The World’s Current Macro Environment and How it Relates to Crypto
Following a huge wave of selling, the crypto market is in turmoil. Not just crypto but other asset classes, including equities and bonds, also experienced one of the toughest months in history.
So how did all this happen?
To answer this question, we must understand the macro environment, which is fundamental to the economy, and the root cause of any pump and dump. In this article, we will try to analyze how the macro environment changes, what measures the Feds are taking to cope with it, and most importantly, what it means to crypto.
Raising Interest Rates
Fed is raising the interest rates as part of its escalating campaign to battle stubbornly high inflation.
Why Does Inflation Happen?
Inflation is a loss of purchasing power over time: your dollar will not go as far tomorrow as it did today. Inflation is usually measured as the annual price change for a basketball of goods. For example, Consumer Price Index (CPI) measures the cost of things urban customers buy out of pocket.
The reason for the inflation we currently suffer from is partly due to supply and partly demand.
- From the supply side, COVID-19 has shut down many factories in the US and China and has clogged shipping routes. The war between Ukraine and Russia (important export countries in steel and oil) only worsens matters.
- From the demand side, the Quantitative Easing (QE) policy in 2020–2021 (including the covid-relief package by the US) and low-interest rates make holding cash and saving less attractive since both provide basically no yield. Therefore, people increase their spending & investment alternatively.
From Economics 101, we learned that increase in demand + decrease in supply = rise in price. In the broadest sense, that’s how inflation comes into play.
Why Inflation Is A Problem?
Most of the time, steady inflation is a good thing to have in any country’s economy since it is often deemed a by-product of the booming economy. When the economy is flourishing, with a low unemployment rate and higher production power, people tend to have higher buying power generally, and steady inflation would not be noticed.
However, when inflation becomes higher, it can have several negative effects:
Erodes Purchasing Power
- When inflation is high, the purchasing power of 1 dollar decreases faster each year, compounding effect makes it worse.
Hurts the Poor Disproportionately
- The poor spend the largest percentage of their income on necessities, so inflation has a larger effect on them than on the upper class.
Wage-price Spiral
- When inflation is high and accelerating, workers expect future inflation to keep rising and thus demand higher wages. Rising wages can increase disposable income and thus push the price higher, creating a conceptual spiral.
Why Raising Interest Rate Can Theoretically Curb Inflation?
We can see from the graph that inflation and interest rates tend to move in the same direction in the past 50 years. To be more precise, interest rates tend to lag compared to inflation. This is because interest rates are an effective measure to curb inflation, as hikes in Interest rates can have several effects that can curb inflation within Fed’s timeframe:
- Increase Saving
- Make It More Expensive To Borrow
- Short-term Recession Curb Consumption
Raising interest rates on many aspects can clamp down on demand and theoretically curb inflation. That’s why Fed is being hawkish since they have to deal with inflation before it goes out of control (hyperinflation). However, as we discussed earlier, inflation is not only caused by demand but also by supply. Hiking interest rates cannot resolve the supply-chain problem we are having, so there are still some concerns about whether being hawkish can save the day.
The Effects Of Raising Interest Rates
Bonds ✚
The pricing formula of bonds shows that a higher rate leads to a lower bond price since when interest rates hike, the cash flow (coupon payments) each period is discounted more, which leads to a decrease in bonds’ prices.
Equities－
Generally, interest rates and equities prices have negative correlations. The first reason is the liquidity in the market. When interest rates rise, there is less money staying in riskier assets. The second reason is about valuation. Discounted Cash Flow (DCF) is a frequently-used model for valuation, and the basic idea is that a company can be evaluated using all of its future cash flows. When interest rates hike, the future cash flows become smaller since the discounted power becomes larger.
This is especially devastating to those growth companies like the tech giants. Most of them had high valuations due to the favorable macro condition in the past 10 years since institutions and investors were willing to give them high valuations for their high expected future cash flows.
Forex ✚
Interest rates in a country can be viewed as the return for holding its currency, and if the interest rate of A country rises faster than B country’s interest rate, it will be more appealing to hold A country’s currency intuitively (enlarged spread), the exchange rate of A currency / B currency will rise.
QE vs. QT
Quantitative Easing (QE)
Quantitative easing (QE) is an unconventional expansionary monetary policy that central banks have turned to once they have reduced their own policy interest rates to, or close to, zero. The central bank creates money electronically and uses it to buy assets, usually government bonds, from the market. This increases the amount of money in the financial system, which encourages banks to lend more and can push interest rates lower, encouraging businesses and households to borrow. In turn, if businesses use the money to invest and consumers spend more, this can give the economy a boost.
Quantitative Tightening (QT)
Quantitative tightening (QT) is a contractionary monetary policy that reverses QE. The government bonds and other assets that central banks have bought from the market through QE programs are held on their balance sheets, massively increasing their size. QT occurs when central banks start to reduce their balance sheets. In 2019, the US Federal Reserve is allowing its bond holdings to mature rather than replacing them. This is known as passive tightening. The Bank of England and European Central Bank have stopped their asset purchase programs but are not yet reducing their balance sheets. This means their balance sheets will shrink relative to GDP over time, known as organic tightening.
