Crypto and Stocks: A Tale of Two Markets and Their Relationship with Interest Rates
“It was the best of times, it was the worst of times…”
The Narrative:
Stocks are dumping and crypto is pumping because banks are failing and people don’t trust the system anymore. This is flight to safety.
Oh, really?
Let’s take a deeper dive into what happened in the last few days and what we can expect going forward.
Bank Run of 2023
Many of these details about the Bank Runs of 2023 were included in last week’s newsletter, Banking on Stability, https://us10.campaign-archive.com/?u=5578e862a4566fbdefb336657&id=49eb733d42 but here is a recap.
In a regulatory filing on March 1st 2023, Silvergate Capital (SI) stated that they were at risk of losing its status as a “well-capitalized” bank under FDIC guidelines. Immediately afterwards, companies like Coinbase, Galaxy Digital , and many other crypto firms stopped utilizing Silvergate to process payments. With losses mounting and their clients leaving, Silvergate announced on March 8th that they would voluntarily liquidate and return all deposits to depositors. Also on the 8th, Silicon Valley Bank (SVB) announced that they would sell $21 billion in available-for-sale securities and take a $1.8 billion writedown in losses from the sale. At that moment, the global financial markets did not have its sentiment shock — it was business as usual… so far. The S&P 500, the benchmark US stock market index, closed the day on March 8th with a 0.14% gain while SVB closed with a 0.16% gain for the same day.
On March 9th 2023, a Twitter-fueled mass hysteria ensued with depositors withdrawing $42 billion in deposits from SVB. This is when global stock markets took a tumble with the S&P 500 index shedding around -1.86% on that day. Since then, we’ve had more developments and more banks involved in financial troubles (Signature, First Republic, and Credit Suisse primarily) with gut-wrenching up and down price action mostly driven by news headlines about more banks coming under stress and regulators attempting to instill confidence in the system.
As of this writing on March 21st, 2023, the S&P 500 is essentially flat since the close of business on March 8th until now with today’s intraday gains helping to bridge that difference. But before today, the S&P 500 was in the negative since the 8th.
The S&P 500 chart looks completely different to those of cryptocurrencies Bitcoin and Ethereum. Bitcoin is up over 28% while Ethereum is up over 14% in the same time period.
So, is this really a flight to safety?
To answer that question, we need to take a look at yet another market — the bond market and interest rates.
In our March 9th 2023 newsletter, Inflation and Ethereum Volatility, we wrote:
When credit and access to liquidity become more expensive, investors tend to be more selective in what assets to buy and hold. When credit and access to liquidity are cheap, investors are more willing to take risks on asset price appreciation based on higher potential future growth while forgoing more current gains such as interest earned or dividends..
When credit and access to liquidity become more expensive, the saying “A bird in the hand is worth more than two in the bush…” becomes the perception and reality of the investor. Current returns are “worth” more than the chance of returns later.
So what happened to interest rates? Here is a look at the US 10-year treasury yield, which is used worldwide as a benchmark for borrowing rates.
The S&P 500 index is an index that includes not only value stocks but growth as well. So although it may appear as if the whole index appears flat just from judging from a point-to-point basis from March 8th until today (March 21st), underneath the hood, we see a completely different story.
As interest rates drop, market participants are more willing to speculate on growth. Not only did this phenomenon affect cryptocurrencies, it affected growth portions of the stock market with growth/tech stocks outperforming value stocks. Most would agree that growth/tech parts of the market catching a bid are not “flights to safety” in any way. We didn’t witness a flight to safety — we saw a flight toward growth speculation!
One ratio chart that many professionals like to use to show relative strength and sector sentiment of the stock market is the growth-to-value chart: IVW/IVE. IVW is the mostly-tech heavy S&P 500 growth exchange traded fund and IVE is the mostly-financial heavy S&P 500 value exchange traded fund. When the ratio IVW/IVE is trending higher, it means that growth stocks, in general, are outperforming value stocks. When the ratio is trending lower, it means that value stocks are outperforming growth stocks. Since March 8th, this ratio has accelerated to the upside. This claim is also supported by the Nasdaq vs. Dow Jones Industrial Average (DJIA) chart. The Nasdaq is very tech/growth heavy while the DJIA is a collection of thirty industrial/cyclical stocks that represent value stocks. The Nasdaq has outperformed the DJIA in the past weeks since bond yields have dropped.
