Where Macro Is Leading Crypto

Note: This is an opinion piece. Although data will be referenced, uncertainty, even among experienced market participants, is high, and I am not a macroeconomist or Fed Chair. These are just insights into how I’m thinking about things; nothing is gospel, and my views can/will change over time. Also, none of this is remotely financial advice. Disclaimer finished, on to the article. 

Summary: Crypto lower for 2-4 more months, followed by a more sustainable reversal. Read on to see my reasoning.

Intro

Crypto’s correlation with equities is undoubtedly high right now; recently, both BTC and the Nasdaq printed seven straight red weeks. BTC is roughly 57% off its highs, and that number is roughly 30% for the Nasdaq. For the foreseeable future, it appears that this strong correlation will continue. Despite the inherent, apparent differentiators that BTC offers (censorship resistance, fixed supply, etc.) and the rising talent level creating new innovations, crypto is broadly trading like high-risk tech stocks.

With this in mind, it makes sense to evaluate “where is the Nasdaq/macro picture going in the coming months?” in order to decipher if and when it makes sense to “throw in your cards” and bid crypto in anticipation of a revival of risk assets. In this article, I’ll try to do just that. I’ll focus mainly on US policy although, obviously, there’s far more to delve into that I won’t touch on here. This will be divided into four sections:

1. Background

2. Financial Situation

3. Geopolitical Situation

4. A Forecast (And What It Would Mean For Crypto)

Background

We’re in a period of liquidity tightening. On May 4th, the Federal Reserve raised interest rates by 0.5% into a range of 0.75%-1%, the largest single raise since 2000, and committed to decrease their now-largest-ever balance sheet starting on June 1st (selling off Treasurys and mortgage-backed securities). Subsequent 50 point raises are likely in the coming months, and the market is pricing in a 60% chance of a 2.50%-2.75% target rate range by December (see graphic below). On top of this monetary contraction, according to David Rosenberg, we’re seeing the second largest fiscal contraction in the past 70 years.

Why is all this being done? Well, mainly, inflation. Due to massive monetary and fiscal stimulus during Covid ratcheting up demand, combined with supply shocks due to congested supply chains and the geopolitical situation with Russia, inflation has been running hot. The Fed wants to cool demand to reduce inflation and, to do this, they aren’t afraid to hurt markets in the process. A “reverse wealth effect” - forcing people to have less to spend - helps them reduce demand.

This means “stocks lower”. To quote a former vice chair of the FOMC, “one way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower”, and, to quote Zoltan Pozsar, head of Short-Term Interest Rate Strategy at Credit Suisse, “Consider the possibility that the Fed, on a singular mission to slay inflation, won’t rest in its pursuit of tighter financial conditions until yields shift higher, stocks fall more, and housing turns as well. The crypto sell-off is just an unexpected bonus.”

For many investors, all this has meant is “well, time to buy the dip again!” However, at the risk of sounding cliche, this time it’s different. Leading into both the 2008 and 2020 crashes, inflation was low. The Fed could afford to stimulate the economy through monetary tightening and QE (quantitative easing - injecting liquidity by buying bonds). This time, inflation is running hot and the Fed and President Biden want to reduce demand, not stimulate it.

For this reason, they do not want to inject liquidity and make “buy the dip” a viable short-term strategy again. This means more tightening, higher yields, and lower stock prices, at least until inflation is under control. And, unless we see some huge black swan event like a major world power buying BTC or Russia demanding it for oil (chances? basically 0%), crypto is likely destined to fall lower as well. We can argue all we want about whether the Fed should have started tightening earlier; regardless, they are now. But, is this strategy actually sustainable? Let’s take a look.

Financial Situation

Sentiment around stocks, crypto, and other higher-risk assets is already terrible. The Nasdaq is trading around $11.8k, levels not seen since August 2020 (the top of the initial leg up after the Covid crash), and the S&P 500 is trading around $3,900 (just about 16% above pre-Covid-crash levels). Corporate earnings have begun to show signs of weakness (Target, Snapchat, and Netflix are some highlights), many VCs are reducing investments and valuations are coming down, credit spreads - a measure of the interest-rate premium corporate bonds offer versus Treasurys - have widened quickly, and the number of analysts calling for a recession has been growing. This is all not great news, but where are we headed now? 

Before I get into that, understand that the US has run high deficits since 2001 (see chart below), and they have been financed by (a) tax receipts, which have recently surged as a result of, largely, inflated asset prices, but mainly by (b) foreign countries buying Treasurys with dollar savings. To quote Arthur Hayes, “[this] allowed the Fed to print money to fight the deflationary aspects of technology and poor demographics, without much inflationary pass through into the real goods economy.” 

