, of course, because it's maybe the key piece of data each month for the Federal Reserve. And rightly or wrongly, the Federal Reserve is the key institution in our economy. Before we get into the CPI discussion, however, there are a bunch of follow-ups from yesterday

Starting point is 00:01:11 that I think are important to check in on. Now, of course, yesterday's big news was all surrounding Paxos. The Wall Street Journal had reported over the weekend that the SEC was planning on suing Paxos for offering an unregistered security. On top of that, Paxos announced first thing in the morning that due to a complaint from the New York Department of Financial Services, they would no longer be issuing BUSD, the stable coin that they had been issuing in partnership with Binance since 2019. The NYDFS clearly had issue with the fact that Binance was calling a different product on a different chain BUSD as well.

Starting point is 00:01:44 The BUSD that they had approved and were regulating was Paxos issued on the Ethereum chain, whereas Binance Pegg USD is on the BNB chain. And remember, as was revealed publicly in January, Binance PegbUSD hasn't always been fully backed one-to-one. At points in 2020 and 2021, it was undercollateralized by as much as a billion dollars. There also seemed to be questions from the New York Department of Financial Services around KYC and AML processes. So a couple additional dimensions to the story since I recorded yesterday. The first is the Circle, USDC aspect of the news. According to Bloomberg reporting published yesterday, Circle tipped off the New York Department of Financial Services

Starting point is 00:02:23 about problems with the Paxos issued BUSD stablecoin. According to an anonymous source, Circle blew the whistle in fall of last year, complaining that on-chain data showed that Binance did not have the reserves to fully back at Stablecoin. I did mention this on the show briefly yesterday, but it was when the news was fresh and hadn't been fully digested by the markets yet. Digging a little deeper, it sort of confirms that the issue was Binance printing B tokens, i.e. B&B chain wrappers for other chains tokens, but then not actually having the underlying collateral locked up, or at least not locked clearly in a designated wallet. Bloomberg source said that the B token version of Circles USDC was also

Starting point is 00:02:59 impacted, claiming that at one point, Binance had only $100 million of collateral for $1.7 billion worth of Binance Pegg USDC. Now, when it comes to the news that Circle had potentially informed on Binance, the community had a few different reactions. The first I would categorize as Snitches gets stitches. Basically, angry responses saying that the crypto industry shouldn't tattle on each other or something like that. A second and related response was that Circle are feds anyways. Bitboy tweeted, if you think the SEC is going after Circle and USDC, then they have you right where they want you. The SEC is not going to ban USDC. They're clearing the path for it. A third category of responses I will group together as Game of Thronesian. In other words, a lot of people

Starting point is 00:03:41 just saw this as a power move, what was to be expected. I saw a number of chaos isn't a pit. Chaos is a ladder-type memes. But then the fourth category of reaction was that Binance is in a tough spot. Dirty Bubble Media tweets, this is a key point. BUSD was Binance's shadow bank solution to accessing dollars. They've been cut off from the dollar at both the banking level and at the shadow banking level. Good luck. Now, that tweet was actually a link to a thread, which is perhaps a little more speculative than I normally share here, but I think is worth discussing, not to say that I agree with the theory behind it, but that it reflects the larger sense that the walls are closing in around crypto from a regulatory and banking perspective. Patrick Tan, the CEO at Noven

Starting point is 00:04:22 Alpha writes, what if BUSD as a security was a red herring all along? Stay with me for a minute. Looking at the case law, unless there are facts we are unaware of, it would be very challenging and nothing short of legal gymnastics to even attempt to argue BUSD on Paxos is a security. But bear in mind, a Wells notice is merely a formal letter informing a recipient of an intention to litigate and providing an opportunity for the respondent to provide cause as to why the SEC should not proceed. NYDFS gets wind of the SEC looking to litigate Paxos and immediately recognizes that it's the Binance-branded B-U-S-D product on Paxos that's problematic, instructs Paxos to no longer mint the stuff.

Starting point is 00:04:59 That means only one thing. B-U-SD is literally a reverse hotel, California. You can't check in any time you like, you can only leave. B-U-S-D market cap can go only one way, zero. Because Binance took the decision to convert all USD-T, U-S-D, and all other stable-coin balances automatically to B-U-S-D, the bulk of trading pairs on Binance are tied to B-U-S-D, which would lead to a predictable fallout.

