Bitcoin Volatility Returns With 15% Drop

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Bitcoin volatility returns with an exchange rate crash.

Aug. 17, marked the return of the much-awaited and notorious bitcoin volatility. After several months of consolidating around the $30,000 level with historically low realized and implied volatility in the bitcoin market, the price finally awakened, bringing about the biggest liquidation event bitcoin has seen in years. Contrary to some opinions by reporters and analysts, the bitcoin crash was not triggered by rumors of SpaceX selling bitcoin or any other news-based event. Unlike a stock, bitcoin doesn’t have earnings calls or bad news about future prospects that can tank the price or dampen the network’s fundamentals.

Yes, events such as the approval (or dismissal) of a spot bitcoin ETF could change the market’s expected flows, but this was not the case during Thursday’s price crash. Instead, the market move was a good, old-fashioned derivative liquidation, a simple instance of more sellers than buyers, with the resolution being a price-clearing mechanism to the downside.

Nearly 2% of longs were liquidated in the extreme price move.

In previous issues, we wrote about bitcoin’s historically low realized and implied volatility, noting that such periods lead to large bounces in volatility and explosive breakouts in either direction. Obviously, the recent resolution was to the downside, but it could lead to a new regime in bitcoin, at least temporarily, as the market attempts to find a new equilibrium in the short-to-intermediate-term.

Since this was largely a derivative phenomenon, let’s explore some of the mechanics behind this massive move. In bitcoin, while the options market is less developed and mature compared to equities, there has been growth relative to the futures market in recent years, and growth in both markets compared to the spot market since 2017. It’s important to note that the proliferation of a futures/derivatives market isn’t necessarily good or bad. With an equal amount of long and short positions, the net impact over a long enough time frame is neutral. However, in the shorter-to-medium term, a developing derivatives market on top of the spot market can lead to large dislocations that result in unexpected volatility, with the market trading aggressively in one direction or the other to resolve the imbalance.

The explosive price correction brought about an equally violent rise in volatility.

When observing a period of downtrending implied volatility derived from pricing in the options market, we can see what traders and speculators think an asset’s future volatility will look like. Short volatility strategies, whether simple or complex, are essentially bets on lower and/or stagnant volatility in the future. In this case, observing the trend in bitcoin’s implied volatility through the Volmex Bitcoin Implied Volatility Index (BVIV), we can conclude that selling or shorting volatility became a popular trade over the summer months, effectively restricting the bitcoin market to a given price range.

When market participants sell volatility through options, market makers respond by adjusting their hedges in the underlying asset, creating a stabilizing “pinning” effect near certain price levels where there is substantial open interest. To maintain a neutral position, market makers dynamically buy or sell the underlying asset in response to price movements of options, reinforcing the pinning effect. This equilibrium, however, can be shattered by unexpected events or shifts in sentiment, causing market makers to rapidly re-hedge. This leads to a sudden and significant price and volatility movement, reflecting the delicate and interconnected nature of options trading, market making and asset dynamics. This is precisely what occurred.

Looking at Deribit, the primary options marketplace for bitcoin/crypto, the spread between their perpetual swaps market and the spot bitcoin market widened massively as implied volatility expanded. Participants who had been making money by shorting or selling volatility were caught unexpectedly, leading to a massive dislocation and liquidation event.

As implied volatility expanded, the spread between perpetual swaps market and spot bitcoin widened on Deribit.

All that being said, this wasn’t just an options-driven event. There was growing leverage in the futures market as well. Spot market volumes at multi-year lows combined with growing derivative volumes and open interest in addition to volatility near multi-year lows, was akin to lighting a match near a pile of dynamite and waiting for ignition. Alas, a spark was lit.

In bitcoin-denominated terms, the daily change in open interest was larger than the collapse of FTX, with 89,000 BTC less open interest than 24 hours prior.

After the move, there was 89,000 bitcoin less open interest than 24 hours prior. 

As a percentage of the futures market, with a 24-hour period to match up the timelines, the move was equivalent to 18% getting wiped out or closing, something that hasn’t been seen since December 2021.

The clearing of 18% of open interest hasn’t been seen since December 2021.
A build up of open interest led to a clearing event on Thursday.
A build up of open interest led to a clearing event on Thursday.

Looking only at open interest liquidations, Glassnode finds 8,141 BTC getting liquidated during Thursday’s move, the largest since November 2021, and approximately 2% of open interest that forcefully got liquidated or margin called.

8,141 bitcoin were liquidated during Thursday’s move.
Long liquidations spiked during the price correction.

Taking a look at funding rates — the variable interest rate paid between long and short positions in the perpetual futures market to incentivize traders to keep the contract price close to the spot market — funding fell to its lowest level since the March banking crisis when Silicon Valley Bank failed and USDC depegged. This shows just how large the dislocation in the derivatives market was relative to the spot market. While it’s too early to draw conclusions about a significant short bias in the market due to the negative funding rate, we will monitor the market over the coming days and weeks. A period of sustained negative funding with rising open interest could bring about conditions conducive to a short squeeze, although this has yet to develop.

A period of sustained negative funding with rising open interest could bring about conditions conducive to a short squeeze.
On Binance, the spread between perpetual swaps market and spot bitcoin widened as the price crashed.

