Crypto Impact: Hard vs. Soft Landing
How will Fed policy affect crypto prices?
by Ryan Shea
Key Take-aways
- The central-bank-induced slump in tradfi asset prices in 2022 not only took crypto down, it also took down the uncorrelated financial asset narrative that came to prominence in 2018. Crypto appeared to transform from uncorrelated alpha to leveraged beta.
- However, while long-run correlation coefficients between stocks and crypto remain high, short-run correlations have dropped to zero over the past couple of months. Instead, crypto has been moving more in tandem with the yellow metal, both of which have rallied sharply since the failure of SVB. The digital gold narrative is undergoing a renaissance.
- Despite assurance from US policymakers that their banking system remains “sound and resilient” face-planting regional bank shares prices and surging money market fund deposits suggest otherwise.
- Tension within the banking sector is already having negative spillover effects to the real economy and bond markets are betting on a fairly aggressive and swift Fed policy reversal.
- With inflation still well-above target and the jobless rate at a 50-year-low the Fed is in a tricky spot. Only when they are pretty much certain inflation will sustainably drop back towards its 2% will they lower interest rates and they are not there yet.
- Achieving the perfect “soft” landing remains possible, but a harder landing is looking increasingly plausible. We do not know how crypto behaves during a recession, but looking at how gold behaved during the Great Recession can give us some guidance.
What exactly is crypto? It is a long-standing and hotly debated topic.
As I stated in a prior research note Bitcoin – the seminal cryptocurrency – has been many things over its 14 years of existence: proof-of-concept, tech plaything, a monetary vehicle for criminals, digital gold etc etc. An additional narrative that came to prominence in 2018 was crypto as an uncorrelated financial asset. Given the obvious potential portfolio diversification benefits such an asset would provide to institutional investors, this narrative certainly contributed to their crypto-curiosity.
However, as many financial market participants know only too well, correlations between financial asset prices are notoriously unstable. The central-bank-induced slump in tradfi asset prices in 2022 not only took crypto down, but consistent with the old market adage that in times of crisis all correlations go to 1, it also took down the uncorrelated financial asset narrative. We can clearly see this in the chart below, which plots the long-run correlation coefficient of crypto1 versus the SP500. During the 2022 market rout it rose from 0.3 to almost 0.6 – a record high (the sharp jump in the middle of the chart was due to the Covid pandemic). Crypto, it appeared, transformed from uncorrelated alpha to leveraged beta.
260-Day Rolling Correlation ((Daily Returns))
Source: Author calculations
The long-run correlation coefficient between crypto and US stocks remains elevated suggesting the uncorrelated financial asset narrative is dead and buried. However, looking at the correlation coefficient over a shorter time frame reveals something rather different. The 60-day2 correlation coefficient between crypto and US stock daily returns has slumped – see chart below. In short, stocks and crypto have been moving independently over the past two months. Does that mean the uncorrelated financial asset narrative for crypto is making a comeback?
60-day Correlation Coefficient (Daily Returns)
Source: Author calculations
Possibly. But as the chart above also shows, while crypto and US stocks are increasingly decoupled, the correlation coefficient between crypto and gold has been moved back into positive territory, which, aside from the most recent boom and bust years, has tended to be the norm. The digital gold narrative for crypto it would appear is undergoing a renaissance.
It does not take a genius to figure out what might be driving these shifting correlations. A fairly hefty clue is that the correlation coefficient between crypto and gold jumped in the week following the failure of Silicon Valley Bank (SVB)3, the largest bank failure in the US since Washington Mutual went under in 2008. Indeed, since SVB went under, gold has rallied 9% while Bitcoin is up more than 36%.
Don’t Bank On It
US policymakers and the luminaries of the banking world have tried to bolster public confidence by reiterating the US commercial banking system is in “good health”4 and downplaying any comparisons with what happened a decade and a half ago. Nevertheless, since SVB’s failure two other US banks have gone to the wall: Signature Bank and First Republic Bank, neither of which one would categorize as small. To give some context, consider the graphic in the following tweet. With combined deposits of over $500bn the failure of these three banks already exceeds that seen in 2008.
US Bank Failures By Size
Source: Twitter
Some analysts and economists are taking succour from the fact that while the size of this year’s US bank failures is large in nominal terms scaled by the size of overall US bank deposits it is smaller than seen during the Great Recession (3% versus 5%). That may be so, but it is far from clear we have seen the last US bank failure of 2023. As I have noted before, the most important asset for a bank is not one recorded on the balance sheet, it’s confidence and this has been undermined5. Such situations are extremely precarious because of the risk of contagion.
