Shūban

by Ryan Shea

One of the big ponderables about cryptocurrencies is how will they perform during global recessions? We know they do very well when economic conditions are benign as evidenced by the stellar performance seen during the “new normal” decade that followed the GFC (or Great Recession as it is known by economists). And, after 2021/2, we also know how they perform when central banks are tightening monetary policy to curtail inflation (not so well). Yet, because Bitcoin – the seminal cryptocurrency – was unleashed into the wild by Satoshi Nakamoto just as the green shoots of recovery were sprouting at the end of the GFC we do not know what impact a synchronized economic downturn will have on the asset class. Admittedly, we do have the Covid pandemic slump but, as I have stated before, this was really the equivalent of policymakers hitting the snooze button on the global economy and hence it was a very atypical economic downturn.

Gaining such understanding and knowledge is far from being an academic exercise. Recessions are unavoidable no matter how often policymakers, lulled by a prolonged economic expansion, hubristically proclaim to have vanquished the business cycle. (UK Chancellor Brown’s “No return to boom and bust” promise in his 2006 budget speech being one of my all-time favourites coming as it did just prior to the deepest economic downturn since the Great Depression). Moreover, it is not just important for participants in the crypto industry but also for the increasing numbers of crypto-curious institutional investors. Many are examining the benefits of including an allocation to cryptocurrencies to enhance the risk-adjusted returns of their portfolios. The early evidence is encouraging – see image below – but the litmus test will be how they fare during a global downturn when investment portfolios experience the most stress.

Portfolio Style Return Metrics (including/excluding Bitcoin, since 2017)

Source: https://coinshares.com/research/the-bitcoin-advantage-enhancing-real-world-portfolios

No Precedent

Absent a real world precedent, one can use analogy to anticipate how crypto will perform in a global recession. This is something I did in a macro presentation I gave last year entitled “Boom, Bust, Next?”. To wit:

“There’s a long-standing tradition of comparing Bitcoin to gold, it’s the equivalent of digital gold. For me, that’s a pretty fair comparison. In fact, I think it’s probably the most compelling narrative.

If we look at the performance of gold, during the Great Recession, what we see is as the teeth of the recession started to bite, we had quite a strong move down in terms of the gold price. There was a 30% drawdown (or correction) and that’s really reflective of the fact that when you’re in a recession, there is a massive scramble for liquidity.

So investors naturally just sell anything that’s not nailed down to the floor.

And, even though you would think that gold would be a valuable asset to own when people are worried about bank failures et cetera, it turns out not to be the case.

What really happens is gold doesn’t start to accelerate until you get the response from policymakers, i.e. a reflationary response.

We got that in 2009 and then subsequently the gold price more than doubled over the next couple of years.

I think that’s the same sort of profile that we need to think when we’re looking at crypto and how it would perform in the event of a recession.”

Early last month we got a small taste of what the impact of a global recession would be on crypto prices and, consistent with the hypothesis outlined above, the initial reaction was not pretty.

The Ides Of March August

During the first week of August crypto prices slumped. The drop, which saw our flagship Top10 Crypto CTI lose around 25% of its value, was on a scale not seen since the blow-up of FTX in November 2022. Back then, the driver was disorderly deleveraging by key participants in the crypto industry. This time it was investor fears that central banks had put their economies on a recessionary trajectory by maintaining overly restrictive monetary policy stances after the release of soft US macro data and a disappointing earnings season which challenged the nosebleed valuations in tech stocks.

Following these developments it increasingly appeared that the US economy (and, by extension, the global economy as per the old adage “when America sneezes, the world catches a cold”) would be unable to repeat the 2023 recession dodge.

Fuelling this fear was the July US employment report, which considerably undershot consensus expectations. Headline payrolls rose just 114,000, roughly half the monthly pace of expansion seen over the preceding year, and the jobless rate witnessed a 0.2 percentage point pop. The latter was especially significant because it triggered the so-called Sahm rule – one of the most reliable indicators of US recession. The Sahm rule is based on the observation that whenever the three-month moving average of the US jobless rate increases by more than 0.5 percentage points above the 12-month low, this coincides with the initial phase of every post-war US recession – see chart.