And just for fun, let’s compare the entire cryptocurrency market cap against IVW/IVE and the inverse 10-yr treasury yield chart. As the reader can see, there definitely is a positive correlation between cryptocurrencies (green-red candle chart) to stock market investors’ bullish growth sentiment on growth vs. value (teal line) and a negative correlation to the 10-yr treasury yields (positive correlation to the inverse of the 10-yr treasury yield — black line).
It is also interesting to note that we see cryptocurrency options open interest (how many options contracts are outstanding being held by market participants) increase and spike around the times when growth stocks outperform value stocks while bond yields are trending downward (or the inverse chart of bond yields are trending higher). Of course most of the options open interest in cryptocurrencies such as bitcoin and ethereum are in call options (a contract that represents a right to buy or bullish bets for the holder). Buying cryptocurrencies is obviously a bullish position but so is buying call options. The biggest difference though is that the call options buyer needs to be right not only in the direction of the move (the price of the underlying cryptocurrency would have to go up) but must also be right in the magnitude and timing of the move as options do expire and the options buyer must pay a premium. It is safe to assume that these call buyers are taking on a lot more short-term risk on taking a loss than a participant who is just buying the actual spot cryptocurrency itself.
Ok… so now what?!
As noted in our previous newsletter, Inflation and Ethereum Volatility, the Federal Reserve has been raising interest rates for all of 2022 into 2023 to curb inflation. This has dampened demand for assets where there is speculation about future growth. When interest rates drop (as was mandated during the 2020 Covid pandemic to bolster economic growth), risk assets like Ethereum enjoyed stunning rallies as investors looked toward future growth rather than current earnings.
Tomorrow on March 22nd, 2023, we will have the Federal Open Market Committee (FOMC) Fed Funds interest rate announcement at 2:00PM ET. It is widely expected that the Federal Reserve of the United States will raise the Fed Funds interest rate by 25 basis points (bps) to target rate 4.75% — 5.00% from the current range of 4.5% — 4.75%.
However, based on futures trading on the Fed Funds futures market, we saw a massive sentiment shift amongst market participants. A month ago on February 21st 2023, the Fed Funds futures market was positioned for the expectation of three more rate hikes between now and the July 26th 2023 FOMC with 5.25% — 5.5% as the highest probability expectation for the Fed Funds rate after that meeting. Fast forward to today, and the Fed Funds futures market is expecting the highest probability scenario to be two rate hikes and the possibility of two rate cuts by the end of July. The Fed Funds futures market is supportive of the thesis that more money is rotating into growth (and crypto) as there is more of an expectation of lower interest rates in the near term later this year.
There is both a caveat and an opportunity that needs to be discussed when talking about the market’s expectation for interest rates. The caveat is that these expectations can change (rather quickly too) based on economic conditions and world events. FOMC tends to be an example of such an event where these expectations can shift. However, that is also where the opportunity is. Today we discussed how rapid changes in bond yields and future expectations on interest rates caused price volatility in risk assets such as cryptocurrencies and global stock markets. If after FOMC, we see another such seismic shift in rates and rate expectations, we may be able to witness excess realized volatility in cryptocurrencies, such as Ethereum (I’m looking at you, stETHvv — Pods Volatility Vault). Although it is too late for the reader to participate in this week’s yield pool (deposits need to be in by Friday, 15:00 UTC), there is a decent chance that we may see outsized price volatility this week or next week as the markets reposition themselves for future expectations. As a reminder, stETHvv produces extra yield when there is an outsized move in the price of Ethereum in either direction.
So, sit back and enjoy the show.
Visit us at pods.finance and check out the Volatility Vault -stETHvv.
Cheers to vol, frens! 🍻
