WEEKLY, Mar 18, 2023
The nuance of liquidity
Hi everyone! I hope you’re all taking care of yourselves – it’s been a helluva week, and I have a feeling we are far from done. Do try to rest up a bit this weekend, you’ll need it.
You’re reading the free weekly Crypto is Macro Now email, where I look at the intersection between the crypto and macro landscapes, poke at established narratives and share listening recommendations. Nothing I say is investment advice! This is coming out a bit later than usual today, apologies, and I haven’t included a reading/listening recommendation section this week because, well, overwhelm – there have been just too many interesting takes on what’s going on for me to be able to filter out a handful of choice ones.
For more detailed market updates and news commentary and narrative updates, plus a lot of charts and some amusing and/or insightful links, do consider subscribing to the premium daily newsletter. Or take out a free trial! 😊
MARKETS
Since the column this week talks about markets, I’m going to keep this section really short and share a few of the things that have left me 😕 this morning that aren’t mentioned further down.
There’s the weekly price moves. I mean, wow.
Yet again, the MOVE US government bond volatility index has rocketed to its highest level since the Great Financial Crisis, suggesting that the supposedly “safest” assets in the market are not so safe after all.
(chart via TradingView)
Rather than a credit confidence crisis, the ructions in the treasury market seem to be driven by a scramble for safe collateral. The US 2-year bond yield plummeted 100 basis points this past week, its steepest 1-week drop in more than 40 years.
(chart via TradingView)
Yesterday delivered further signs that the economy is cooling, giving the Fed more breathing room to pause. Last week, US retail sales, PPI and a leading manufacturing index all came in lower than expected and notably lower than the previous month; on Friday we saw that industrial production did the same, on both a month-on-month and year-on-year basis.
What’s more, the monthly University of Michigan survey showed that consumers are getting more pessimistic, a necessary condition for spending and inflation to come down.
CME futures-priced rates expectations have been flip-flopping wildly all week, which is unusual so close to an FOMC meeting. After showing an almost certainty that there would be a 50bp hike just a couple of weeks ago, the market swung to no hike, to a for-sure 25bp hike, and now it’s basically saying “no idea”.
(chart via CME FedWatch)
The last time bitcoin’s dominance was this high was during last May’s Terra/Luna crash as the market aggressively rotated into the “quality” crypto asset. We’re not seeing that this time, since the overall market cap is up – this rise is being driven by new money entering the market. BTC.D is even higher now than its previous peak in October 2021, when BTC rose to over $60,000 as a result of institutional inflows.
(chart via TradingView)
BTC spot exchange volumes have risen to levels even higher than those seen in October 2021.
(chart via The Block)
Something has definitely changed regarding crypto sentiment over the past few days. Things move fast in crypto markets, and we may see corrections and lulls, but we are unlikely to find ourselves in the end-2022 ennui again for quite some time. What’s more, this run-up is starting to look very different from the last one.
I’ll be talking about this in more detail in the daily emails coming up – do think about subscribing if you’d like to receive them!
COLUMN
Crypto and the Liquidity Question: More Complex Than It Seems
Three years ago today, markets were reeling from a particularly bad week. The S&P 500 had lost almost 17%, the DJIA had suffered its worst one-day drop on record, and BTC had plummeted over 50% to just below $4,000 before recovering slightly. The number of COVID-19 cases was rocketing up around the world; New York City was closing all bars, restaurants and schools; in Spain, we were several days into lockdown. Things were looking bad.
The financial machine was springing into action. On March 15, 2020, the Fed slashed its benchmark interest rate by 100 basis points to almost zero and committed to boosting its bond holdings by at least $700 billion. The message was one of “we’ll do whatever it takes”, and it worked: the global economy staggered and then limped, but markets soared.