What gave added potency to the triggering of the Sahm rule is that the timing coincides with another reliable – this time market-based – US recession indicator, namely the slope of the US Treasury curve.

A Slippery Slope

As can be seen in the chart below, inversion of the 10-2’s US Treasury yield curve (meaning 2-year nominal bond yields are higher than 10-year nominal bond yields) has preceded every recession over the past 50 years with only one false-positive occurring in the post-war period (1966). Such is the reliability of the signal based on the slope of the yield curve that it is included in most econometric models used to predict recession probabilities.

Critically though, US recessions do not immediately start the moment the US Treasury curve inverts, rather it occurs with a lag. This lag is highly variable and while the average lag is 12 months, it can be as short as six or as long as 30 months. The current inversion began in early July 2022 implying a duration of 24 months putting it towards the longer-end of the range but still comfortably inside it.

Furthermore, as can also be seen in the chart, immediately prior to the onset of a US recession the yield curve disinverts. This bull steepening occurs because investors start to price-in the central bank’s response to decelerating economic growth which causes short-term interest rates to fall more sharply than long term interest rates. (FYI: Rates, or yields, are the inverse of the bond price so a declining yield means a higher price, hence the bullish tag. Yield curves can also bear steepen, meaning long-term interest rates rise faster than short-term interest rates.)

At present, the US 10-2’s yield curve is just 8bp away from this happening because investors have marked down their expectations of the Fed funds target rate following the recent soft data. According to the CME Fed Watch Tool, the market is split between expecting a 25bp cut at the September 18 FOMC meeting and a 50bp cut, with a further 50bp of cumulative easing priced by year-end.

When asked, most crypto players would reply that lower interest rates constitute a bullish signal for prices (remember all those bullish Fed pivot stories in 2023 early 2024?). However, the price action observed in early August suggests the opposite is true when the driver for the pivot is an imminent recession, aka hard landing.

Carried Away

Compounding the negativity that impacted both tradfi and crypto asset markets in early August was a 12% slump in Japan’s benchmark Nikkei 225 equity index – one of the largest daily percentage point declines ever recorded for a major stock market index¹. The size of the decline, and the associated gyrations in the forex market due to the aggressive unwind of the now infamous yen carry-trade², is testament to the magnitude of the economic challenge facing Japanese policymakers.

After hiking rates for the first time in over 17 years the week prior, the Bank of Japan’s key interest rate stands at just 0.25% meaning, unlike the Fed which has room to cut borrowing costs to ward off economic headwinds, the Bank of Japan has much less room for conventional monetary policy manoeuvre. For a country with a record breaking government debt load (over 230% of GDP), half of which is owned by the central bank, this is an extremely precarious situation. Indeed, just how precarious was made clear by the speed with which Japanese monetary policymakers capitulated.

In a speech to Japanese business men just three days after the equity market slump, Shinichi Uchida, deputy governor of the Bank of Japan, made it clear Japanese monetary policymakers would refrain from hiking rates “when financial markets are unstable”.

V-Shaped Recovery

Remarkably, policy capitulation by the Bank of Japan, combined with a couple of better US macro data prints (notably stronger retail sales), was all it took for global investors to shrug off the risk of an imminent US recession signalled by the Sahm rule and the disinversion of the US yield curve and re-embrace the more market-friendly soft landing “goldilocks” scenario. This rapid evaporation of risk aversion resulted in tradfi and crypto asset prices experiencing a V-shaped recovery as evidenced by the Trakx Top 10 Crypto CTI finishing the month 13% above the early August lows. Indeed, the speed of the market recovery was such that one could very easily be forgiven for thinking that the early August correction was nothing more than a bad dream.

That said, what many investors celebrating the market bounce-back appear to have overlooked is that the market instability Uchida referred to in his speech was in no small part the consequence of the Bank of Japan’s rate hike and this has potentially profound long-term implications not only for Japan but also crypto.