What seems like an isolated problem initially can quickly become something a lot more serious as evidenced by former Fed Chair Bernanke famous (perhaps infamous with the benefit of hindsight) comment made in May 2007 that “subprime is contained”6. How wrong that assessment proved to be.
The Bottom Line
The problem facing US commercial banks this time around is that after more than a decade of historically low nominal interest rates many have assets on their balance sheets that yield considerably less than market funding rates, which jumped sharply as the Fed aggressively tightened monetary policy. This hurts their profitability. Assuming bank deposits are sticky, this would not be necessarily fatal because over time they should be able to earn their way back to financial health. Unfortunately for them, we no longer inhabit such a world. Electronic cash transfers can be made in a matter of seconds and with money market funds (MMFs) offering much higher returns for less risk – MMFs invest in “safe” liquid assets such as Treasury bills7 or reverse repos with the Fed (!) - the commercial banks have been losing out big time as evidenced by the strong inflows to MMFs over recent weeks – see chart.
Source: Twitter
Chair Powell may describe the US banking system as “sound and resilient” but it is clear from the surge of inflows in US money market funds, not to mention the recent face planting in the share prices of numerous US regional banks, that his positive take on the situation is not wholly shared by investors nor, more importantly, by depositors with the regional banks.
The newly created BTFP helps from a liquidity perspective, but it doesn’t benefit all US commercial banks because not all assets of the banking system are eligible for the programme. Only lower US interest rates will bring the commercial bank sector sustained relief. However, unlike the last time the US banking system was under pressure, the Fed is (so far at least) showing no inclination to move in that direction.
The critical difference between then and now is the US macro backdrop. When the Fed instigated the 2007 easing cycle the real, or inflation-adjusted, funds rate was firmly in positive territory and inflation was in line with their price stability mandate8. Today the real funds rate (on an ex post not an ex ante basis9) has only just gone positive and inflation - both headline and core10 - is more than double the Fed’s 2% goal. In addition, the recent US non-farm payroll report showed the jobless rate at a 50-year low. This macroeconomic constellation puts the Fed in a much tricker position.
Unless it is prepared to risk a de-anchoring of inflation expectations and letting the inflation genie out of the bottle the Fed can only cut interest rates when it is pretty much certain that inflation will sustainably drop back towards its 2% target. It may be possible to achieve such an outcome via a modest weakening in economic growth. However, achieving a “soft-landing” is far from easy when one has to steer via the rear view mirror (macro data published with lags). Throw in the recent bank turmoil into the mix and it becomes infinitely harder.
Wall Street vs. Main Street
Tension within the banking sector is already having negative spillover effects to the real economy. The just published Q1 Fed Senior Loan Officers Survey showed across-the-board tighter lending standards being applied by banks and slumping demand for commercial and industrial loans11 – see chart. We have seen divergence on this scale before: in the aftermath of the Covid Pandemic and during the GFC. On both occasions the US economy suffered a recession.
Bond markets clearly get that, which is why they are pricing in a fairly aggressive and swift reversal in the target funds rate with the modal expectation being almost 200bp of cuts priced over the next 18 months, potentially beginning as early as July – see chart below.
Source: CME Group
But the Fed either doesn’t get it or can’t deliver because the rear-view macro data are incompatible with rate cuts. An impending credit crunch would provide the Fed with a solid rationale to ease monetary policy notwithstanding the current macro data, yet it is difficult for them to use this argument when they are on record as describing the US banking system as “sound and resilient”.
Overall, this suggests that – at a minimum - parts of the US banking sector will remain under pressure, that more US regional banks are likely fail and even if not, credit in the US economy will be curtailed all of which increase the odds that the economic landing will be of the harder rather than softer variety.
What are the implications for crypto that flow from this?
Unchartered Territory
Given Bitcoin was unleashed on the world very early in 2009 and was very much on the periphery of finance - not to mention the world-at-large - until well after the end of the Great Recession, we have no precedent for how it performs during bank crises or recessions (the Covid recession doesn’t count in my mind because it was more akin to pushing a pause button on the global economy). However, as I have previously observed...
“Satoshi’s decision to incorporate many of gold’s features was smart for several reasons, one of which was that it allowed Bitcoin to lean on gold’s credibility as a store-of-value. A track record based on long historical experience could be replaced by logic (same features = same outcome), making adoption much faster.”
Logic, as alluded to above, suggested that Bitcoin and other limited supply private unbacked crypto currencies would perform similarly to gold in such circumstances12. The up-tick in the correlation between crypto prices and gold concomitant with the outbreak of tension in the US banking system, certainly lends weight to this prior belief. For me, and I suspect many others in the crypto industry, this is important. Given this, and the rising likelihood of a harder landing for the US economy, it is worth examining how gold behaved during the Great Recession.
