Monday, Jan 16, 2023

“We may have all come on different ships, but we're in the same boat now.” – Martin Luther King, Jr. ||

Hello everyone, and happy Monday! I hope you all had a restful weekend, because it feels like it’s going to be an eventful week. For my US readers, I hope you enjoy the holiday Monday! And for those of you in Davos, I hope you get a little bit of snow at least, for the essential wintery vibe.

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MARKETS

USD outlook

One trend that attracted significant attention last year in spite of plenty of dramatic competition for our mental bandwidth was the rapid rise of the US dollar relative to other currencies. Strangely, that attention abated as the direction turned – but the current trend is, if anything, even more significant in terms of market impact.

The DXY index, my preferred dollar tracker (mainly for convenience), reached a 10-year peak in October after increasing almost 20% since the end of 2021. Since then, it has declined down to May 2022 levels, although is still relatively high compared to most of this century so far.

(chart via TradingView)

A large part of the 2022 increase in the value of the dollar can be attributed to three main factors:

• The expectation of rising interest rates, which would make the dollar more profitable to hold relative to other currencies.

• The eruption of war in Europe, which triggered a rush into the “safe asset” of the global reserve currency.

• A further demand boost from the high prices of many commodities.

Among the many reasons we were transfixed by the climb was because a high dollar squeezes the global economy by making dollar-based debt more expensive to service, and by making imports priced in dollars more costly. This especially hits emerging economies that have to pay for crucial commodities in dollars while having limited dollar income from exports. The bleak outlook for economies in this dollar trap discourages investment which further hurts their outlook in what rapidly becomes a destructive spiral.

This increase was always going to be unsustainable, as it would have eventually led to a wave of emerging economy defaults. The concern was that the trend wouldn’t turn in time, and the resulting strain on global finance would cause considerable damage to entire regions, people and most likely also the US debt market. The lack of an alternative “safe haven” asset painted a gloomy picture of the global financial landscape. At times it felt like we were watching two trains on a collision course and we couldn’t do anything about it.

It was also a significant contributor to the crypto market’s slump, given the typically inverse relationship between BTC and the DXY. This can be attributed to the denominator effect (when the denominator in BTC/USD goes up, the whole ratio goes down), and to what the dollar’s value says about rates expectations and dollar availability (i.e. overall liquidity).

The post-October descent has brought market relief, as well as some surprise at the speed of the correction. What is especially interesting about the current situation is the drivers of the shift, and whether we think they will continue. These drivers include:

• The decline in key commodity prices. Oil is below its level on the eve of the Ukraine invasion. So is wheat. Natural gas is back to mid-2021 levels. While supply chain issues could force some spikes, a slowdown in the global economy is likely to dampen demand growth, at least for the short term.

• The market is discounting peak US rates in 2023, with fed funds futures even pricing in a cut before year end. Steady or even declining US rates while other regions are still raising changes the relative yield profile of the USD.

• Less fear of a harsh global recession (recent data in the US and EU have stoked hopes of a soft landing, with China expecting growth in 2023) mitigates the need of a “safe haven” currency.

• Concerns are starting to circulate about the US federal debt ceiling which could cause treasury market volatility, further weakening the “safe haven” support.

• And cracks are appearing in the dollar’s role as the global reserve asset. Eight of the top 10 foreign investors in US treasuries reduced holdings in October. India is starting to trade with Russia in rupees and last year purchased Russian coal using yuan. Moves are afoot to boost the use of the “petroyuan” as China cements trade agreements with the Middle East.

Looking ahead, these trends are likely to continue and possibly even accelerate, suggesting continued declines in the DXY. This would be good for emerging economies and should lift the global outlook, further weakening the need for dollars as a safe haven while lowering the risk of higher-yield alternatives.

It would also be good for crypto.

A symbolic breakthrough

The total crypto market capitalization briefly touched $1 trillion overnight. This doesn’t have any real significance other than symbolic, but it is nevertheless a significant threshold. A small market is not really worth any large investor’s time – it would be difficult to accumulate a position large enough to compensate expensive analyst, compliance and back-office hours without incurring liquidity risk. Even $1 trillion is tiny in relative terms, but it would put crypto back on some funds’ radar, and – as you’ve probably heard me say before – all it takes to kick FOMO up several notches is for one large inflow (or a handful of large-ish ones), especially given the absence of convinced sellers.

Still, the blip above $1 trillion was brief, but could be recovered should this current rally continue, and the psychological win could keep momentum going.

Market balance

I’ve written before about bitcoin’s market dominance (BTC.D) and how it can be used to gauge risk appetite – when bitcoin’s dominance is increasing, it can mean that the market is fearful and rotating into the relatively “safe” crypto asset (“safe” in this case meaning the lowest non-stablecoin volatility, the highest liquidity, the broadest range of onramps and the longest track record). We saw this narrative relationship break down late last year as, rather than rotate into relative safety, investors simply left the market.

It looks like we’re seeing the reverse happen now. Since the beginning of the year, BTC.D has shot up, but not because the market is fearful (there is still considerable uncertainty regarding the full contagion from recent drama, although expectations that more bad news could further hurt prices are diminishing). Rather, it seems that macro investors are coming back in, but tentatively, and BTC is the gateway asset – the one they would most likely onboard first.