Q2 2022 REVIEW
Review of financial markets in Q2 2022, with an emphasis on crypto.
Executive Summary
Q2 2022 confirmed our fears of how we imagined the market to react following the Fed tightening monetary policy. Admittedly, we did not expect it to be that brutal. And from sentiment across the board, it seems like the majority of actors got caught by surprise. I did express my concerns in my Q1 2022 Review, but the rapid downturn crushed my hope and belief that the space was strong enough and prepared to face the storm that’s been approaching crypto town (jungle) for months. Everyone’s bottom target got crushed one after the other as order books turned ask only with no strong bid in sight to absorb the carnage. Things accelerated fast as the Terra/LUNA shit show exposed who was swimming naked. And it unfortunately wasn’t who we were expecting. As the sea receded, the supposedly most sophisticated investors, traders, and entities were in fact very exposed to the LUNA and UST scam, which triggered a contagion effect across the entire crypto space through sudden panic and insolvencies left and right. The LUNA related crash was also revealing of poorly managed businesses in the space. And that unfortunately involved all of the borrow/lending platforms, which are the bridge between fiat and crypto world, and the liquidity distributors, hence referees in a way, of who gets to play with the cash. It appears the cash was not in the hands of the best players. Fed tightening means liquidity drying up. And risky assets are the most exposed to its effects, as investors pull out of risk assets before they do of blue chips. This monetary paradigm change is really what separated the actors that were skilled from the ones that were lucky from being early, and leveraged that with easy irresponsible access to debt. Don’t get it wrong, the crypto crash is not solely due to the LUNA ecosystem downfall. It is related to a change in paradigm as the Fed stops the music.
Fed procrastination and ECB mess up
Fed and US Government officials finally admitted that their transitory inflation narrative was bullshit, denying of the reality, or incompetence at best. So the Fed finally decided to put their shit together and act. Not only did they act, but they accelerated the economic tightening in an attempt to catch up with how behind the curve they have been for the past 18 months. Demand-pull type of inflation can only get dealt with one way, and that is by crushing demand. The Fed is going that route by pulling liquidity out of the system through Quantitative Tightening and a series of rate hikes to slow down economic activity.
Because of Central Banks procrastination on flighting inflation, markets now have to face an improvised emergency plan composed of accelerated rate hikes and liquidity rug pull through a very aggressive, unprecedented QT plan. To recap on the hawkish plan time: Federal Funds Rate went from 25bps at the start of the year, to 175bps today, with the upcoming rate hikes currently expected as follows: 75bps in July, 50bps in September, 50bps in November, and 25bps to end the year. Picture this: from 0.25%, to 3.75% within 12 months. The hikes aim to reach a terminal rate of close to 4% as things currently stand. We still have a long way to go. Meanwhile the Fed also have to take care of their balance sheet.
The QT plan is as follows: $47.5B per month for 3 months starting June 2022 “supposedly”, then $95B per month from September onwards until the Fed judges necessary. I say supposedly because the Fed only reduced their balance sheet by $7B in June. $40B short of the initial plan… They must believe that the market can’t take in accelerated hikes and a rapid crush in liquidity at the same time. Nonetheless the balance sheet will have to be drastically reduced, maybe after the rate hikes come down. Powell recently mentioned the end point would be a $3T balance sheet reduction from where it is now. There is a long way to go.
The European Central Bank has long been hoping and relying on the Fed to stay still. Instead of looking into the core issues within the Euro Zone, they procrastinated and waited to see what the Fed will do. But inflation kept accelerating and as the ECB waited they got way behind the curve. To the point where it will be impossible not to avoid a long prevailing economic crisis on the old continent. Inflation is slowly approaching the 10% mark, while it has already reached it in certain countries (Spain, Greece, Slovenia, amongst others). Inflation reached levels not seen since the 80s in France, and 70s in Germany. Lagarde must have felt betrayed when Powell announced that he is actually happy about a US Dollar getting stronger: “The Federal Reserve’s strong commitment to our price stability mandate contributes to the widespread confidence in the dollar as a store of value.” The Euro has been collapsing to levels not seen since the implementation of the common currency. Germany recorded a negative trade balance for the first time since 1991, although the euro is weaker, and that because of surging energy prices that should continue to remain high in the near future.