Reduced asset prices, corporate earnings, and other metrics like home sales and US manufacturing, all of which we are already seeing and would obviously be present in a recession, lead to reduced US tax receipts. Reduced US tax receipts means that the US has less money to pay interest on their debt, and Treasury sales become more important. Keep this and the above paragraph in mind - I’ll come back to these points soon.

Geopolitical Situation

A caveat: Longer-term, we do want to move to more green energy and more robust, not-as-dependent-on-outside-nations (“de-globalized”) supply chains, but we aren’t there yet. I’m looking at the coming, shorter-term months/years here, not the coming decades.

As I was walking on the treadmill the other day, a headline ran across the TV screen: “Russia Black Sea Blockage Hurts Global Food Supply”. In the latest chapter of the Russia/Ukraine turmoil, it looks like Russia is blocking some Ukraine exports, putting pressure on global food supplies. I won’t go back and re-hash all of the geopolitical problems that have resulted from the Russia/Ukraine situation, but safe to say that it has put pressure on available energy (especially for Europe, who basically cannot cut out Russian energy without triggering a crisis or having to inflate currency rapidly), energy prices, and other commodities like grains. It has also led to some forms of “commodity hoarding”, like Indonesia banning palm oil exports and multiple countries (including India, Ukraine, and Egypt) banning wheat exports. 

Russia, in addition to the havoc wreaked on Ukrainain citizens, has several financial weapons at their disposal. These include requiring RUB payment for energy (already being done, sending the RUB on a 150%+ run against the dollar since early March - see below), and requiring gold for energy, which is not completely off the table in the future (and which would drive the price of gold far higher).

Further, it has become apparent that, as much as we’d like to ratchet up oil production elsewhere, it’s basically impossible to do in a meaningful way on such short notice and with reduced investment over recent years. OPEC is missing production targets, Brazil has said it cannot increase oil output, US oil reserves are falling, and the Permian Basin appears to not be pushing up production either. All of these commodity issues only add fuel to the fire for “risk-off” behavior.

So, it’s obvious that the geopolitical situation is causing major financial and humanitarian issues. It is also, more “quietly”, creating headwinds to the Fed’s tightening plan (credit to Luke Gromen, whose writing helped me wrap my head around this). Earlier this year, the US snatched Russia’s foreign reserves right out from under them as part of some economic sanctions. On the surface, this sounds great and like just punishment for the turmoil caused by the invasion of Ukraine. However, for non-Russia foreign nations it begs some questions:

“Are my assets invested in the US markets/Treasurys really safe, as I’ve considered them to be for years?” and “If I’m considered a bad actor by the US at any point in the future (and many countries have been considered to be just that over the years), will my assets stored with them be taken away?” 

These concerns could result in more selling of US assets, like Treasurys, by foreign nations…at just the time that the US needs more buyers to offset the Fed’s Treasury sales and new issuance over coming years. Remember, the US finances its debt through tax receipts (likely to fall) and US Treasury sales. Less demand for Treasurys equals even higher yields, which means the US needs to pay higher interest on its debt.

Note: I understand that many foreign nations will not directly sell Treasurys at the risk of further hurting the global financial system, but at the very least they may strongly reduce future buying.

Not only do those concerns potentially result in less Treasury demand, but other issues could also contribute to reduced demand. To name a few:

1. China’s recent economic issues have driven sharp selling of Chinese government bonds and CNY weakness, which could cause China to sell US assets to defend the currency.

2. China’s Communist Party has recommended that senior officials sell foreign assets to avoid possible asset seizures.

3. The JPY has weakened against the dollar to levels not seen since 2002 as they’ve implemented yield curve control to avoid going bankrupt, and is now selling Treasurys to defend it. Japan has historically been one of the largest buyers of Treasurys.

4. The EUR weakened against the dollar to levels not seen since 2017 (I’ve heard theories about the US potentially having to step in and buy their debt, but can’t really comment on that as I don’t understand it yet).

Again, the US needs Treasury buyers to finance the massive deficits it runs; if foreign nations reduce buys or actually become sellers, this puts a major dent in the US’s ability to finance those deficits. I will note that, right now, Treasury yields are falling as demand increases…but lots of this is due to weakening economic growth projections, and issuance is set to increase. Even if issuance increases less than expected (issuance was cut a bit for q2 2022), spending is still very high which demands UST increases as tax receipts fall.

Who else could be a buyer? How about US banks? It looks like that won’t work, as Jamie Dimon has already stated that JP Morgan would not be using excess cash to buy these. The US could relax some regulations around banks, but I’m unsure if regulation changes alone could bring in the volume needed to keep Treasury yields somewhat compressed. Combine this with, as mentioned earlier, likely-declining tax receipts, and the US is not able to finance its debt as easily given higher interest rates demanded by remaining Treasury buyers. 

