More complex than it seems

Three years ago this past weekend, the markets were chattering after a particularly bad week. The S&P 500 had lost nearly 17% of its value, the Dow Jones Industrial Average had had its worst one-day drop ever, and bitcoin (BTC) had fallen over 50% to just below $4,000 before recovering slightly. The number of covid-19 cases rose sharply worldwide; New York City closed all bars, restaurants and schools; in Spain we were in lockdown for several days. Things looked bad.

Noelle Acheson is the former head of research at CoinDesk and Genesis Trading. This article is an excerpt from her Crypto is macro now newsletter, which focuses on the overlap between the changing crypto and macro landscape. These opinions are hers and nothing she writes should be taken as investment advice.

The financial machine started. On March 15, 2020, the US Federal Reserve cut its benchmark interest rate by 100 basis points to near zero and committed to increasing 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 faltered and then limped, but markets rallied.

That week made history on so many levels. It also sparked a wave of armchair virologists on Twitter to keep us updated on every last detail of the COVID threat. We didn’t know it then, but that wave set us up for what we live through today.

If you’ve spent any time on Twitter in the past week, you’ll have noticed a new breed of liquidity experts telling us that the Fed’s actions in recent days mark a return 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 trying to teach bona fide experts, and disinformation mixes with nuance to create an uncomfortable mixture of hope, mistrust and confusion.

Apart from superficial analysis of social media, the events of three years ago also set us up for what we are going through today on a more serious level. The liquidity that the Fed would inject into the economy in 2020-2021 created an easy 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 leading to the sharpest rise in consumer prices in over four decades.

This in turn triggered the fastest rate hike cycle since the 1980s, which decimated asset prices and destabilized the balance between bank assets and liabilities. The crisis that began in 2020 when the pandemic introduced unprecedented stimulus entered a new phase three years later almost today, with the closure of three US financial institutions within a week and the disappearance of a 166-year-old global systemically important bank (Credit Suisse) which a separate organization.

As it tends to do when faced with the strain on the banking system, the Fed has again jumped into action. To make more funds available to meet withdrawals, it announced two Sundays ago the opening of a new funding facility called the Bank Term Funding Program (BTFP). This enables the banks to deposit government debt as collateral in exchange for a loan of 100% of the face value, even though the market value of the collateral is much lower.

This is where the crypto market started to get excited. From a local low of $19,700 on Friday 10 March, BTC surged 42% to over $28,000 nine days later. (Stock and bond markets also rose, but by negligible amounts in comparison.) Crypto Twitter celebrated the end of monetary tightening, the beginning of another QE, and the beginning of a new bull run.

Things are actually looking more positive for the crypto asset market, but for more complex reasons than “QE is back!” chorus would you believe.

QE involves direct purchases of securities by the Fed. This does not (yet) happen. However, BTFP is a form of monetary relief. The Fed lends at par against bonds that are worth less, essentially speeding up the bonds’ full value. The difference between the market value of the bonds and 100% of the 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 last Thursday. This is a small amount compared to the volume of underwater bonds weighing on bank balance sheets (just the total amount of unrealized losses on securities held by US banks is about $650 billion). But banks will only use this facility if they 1) need to (it’s not cheap funding), and 2) have the required quality of collateral.

A more worrying increase was seen in the Fed’s discount window, where banks borrow directly from the Federal Reserve rather than from other banks. In the week to March 15, banks had borrowed a record $152.8 billion from the discount window, even higher than during the Great Financial Crisis of 2008.

Technically, this is not a new injection of money as the banks put up collateral in exchange for the loan. But regardless of the collateral conditions, 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 increases liquidity.

But the economy as a whole just became much less liquid. The increase in the discount window highlights how scared the banks are. Fed support is seen as a last resort for banks. They only turn to the Fed when they can’t borrow from each other because it’s a more expensive option. If the banks don’t lend to other banks, you can bet that they won’t lend to business customers either. This wave of liquidity is supposed to engulf the market as a result of the Fed’s move? Apart from the relatively small amount advanced via BTFP, it is not yet real.

Then again, it doesn’t really have to be for the markets to react. What matters more to markets are expectations, and they seem to signal that tightening is pretty much over and that the current crisis will force the Fed to loosen quickly. We see this in Fed Funds futures prices, which now suggest that Federal Reserve Chairman Jerome Powell will begin cutting interest rates in July. We also see it in the price of oil, which recently fell to its lowest daily close since the end of 2021 on the back of lower expected demand. You don’t need as much energy if the activity slows down.