That week made history on so many levels. It also unleashed a wave of armchair virologists on Twitter, to keep us up to date with every minutia of the COVID threat. We didn’t know it then, but that wave set us up for what we’re living through today. If you’ve spent any time on Twitter over the past week, you’ll have noticed a new breed of liquidity experts telling us that the Fed’s actions over the past few days mark a reversion to quantitative easing (QE) and/or a pivot. In 2020, more of us got into the habit of getting our news from Twitter, regardless of the quality. Fast forward three years and we have a similar mindset: new liquidity pontificators are trying to teach bona-fide experts, and disinformation blends with nuance to create an uncomfortable mix of hope, distrust and confusion.
Superficial social media analysis aside, the events of three years ago also set us up for what we’re going through today on a more serious level. The liquidity that the Fed would inject into the economy in 2020-21 created an easy money environment that pushed up asset values, flooded startups with eager venture capital funding and loaded bank balance sheets with low-yielding government bonds as well as some riskier securities. It also ended up fuelling the steepest increase in consumer prices in over four decades.
This in turn triggered the fastest interest rate hiking cycle since the 1980s, which decimated asset prices and destabilized the equilibrium between bank assets and liabilities. The crisis that began in 2020 as the pandemic introduced unprecedented stimulus entered a new phase three years later almost to the day, with the closure of three US banks in the space of a week.
As it tends to do when faced with banking system strain, the Fed has again jumped into action: to make more funds available to meet withdrawals, last Sunday it announced the opening of a new financing facility called the Bank Term Funding Program (BTFP). This enables banks to deposit government debt as collateral in exchange for a loan of 100% of its face value, even if the collateral market value is much lower.
Here is where the crypto market started to get excited. From a local low of $19,700 on Friday, March 10, BTC went on to soar 35% to almost $27,000 a week later. (Stock and bond markets also rallied, but by insignificant amounts in comparison.) Crypto Twitter celebrated the end of monetary tightening, the onset of a new QE and the dawn of a new bull run.
Things do indeed look more positive for the crypto asset market, but for more complex reasons than the “QE is back!” chorus would have you believe.
1) Technically, it’s not. QE involves the direct purchase of securities by the Fed. This is not (yet) happening. The BTFP is, however, a type of monetary easing. The Fed is lending at par against bonds that are worth less, essentially bringing forward the bonds’ full value. The difference between the market value of the bonds and the 100% of face value the Fed will lend is new money in the system.
So far, $11.9 billion of the new facility has been used, according to a Federal Reserve report released on Thursday. This is a small amount compared to the volume of underwater bonds weighing down bank balance sheets (just the total amount of unrealized losses on securities held by US banks is around $650 billion) – but banks will only use this facility if they 1) need to (it’s not cheap funding), and 2) have the requisite quality of collateral.
A more worrying surge was seen in the Fed’s discount window, through which banks borrow directly from the Federal Reserve rather than from other banks. During the week leading up to March 15, banks had borrowed a record $152.8 billion from the discount window, even higher than during the Great Financial Crisis.
Technically, this is not a new money injection as the banks deposit collateral in exchange for the loan. But whatever the collateral terms, the Fed is essentially exchanging less liquid assets for more liquid ones – bonds for cash. This increases the circulation of funds in the market, which boosts liquidity.
But the economy as a whole just got a lot less liquid. The discount window surge highlights how scared banks are. Generally seen as a last resort, banks only turn to the Fed when they can’t borrow from each other, since it is a more expensive option. If banks are not lending to other banks, you can bet they’re not lending to corporates, either. This wave of liquidity supposedly engulfing the market as a result of the Fed’s moves? Aside from the relatively small amount advanced via the BTFP, it’s not yet real.
Then again, it doesn’t really need to be for markets to react. What matters more for markets are expectations, and they seem to be signalling that tightening is pretty much over and that the current crisis will force the Fed to loosen fast. We’re seeing this in fed funds futures pricing which is now suggesting Fed Chair Powell will start cutting rates in June. We’re also seeing it in the oil price, which last week dropped to its lowest daily close in over a year on the back of lower expected demand – you don’t need as much energy if activity is slowing.
2) Expectations of easing matters more for BTC than for other assets. Loose monetary policy generally implies more funds (because money is relatively easy to borrow) chasing higher returns (because lower interest rates means lower yields on safer assets such as government bonds). This tends to push investors further out the risk curve because that’s where the higher returns are, which is why we talk about higher “liquidity” favouring “risk assets”.