Where We Are Right Now?
Central banks around the world have been implementing QE for the past decade. When QE is implemented, since bond sellers are unlikely to buy bonds again, their money flows into riskier assets, including corporate bonds, equities, and cryptocurrencies.
As a result, in the past 13 years, QE has increased its valuation a lot. The total value of stocks / GDP Ratio can be a good indicator to see how high stocks are being priced compared to real outputs.
Fed’s Next Step
Fed has been setting its foot on quantitative tightening through treasury and MBS, and it will shrink its balance sheet by $95 billion a month, which is twice the pace of the 2017–2019 QT cycle.
Currently, Fed has around $9 trillion on its balance sheet, about 2.5x compared to its pre-covid status. The question is, “what is the equilibrium point where Fed slows down/stops QT since the inflation problem has been resolved”. It’s unlikely that the endpoint will be $3.5 trillion, which was the pre-covid balance, since curbing inflation is the goal. If we assume that Fed wants to shrink the balance sheet to its pre-covid level, this makes $7 trillion the equilibrium point at this QT cycle. It still takes around 21 months to reach that point at this pace.
What Does It Mean To Crypto
Crypto, as a newbie that was born since the start of QE and zero interest period, has benefited a lot from the macro environment in the past 10 years. Although we’ve seen some solid growth in crypto as a whole, including DeFi innovations, NFTs, and many infrastructures have been built, we have to acknowledge that crypto is still a risky/volatile asset class in the world, and in the short term, we cannot fight the macro trend.
QT
During QT, Fed sells the bonds on their balance sheet back to commercial banks and large financial institutions to collect cash, making cash in the open market more scarce and therefore gets more expensive to borrow. To pay back old debts, companies will liquidate their financial assets, which pushes asset prices to drop. Also, with higher interest rates, creates similar effects on borrowing, therefore causing a damping effect on all expansionary activities, including purchasing/investing in crypto. In short, with less money on the table, most financial assets lose value, and crypto is no exception.
Interest Rates
Similar to the effects that QT has on crypto, hikes in interest rates will also reduce the liquidity in the market, and investors are scaling back on crypto to fit their risk tolerance. With higher interest rates, the market has less money to invest, and the opportunity cost of investing in non-yielding assets like Bitcoin increases compared to buying bonds or saving. In general, higher borrowing costs alter the risk-reward scenario of such trades, meaning that your potential return drops as your costs go up.
Expectations
The uncertainty that things could get worse before they get better is haunting the crypto industry, and this can be the main cause of the plummet in prices recently. Investors tend to “buy high, sell low” because they are affected by market sentiments, and therefore when the price and volume are down in the crypto industry, the “panic sell” pushes itself and creates a death-spiral-like scenario.
When Bottom?
We are facing one of the worst downturns in crypto history, with the expected hikes in interest rates and QT and the margin call news from many large institutions that were once thought to be “too big to fail”. In any financial market, the expectation is all that matters. Prices don’t bottom when the interest rates spike to their peak, usually before that. So how close are we to the bottom?
Past Performance
- Maximum Drawdown (Bearish)
In the last bull market, BTC dropped 84.82%, and ETH dropped 94.5% from their previous ATH, so if history repeats itself again, we can see as low as $10,423 for 1 BTC and $275 for 1 ETH.
2. Weekly 200 MA (Bullish)
From 2017–2022, we can see that whenever Bitcoin price touched the weekly 200MA line, it was close to the bottom and was a good buying opportunity.
Onchain Data
- NUPL (Bullish)
Net Unrealized Profit/Loss (NUPL) is an indicator that shows the onchain profit or loss in addresses that hold Bitcoin. In the past 4 years, it was a good buying opportunity when NUPL turned negative. The NUPL for Bitcoin is negative now.
Short-term NUPL, which excludes long-term holders, can better capture the short-term speculation sentiment. It’s also entering the buying zone.
2. MVRV-Z Score (Bullish)
MVRV Z-Score is a Bitcoin metric that uses blockchain analysis to identify periods where Bitcoin is extremely over or undervalued relative to its ‘fair value’. It’s also suggesting Bitcoin has been oversold & is undervalued.
3. Realized Market Cap (Bullish)
Realized capitalization (realized cap) is a variation of market capitalization that values each Bitcoin based on the price when it was last moved, as opposed to its current value. As such, it represents the realized value of all the coins in the network, as opposed to their market value. It shows Bitcoin is undervalued now.
Closing Thoughts
We have seen some strong traction in the industry in the past two years, and many institutions, including those who were once bearish about the future of digital assets, have become large adopters lately.
The macro economy, however, has posed a threat to the crypto industry, and the consequent plummet has caused a lot of FUDs, which is pushing the price further down. Although from recent price reactions and on-chain data, prices have seemingly formed a consolidation, it still takes time to verify whether we are at a real bottom or just another local bottom since, in this period, any indicator that shows the economy is deteriorating can drag us down again.
The silver lining is that, as we are witnessing a lot of liquidation (deleveraging) events, the market has gradually priced the future in through market sentiments and investors’ expectations and therefore becomes healthier and stronger.