Final Note:

In conclusion, while Thursday’s move was the largest bout of volatility seen all year and the largest bitcoin derivative-driven phenomenon in quite some time, it is typical of periods of extremely low realized and implied volatility in any market, let alone that of a notoriously volatile and unpredictable digital asset still in its monetization phase. In the short term, we now expect a pickup in volatility and greater uncertainty as the price tries to find a new equilibrium point, with plenty of news ahead regarding potential bitcoin spot ETF approvals heading into 2024.

That concludes the excerpt from a recent edition of Bitcoin Magazine PRO. Subscribe now to receive PRO articles directly in your inbox.

Bitcoin Market Dynamics: On-Chain Trends & Realized Market Capitalization

The article below is an excerpt from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

Bitcoin Market Dynamics

The goal of this article is to zoom out and highlight some of the latest bitcoin market moves through the lens of on-chain data: realized price, profit-taking behavior and bitcoin supply levels.

Currently, bitcoin is trading at approximately 1.5x its realized price, which recently resurged past the $20,000 mark. This milestone provides an interesting perspective and other on-chain data helps us paint a more comprehensive picture. Following typical bitcoin capitulation events, the supply often gets constrained by the participants with the most conviction. We now find ourselves precisely in such a phase: A mere 13% of circulating supply is held on exchanges and in the hands of short-term holders.

However, it’s important to note that while current price action and realized profits do not necessarily support the notion of a full-fledged bull market, we thus far have witnessed previous realized losses/on-chain capitulation turning into a small yet steady stream of profits (old coins moving at a higher price level than they were acquired for).

As shown below, the market-value-to-realized-value metric paints a picture of the birth of a nascent new bull market, with valuations no longer at bottom-barrel levels but still far from relatively overpriced, currently ranking in the 39% of historical readings. 

Looking at the rate of change of the realized price, the historical analog of the current market look to be the early months of 2016 and the summer of 2019, where price had sufficiently rebounded off the lows, with most of the bleeding finally over, as the market consolidated amid constrained supply conditions and a growing network effect of real world adoption.

Realized Cap, Not Market Cap

The logarithmic chart of bitcoin’s realized market capitalization, reflecting the aggregate value of all bitcoin at their last traded price, demonstrates the asset’s resilience. Unlike market cap, which is the product of circulating supply and current price, the realized cap shows the precise value of each bitcoin UTXO, courtesy of its transparent ledger.

Realized cap paints a far different picture regarding bitcoin’s monetization compared to what one may be led to believe when viewing bitcoin’s hyper-volatile mark-to-market exchange rate.

A mere 15% below the realized market cap all-time high, capital inflows have returned, resembling previous bear market recoveries. During recovery periods following bitcoin bear markets, we have seen a reclaim of the previous all-time high in realized market cap while bitcoin was still 40%-60% below its all-time high exchange rate. This historical dynamic demonstrates a couple things:

First, it suggests that capital inflows can continue to seep into bitcoin without necessarily triggering a raging bull market, instead leading to an environment of chop and consolidation. This is often characterized by a tug-of-war between marginal buyers and sellers, where price levels witness repeated tests of resistance and support, all while accumulation from HODLers continues under the surface.

Second, it shows a historical reality where bitcoin’s true valuation — the price where all its supply has traded hands — surpasses the all-time high long before the media frenzy and new wave of speculative inflows arrive again. One can view this as an ode to the “smart money” investors, who don’t need the explicit signal of a nominal exchange rate all-time high to understand that bitcoin’s fundamentals are stronger than ever.

A demonstration of this dynamic is the net realized profits relative to the bitcoin market cap. Following the worst of a bear market capitulation, bitcoin market inflows are distinctly positive (but not yet over zealous) while the exchange rate grinds higher to eventually flirt with price all-time highs.

Once the all-time high is broken, inflows ramp up dramatically. The setup for this market cycle is still in the early stages. 

Unrealized Profit/Loss

We’ve examined realized profit and loss cycles, so now let’s turn to the unrealized side of the equation.

Relative Unrealized Profit/Loss (NUPL) is an insightful metric designed to gauge investor sentiment in the bitcoin market by calculating the total unrealized gains or losses across the current supply. To calculate the NUPL, subtract the realized cap (which represents the value of each bitcoin when it last moved on the blockchain) from the market cap, then express this difference as a ratio of the market cap. This metric works to standardize the state of the unrealized profits/losses held by investors using the market capitalization to account for an ever changing market valuation.

  • A higher ratio typically suggests a state of greed or speculative froth among investors, indicative of potential market tops or overbuying conditions.
  • In contrast, a lower ratio generally signals an atmosphere of fear or capitulation, potentially pointing to market bottoms or overselling scenarios.

In the current climate, NUPL stands at 0.37, a level we can categorize as optimism/anxiety, depending on the trend direction.

It’s noteworthy that the bitcoin market has never seen a recovery in NUPL from the capitulation phase to the optimism phase without a subsequent visit to one or both of the two highest tiers of NUPL: belief and euphoria.

Translated into simpler terms, this suggests that bitcoin market recoveries, even from the most severe conditions, lead to brighter days ahead due to the resilience of the bitcoin HODLer base and a consistent transfer of coins from weak hands to strong ones. The ongoing wealth transfer underpins market recoveries, reinforcing bitcoin’s inherent strength and setting the stage for further growth and potential price appreciation during the next period of capital inflows.