Starting point is 00:05:21 BUSD leaves Binance and with it trading volume, which would necessarily affect BNB, which is what's led to the recent sharp fall in BNB. Customers cash out of BUSD and sell BNB leading to a self-fulfilling death spiral. Users lose confidence in BUSD, and because BUSD flows are larger than other flows on Binance, this undermines finance as an exchange, which undermines confidence in B&B. The U.S. has already cut Binance's banking facilities by forcing Silvergate and signature bank to sever ties, same in Europe and other jurisdictions as well. Binance can't get access to USD to keep churning its exchange, now it can't get access to USD via BUSD as well. Even without a single affidavit being filed, the SEC may have already been able to accomplish its mission of kneecapping

Starting point is 00:06:02 Binance with nothing more than a Wells notice. Was that the goal to begin with? So the question becomes, is this what the market's thinking? Well, Binance did endure more than $830 million in net outflows on Monday as news of the BUSD enforcement action spooked markets. Nansen data showed 2.8 billion in withdrawals, but it was offset by 2 billion in deposits. Monday's outflows were the largest net daily outflows experienced by Binance since November. They even surpass those triggered by December's round of Binance fudge surrounding less than satisfying proof-of-reserve reports from the exchange. Still, it is worth pointing out that these numbers are quite manageable for an exchange of Binance's size, at least at this point. However, bringing it back to Paxos, while we obviously

Starting point is 00:06:42 had some clarity yesterday on how they were dealing with the NYDFS, i.e. ending the issuance of BUSD, we didn't really get any comment around the SEC news until later in the day. Their press release acknowledged receiving a Wells notice on February 3rd and then went on to say, quote, The Wells Notice states that the staff of the SEC is considering recommending an action, alleging that BUSD is a security and that Paxos should have registered the offering of BUSD under the federal securities laws. Paxos has issued the following statement.

Starting point is 00:07:08 Paxos categorically disagrees with the SEC staff because BUSD is not a security under the federal securities laws. This SEC Wells notice pertains only to BUSD. To be clear, there are unequivocally no other allegations against Paxos. Paxos has always prioritized the safety of its customers' needs. BUSD issued by Paxos has always backed one-to-one with U.S. dollar-denominated reserves, fully segregated and held in bankruptcy remote accounts. We will engage with the SEC staff on this issue and are prepared to vigorously litigate if necessary." End quote.

Starting point is 00:07:38 So this is good. This is Paxos saying we're not just going to accept the securities designation. We will take it to court if it has to get there. And frankly, I think that with the state of regulation as it is right now, court battles are going to be an important part of this next phase. And in this next phase, the news just keeps coming. Another story from Bloomberg late yesterday talks about a new draft proposal from the SEC under which hedge funds, private equity firms, and pension funds might find it more difficult to deal with crypto. According to Bloomberg sources, the SEC plans to propose rule changes on Wednesday that would make it harder for crypto firms to be qualified custodians. That's a designation which allows them to custody assets for money

Starting point is 00:08:13 managers. Hedge funds, as well as some venture capital and pension funds are required to use qualified custodians to hold their clients' assets. If finalized, the rule change could force institutions that have dipped their toes into crypto to move their customers' holdings elsewhere. There's also the potential for surprise audits related to their custodial arrangements. For the proposal to be passed, a majority of the five-member SEC would need to approve it. Anyway, as you see, the regulatory antagonism sub-themed is giving no indications of letting up, but for Now, let's switch over to the macro. So, coming into CPI Day, where were we?

Starting point is 00:08:45 Maybe another question to ask is, what signals has the Fed been sending over the last month and what would various inflation scenarios do to impact those signals? Summing up Fed commentary for the last four weeks or so, we've heard, one, an acknowledgement that inflation is easing, that we seem to have hit a disinflationary period. Two, we've also heard continued concern around services inflation, wage and labor market tightness, and a general persistence of the attitude that we're going to need to get rates up above 5% and keep them there. At the same time, there has been an unwillingness from Fed officials, especially Powell, to really aggressively tamp down on stock market enthusiasm. This has specifically

Starting point is 00:09:20 taken the form of him not really acknowledging loosening financial conditions. All of this has led many to think that the Fed has this mythical soft landing locked firmly in their sights. So what could have been majorly disruptive today? Well, of course, a real shock to the system up, like inflation trending upwards in a major way. December's initial inflation data was headline CPI at 6.5% year-over-year, which had slowed from 7.1% in November, core CPI at 5.7% year-over-year, and monthly headline at 0.1%. Revised numbers had already put a damper on some of the enthusiasm that we had coming out of that initial announcement. Monthly headline data was revised up to 0.1% instead of being in negative territory. Now, coming into today, analysts on average

