Q1 2022 REVIEW
Executive summary
Q1 2022 was a long and painful crab price action for Bitcoin as it ranged within $34K and $45K since January. The correlation with legacy markets has become more relevant as macro economic conditions are tightening, and Bitcoin has undoubtedly been accumulated by traditional investment funds since the beginning of covid related QE, who also have a focus on the tech industry and high growth stocks. As a result, we believe Bitcoin’s short term future is tied to the US stock market and our focus is on the macro economic picture for the next 12 months, to make sure we are aligned as a fund with the story macro economic indicators are telling us across global markets and prepare for the highest probability outcome. We firmly believe that failing to recognize what is happening in global markets and the implications to crypto is the path to getting a harsh wake up call in the coming months. Our Q1 2022 review goes over what happened in the markets and identifies the trends and narratives to pay attention to for the coming months.
The long awaited FOMC March 16 announcement came out with a 25bps rate hike. This decision follows expectations and is totally in line with current market conditions, with increased uncertainty in the recent weeks amid disrupted supply chain caused by zero covid tolerance policy in China causing major city lockdowns, and the Russian invasion of Ukraine. We believe that this first announcement is a warm up for markets to prepare participants for a series of rate hikes and less accommodative overall market conditions, with the introduction of quantitative tightening, hinted by Jerome Powell to come as soon as the May meeting. This announcement would be combined with a minimum of 50bps rate hike expected by the market as of today. These monetary measures coincide with the end of covid related accommodative measures and reflect the Fed’s declared priority to fight surging inflation caused by unprecedented QE, as well as a series of supply-chain disruptive events that accelerated the inevitable outcome of these policies.
The eurodollar futures curve predicts a series of 6 to 7 rate hikes by end of the year, with the Fed funds rate reaching up to 2.5% in 2022, at time of writing. The implied terminal rate has skyrocketed in recent weeks as it currently sits at 3.15% and expected to hit as soon as June 2023. This puts the yield curve under pressure with the 10s2s just 0.04% off inverting. The odds of an upcoming looming recession are certain as the Fed has to hike in an ending business cycle to tackle record level inflation. It’s a matter of when.
Inflation reached a 40 year historical record as the US hasn’t seen a 7% year-over-year increase since 1982. CPI numbers in January and February have accelerated the Fed’s decision to tackle inflation with top priority. We expect the upcoming CPI numbers to portray further growing inflation as the March numbers did not reflect the recent disruptions caused by Russia’s invasion of Ukraine and the international sanctions that followed.
The invasion of Ukraine by Russia accelerated disruptions across all supply chains. Commodities markets were especially impacted by the February events with energy, metals, industrial, and agricultural goods reaching record high levels. Oil surged back to triple digits territory, topping highs not seen since 2008 as Russia accounts for 10% of global production. Russia is also the second largest gas producer, further impacting overall energy prices globally.
We also saw disruptions in industrial material prices with the nickel market literally falling apart as Russia is the 3rd largest producer. There are also concerns that the on-going conflict will have continued impact on food prices thus further impacting consumers purchasing power in the coming months. Russia is the largest exporter of fertilizers, accounting for 13% of the market. The prices of wheat and corn used as proxy to identify short term trend in inflationary pressure indicate that prices of final goods resulting from this conflict will continue to negatively impact consumers.
In addition to disruptions caused by war in Eastern Europe, we also saw a number of large Chinese cities going back into full lockdown as the country continues to follow a strict zero covid policy. For instance the city of Shenzhen, 4th largest port in the world shut down its shipping companies and warehouses for several weeks, further impacting supply chains.
The invasion of Ukraine was followed by a wave of sanctions from the international community against Russia. This brought back the Bitcoin being used as money laundering and sanction evasion means narrative as the US and Europe threatened to cut Russia out of the SWIFT system. It may have a longer term impact on the crypto ecosystem as politicians and regulators will be using this situation as a use case to base their future law propositions on. We notice that EU regulators are actively working on these topics as publicly circulating law drafts suggest that self custodial wallets and DeFi protocols could be under high scrutiny, or even banned from the fiat on ramps without full KYC/AML rules compliance.
To continue on the regulation topic, Q1 also had the crypto market nervous about the outcome of the Markets in Crypto-Assets (MiCa) presented at the European Parliament’s Committee. The initial text proposed the prohibition of the issuances, or offerings of crypto-assets that rely on Proof-of-Work protocols. If the law had passed in this form, it could have led to a deadly regulation that excludes Bitcoin and other PoW blockchains from Europe. The Association of EU companies in Digital Assets showed strong opposition to any ban on PoW activities on the old continent, and warned on multiple shortfalls and adverse effects of the proposal. Fortunately a majority of the European Parliament’s Committee on Economic and Monetary Affairs has voted against the bill. What resulted from MiCa is PoW now falling under sustainable finance taxonomy, obliging market participants to follow green objectives should they be willing to seek investments from public entities and private companies.
This quarter also saw CBDC talks make a come back, as Fed Chair Jerome Powell announced that a study on the costs and benefits of a potential Central Bank Digital Currency will be published in the coming weeks. JPow explicitly listed four qualifications that would make a CBDC work, namely ensure user privacy, be identity verifiable, be intermediated, and be widely accepted as a means of payment. Despite listing these attributes and the upcoming study, the Fed made clear that they are only at the beginning of this journey and exploring the space.
Our growing concern after taking into consideration global macro trends and the economic outlook is the impact the financial downturn will have on Bitcoin and the rest of the crypto market. We believe Bitcoin has been widely accepted as a legitimate asset to be held in traditional portfolios through 2020 and 2021 as fund managers have been more opened to publicly disclose their positive point of view on digital assets. While these large portfolios unquestionably helped Bitcoin and the rest of the space on the way up to new highs, we believe the growing correlation with the stock market short and medium term is something to look out for as portfolio re-balancing and a wave of de-leveraging positions would bring Bitcoin down with traditional holdings. Our conviction lays around the fact that an inevitable downfall in financial markets will drag Bitcoin down which would then allow it to lose the correlation. And while previously praising fund managers publicly call Bitcoin a failed experiment, inflation hedge narratives will make a come back as the Fed won’t be able to keep inflation under sustainable levels as the eurodollar futures curve forecast the terminal rate to be reached mid 2023. This is when we’ll be looking to consolidate our favorite crypto assets positions.
As a counter argument to this take, we often hear that on chain analytics look bullish as whales continue to accumulate Bitcoin and the liquid supply gets absorbed. But we keep in mind that we actually don’t know how much of the Bitcoin held by investors and speculators is held as collateral, which if it is high enough would cause a cascade effect and contagion across the entire crypto market as these positions are forced to deleverage.