Having just recovered from the depths of the bear market in late 2022, the setup now mirrors historical market recoveries of past cycles, as bitcoin once again climbs the wall of worry. 

Free Float Constraints And UTXO Distribution

Another metric we can look at to show just how sparse the figurative air is above the current trading range is the UTXO Realized Price Distribution (URPD).

The URPD reveals that above $31,000, only a limited supply has exchanged hands, with the majority of transactions occurring in the $15,000-$30,000 range. The first major resistance point from a supply distribution level is around $40,000. This also aligns with the spot volume trading distribution, as well as the technical breakdown of the chart. 

With bitcoin looking to spring past the levels last visited around the time of the LUNA/UST-induced crypto contagion, demise of multiple exchanges and the industry’s largest hedge fund, Three Arrows Capital, what can turn the bullish setup into a reality?

Capital inflows and a primed supply side that is constrained to historic levels.

Looking at the free float supply of bitcoin, what we define as exchanges’ balances in addition to short-term holder supply, the current setup points to the tightest supply conditions bitcoin has ever experienced. 

While it is true that supply has been sufficiently constrained from a historical context since early 2022, we view the dynamic a bit differently today, with the nascent bitcoin market having endured its largest capitulation period ever.

Relatedly, we can see a steady dose of accumulation occurring throughout the course of the two years, with contagion events being the only things to temporarily reverse the trend.

We expect the abundance of positive news stories related to bitcoin spot ETF filings to materialize in continued positive inflows, with plenty of opportunistic investors and speculators looking to front run the approval and launch of spot bitcoin ETFs by legacy institutions.

While we expect that the approval of an ETF to come somewhere in the late months of 2023 or early months of 2024, the cycle reset coupled with primed supply-side conditions could lead to continued positive price action through year’s end.

In our view, macro correlations and market conditions still hold significance in the bitcoin market, but the idiosyncratic catalysts of a potential spot ETF approval and the halving arriving near the same time — plus rate cuts likely to arrive in 2024 — has us leaning bullish.

In the short-term, bitcoin ranging from anywhere between $20,000-$40,000 wouldn’t be surprising with such an illiquid market.

However, taking a longer view, the supply-side dynamics and potential for increased demand flows is eerily similar to the setups that led to previous raging bull markets. 

That concludes the excerpt from a recent edition of Bitcoin Magazine PRO. Subscribe now to receive PRO articles directly in your inbox.

The Growing Disconnect In Financial Markets

The article below is from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

Disinflation And Monetary Policy

As we delve deeper into 2023, the U.S. economy finds itself at a crossroads. Disinflation seems to be setting in as a direct result of the Federal Reserve’s tightening monetary policies. This policy shift has led to a notable slowdown in the annualized sticky Consumer Price Index (CPI) over recent months. With this in view, the conversation among market participants has gradually shifted away from inflationary concerns and toward trying to understand the impact of the tightest monetary policy in a decade and a half.

Sticky CPI has slowed down in recent months.

The high inflation we’ve experienced, particularly in the core basket (excluding food and energy), concealed the effects of the swiftest tightening cycle in history. Inflation was partially fueled by a tight labor market leading to increased wages, and resulting in a sustained second-half inflationary impulse driven more by wages than by energy costs.

It’s worth noting that the base effects for year-over-year inflation readings are peaking this month. This could lead to a reacceleration of inflationary readings on a year-over-year basis if wage inflation remains sticky or if energy prices resurge.

Chances of inflation heading higher by Q1 of 2024 remain high.

Interestingly, real yields — calculated with both trailing 12-month inflation and forward expectations — are at their highest in decades. The contemporary economic landscape is notably different from the 1980s, and current debt levels cannot sustain positive real yields for extended periods without leading to deterioration and potential default.

Historically, major shifts in the market occur during Fed tightening and cutting cycles. These shifts often lead to distress in equity markets after the Fed initiates rate cuts. This isn’t intentional, but rather the side effects from tight monetary policy. Analyzing historical trends can provide valuable insights into potential market movements, especially the two-year yields as a proxy for the average of the next two years of Fed Funds.

The 2-year yield has tracked closely with the Fed Funds rate.
Fed Funds Futures are pricing in lower rates in both 2024 and 2025.

Bonds And Equities: The Growing Disconnect

Currently, there’s a sizable and growing disconnect between bond and equity markets. It’s not unusual for equity earnings to outperform bonds during an inflationary regime due to equities’ superior pricing power. However, with disinflation in motion, the growing divergence between equity multiples and real yields becomes a critical concern. This divergence can also be observed through the equity risk premium — equity yields minus bond yields.

The growing divergence between equity multiples and real yields is becoming a critical concern.

Research from Goldman Sachs shows systematic investment strategies, namely Commodity Trading Advisors (CTA), volatility control and risk-parity strategies, have been increasingly using leverage to amplify their investment exposure. This ramp-up in leveraging has come in tandem with a positive performance in equity indices, which would be forced to unwind during any moves to the downside and/or spikes in volatility. 

CTA using leverage to amplify their investment exposure as the SPX rises.
When volatility returns, leverage will have to unwind.

Research from JPMorgan Chase shows their consolidated equity positioning indicator is in the 68th percentile, meaning equities are overheated, but continuation higher is possible compared to historical standards.

