May 22, 2023
Risk on in tradfi land this week as optimism that a deal will be reached to lift the debt ceiling powered stocks higher, with the Nasdaq hitting 13-month highs. AI excitement with investors getting bulled up on the potential productivity and margin gains adds a positive narrative. However, as I’ve written about previously, for a market under-positioned risk, pain is to the upside, and this felt like a painful “grabby” move to chase higher.
Crypto not joining the party, continuing its divergence away from equity correlations as higher US yields, a stronger dollar, and anticipation of a post-debt ceiling lift liquidity squeeze creates a strong headwind to offset the risk-on pull. Consequently, we chopped around 27k and 1800 in tight ranges for BTC and ETH, respectively. The volatility bleed lower continuing as a result 😞.
US economic data, whilst mixed, broadly continues to come in on the soft side and perhaps best summarized by the Leading Economic Index (LEI), which fell 0.6% in April, declining for the 13th month in a row and the lowest reading since September 2020. Justyna Zabinska-La Monica, the Conference Board’s senior manager of business cycle indicators, said “The results signal a worsening economic outlook” and predicts a contraction of economic activity in the current quarter, “leading to a mild recession by mid-2023. In addition, weak earnings from Home Depot and Target underscore the soft underbelly of the US consumer.
However, the continued deterioration in the data was overshadowed this week by hawkish Fed speak, with the general tone being one of “still more work to do” and more hikes remain possible. JPow speaking on Friday, backing up what feels like coordinated messaging to talk the market down from expectations of rate cuts, although he did continue to signal a pause by saying, “we can afford to look at the data” and once again highlighted the on-going credit tightening as doing the Fed’s job and lowering the terminal rate endpoint.
A big move in the front end of the US rates curve, with 2yr yields hitting 4.35% highs, the highest levels since mid-March. Expectations of the debt ceiling lift are doing most of the work. Indeed headlines late Friday that House Speaker McCarthy’s top debt-ceiling negotiators “abruptly left a closed-door meeting with White House representatives soon after it had begun” dented the optimism and drove 2yr yields some 15bps lower before recovering to close at 4.27%. The rates dynamic is not working favorably for BTC currently, and while in the big picture, it doesn’t change the supportive “peak rates” narrative, this correction and debt-ceiling-led volatility is a negative development short term.
Also negative for crypto is the renewed dollar strength, which continued to grind higher (although notably faded into a key resistance zone).
In particular, the move higher in USDCNH, which I highlighted as a concern last week, broke above the psychological 7.00 level to reach highs of 7.0750 before prompting verbal intervention from the PBOC vowing to “curb speculation in the Forex market.” Underpinning the move is a policy divergence to the US, with the PBOC responding to last week’s soft data by net injecting 25bn Yuan via its medium-term lending facility and rolling existing loans, albeit keeping the interest rate unchanged. Markets, however, continue to expect monetary easing may be inevitable to support the economic recovery. As a result, data this week continued to reflect a soft impulse, with Fixed Asset Investment for April falling to 4.7% from 5.1% prior and industrial production falling short of expectations of 10.9% to come in at 5.6%, albeit up on March’s 3.9%.
USDCNH moving higher tends to lead the broader dollar, as attempts to smooth volatility by selling USDCNH see the dollars recycled and repurchased against other foreign currencies to maintain stable FX reserve ratios. This can drive a vicious circle of dollar strength which, as the below chart shows, is typically negative Bitcoin.👇
Global net liquidity remains stable, validating this range-bound action for Crypto. Interestingly, net dollar liquidity has improved as the Fed balance sheet unwinds under Quantitative Tightening (down another $46bn in the past week) is off-set by the Treasury General Account (TGA) drawdown (as of Monday, this stood at $87.4bn, down $52.6bn from Friday.) This is a contributing factor driving this move higher in Nasdaq.
As a reminder, the TGA is essentially the US Treasury’s checking account at the Fed. Because of the debt ceiling, the Treasury is currently unable to issue debt, so to meet spending requirements, they need to draw down the cash held at the Fed and spend in the economy, thus injecting liquidity. When the TGA is rebuilt, the Treasury does so by issuing debt and draining liquidity out of markets. This is where I believe the debt ceiling lift, when it arrives, will be a short-term negative factor for Bitcoin and risk more broadly.👇
The treasury General account is set to be replenished to $500bn by the end of June (assuming a debt ceiling lift.) This will be done mainly via issuing T-bills and suck cash/liquidity out of our markets. A potential offset may be the over $2trn in cash sat with the Fed’s overnight Reverse Repo (RRP) facility, which potentially will get teased out and used to purchase bills. Nonetheless, USD liquidity is set to fall sharply once the debt ceiling gets lifted and the Treasury returns to the debt markets.
The below chart shows BTC against net USD liquidity (Net USD Liquidity = Fed Balance Sheet - [TGA + RRP].) When net dollar liquidity rises, this is a positive driver for Bitcoin. However, with the debt ceiling lift, we’re set to see a sharp fall in net dollar liquidity as the TGA rebuilds, and all else equal, this will weigh heavily on crypto and broad risk.
The medium-term outlook for Crypto continues to remain positive on the shifting macro dynamic as the Fed “pause” and eventually cut. Data continues to soften, and China is now exporting its deflation to the rest of the world. We can expect PBOC rate cuts and more liquidity injections as they battle a stuttering post-lockdown economy. In addition, US inflation continues to head lower. 5yr breakevens now at 2.19%, and “real-time” CPI inflation as measured by Truflation sits at 3.04% compared to the Fed’s lagging 4.9%. Inflation is yesterday’s news, and as the lagged data catches “down” with reality, we remain confident that this rate hike cycle will be over.
The US banking stresses remain despite a recovery in US regional banks stocks this week. To wit, the use of the Fed’s Bank Term Funding Program (BTFP) rose to record highs of $87bn last week. Bank deposit outflows also continue (Money Market fund inflows the beneficiary - up another $13.6bn to a record $5.34trn), and Janet Yellen dented the bank stock rally late Friday, telling the prominent bank CEO’s that “more bank mergers may be necessary as the industry continues to navigate through a crisis.”
The end game is sharp Fed cuts to off-set the disinflationary, recessionary impact of a credit crunch, or an explosion of Fed liquidity akin to what we witnessed in March as the Fed is the ultimate lender of last resort to an ailing banking system unable to sustain high rates. Both outcomes are positive for Bitcoin.
Short term, however, the debt ceiling drama is creating a negative dynamic for crypto, with front-end rates spiking higher, the dollar strengthening and liquidity set to turn from a tailwind to a full-blown headwind. With Nasdaq pushing new highs, Broad “risk” trading well has kept crypto supported, but I suspect a more challenging risk environment in the weeks ahead. It remains a BTFD market, but caution is required here. Bitcoin's reluctance to join the risk party is a forewarning of stormier waters ahead. Trade accordingly.
David Brickell 💜