Crypto's Vol Compression
Crypto has officially entered the summer doldrums.
Last month’s excitement, triggered by the spate of spot Bitcoin ETF filings in the US which propelled many crypto prices to fresh year-to-date highs (the Trakx Top 10 Crypto CTI is up 49% since January 1, 2023), has gradually faded. As a result, crypto price volatility, a feature of crypto that typically gets cited as a negative, has fallen to historically low levels – see chart.
30-Day Standard Deviation of Daily Returns
Part of the reason for the lack of price movement is that while institutions are coming to crypto (as per the title of the Trakx June Update), their arrival may not be as quick as some of the bulls hoped.
Bitcoin ETF Application Timeline
Various spot Bitcoin ETF applications were published on the official Federal Register on July 19, which fires the starting gun on the SEC decision process. While the SEC has an initial 45 day window to decide on these applications, the process can be extended up to 240 days (meaning an effective deadline of March 2024). In light of the recent ruling by the US district court against the SEC in relation to XRP token sales (sales to retail investors were not deemed securities contrary to the SEC claim), it is clear that applying regulations to crypto assets is far from straightforward. As a result, it is quite plausible the SEC is in no hurry to assess and decide on these Bitcoin ETF applications, pushing out the time when crypto adoption by institutions starts to take off.
It is not just ongoing regulatory issues that has contributed to the lacklustre price action in crypto, it is also a consequence of considerable macro uncertainty. Of course, one may not readily appreciate this from simply looking at the performance of equity prices.
Global equity markets have climbed a wall of worry over recent months, playing catchup to crypto in clawing back the heavy losses witnessed last year. Helping to lift sentiment towards stocks has been the surprisingly resilient real economic activity data, particularly in the US, not to mention the hype about AI, which has been a further shot in the arm for tech stocks.
Inversion Implications
While equity investors appear to be downplaying recession risks and upping the probability of a soft landing, it is noteworthy that bond markets remain far from convinced. The slope of the yield curve (both in nominal and real, ie. inflation adjusted) is strongly inverted i.e. short-term interest rates are above long-term interest rates. Historically, an inverted yield curve has been a reliable lead indicator of recessions – see chart. In fact, every US recession in the post-war period has been preceded by an inverted yield curve. Of course, “this time could be different”, but there is a reason why those four words are considered the most dangerous in the investing world.
US Yield Curve (10-year nominal minus 2-year nominal)
In my view, equity investors failed to take into consideration that yield curve inversions precede recessions by some considerable time; on average, recessions begin around 15 months after the curve inverts1. Having jumped the gun last year, so to speak, and priced in a recession, the failure of it to materialize so far means equity investors have been forced back into the market. This does not, however, mean the risk of recession is receding.
Rather, when one looks at the above chart what should be apparent is that recessions typically coincide with the curve re-steepening after it inverts. Given both the Fed and the ECB, as expected, hiked their target interest rates at last month’s policy meetings, we are not yet at this point. History suggests the recession is still a little way off.
It is not just the inversion of the yield curve that implies recession risks remain elevated.
While backward looking macro data are holding up, surveys conducted by central banks confirm that credit demand – another leading indicator of economic growth – is being rapidly curtailed. In fact, late last month the ECB Bank Lending survey showed demand for credit contracted at a record pace in Q2, beating the drop seen during the Great Financial Crisis (GFC) – see chart – and mirroring the decline in US credit demand seen in the Fed’s equivalent Senior Loan Officer survey that has just been published.
Changes In Demand For Loans Or Credit Lines To Eurozone Enterprises
Source: ECB
This is clear evidence that the aggressive monetary tightening enacted by central banks over the course of the last 18 months is filtering through into the real economy. That said, even though inflation rates may have peaked, after such a prolonged and substantial overshoot central banks are concerned about lingering price pressures, meaning it is too early for them to contemplate interest rate cuts anytime soon, all of which adds to the macro uncertainty.
Lack Of Recession Precedent
For crypto there is an additional complicating factor. Equities have been around a long time. Investors recognize that in economic expansions stock prices typically appreciate in value, while they underperform during recessions. The problem for crypto though is that the asset class is still very much in its infancy. We know from the experience of the past 14 years that cryptocurrencies perform well in economic expansions, but we don’t really know how they perform during recessions because although Bitcoin came into being in 2009 it remained a tech play thing until well past the GFC. There is no recession precedent for crypto.
As a risk asset it could underperform, but equally, because cryptocurrencies (just like gold) lie outside the fiat money system, they can be viewed as a hedge against the build-up of stress in the tradfi banking system. Indeed, that is exactly why cryptocurrencies rallied in the spring, when, as a direct consequence of the Fed hiking interest rates at the fastest pace in more than 40 years, three US banks failed. The Fed’s BTFP programme may have stabilized things earlier in the year, but that was when the US jobless rate was at a record low and the economy was still expanding (at least according to the official GDP data). A recession would be a different ballgame entirely. It would not just be Treasuries causing balance sheet impairment for tradfi banks, they would also have to contend with falling value of other assets on their books, including most notably commercial real estate prices. A priori it is hard to assess what the aggregate effect of this would be on crypto prices2 .
In light of the uncertainty about the cyclical outlook, combined with crypto’s lack of recession precedent, it would seem crypto investors are following the advice given to me when I was a young man growing up in the north of England: “When in doubt, do nowt3”, and this has contributed to the volatility compression we have witnessed in crypto prices over the past several weeks.
1Bear in mind that is an average. There is considerable variability in the lags between inversion and recession. For example the US curve inverted in February 2006 and what is now known as the Great Recession didn’t begin for until two years later.
2To shed some light on how cryptocurrencies could perform in a recession we need to draw some analogies, something I did in a recent video presentation entitled “Crypto Outlook: Boom, bust, next?” available on the Trakx website - see: https://trakx.io/crypto-outlook-boom-bust-next/ .
3Nowt is slang for nothing.
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