Uptober: The Crypto Rally Resumes
In crypto circles October is often renamed Uptober in recognition of the fact that for whatever reason, seasonals seem to be positive for crypto in the 10th month of the year. 2023 was no exception with the market cap of cryptocurrencies having risen to $1.2tr, some 45% above the cycle lows seen in the aftermath of FTX bankruptcy last November, which many of the doomsters thought at the time would constitute a “crypto extinction” event.
Obviously, the cryptocurrency with the longest price history is Bitcoin so it has the fullest dataset by which to observe seasonality. As can be seen in the image below, October has indeed been one of the most favourable months of the year. Bitcoin’s price has risen in nine out of the 13 Octobers for which we have available data, generating an average monthly gain of 25%.
Bitcoin Monthly Returns
As I noted in the previous monthly update, ideologically I am not a huge fan of predictable asset price patterns because as an economist I believe investors are rational, forward-looking profit-maximizers who would front-run any apparent predictable price pattern in the hope of extracting additional alpha - temporal arbitrage that should lead to the corruption to the pattern. Moreover, it is difficult to provide a logical explanation for why October (or April for that matter which has even more positive seasonals: fewer down months and higher average returns) should be more positive than any of the other months of the year. Nevertheless, one cannot deny that last month the seasonals played out right on cue.
What is especially interesting about last month’s surge in crypto prices is that it was not driven by improved investor risk appetite nor increased global liquidity – two drivers that have been associated with previous crypto price rallies. For all the chatter about “soft-landings” in the US economy, it is worth noting that global equity markets have been steadily drifting lower since the summer and this downtrend was extended by a further 2-3% in October. Such price action is not indicative of increased risk appetite, rather investor optimism has weakened given the reluctance of Fed officials to confirm that the peak in the Fed funds cycle is upon us and, by extension, that the next policy move will be an interest rate cut. A hawkish pause is probably the most apt description of the Fed’s policy stance at present, something that is reflected in the pricing of Fed fund futures1.
In addition, investors have had to contend with a sharp escalation in geopolitical tension in the Middle East after the recent terrorist attack on Israel and their response in the Gaza Strip. Just as we witnessed last spring when Russia invaded Ukraine, investors do not respond well to sabre-rattling, especially given the rather obvious potential for other, larger, countries to be dragged in. As a result, investors require increased expected returns to offset the perceived increase in risk, which in terms of equities means lower spot prices.
In an environment where stock prices are declining, and where geopolitical tensions are ratcheting up, one would naturally expect investors to seek shelter by buying classic safe-haven investments like government bonds, especially as they are now offering the highest rates of return – both in real and nominal terms – in more than 16 years. Remarkably, though this has not been true. Quite the reverse, the US 10-year Treasury yield – one of the most important reference interest rates in the tradfi world – last week hit 5%. This is not a particularly important number economically, aside from it being its highest level since 2007, but it is psychologically significant.
As mentioned, reluctance on the part of the Fed and/or other central banks to signal a shift towards monetary easing is likely a contributing factor weighing on US Treasuries. However, it is also likely reflective of non-cyclical factors. My basis for reaching this conclusion is that, as mentioned above, real, or inflation-adjusted, 10-year US Treasury yields have moved higher in tandem with nominal bond yields – see image.
US 10-year Treasury Yields (Nominal and Real)
Source: Fred Database
Such price action at the long-end of the US yield curve only makes sense if one of two things is correct (the likelihood of them both being correct is effectively zero). Either investors believe the long-run potential growth rate of the US economy, which is assumed by the Fed and the CBO to be 1.82, has risen over the past several months, justifying the need for higher real interest rates to maintain intertemporal equilibrium, or investors are attaching a greater risk premium to US government debt3.
Now ask yourself, which of those two scenarios seems more likely given current circumstances?
For those who still hold out hope for the more optimistic interpretation (namely, potential GDP growth in the US has risen) take a look at the gold4 price – see image below. Over the past month, the price of the yellow metal has jumped 7%, and is threatening to break to fresh nominal highs. Just like the crypto market, but unlike the US bond market (remember yields are the inverse of the price), gold is acting like a safe-haven asset. Those with a more sceptical take on crypto, no doubt, consider calling the likes of unbacked cryptocurrencies like Bitcoin or Ethereum safe havens is classic “shilling”. However, Larry Fink, CEO of the world’s largest fund manager and a denizen of the tradfi world made that exact comparison in a TV interview last month5. Coming from someone with that pedigree, and who has a spot Bitcoin ETF application filed with the SEC, his comments are hard to ignore.
Gold Vs. Bitcoin
Source: Trading View
As to why investors may be attaching an increased risk premium to US government debt, one only needs to take a look at the recent fiscal trends in the US. The US fiscal year ends in September and over the past 12 months, the Biden administration recorded a deficit of $171bn – a figure only exceeded during the Covid years - taking the outstanding stock of government debt to $33.6tr, or 124% of nominal GDP. To put some perspective on these numbers, in the past month alone the US government added over $600bn to the total debt stock6 – that is an increase equivalent to the entire market cap of Bitcoin and triple that of Ethereum!