Among risk assets, BTC is the most sensitive to swings in liquidity. It is unarguably a risk asset in the traditional sense of the term (given its high volatility), and unlike stocks and bonds, it has no earnings or credit rating vulnerability. Unlike almost all other assets, it is untethered to the real economy except through the impact of liquidity flows. In an environment of likely earnings expectations downgrades and overall corporate fragility, a “pure play” is likely to appeal to macro investors. The recent outperformance of BTC relative to other crypto assets, as well as the jump in spot and derivatives volumes, suggests that this is already starting.
3) A more crypto-specific narrative is building. The expected renewal of US money printing, should it materialize, will further debase the dollar, highlighting the store-of-value properties of assets with a fixed supply. Gold has been the traditional haven over the centuries, and this week reached its highest point since the aftermath of the Ukraine invasion early last year. However, gold is not exactly seizure-resistant, is hard to store unless via a centralized third party, and is complicated to spend. BTC, on the other hand, is digital, can be moved with relative ease, and is an evolving technology with use cases yet to emerge.
This is likely to feature in portfolio recalibration decisions of professional managers who left the crypto market next year, as well as those who have so far been bemusedly or skeptically watching from the sidelines. All will remember what happened the last time monetary easing combined with a rapidly changing marketplace and a new type of liquid asset. Many will want to avoid being accused of missing out a second time, especially when many of the imagined barriers three years ago (an unstable system, consumes too much energy, likely to be banned) have to some extent been debunked.
It’s not just professional investors that are taking notice. On Thursday, Axios reported that app monitoring service Apptopia detected a sharp increase in crypto wallet downloads since the closure of Silvergate – institutions tend not to custody crypto assets on mobile apps, so this is more likely to reflect a pickup in retail interest.
And it could be that the pickup is warming up, just like the evolving banking crisis. The Fed’s moves last weekend may have stemmed some of the panic, but they are metaphorically a Band-Aid on a severed artery. A paper published this week by a team of researchers from Stanford, Columbia and other universities shows that 10% of banks have larger unrecognized balance sheet losses than SVB, 10% have lower capitalization and almost 190 banks are at risk of impairment to insured depositors, with roughly $300 billion of insured deposits potentially at risk. Trust in the banking system seems to be wobbling, judging from the strong flows out of banks – this week, money market funds saw their largest inflows since April 2020. The banking problems in Europe are for now distinct, but corporate troubles there, exacerbated by weakened trading desks and wealth management divisions, could further hurt the very confidence the global banking system relies on.
In this environment, an asset that does not rely on centralized trust is likely to attract more attention. What’s more, after a year of an astonishing sequence of serious blows, crypto markets have shown remarkable resilience in recent months. Even amid the stress of last weekend, trades got executed, assets moved, a stablecoin de-peg rectified, and the only transaction limitations were due to lack of access to fiat onramps outside traditional banking hours. In other words, crypto markets worked. Banking didn’t, and given the number of trading halts endured last week, traditional markets didn’t either.
So, while BTC and the broader crypto ecosystem will benefit from looser monetary policy, more so even than other assets, the story is more nuanced than it may seem. On the one hand, monetary policy is not notably looser just yet, although expectations of a shift in that direction do seem to have been driving this week’s moves. On the other hand, the crypto narrative is gearing up to take on even more layers, each of which will lend price support. It is also gearing up to take on even more relevance in what lies ahead.
Many of us in our ecosystem have long been aware that BTC is unlikely to truly show its longer-term worth at a mainstream level until the global financial system’s fragility is laid bare for all to see. That means a lot of pain for a lot of people. Let’s hope that the new wave of armchair liquidity experts cheering the recent price performance remember that.
Have a good weekend!
I have to follow up the Siberian throat singing I shared last weekend with a possibly even more epic take on Mongolian rock music. This one also has extraordinary instruments, stunning scenery, impressive costumes and an astonishing script – but instead of techno twang, this one is full-on heavy metal. Almost cathartic.