How can the Fed fix this? Well, they could cut deficits by some % of GDP so that they don’t have as much debt to pay off, but this would very likely trigger a recession. Or, just as Arthur Hayes mentioned in a recent article, they can implement yield curve control! To quote Hayes:

“Remember that the Fed has an institutional reference point for implementing YCC. All it takes is dusting off the covers of the post-WWII history books on how the Fed and Treasury colluded to fix the 10-year treasury yield and cap retail bank deposit rates so that real rates were extremely negative. These negative real rates allowed the USG to inflate away the debt incurred to win the war.”

This would entail the Fed stepping in and buying enough Treasurys to cap their yield at some level - which expands the balance sheet! It’s also exactly what Japan has been forced to do, and it would enables rates to be kept at some defined level and keep the government’s interest payments down.

With all of this in mind, we can understand the forecast below.

A Forecast (And What It Would Mean For Crypto)

It appears that the Fed is caught between a rock and a hard place:

1. Inflation has been running hot, so they need to reduce demand so that it can cool down and the citizens do not continually have their buying power reduced (especially important in an election year like 2022).

2. The ability for the Fed to sustain tightening, in the face of the factors mentioned above, is questionable; the situation we’re in is not conducive to tightening without inflicting major pain on markets (“causing something to break”), causing a recession, and raising the potential for the US to default on its debt.

Due to this, my view is that the Fed will be forced to either pause their tightening schedule or actually reverse course by implementing yield curve control and/or QE by the end of August. There are several factors involved in this forecast:

1. Inflation, by many estimates, is beginning to cool off. In a couple months, although inflation numbers may not be low, they may be low enough for the Fed to feel that it is politically acceptable to say “we’re slowing down on the tightening here”. 

2. By this time, markets will likely have experienced even more pain. If this happens, and especially if it curbs demand, this can give the Fed yet another reason to say, “we’re slowing down on the tightening here”. 

3. Tax receipts may begin to show signs of weakness and a lack of Treasury buyers may become so apparent that, in order for the US to finance its debt, the only acceptable move will be to cap yields or print more money. 

4. Keep in mind that, as I mentioned earlier, these views could change, and the “end of August” timeline is just an estimate (I am not personally keeping track of specific metrics that could help time this even better; I leave this up to the professional macroeconomists). 

In the meantime, more pain in markets seems logical. As quoted earlier, “Consider the possibility that the Fed, on a singular mission to slay inflation, won’t rest in its pursuit of tighter financial conditions until yields shift higher, stocks fall more, and housing turns as well. The crypto sell-off is just an unexpected bonus.”

To, once again, quote David Rosenberg, “For the equity investor, it is time to be smart, resist temptation, wait for a less unhinged market to develop and when better conditions emerge, dip your toes in. Wait for signs of a confirmed uptrend and do not get lured into these short-term bear market rallies. When the time comes, and it will, lift your exposure slowly. But for now, best to focus on capital preservation and being as defensive as possible. The uptrend line is under downward pressure, and that is all anyone needs to know. Add to that the historical record showing that recession bear markets don't typically end at the -20% mark, and they certainly don't end with the Fed still tightening policy. And the central bank seems fine with repeated 50 basis point hikes into the summer, and Jay Powell was up-front last week when asked about the markets — that ‘there could be some pain involved to restoring price stability.’ Duh. To achieve that holy grail without food and energy helping will require the Fed doing something it has never done before, which is to create the conditions for deflation in the core CPI (-1.8% to be exact).”

What’s all this mean for crypto? First of all, I don’t think crypto is going anywhere. Broader societal trends continue to shift to empowering end-users, creators, entrepreneurs, etc., funds continue to flow into the ecosystem (a16z alone is investing over $7 billion), and the talent level in crypto has stepped up another level over the recent months.

However, for now, I do not expect any sustained moves upwards. The appetite for risk is low, economic issues abound, and the potential for traditional risk-on assets (like high-growth tech) to move even lower seems stronger than not, driven by a Fed who wants to see them move lower. Alts, making up some of the highest-risk assets in existence, are especially prone to decline (which is obvious given recent market moves). Still, my current view is that this will not last as long as some anticipate (1-2 years). My perspective, which is still evolving, is viewing this depressed period in terms of months. 

So, to summarize again: crypto lower for 2-4 more months, followed by a more sustainable reversal.

Now is a great time for a little break from markets, and for research and building, until we get broader signs that appetite for risk-taking is back. Or, until some major power decides to adopt BTC or push for majorly pro-crypto regulations, in which case we can throw a lot of this analysis out the window and throw all our money at Bitcoin immediately (/s…kind of).