Loose monetary policy generally means that more funds (because money is relatively easy to borrow) chase higher returns (because lower interest rates mean lower returns on safer assets such as government bonds). This tends to push investors further out of the risk curve because that’s where the higher returns are, which is why we talk about higher “liquidity” favoring “risky assets.”

Among risk assets, BTC is the most sensitive to liquidity fluctuations. It is arguably 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 for the influence of liquidity flows. In an environment of likely downgrades to earnings expectations and general corporate fragility, a “clean play” is likely to appeal to macro investors. The recent outperformance of BTC relative to other cryptoassets, as well as the jump in spot and derivative volumes, suggests that this is already underway.

The expected renewal of US money printing, should it materialize, would further depreciate the dollar, highlighting the store-of-value properties of fixed-supply assets. Gold has been the traditional haven over the centuries, previously reaching its highest point since the aftermath of the Ukraine invasion early last year. However, gold is not exactly resistant to attacks, is difficult to store unless via a centralized third party, and is complicated to use. BTC, on the other hand, is digital, can be moved with relative ease, and is an evolving technology with use cases that have yet to emerge.

Even more immediate is growing concern about banking. About 14 years ago, Bitcoin’s creator Satoshi Nakamoto included in the very first block a link to the headline “Chancellor on the Rand of Second Bailout for Banks” (taken from the London Times). While few expect bitcoin to replace fiat anytime soon, many may come to see it as a means of insurance that can be used for economic activity in the unlikely scenario that banks cease to function. Bitcoin was created as an alternative to traditional, centralized finance – that narrative takes on greater relevance in today’s uncertainty.

All of this is likely to factor into the portfolio recalibration decisions of professional managers who left the crypto market next year, as well as those who have so far been confused or skeptically watching from the sidelines. Everyone will remember what happened last time monetary easing combined with a rapidly changing marketplace and a new type of liquid assets. Many will want to avoid being accused of missing out a second time, especially when many of the barriers imagined three years ago (an unstable system, using too much energy, likely to be banned) have been debunked to some extent.

It’s not just professional investors who notice. On Thursday, Axios reported that app monitoring service Apptopia detected a sharp increase in crypto wallet downloads since the shutdown of Silvergate Bank. Institutions tend not to store crypto assets on mobile apps, so this is more likely to reflect an increase in retail interest.

And it could be the pickup is heating up, just like the developing banking crisis. The Fed’s moves to prop up US banks may have stopped some of the panic, but they are metaphorically a Band-Aid on a severed artery.

A paper published last week by a team of researchers from Stanford, Columbia and other universities shows that 10% of banks have larger undisclosed balance sheet losses than Silicon Valley Bank; 10% are undercapitalized and nearly 190 banks are at risk of impairment for insured depositors, with around $300 billion in insured deposits potentially at risk. Confidence in the banking system appears to be faltering, judging by the strong flows out of the banks – last week money market funds had their biggest inflows since April 2020. The banking problems in Europe are currently evident but still relevant, and corporate problems there, exacerbated by weakened trading desks and wealth management departments, could further damage the confidence on which the global banking system depends.

In this environment, a resource that does not rely on centralized trust is likely to attract more attention. Moreover, after a year of an astonishing sequence of severe blows, crypto markets have shown remarkable resilience in recent months. Even amid the stress of last weekend, trades were executed, assets were moved, a stablecoin depeg was fixed and the only transaction limitations were due to a lack of access to fiat on ramps outside of traditional banking hours. In other words, crypto markets worked. Banking did not; given the number of trading halts last week, neither did traditional markets.

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 might seem.

On the one hand, monetary policy is not significantly looser yet, although expectations of a shift in that direction appear to have driven this week’s moves. On the other hand, the crypto narrative is preparing to take on even more layers, each of which will provide price support. It is also preparing to gain even more relevance during what lies ahead.

Many of us in our ecosystem have long been aware that BTC is unlikely to truly show its long-term value on an ordinary level until the fragility of the global financial system is visible to all. That means a lot of pain for a lot of people. Let’s hope the new wave of armchair liquidity experts cheering on the latest price action remember that.