End of Tightening, End of Crypto Winter?
The US Federal Reserve and other major central banks contemplate a possible rate hike pause, and the money market sees an outright end of the tightening cycle. What does a central bank’s pivot mean for crypto?
The Tightening Cycle
Last year was marked by a very aggressive monetary policy tightening by major central banks. The US Federal Reserve, the Bank of England, and the European Central Bank (as well as many smaller peers) increased their policy rates from a near-zero level in 2021 to 3-5% now. Many central banks also engaged in the so-called quantitative tightening, directly “burning” money by reducing their balance sheets.
Policy Rates of the Federal Reserve, the Bank of England, and the European Central Bank
That was a primary reason behind the “everything” drop in 2022, as stocks, bonds, and crypto declined. Oil traded sideways despite a major supply shock related to Russian sanctions as a reaction to the war in Ukraine.
Performance of Long-Term Bonds (TLT ETF, Blue), S&P 500 (Green), Brent Oil (Yellow), and Bitcoin (Red)*
* All are indexed at 100 as of December 31, 2021
Long-term bonds are represented by iShares 20+ Year Treasury Bond ETF (TLT)
Wait and See
The recent news suggests a possible pause in the tightening cycle. Last week there were monetary policy meetings by 3 major central banks: the Federal Reserve, the Bank of England, and the European Central Bank. All of them were generally more dovish compared with very hawkish market expectations. The central banks see a possible pause in a hiking cycle in the next few months in order to gauge the effect of tightening on economic growth and inflation. The Bank of England was the most dovish one, making the case for no further hikes. The Federal Reserve discussed a disinflation theme and hinted that hikes may end in May. All in all, the relentless tightening of the last year turns into a wait-and-see mode.
The central banks’ pivot to a more relaxed stance becomes possible due to a better inflation picture, particularly in the US. Inflation remains near multi-decade highs but has seemingly peaked and started to decline.
YoY CPI in the US, UK, and Eurozone
The money market is almost sure that the pause will turn into the end of the tightening cycle, expecting the Federal Reserve to slash rates in the second half of 2023. The yield curve is inverted after 1 year (till 5-7 years) both in the US, UK, and euro area with the US curve having the most significant inversion. The market sees short-term rates as unsustainably high.
Yield Curves in USD, GBP, and EUR
Importantly, at the last meeting, the Fed did not push back against the market pricing as aggressively as it had been at a few previous meetings. It looks like the Fed is tired to fight the markets and has started to align its view with the market view.
The Fed Rate and Global Liquidity
The Fed rate is always important, but now even more than ever before. Fed tightening was very front-loaded in the current cycle, as market participants effectively reduced liquidity in anticipation of Fed actions. Forecasting higher short-term rates, market participants parked a lot of cash in the overnight reverse repo with the Fed, effectively taking that money off the market and the economy. Everyday money market funds and other investors routinely park huge money with the reverse repo facility. its current size is as much as 2 trillion dollars! I believe that inflows into the repo facility were a primary reason for the last year's market drop as well as outflows this year determined a rally.
Overnight Reverse Repurchase Agreements at the Federal Reserve (USD Billion)
Crypto is particularly sensitive to global liquidity changes. Unlike stocks, crypto has no fundamentals linking it to economic growth or decline, so it may not be influenced by an economic slowdown and a recession as much as stocks and other risk assets. Unlike bonds, crypto is not directly determined by an expected policy rate path.
What Can Go Wrong
The markets strongly advanced this year, reflecting the inflation slowdown, and last week the Fed largely endorsed the rally. Is it all clear now for continued growth? Of course, there is a caveat. The central banks’ pivot holds only as long as macro fundamentals allow it.
For example, US labor market strength may become an obstacle to a looser monetary policy, as the recent data for January showed that the unemployment rate is at the 50-year low and, even more importantly, trends lower rather than higher (in mainstream macroeconomics too low unemployment rate indicates an overheated economy, pressuring inflation higher).
US Unemployment Rate (%)
* Shaded areas represent recessions
The bottom line is that the central banks’ pivot is clearly positive for crypto (as well as most other assets), but this change of a policy reaction function is largely a reflection of an improved inflation picture. Given the big rally this year, the pivot may be largely priced in. I remain optimistic about crypto for this year, but a further short-term upside may require better macro data or crypto-specific catalysts. In the short term, both crypto and broader markets will focus even more on incoming statistics, particularly on the US inflation and the labor market.
In the mid-term, that does look like an end of crypto winter (or at least a beginning of this process). The monetary policy cycle turns this year, and there is better global liquidity ahead, supporting crypto prices.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.