Equities are overheated, but continuation higher is possible.

The fate of equity markets in the short-to-medium term will be determined by earnings, with 80% of S&P 500 companies set to complete their reporting by August 7.

Any disappointment during earnings season could lead to a reversion in equity valuations relative to the bond market.

Most S&P 500 companies with report earnings by August 7.
Real returns in bonds are completely diverged from the Nasdaq.

Another interesting note is from a recent Bank of America survey, where client concern around the health of financial markets has risen in recent months at the same time as equity markets continue their uptrend.

More people are reporting concerns about financial stability.

Headwinds Ahead For The U.S. Consumer?

The robust earnings surprises and the U.S. consumer market’s resilience are being underpinned in part by excess savings from the COVID-era fiscal stimulus. However, it’s worth noting that these savings are not uniformly distributed. A recent BNP Paribas report estimates that the top income quintile holds just over 80% of the excess savings. The savings of the lower-income quintiles are already spent, with the middle quintile likely following suit soon. With factors like the resumption of student debt obligations and emerging weaknesses in the labor market, we should brace ourselves for potential stress in consumer markets.

Excess savings for most households have completely dwindled.

Despite potential consumer market stressors, the performance of the U.S. economy in 2023 has surpassed expectations. Equity markets have put on a stellar show, with the bull market appearing unrelenting. Amidst these market celebrations, we must maintain a balanced perspective, understanding that the path forward may not be as clear cut or straightforward as it appears.

Final Note

We highlight developments in equity and interest rate conditions as we find it crucial to recognize the growing liquidity interplay between bitcoin and traditional asset markets. To put it plainly:

It signals substantial demand when the world’s largest asset managers are competing to launch a financial product that offers their clients exposure to bitcoin. These future inflows into bitcoin, predominantly from those currently invested in non-bitcoin assets, will inevitably intertwine bitcoin more closely with the risk-on/risk-off flows of global markets. This isn’t a detrimental development; on the contrary, it’s a progression to be embraced. We expect bitcoin’s correlation to risk-on assets in the traditional financial markets to increase, while outperforming to the upside and in a risk-adjusted manner over a longer time frame.

With that being said, turning back to the main content of the article, the historical precedent of significant lag in monetary policy, combined with the current conditions in the interest rate and equity markets does warrant some caution. Conventionally, equity markets decline and a technical recession occurs in the United States after the Fed begins to cut interest rates from the terminal level of the tightening cycle. We haven’t reached this condition yet. Therefore, even though we’re extremely optimistic about the native supply-side conditions for bitcoin today, we remain alert to all possibilities. For this reason, we remain open to the idea of potential downward pressure from legacy markets between now and mid-2024, a period marked by key events such as the Bitcoin halving and possible approval of a spot bitcoin ETF.

That concludes the excerpt from a recent edition of Bitcoin Magazine PRO. Subscribe now to receive PRO articles directly in your inbox.

RFK Jr. Announces Bold Plan To Back Dollar With Bitcoin, End Bitcoin Taxes

Speaking at a Heal-the-Divide PAC event, Democratic Presidential Candidate Robert F. Kennedy Jr. outlined specific Bitcoin-focused policies that he would enact as president, including gradually backing the U.S. dollar with bitcoin and making bitcoin profits exempt from capital gains taxes.

“My plan would be to start very, very small, perhaps 1% of issued T-bills would be backed by hard currency, by gold, silver platinum or bitcoin,” Kennedy said, describing his vision for returning to a hard currency standard in the U.S.

He added that, depending on the outcome of that initial step, he would increase that allocation annually.

This potential policy reimagines the financial system, pointing to a future where bitcoin’s absolute scarcity and sound monetary principles reinforce the U.S. dollar’s eroding position as the world reserve currency.

“Backing dollars and U.S. debt obligations with hard assets could help restore strength back to the dollar, rein in inflation and usher in a new era of American financial stability, peace and prosperity,” he declared.

In addition, Kennedy announced his administration “will exempt the conversion of bitcoin to the U.S. dollar from capital gains taxes.”

“The benefits include facilitating innovation and spurring investment, ensuring citizen privacy, incentivizing ventures to grow their business and tech jobs in the United States rather than in Singapore, Switzerland, Germany and Portugal,” he added. “Non-taxable events are unreportable and that means it will be more difficult for governments to weaponize currency against free speech, which as many of you know, is one of my principal objectives.”

During his announcement, Kennedy reiterated the slew of commitments he made to foster Bitcoin adoption during a speech at the Bitcoin 2023 conference in May, which included “defending the right of self custody of bitcoin,” upholding “the right to run a node at home” and defending “industry-neutral regulation of energy.”

Kennedy framed his commitments to Bitcoin as integral to the ideals of his uncle, President John F. Kennedy, and his own vision for governing a free and equitable country.

“My uncle, President Kennedy, when he was in office, understood the importance of hard currency and the dangers of having pure fiat currency with no other option,” Kennedy said. “He understood the relationship between fiat currency and war, fiat currency and … very, very destructive environmental projects and also these giant aggregations of wealth and the unbalance, the disparities in wealth that are the ultimate yield of every fiat currency.”