Worse, because of the increase in interest rates enacted by the Fed to tackle the inflation overshoot, the cost of servicing this debt load jumped to an annualized rate of more than $900bn in Q2. On a net basis, which excludes intra-governmental transfers, this makes it the fifth largest category of spending (10%), just behind healthcare (11.9%) and National Defence (14%)7. As I noted in a research note published last February, US fiscal and monetary policy are on a collision course and the implications for crypto are clear. To wit:
“Monetary policy cannot succeed on its own8. This is something I think a lot of people fail to appreciate. (In terms of cryptocurrency implications, the Fed going it alone is bearish in the short-term, but longer-term because of the implied rise in the debt-to-GDP ratio, it is bullish as it keeps alive the fiat failure possibility).
Last year crypto investors were focused on the negative first leg – Fed fears – but given how monetary and fiscal trends have evolved since then it is the positive second leg – fiscal fears – that is coming to the surface, and combined with falling international trust (the flip-side of rising geopolitical tension) this is what is driving both crypto and gold higher (importantly they are both benefiting from their being outside assets9).
How Will This Be Resolved?
The most benign solution would be for the Biden administration to grasp the fiscal nettle and enact sustained fiscal tightening, critically cutting expenditure, thereby taking the strain off the Fed to use monetary policy to manage demand in the economy and providing them with some leeway to lower interest rates (mildly crypto positive). This is politically challenging to do even in normal times, and we are far from normal times given what is happening in Ukraine and Gaza and with a Presidential election only a year away.
This, of course, presupposes that the US economy does not meanwhile succumb to the recessionary headwinds that have been persistently building over recent quarters. Should such a scenario unfold, this would inject some near-term uncertainty into the macro (and therefore crypto) landscape, but the end result would be the same. Lower nominal interest rates would swiftly follow, and (very) probably it would result in real interest rates returning to negative territory that defined much of the past decade when recall crypto went from zero to a $3tr market cap asset class.
The alternative is that the Biden administration fails to introduce fiscal consolidation and the Fed keeps interest rates higher than would otherwise be the case. Assuming a recession is avoided (see above), this mix does absolutely nothing to assuage investor concerns about the long-run creditworthiness of the US. Moreover, it is doubtful how long this policy mix could be sustained.
Both the Fed and US regional banks are suffering the consequences from the back-up in US government bond yields. The Fed is currently underwater in terms of its mark-to-market losses on its QE-bloated balance sheet to the tune of $110bn – see image – while the regional banks still have over $108bn parked in the Fed’s Bank Term Funding Programme (aka Buy The F*cking Paper) emergency programme introduced after the failure of SVB created in March and which is supposed to expire after one year.
Fed Earnings Remittances Due to the U.S. Treasury
Source: Fred Database
When investors are already doubtful about the US government’s ability to repay its debts in anything other than devalued, freshly printed, greenbacks, the last thing the government needs is renewed worries about the health of the US banking system. Indeed, facing such a situation the Fed could very well decide to give itself some additional degrees of policy freedom by “tweaking” its inflation goal to allow for rates sustainably above 2%, something it can do unilaterally as its mandate only contains a commitment to maintaining price stability. Such a scenario certainly cannot be ruled out. Neither can shifting the goalposts entirely and adopting a yield curve target – a long-standing prediction of mine10 - that effectively makes the money supply (and ultimately inflation) endogenous. These outcomes would be unambiguously positive for crypto prices, something rational, forward-looking profit-maximizing crypto investors are all too aware of.
ANY INVESTMENT IN DIGITAL ASSETS IS AN INHERENTLY RISKY INVESTMENT. IF YOU ARE IN ANY DOUBT ABOUT INVESTING, THE COMPANY RECOMMENDS YOU CONSULT WITH YOUR FINANCIAL ADVISOR.
2Adding in the Fed’s 2% inflation target, that approximates to a nominal US GDP growth rate of about 4.5%, which is lower than any point on the US yield curve. This means monetary policy is restrictive, implying growth-impinging if sustained for any length of time. Obviously, divergences between nominal interest rates and nominal potential GDP can divergence from time-to-time as central banks pursue their inflation objectives. However, divergence cannot be sustained for any prolonged period of time without causing either a financial bubble (nominal interest rates are too low relative to nominal potential GDP growth, as occurred in the pre Great Recession period) or a recession (when, as is currently the case, nominal interest rates exceed nominal potential GDP growth which serves to discourage investment).
3The reason why the two are mutually inconsistent is that higher US potential GDP growth makes improves government debt sustainability.
4Dylan Grice, who I have known since his days working as a macro strategist at SocGen, once described being long gold as the equivalent to being short human ingenuity, by which he mean that buying gold does not directly contribute to an economy’s productive capacity.
8By going it alone, I meant that the Fed takes over the bulk of the responsibility for demand management of the economy and ensuring that inflation returns back to target i.e., the absence of fiscal consolidation.
9As to why this is an important characteristic – see: https://trakx.io/bitcoin-the-inside-out-narrative/
10I first made this prediction back in 2013, several years before the BoJ introduced its yield curve control (YCC) policy, a policy it is finding extremely difficult to extricate itself from.