Starting point is 00:10:04 were guessing that we would see 6.2% year-over-year inflation. However, in a lot of ways, the big discussion wasn't so much what the exact number was going to be, but the divergence in signals from stocks and bond markets and who was right. Over the last few months, stocks of bonds have been sending very different signals. Short maturity bonds have seen their yield slowly walking up, with the three-month treasury rate moving from around 4.1% in November to 4.8% yesterday, but at the same time, during that time, stocks have had a cautious rally. The S&P 500 is up 7% since the start of November. Dan Suzuki, Deputy Chief Investment Officer at Richard Burnstein advisors said, quote, the stock market wants to have its cake and eat it too. The market is

Starting point is 00:10:43 pricing in a Goldilocks scenario of better growth yet continued disinflation and probably underpricing the negative risks from both the growth and inflation sides. Art Hogan, chief market strategist at B. Riley said, the CPI is going to be a test of who's got it right, the bond market or the stock market. Join CoinDesk's Consensus 2023, the most important conversation in crypto and Web3, happening April 26 through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Immerse yourself in all that blockchain technology has to offer creators, builders, founders, founders, brand leaders, entrepreneurs, and more.

Starting point is 00:11:25 Use code breakdown to get 15% off your paths. Visit consensus.com or check the link in the show notes. So what actually happened? Bloomberg writes, inflation digs in to start 2023, pointing to longer Fed flight. The lead of the piece reads, U.S. inflation doesn't look like it's going away anytime soon. Consumer prices rose 0.5% in January the most in three months,

Starting point is 00:11:54 and the annual inflation rate came in at a higher than expected 6.4%. In some key categories from energy to various goods as clothing, the slowdown in cost that was a feature of the final months of 2022 looks to have stalled out or even reversed. So basically, we got slightly higher than expected headline inflation. It was still a downward trend from the year-over-year number from last month, but it was still higher than expected. However, given it was so close to lining up with expectations, most people went deeper into the report to try to get a better sense of what was

Starting point is 00:12:27 going on. A huge amount of the discussion was around the housing piece. Bloomberg, for example, wrote, housing costs were by far the biggest contributor to the monthly increase in the consumer price index, accounting for almost half of it. But they also point out, quote, Because of the way those numbers are calculated, there's typically a significant lag before real-time market conditions, which suggests the pandemic housing boom is over, show up in the government's inflation figures. So effectively, we have housing and shelter driving a big part of this inflationary number, but it's really lagging data. Core CPI without shelter was at 3.9%, which is obviously a much lower number. Jeff Snyder wrote, today's CPI was mostly shelter imputations. A little bit of

Starting point is 00:13:07 transitory, yeah, I said it, rebound in gasoline prices. Other than that, damn, now I have to agree with Jay Powell. The full disinflationary process has reached its fourth month in a row. Now, one specific area that's been getting a lot of press time lately is food, and it's easy to see why. Food price inflation is still pretty crazy. Food overall is up 10%, dairy is up 14%, cereal is up 15%. Eggs, meanwhile, were up 8% just in the month of January alone. So, of course, the real question is what the Fed is likely to think about all of this, and I honestly believe that this report probably changes next to nothing in their outlook. Let's talk about services inflation, which has been one of their biggest areas of focus. Mike Consol from the Roosevelt

Starting point is 00:13:50 institution said, quote, breaking inflation into goods, housing, and non-housing services, this was really driven by goods going positive. Goods was negative in previous months taking off the headline. Non-housing core services, what the Fed says it's watching, didn't actually drive any increase. Indeed, I think in some ways it's possible that this report, and what it's doing in markets is right in line with what the Fed is hoping for. Remember, up until a couple weeks ago, markets were pricing in the Fed actually cutting by the end of this year. After that hot jobs report in January, that expectation was pushed out into next year. But after this, Nick Timoros from the Wall Street Journal writes, over the past two weeks, the interest rate futures market has

Starting point is 00:14:29 done an about face on the rate cuts that had been priced in by year end. Markets have pushed their estimate of the terminal rate to around 5.2% by June and July, and C rates at 5.1% by December. quote. Those numbers are much more in line with what the Fed was projecting late last year. After the report, stocks were slightly lower, but overall, it was just kind of a nothing burger. So that I think is the CPI story for now. To me, this seems like a report that's likely to confirm the Fed's sensibilities about where things are more than challenge them in any meaningful way. But over the next couple days, with Fed speakers being trotted out, we'll get a chance to see whether that's actually the case. For now, I appreciate you listening as always, and until

Starting point is 00:15:08 tomorrow, be safe and take care of each other. Peace.

The Breakdown - Slightly Hot Inflation Print Probably Won’t Change the Fed’s Perspective

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