Reflecting on the history of fiat currencies, Kennedy didn’t mince words, citing the frequent use of unbacked paper currency to fund wars without the need for specific government taxation or citizens’ approval.

“Fiat currency was invented to fund wars,” he said. “I like base currencies because they make it more difficult, you have to go to the public. You can’t just print money to fund the war and tax the public through the hidden tax of inflation. You actually have to go to the public and say, ‘Here’s what this war is going to cost.’”

He emphasized his regulatory outlook that “bitcoin is not a security and should not be regulated as one” and his commitment to “put an end to the current policies of the Biden administration that are invited by Choke Point 2.0 to punish banks that are dealing with bitcoin.”

Reflecting on the broader implications of these policies, Kennedy alluded to the financial circumstances that currently face the United States. A steady growth rate of 6.5% in national debt over the past decade makes the case for forward-looking and comprehensive fiscal strategies from the highest office. Against this backdrop, Kennedy’s proposal for the U.S. Treasury to acquire assets such as bitcoin and precious metals is an approach that’s meant to offer an insurance policy against the country’s mounting debt.

Kennedy’s steadfast conviction in Bitcoin signals a coming political paradigm shift, where bitcoin is seen not just as an asset, but as a prudent policy tool to ensure the nation’s fiscal longevity and an opportunity to attract intellectual capital to U.S. shores. 

Bank Term Funding Program: A Primer On The Fed’s Shiny New Tool

The debate around whether or not this policy is a form of quantitative easing misses the point: Liquidity is the name of the game for global financial markets.

The article below is an excerpt from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

QE Or Not QE?

The Bank Term Funding Program (BTFP) is a facility introduced by the Federal Reserve to provide banks a stable source of funding during times of economic stress. The BTFP allows banks to borrow money from the Fed at a predetermined interest rate with the goal of ensuring that banks can continue to lend money to households and businesses. In particular, the BTFP allows qualified lenders to pledge Treasury bonds and mortgage-backed securities to the Fed at par, which allows banks to avoid realizing current unrealized losses on their bond portfolios, despite the historic rise in interest rates over the past 18 months. Ultimately, this helps support economic growth and protects banks in the process.

The cause for the tremendous amount of unrealized losses in the banking sector, particularly for regional banks, is due to the historic spike in deposits that came as a result of the COVID-induced stimulus, just as bond yields were at historic lows.

Shown below is the year-over-year change in small, domestically chartered commercial banks (blue), and the 10-year U.S. Treasury yield (red).

TLDR: Historic relative spike in deposits with short-term interest rates at 0% and long-duration interest rates near their generational lows. 

Banks saw a spike in deposits with short-term interest rates at 0% and long-duration interest rates near their generational lows.
The rise in Treasury yields led to massive unrealized losses for banks holding bonds.
Source: Bloomberg

The reason that these unrealized losses on the bank’s security portfolios have not been widely discussed earlier is due to the opaque accounting practices in the industry that allow unrealized losses to be essentially hidden, unless the banks needed to raise cash.

The BTFP enables banks to continue to hold these assets to maturity (at least temporarily), and allow for these institutions to borrow from the Federal Reserve with the use of their currently underwater bonds as collateral.

The impacts of this facility — plus the recent spike of borrowing at the Fed’s discount window — has brought about a hotly debated topic in financial circles: Is the latest Fed intervention another form of quantitative easing?

In the most simple terms, quantitative easing (QE) is an asset swap, where the central bank purchases a security from the banking system and in return, the bank gets new bank reserves on their balance sheet. The intended effect is to inject new liquidity into the financial system while supporting asset prices by lowering yields. In short, QE is a monetary policy tool where a central bank purchases a fixed amount of bonds at any price.

Though the Fed has attempted to communicate that these new policies are not balance sheet expansion in the traditional sense, many market participants have come to question the validity of such a claim.

If we simply look at the response from various asset classes since the introduction of this liquidity provision and the new central bank credit facility, we get quite an interesting picture: Treasury bonds and equities have caught a bid, the dollar has weakened and bitcoin has soared. 

Treasury bonds and equities caught a bid while the dollar weakened.
Bitcoin soared with the liquidity being added into the system from the BTFP.

On the surface, the facility is purely to “provide liquidity” to financial institutions with constrained balance sheets (read: mark-to-market insolvency), but if we closely examine the effect of BTFP from first principles, it is clear that the facility provides liquidity to institutions experiencing balance sheet constraint, while simultaneously keeping these institutions from liquidating long-duration treasuries on the open market in a firesale.

Academics and economists can debate the nuances and intricacies of Fed policy action until they are blue in the face, but the reaction function from the market is more than clear: Balance sheet number go up = Buy risk assets.

Make no mistake about it, the entire game is now about liquidity in global financial markets. It did not used to be this way, but central bank largesse has created a monstrosity that knows nothing other than fiscal and monetary support during times of even the slightest distress. While the short-to-medium term looks uncertain, market participants and sidelined onlookers should be well aware as to how this all ends.

Perpetual monetary expansion is an absolute certainty. The elaborate dance played by politicians and central bankers in the meantime is an attempt to make it look as if they can keep the ship afloat, but in reality, the global fiat monetary system is like an irreversibly damaged ship that’s already struck an iceberg.

