CRYPTO QUAKE – WHY CYPTO ASSETS ARE FALLING AND WHAT COMES NEXT
It is no news to anyone at this stage that crypto-related prices have crashed over recent weeks. Bitcoin set new all-time highs on November 10th, 2021 at $68,991. Since then, the price of the asset has been in a sharp downward trend to a cycle low of $32,970. This translates into a 52.2% reduction in the price of bitcoin. Other crypto assets have suffered even sharper losses.
The key question everyone in the market is currently asking is: What will happen next?
Factors driving the market
Before answering this question, it is necessary to understand how the financial and economic context affects these assets. There are many market participants that still believe crypto assets are completely independent from traditional financial markets. However, crypto assets are nowadays well embedded in every day’s financial life and decisions. Why? Three reasons:
- Because Wall Street nowadays actively trade crypto assets.
- Because institutional investors are starting to allocate a percentage of their portfolios to crypto assets.
- Because there are now options and derivative products on Bitcoin. Options and derivatives are typical hedging instruments that can also be used with speculative purposes (and are broadly used by Wall Street).
Overall, this means investors in crypto and Wall Street investors are becoming closer when it comes down to crypto assets. It is just a simple fact: as long as Wall Street players come into the crypto space, crypto markets should be treated more and more as traditional finance assets.
This can be seen in the correlation (i.e. how close the price of two assets move together either up or down) between Bitcoin and the Nasdaq 100 index. It is near its highest level ever and, also, it has remained positive since early 2020. This is quite important as it basically is telling us that the tech sector in the US and crypto markets are moving in tandem, which means that the price of crypto assets is moving like growth stocks (Tesla, Google, Facebook, Microsoft, Netflix, Amazon, Apple, and similar).
We, as investors, whether we like it or not, need to adapt to these changes in the crypto market structure. It would be irresponsible not to do so.
Then, if crypto assets are now moving in tandem with other risk assets such as tech stocks, perhaps we can use some of the market data we have from over a hundred years of tracking these markets in order to reach some valuable conclusions about potential movements in crypto assets which, due to their short life, do not allow for this kind of analysis.
From a macroeconomic point of view, there are two main factors that have dominated global markets in history
- Gross domestic product (GDP), i.e., economic growth,
- Consumer price index (CPI) or inflation, i.e., changes in prices paid for goods and services.
These two factors are responsible for the majority of the market movements that we see.
There is an important caveat to consider here: it is not the absolute level at which these indexes sit that is important, but their growth rate. In other words, if GDP annual growth rate in January is 3%, it means that GDP grew 3% compared to the same date one year earlier. Understanding this is absolutely critical.
Second caveat: investors are not interested in the current growth rate of GDP, but in how growth rates change. Let’s understand this with one example. If GDP’s growth rate in January is 3%, but in February is 1%, some people may think: “that’s fine, GDP is still growing rather than decreasing”. This is a huge mistake. As we said earlier, investors are interested in how these growth rates change. So, from 3% in January to 1% in February, means that the economy is decelerating, i.e. growing slower. The same rationale is used with inflation.
Now that we understand this, we can go deeper into the macro rabbit hole. If investors are interested in growth rate changes in GDP (economic growth) and inflation (changes in prices), then there are 4 macroeconomic regimes:
- GDP accelerating and inflation decelerating
- GDP and Inflation both accelerating
- GDP decelerating and inflation accelerating
- GDP and Inflation both decelerating.
These are the 4 regimes that explain most of the market moves globally.
Regime #1 means the economy is booming and prices are falling. Consumers enjoy a better purchase power as their savings buy more goods with the same amount of money. All sectors enjoy increase production and central banks are happy.
Regime #2 is also good: the economy accelerates, but prices are also increasing. The economy is growing and businesses produce more. But central banks now should be wary as the economy is overhearing which leads to higher interest rates (slower economic growth).
Regime #3 is not that great. Prices are up but the economy is slowing. Businesses are forced to increase prices which leads to less sales. Commodity prices are on the rise which means higher power prices and lower purchase power for consumers. Central banks are trapped as higher interest rates mean an even slower economy.
Regime #4 is the worst possible scenario, everything slows down. The economy is slowing down across the board. Risk asset prices collapse, equity markets crash (so does bitcoin), there is an exodus towards safe assets. Typical growth sectors correct to “normal levels”.
Current macro regime
With the above in mind, and in order to understand this article’s main question “what happens next with Bitcoin/crypto assets?” we need to know in what economic regime we are. The next two charts are clear: we are in Regime #4.
The first chart shows that economic growth, represented by the OECD leading indicator index (an index that tracks most of the main indicators that help forecasting economic growth) is flipping downwards, i.e., decelerating. High beta stocks (tech, growth stocks) are also flipping. Bitcoin is also topping relative to historic levels against US treasuries (this chart has been borrowed from the great Darius Dale, macro risk manager and Founder at 42Macro).
The second chart shows inflation across various indicators (CPI – consumers inflation; PPI – producers inflation; World CPI; inflation surprise index – an index showing inflation readings relative to expectations). It also shows the 5-year, 5-year inflation swap forward, which shows market priced inflation expectations in 5 years and onwards. What the second chart is telling us is the following: inflation is at the highest level that it has been over the last decades, but also that after such increase it will start to decelerate.
There is an important observation here. Inflation will remain high on an absolute level, but it will not be accelerating (i.e., we won’t see double digit inflation). This can be seen in the 5y5y inflation swap forward which is already flipping to the downside.
Economic and financial implications
The current regime is pretty bad for markets as we have already seen. Nasdaq is near crash levels (a drop of 20% or more) and Bitcoin has lost more than 50% of its value.
However, there is a third element that we need to add into the formula: the Federal Reserve. The Fed has announced it will start increasing interest rates this year. Higher interest rates are typically negative for economic growth. This is because it is more expensive to borrow money for businesses and because consumers start to earn better interests for their savings (yes we know they are very low anyways but this is the theory). So we have the world’s more important central bank increasing interest rates to fight inflation into a decelerating economy: this is the formula for disaster!
Markets could well keep correcting and crypto assets could continue falling.
By carefully analysing the first chart above, we know that BTC has lost between 76% and 83% of its value during previous Regime #4. This implies that the current crash could well continue.
This is obviously not known and we don’t have a crystal ball. But, if past moves help when assessing the future, it seems to us that we need to be careful at the moment, instead of aggressive.
The fact that absolute inflation is at the highest level it has been in over 40 years in the US suggests the Fed will need to increase interest rates. How many hikes they will perform is yet to be seen. It is broadly understood that the Fed cannot simply hike rates as that would send the markets in a downward spiral after two decades of incredibly loose financial conditions.
In any case, is time to be cautious under current market conditions.
Please let us know if you like this kind of content. We at Brickken are always looking at markets and macro in order to comprehend how to best protect our investors and community. We look forward to help each other during uncertain times and we wish you the best of luck out there.