Most people recall that gold prices rose sharply as risk averse investors sought to protect themselves by purchasing what was then widely considered to be the best safe-haven asset13. However, there is an important caveat to add, something people may not recall14. The gold price did not go up in a straight line. In 2008, when the US economy entered what turned out to be the deepest economic downturn since the Great Depression, gold initially surged to a record nominal high just over $1,000 per troy ounce but the bull run most people remember didn’t really get going until after it had experienced a 30% pull-back.
Gold (GC=F) vs. SP500 (^GSPC)
Source: Yahoo Finance
This pull-back was due to the fact that at times of severe financial stress everyone including banks, investors and joe public scramble for liquidity such that anything not nailed down gets sold, including financial assets whose characteristics should mean they are strongly in demand. Only when it was clear that policymakers around the globe were prepared to throw an entire kitchen sink’s worth of reflationary policies at the economy in order to kickstart the recovery did the gold bull-run really get going.
2008 Redux?
Obviously, no one can predict with confidence how the US economy will perform over the coming quarters and anyone who tells you otherwise is either a fool or a charlatan. There are many eerie similarities between now and the Great Recession, but also some fairly significant differences.
Some take comfort from the fact that the US banking crisis seems to be “contained” to regional banks and on that basis hope for a soft landing. I am less convinced because there is no escaping the fact that the macro landscape is worse. Not only is inflation uncomfortably high for the Fed, meaning the hurdle to monetary easing is higher than in 2007, but government debt is also substantially higher, which means less room for anti-cyclical fiscal policy, especially when US politicians are playing their periodic game of chicken with the debt ceiling. Given this, I would not be at all surprised if the US economy surprises on the downside.
Of course, I may be wrong in my judgement that the Fed will fail to match the bond market’s expectations about a swift and imminent turn in the US monetary policy cycle, but for that to happen it would take a serious escalation in banking tension and a pretty unambiguous signal that a hard economic landing is already in the pipeline.
As a result, in my view, the odds of US policymakers achieving the perfect landing are fairly slim, and like gold in 2008, crypto might well experience some selling pressure in such circumstances. That said, let us not forget that 2024 is an election year and recessions do not play well with the voters. So, while it may take some economic pain to get them there, eventually US policy makers will respond with a reflationary policy mix – a “macro” prelude to much higher gold and crypto prices (not to mention more fuel for the USD doom-mongers).
Until next time.
Ryan Shea, crypto economist
1I am using Bitcoin’s USD price as the crypto proxy. The validity of this assumption will be discussed in an upcoming research note.
2The reason for choosing a 60-day window, which is approximately two months, will become apparent shortly.
3Silvergate – the crypto-friendly bank – announced on March 8 that it would wind down operations and voluntarily liquidate repaying depositors in full so it does not show up in the FDIC list of bank failures, even though it is widely considered a bank failure - see: https://www.fdic.gov/bank/historical/bank/bfb2023.html
4See: https://www.wsj.com/articles/yellen-says-banking-system-healthy-after-svb-collapse-d67002e1
5Research such as this produced by Stanford Business School clearly have not helped – see: https://www.gsb.stanford.edu/faculty-research/working-papers/monetary-tightening-us-bank-fragility-2023-mark-market-losses
6See: https://www.forbes.com/2007/05/17/bernanke-subprime-speech-markets-equity-cx_er_0516markets02.html
7Assuming, of course, the US government doesn’t default as a result of the debt ceiling limit – see: https://www.cfr.org/backgrounder/what-happens-when-us-hits-its-debt-ceiling
8The Fed did not formally adopt an explicit 2% inflation goal until 2012 – see: https://www.federalreserve.gov/newsevents/pressreleases/monetary20120125c.htm
9That is to say using realized inflation not inflation expectations.
10Readers may have seen comments about US “super core” inflation, which service prices excluding costs of rent and shelter, is running at an annualized rate of 1.4% and this is being put forward for justification that the Fed has scope to cut interest rates. That is fine, but the y/y rate is still above 5% and as far as I recall everyone requires food, energy and housing to survive. To me, such comments look like analysts with dovish Fed calls grabbing for straws.
11The readings for commercial real estate are even worse.
12This was not by accident as evidenced by Satoshi adding the following headline to Bitcoin’s genesis block “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” – see: https://news.bitcoin.com/14th-anniversary-of-bitcoins-genesis-block-a-look-back-at-the-birth-of-cryptocurrency/
13See: https://www.bls.gov/opub/btn/volume-2/pdf/gold-prices-during-and-after-the-great-recession.pdf
14I was working as a portfolio manager at one of the world’s largest sovereign wealth funds at the time so very much at the coal face. I was also long gold personally so acutely aware of what was happening with the gold price.