Let us not forget that there is no way out of 120% debt-to-GDP as a sovereign without either a massive unforeseen and unlikely productivity boom, or a sustained period of inflation above the level of interest rates — which would crash the economy. Given that the latter is extraordinarily unlikely to occur in real terms, financial repression, i.e., inflation above the level of interest rates, appears to be the path going forward.

CPI continues to run hot at the same time the debt-to-GDP ration is incredibly high.

Final Note

For the layman, there is no dire need to get caught up in the schematics of the debate whether recent Fed policy is quantitative easing or not. Instead, the question that deserves to be asked is what would have happened to the financial system if the Federal Reserve didn’t conjure up $360 billion worth of liquidity from thin air over the last month? Widespread bank runs? Collapsing financial institutions? Soaring bond yields that send global markets spiraling downwards? All were possible and even likely and this highlights the increasing fragility of the system.

Bitcoin offers an engineering solution to peacefully opt out of the politically corrupted construct colloquially known as fiat money. Volatility will persist, exchange rate fluctuations should be expected, but the end game is as clear as ever.

That concludes the excerpt from a recent edition of Bitcoin Magazine PRO. Subscribe now to receive PRO articles directly in your inbox.

Relevant Past Articles:

Silvergate Solvency In Question As Crypto Banking Troubles Brew

Silvergate clients flee as stock price plummets and regulatory questions mount across the industry. Options for crypto banking partners are dwindling.

The article below is an excerpt from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

Trouble Brewing In Crypto-Land

Developments around crypto on- and off-ramps have been heating up, as Federal Reserve Member Bank Silvergate Capital watched its depositors flee and its stock price plummet. Along with Signature Bank, Silvergate is the other key U.S. bank that works closely with the crypto sector.

The reason for the extreme concentration of banking interests that are willing to deal in the crypto sector is the general lack of regulation around know-your-customer and anti-money laundering (KYC/AML) policy that exists in the industry for offshore entities, as well as the issues with the broader industry being rife with unregistered security offerings and plenty of fraud.

Of course, we believe there is a clear distinction between bitcoin and the broad term colloquially referred to as “crypto”, but the lines remain blurred for many regulators and government agencies.

Thus, there have historically been very few entities in the regulated U.S. banking system that have been willing to work with crypto firms to access established USD on- and off-ramps, which presents a unique challenge to companies who are in the business of moving money and/or processing payments and transactions.

In regards to Silvergate, we have been monitoring the situation closely since November — after the collapse of FTX — as it became apparent that Silvergate played a role in serving FTX and Alameda by giving them access to USD rails.

As we wrote on November 17, (emphasis added):

“Who else is at the center of many institutions in the market? Silvergate Bank is one of those. Since the beginning of November, their stock is down nearly 56%. Silvergate Bank is at the nexus of banking services for the entire industry, servicing 1,677 digital asset customers with $9.8 billion in digital asset deposits. FTX accounted for less than 10% of deposits and the CEO has tried to reassure markets that their current loan book has faced zero losses or liquidations so far. Leveraged loans are collateralized with bitcoin that can be liquidated as necessary. Yet, the ongoing risk is a complete bank run on Silvergate deposits.. Although the CEO’s comments sound reassuring, the stock performance over the last two weeks tell a much different story.” — The Contagion Continues: Major Crypto Lender Genesis Is Next On The Chopping Block

Since the implosion of FTX, shares of Silvergate Capital have fallen by 83%, putting the current drawdown from the all-time high price at an eye-watering 97.3%. 

As referenced in the November 17 article, Silvergate’s share price isn’t imploding due the performance of a crypto token as was the case for many companies in the crypto winter of 2022, but rather from a deposit exodus that has forced the firm to liquidate long-duration securities at a loss in order to remain liquid.

Link to embedded tweet.

As a traditional fractional reserve bank, Silvergate took client deposits — which drastically increased in 2021 — and lent them out over a long duration, into U.S. Treasury bonds, in particular. In practice, firms would lend their money to Silvergate by depositing at 0% in order to utilize their Silvergate Exchange Network (SEN), and Silvergate would then lend out those same dollars at a higher interest rate over a long period of time. This is a great business model — as long as your loans don’t fall in value at the same time as clients go to withdraw their funds.

“Customers withdrew about $8.1 billion of digital-asset deposits from the bank during the fourth quarter, which forced it to sell securities and related derivatives at a loss of $718 million, according to a statement Thursday.” — Silvergate Tumbles After FTX Implosion Prompts $8.1 Billion Bank Run

As commentary has ramped up about the incompetence and irresponsibility of Silvergate’s management, we need to interpret some of the nuance surrounding the situation.

Link to embedded tweet.

A majority of Silvergate’s deposits came during a world of zero-interest-rate policy, where short-duration Treasury securities offered 0% yield. This phenomenon is one of the core reasons why Silvergate invested in longer-duration instruments. The bonds fell in value as global interest rates rose throughout 2022.

With long-duration debt securities, money isn’t lost in the case of rising interest rates as long as the bond is held to maturity (and not defaulted upon), but in the case of Silvergate, fleeing deposits forced the firm to realize the unrealized losses on their securities portfolio — a nightmare for a fractionally reserved institution. 

With solvency worries mounting in recent months, companies frontran speculation about exposure to the bank, with names such as Coinbase, Paxos, Circle, Galaxy Digital, CBOE and others communicating about their banking relations with Silvergate. Coinbase explicitly announced their move to Signature bank.