Let me explain.

Shūban

(The English translation of the Japanese word shūban is the final stage.)

Those with an optimistic bias might consider that as long the Japanese central bank takes a very, very, gradual approach to monetary tightening and leans heavily on forward rate guidance (central bankers tell investors what they intend to do well ahead of time to minimize potentially destabilizing surprises) then the hiking cycle can continue without any further hiccups.

When it comes to the future anything is possible, but it takes a lot of things to go right for such a benign outcome to occur. Indeed, in the 35 years since the bursting of its huge domestic asset price bubble, the Bank of Japan has tried on a few occasions to wean its economy off very accommodative monetary policy. Each time it has failed and been forced to reverse direction, and each time it has faced strong criticism from its politicians.

With Japan’s debt-to-GDP ratio having ratcheted up to a record peacetime high during these three decades, Bank of Japan officials can no longer ignore the fiscal consequences of their monetary policy actions, especially when half of it is sitting on their balance sheet. Indeed, their ability to maintain operational independence is severely compromised. This is why I have previously stated that Japan is at the vanguard of fiscal dominance, a regime where interest rates are not set on the basis of achieving low and stable inflation outcomes but to ensure government solvency. In other words, monetary policy becomes subservient to fiscal policy.

Such a hierarchical macro policy framework runs contrary to the current set-up where central banks are operationally independent and free to calibrate their monetary policy stances unhindered by political influence. Indeed, most investors have no experience with such set-ups and probably consider such notions as fanciful and unlikely. However, one does not have to go that far back in the history books to see the hands of politicians all over the “monetary policy tiller” so to speak (eg. the Bank of England was only granted its independence in 1998!) Moreover, this is not just crypto-bro hyperbole. Earlier this year, Kristalina Georgieva, Managing Director of the IMF, warned about increased challenges to central bank independence and the risk of fiscal dominance.

Japan may be closer to this policy making tipping point than most other countries, but it is worth noting that many (read: most) countries in the developed world have historically elevated debt loads as a result of the policy choices made in response to the Great Recession and the Covid Pandemic³. As such, it will not take much for them to find themselves facing a similar predicament, where the independence of central banks is nothing more than a fig leaf.

In fact, a global downturn, which contrary to the recent market rebound remains a strong possibility given the Sahm rule and the US yield curve signals⁴, could be just the catalyst to bring about regime change.

Faced with such macro conditions central banks will naturally begin to ease monetary policy, but governments will also inevitably respond by injecting deficit financed fiscal stimulus. Already elevated government debt-to-GDP ratios will get pushed even higher. And, given “history is full of examples of high government debt eventually being resolved through higher inflation and financial repression” to borrow the words of ECB board member Isabel Schnabel (not Satoshi Nakamoto as I am sure some of you thought) it will not take much for public confidence in the ability of governments to repay the debt without resorting to the printing press to crumble. At such a point, the central bank will be forced to step in and backstop the bond market. Such a scenario was outlined by Charles W. Calomiris, a Professor at Columbia Business School, in a working paper published by the Federal Reserve Bank of St Louis published last year; again not another crypto-bro type seeking to “pump his bags”. Obviously, if (when?) such an outcome occurs the benefits of owning a decentralized private digital currency that is inviolable to government manipulation will be abundantly clear. So, even though developments last month suggest cryptocurrencies may well get “hit” by a global recession, one can be certain that they won’t stay down for very long.

1 Only the 1987 Black Monday crash witnessed a higher daily percentage point decline – see: https://en.wikipedia.org/wiki/Black_Monday_(1987)

2 USD/JPY dropped 8% in less than a handful of days in early August.

3 This is not even taking into account future unfunded liabilities – see: https://trakx.io/resources/research/london-calling/

4 Of course, it could be that “this time is different”. Indeed, the creator of the Sahm rule does not believe a US recession is imminent (see: https://news.bitcoin.com/claudia-sahm-warns-fed-delayed-rate-cuts-could-spur-unnecessary-recession/) . However, there is a reason why these four words are considered the most dangerous in the investing world.