Connecting the Dots

Episode 4 - Tides are Turning

Key Points (and speed read for beginners)

• Big week ahead for markets with the FOMC likely to slow the pace of hikes to 50bps and there’s hope that US CPI data continues to slow.

• Big picture macro themes are changing as focus shifts away from inflationary fears towards growth/recessionary fears. This has vastly different cross-asset implications.

• As the long USD, short bonds, long oil “inflation trade” unwinds, financial conditions are easing and liquidity impulse improving.

• Most of the deleveraging in crypto appears to have occurred post the summer blow ups of Luna and Celsius, but were still waiting to see if there’s any dead bodies, post FTX.

• Despite the doom and gloom in crypto, there are some positive underlying catalysts building in the macro backdrop.

The Tides are Changing

A big week ahead for markets with the FOMC meeting likely to see the Fed slow the pace of hikes to 50bps yet, as telegraphed, raise the expected terminal rate - slower but for longer. US CPI is also in focus and markets will be hoping to see continued evidence that inflation is slowing down, building on last month's downside miss that sparked a huge rally in stocks.

Macro watchers, however, should be focused on big picture thematics and trends and gauging when those trends are changing to position accordingly for the next macro regime. So we acknowledge that this week’s events will likely induce some short term volatility, it's important to focus here instead on the underlying shift in the macro dynamic which we started to write about a month ago.  And it's a BIG deal...

Whatever Powell says on Wednesday and however much commentators try to decipher if he's hawkish or dovish, markets are beginning to price a new regime.

Focus has shifted away from inflationary fears and now towards growth/recessionary fears and this has vastly different cross-asset implications. This is the "voice" you should be focused on here and it's starting to scream more loudly.

FX typically sniffs out regime change more quickly than other asset classes and the dollar, which we highlighted had broken an important trend support in early November has accelerated moves to the downside. Something's changed and the dollar is starting to price a new regime - the end of the Fed hike cycle.

USD breaking down

Bonds pricing a recession....

5yr breakeven inflation (where the market estimates inflation will average over next 5 years as implied by Treasury Inflation Protected Securities - TIPS) now sits at 2.3%, down from as high as 3.6% when the Fed started to tighten rates back in March. Meanwhile, the much vaunted recession indicator of the 2s10s curve inversion was at one point last week over 80bps inverted, the most in 4 decades and even the Fed's preferred recession indicator of the 3month Vs the 3mnth 18month forward curve is also inverted. We're starting to see bond yields at the longer end of the curve break down and so called "duration" rally.

10yr US yields breaking down

Oil is also breaking down despite China "re-opening" and Russian oil price caps, giving back all of its gains for the year.

Liquidity cycle is turning...

All of this is the unwind of the "inflation trade" - long USD, short bonds, long oil being the big expressions of that trade.

Importantly this is helping to ease financial conditions and improve liquidity. Remember, as we wrote in “Episode 2 – The Macro Sands are Shifting” markets are merely a function of rates and liquidity and it feels like we're past "peak rates" as priced by markets and the liquidity cycle is in the process of bottoming out. 

Whilst the Fed continues to engage in Quantitative tightening, we're starting to see off-sets with high money market rates "teasing out" the over $2trn that is parked every night at the Fed via the Reserve Repo Facility. The treasury has also been running down the Treasury General Account (TGA) held at the Fed. 

For simplicity here, when RRP and the TGA are rising, liquidity is being withdrawn from markets. When they start to fall, liquidity is "injected" back into markets and we're seeing this play out at the moment.

Additionally, the Chinese credit impulse is turning higher as China is also back to injecting liquidity - not for nothing, China Credit Impulse tends to positively impact global growth with a 6 to 9 month lag which potentially cushions the US economy from the Fed's overtightening.

So despite all the doom and gloom and whilst we would agree the US is heading for recession, there are some positive underlying catalysts and with improved liquidity and lower rates across the curve risk assets broadly should get some support.

What does this mean for crypto?

Crypto remains short term, a high beta risk asset highly dependent on liquidity. So if we think risk will find support and more importantly the liquidity cycle is set to turn higher, this is very positive for crypto.

Additionally, this macro transition from pricing peak inflation to now focusing on slowing growth is driving the rally in duration.  This has significant implications for Crypto, as Crypto is the longest duration asset!

Clearly, Crypto has its own problems at the moment post the FTX implosion. Markets are still waiting to see where the dead bodies are hiding (Orthogonal the latest confidence zapping news to digest!) and with each dead body floating to the surface, forced liquidations maintain a negative flow dynamic.

However, most of the deleveraging in crypto appears to have occurred post the summer blow ups of Luna and Celsius. Those left remaining are us degen diamond hands hodlers. Hence realised (and implied) volatility is now sat at its lowest levels of the year and general appetite to take crypto risk remains low (especially as those playing in the centralised exchange (CEX) world take time to evaluate counterparty risk).

The macro backdrop however is turning far more supportive and whilst short term uncertainty remains high amidst the FTX fall out, we continue to believe that we're in a bottoming out process. 

IF the crypto news cycle can bottom alongside the liquidity cycle in macro, we can again start asking, wen moon ser!

DISCLAIMER: The content in this newsletter is not financial advice. This newsletter is strictly educational and is not investment advice or a recommendation to buy or sell any assets or to make any financial decisions. Crypto markets are volatile, please be careful and do your own research.