“We are facilitating fiat withdrawals and deposits using Signature Bank, effective immediately.” — Coinbase memo

One concern is that many of these firms are turning solely to Signature bank, which further centralizes the off- and on-ramps currently utilized by the crypto industry, even though Signature has a much larger market capitalization and more diversified depositor base than Silvergate.

The current state of Signature’s digital asset deposit base is unknown, as the firm communicated its desire to reduce reliance on crypto-related deposits in early December.

“Signature Bank (SBNY) will shrink its deposits tied to cryptocurrencies by $8 billion to $10 billion, signaling a move away from the digital asset industry for the bank that until recently had been one of the most crypto-friendly companies on Wall Street.

“We are not just a crypto bank and we want that to come across loud and clear,” Signature Bank’s CEO Joe DePaolo said at an investor conference in New York hosted by Goldman Sachs Group on Tuesday.” — Coindesk

The timeline of these events is important because of the recent developments regarding the industry’s flight from Silvergate coming at the same time that Signature appears to be handcuffing the use of its rails with key industry players.

Final Note

Following a disastrous 2022, regulators are ramping up their careful examination of the crypto sector, and one of their main targets is the connection between the industry and the legacy banking system. As Silvergate looks to be all but dead in the water with nearly every major industry player announcing plans to sever ties, the increasing reliance on Signature Bank, a bank that has announced its intention to distance itself from the space, remains… worrisome.

While this poses no fundamental risk to the functioning of the Bitcoin network or its properties as an immutable settlement layer, the clampdown and increasing centralization of USD on- and off-ramps is a key risk for short-to-intermediate term liquidity in the bitcoin and broader crypto market.

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The Big Flip: Interest Rate Expectations Repricing Upward

The Big Flip thesis has been gaining traction in the financial world and describes the market’s misplaced belief in the path of inflation and policy rates.

The article below is a free full piece from a recent edition of Bitcoin Magazine PRO, Bitcoin Magazine’s premium markets newsletter. To be among the first to receive these insights and other on-chain bitcoin market analysis straight to your inbox, subscribe now.

The Big Flip

In this article, we break down a macro thesis that has been gaining an increasing amount of traction in the financial world. The “Big Flip” was first introduced by pseudonymous macro trader INArteCarloDoss, and is based on the market’s apparent misplaced belief on the path of inflation and subsequently the path of policy rates. 

Link to embedded tweet.

To simplify the thesis, the Big Flip was built upon the assumption that an imminent recession in 2023 was wrong. Even though the rates market had fully priced in the belief that an impending recession was likely, the big flip and recession timeline may take longer to play out. In particular, this change in market expectations can be viewed through Fed fund futures and short-end rates in U.S. Treasuries.

In the second half of 2022, as the market consensus flipped from expecting entrenched inflation to disinflation and an eventual economic contraction in 2023, the rates market began to price in multiple rate cuts by the Federal Reserve, which served as a tailwind for equites due to this expectation of a lower discount rate.

In “No Policy Pivot In Sight: "Higher For Longer" Rates On The Horizon,” we wrote:

“In our view, until there is meaningful deceleration in the 1-month and 3-month annualized readings for measures in the sticky bucket, Fed policy will remain sufficiently restrictive — and could even tighten further.”

“While it is likely not in the interests of most passive market participants to dramatically alter the asset allocation of their portfolio based on the tone or expression of the Fed Chairman, we do believe that “higher for longer” is a tone that the Fed will continue to communicate with the market.

“In that regard, it’s likely that those attempting to aggressively front-run the policy pivot may once again get caught offside, at least temporarily.

“We believe that a readjustment of rate expectations higher is possible in 2023, as inflation remains persistent. This scenario would lead to a continued ratcheting of rates, sending risk asset prices lower to reflect higher discount rates.”

Since the release of that article on January 31, the Fed funds futures for January 2024 have risen by 82 basis points (+0.82%), erasing over three full interest-rate cuts that the market originally expected to take place during 2023, with a slew of Fed speakers recently reiterating this “higher for longer” stance.

As we drafted this article, the Big Flip thesis continues to play out. On February 24, Core PCE price index came in higher than expected.

Fed fund futures continue to reprice higher as interest-rate expectations rise.

Shown below is the expected path for the Fed funds rate during October, December and in the present. 

Source: Joe Consorti

Despite the disinflation CPI readings on a year-over-year basis during much of the second half of 2022, the nature of this inflationary market regime is something that most market participants have never experienced. This can lead to the belief of “transitory” pressures, when in reality, inflation looks to be entrenched due to a structural shortage in the labor market, not to mention financial conditions that have greatly eased since October. The easing of financial conditions increases the propensity for consumers to continue to spend, adding to the inflationary pressure the Fed is attempting to squash. 

Unemployment is at 53-year lows.

With the official unemployment rate in the United States at 53-year lows, structural inflation in the workplace will remain until there is sufficient slack in the labor market, which will require the Fed to continue to tighten the belt in an attempt to choke out the inflation that increasingly looks to be entrenched.

While flexible components of the consumer price index have fallen aggressively since their peak in 2022, the sticky components of inflation — with a particular focus on wages in the service sector — continue to remain stubbornly high, prompting the Fed to continue their mission to suck the air out of the figurative room in the U.S. economy.

Sticky CPI measures inflation in goods and services where prices tend to change more slowly. This means that once a price hike comes, it’s much less likely to abate and is less sensitive to pressures that come from the tighter monetary policy. With Sticky CPI still reading 6.2% on a three-month annualized basis, there is ample evidence that a “higher for longer” policy stance is needed for the Fed. This looks to be exactly what is getting priced in.

Sticky CPI remains elevated.

Published on February 18, Bloomberg reiterated the stance of disinflation flipping back toward a reacceleration in the article “Fed’s Preferred Inflation Gauges Seen Running Hot.”

“It’s stunning that the decline in year-over-year inflation has stalled completely, given the favorable base effects and supply environment. That means it won’t take much for new inflation peaks to arise.” — Bloomberg Economics 

After inflation seemed to be abating, January PCE comes in hotter than expected.

This comes at a time when consumers still have approximately $1.3 trillion in excess savings to fuel consumption. 

Source: Gregory Daco

While the savings rate is extremely low and aggregate savings for households is dwindling, the evidence suggests that there is plenty of buffer to continue to keep the economy piping hot in nominal terms for the time being, stoking inflationary pressures while the lag effects of monetary policy filter through the economy. 

Personal savings are dwindling.

It is also important to remember that there is a section of the economy that is far less rate-sensitive. While the financialized world — Wall Street, Venture Capital firms, Tech companies, etc. — are reliant on zero interest-rate policy, there is another section of the U.S. economy that is very much insensitive to rates: those dependent on social benefits.

Those who are dependent on federal outlays are playing a large part in driving the nominally hot economy, as cost-of-living adjustments (COLA) were fully implemented in January, delivering a 8.3% nominal increase in buying power to recipients.

Year-over-Year change in Social Security benefits. Source: FRED

Social security recipients are actually not in possession of any increased buying power in real terms. The psychology of a nominal increase in outlays is a powerful one, particularly for a generation not used to inflationary pressure. The extra money in social security checks will continue to lead to nominal economic momentum.

Core PCE Comes In Hot

In Core PCE data from February 24, the month-over-month reading was the largest change in the index since March 2022, breaking the disinflationary trend observed over the second half of the year which served as a temporary tailwind for risk assets and bonds. 

Source: Nick Timiraos
U.S. Inflation gauges reaccelerate.

The hot Core PCE print is vitally important for the Fed, as Core PCE notably carries a lack of variability in the data compared to CPI, given the exclusion of energy and food prices. While one may ask about the viability of an inflation gauge without energy or food, the key point to understand is that the volatile nature of commodities of said categories can distort the trend with increased levels of volatility. The real concern for Jerome Powell and the Fed is a wage-price spiral, where higher prices beget higher prices, lodging itself into the psychology of both businesses and laborers in a nasty feedback loop.

Inflation is lasting longer than hoped as shown by the Sticky CPI.
The job market is still too hot for the demand destruction needed to bring inflation down.

“That’s the concern for Powell and his colleagues, sitting some 600 miles away in Washington, and trying to decide how much higher they must raise interest rates to tame inflation. What Farley’s describing comes uncomfortably close to what’s known in economist parlance as a wage-price spiral – exactly the thing the Fed is determined to avoid, at any cost.” —- “Jerome Powell’s Worst Fear Risks Coming True in Southern Job Market

The Fed’s next meeting is on March 21 and 22, where the market has assigned a 73.0% probability of a 25 bps rate hike at the time of writing, with the remaining 27% leaning toward a 50 bps hike in the policy rate.

Source: CME FedWatch Tool 

The increasing momentum for a higher terminal rate should give market participants some pause, as equity market valuations increasingly look to be disconnected from the discounts in the rates market.

A lead Morgan Stanley strategist recently expressed this very concern to Bloomberg, citing the equity risk premium, a measure of the expected yield differential given in the risk free (in nominal terms) bond market relative to the earnings yield expected in the equity market.

“That doesn’t bode well for stocks as the sharp rally this year has left them the most expensive since 2007 by the measure of equity risk premium, which has entered a level known as the ‘death zone,’ the strategist said.

“The risk-reward for equities is now ‘very poor,’ especially as the Fed is far from ending its monetary tightening, rates remain higher across the curve and earnings expectations are still 10% to 20% too high, Wilson wrote in a note.

“‘It’s time to head back to base camp before the next guide down in earnings,’ said the strategist — ranked No. 1 in last year’s Institutional Investor survey when he correctly predicted the selloff in stocks.” — Bloomberg, Morgan Stanley Says S&P 500 Could Drop 26% in Months

The S&P 500 equity risk premium is in the "death zone."

Final Note:

Inflation is firmly entrenched into the U.S. economy and the Fed is determined to raise rates as high as needed to sufficiently abate structural inflationary pressures, which will likely require breaking both the labor and stock market in the process.

The hopes of a soft landing that many sophisticated investors had at the beginning of the year look to be dissipating with “higher for longer” being the key message sent by the market over recent days and weeks.

Despite being nearly 20% below all-time highs, stocks are pricier today than they were at the peak of 2021 and the start of 2022, relative to rates offered in the Treasury market.

This inversion of equities priced relative to Treasuries is a prime example of the Big Flip in action.

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