Risk and uncertainty caused bond spreads to explode. The benchmark Germany-Italy spread got back to Covid crisis level, highlighting growing economic instability in Europe. The ECB had an emergency meeting to discuss possible ways to move forward, and they came up with a yield spread control program, which is essentially a yield curve control. The program consists in allocating the proceeds of maturing government bonds of France, Germany, and the Netherlands, to purchase government bonds of Italy, Portugal, Greece, and Spain, in an attempt to close the spread gap and avoid a sovereign debt default in these countries.
CeFi shenanigans
Financial markets are only healthy if there is liquidity in the system. And that liquidity is provided by the Fed, from which the cash transits to the banking system before reaching financial markets and all its branches. Crypto and other high risk assets being the furthest away branch from the trunk, it gets provided last when the Fed opens the faucet, and dries up first when they close it. So the “crypto financial system” represented by its borrow lending platforms is the first to get affected by a drying up liquidity. These platforms are the bridge between traditional finance (fiat money) and crypto, and that bridge got tighter as less cash transits. BlockFi, CoinFlex, Nexo, Celsius, Voyager, Genesis, all face massive losses and insolvencies as their creditors default and the cash reserves are not sufficient to cover for the bank run. Without going into specific entities, they either limit withdrawals, negotiate a buy out, or face massive losses. CeFi platforms will have to prove much better credentials going forward. Reserve requirements should be much higher than they are today, transparent, audited, and tightly regulated.
Funds blowing up
Some heads are going to roll on the trading floor in the coming months. 3AC is under investigation in several jurisdictions following their collapse amid overexposure, to say the least, in the Luna ecosystem. Their downfall drags Defiance with them as they were liquidity providing. Delphi Digital, although still up and running took a huge loss on the Luna scandal. Same applies to Hashed, the multi-billion Korean crypto fund now basically back to square one.
Miners are next
We’ve seen platforms and funds blowing up, but the next actors at risk are more concerning as they’re the ones who actually set the price floor for Bitcoin. And they’re unquestionably miners.
From Arcane Research, upcoming machine payments greatly outpace the current miners cash flows, which are shrinking as the price of Bitcoin drops. Marathon has $260M in machine payments to cover this year alone, with assets and Bitcoin in collateral against their loans. It will be interesting to dig into $MARA and $RIOT earnings report for Q2 as they should display weakening businesses. We will pay close attention to their solvencies, and their enterprise value to Bitcoin holding value. This ratio could provide a potential buy opportunity should the balance sheets prove themselves to be strong enough to sustain a long period of distressed Bitcoin prices.
Thread on the topic of Bitcoin mining that’s being updated as news come in here:
Route cause: liquidity
Markets can only function correctly if they are provided with the sufficient liquidity. Quantitative Easing provided more than enough of it, hence the historical bull market of the past 2 years. However, as financial markets kept rising, core structural issues within the real economy still existed. Supply did not keep up with demand and the Fed eventually had to intervene with tightening policies in an already weakened and ending cycle.
I view crypto valuation as being divided in two layers. The first layer is the foundation layer I define as the fundamental values, vision, and future the blockchain tech and crypto introduces. The idea of Bretton Woods 2.0, or fully decentralized world. It is the basis values. They will be defended by die hard believers and builders who will always be here, no matter what mainstream believes or price dictates. The second layer is all of the leverage that plugs itself on the foundation layer. That leverage is directly linked to the available liquidity in the system, which itself is directly linked to what the Fed dictates. The unhealthy leverage, needs to be washed out for the space to grow organically.
Good bubble, bad bubble
I already hear the non crypto believers, skeptics, critics, and haters screaming “we told you so”, “crypto was a scam all along”, or “you must be dumb for investing in “virtual” money”. But remember these are the mainstream sheep we are betting against. Uneducated and clueless about the value proposition and upside potential of this industry. And mainstream is usually wrong, so we’ll happily revisit and see who has the last laugh. Because whether distracters like it or not, crypto is here to stay, and it is going to take over its dues, fast, leaving the non believers caught off guard. Crypto may have risen too fast, highlighting and exaggerating the exuberance of the all markets bubbles, but the fall in valuations don’t define the true value of what has been built so far. The underlying technology still works, Bitcoin is still processing transactions and piling blocks after blocks, while DeFi protocols are still accessible to daily users, and builders continue to express their vision through code. Code is law, and that hasn’t failed. What failed the space yet again, is human fuck ups. And God, that was one huge pile of fuckeries under the hood… The bright side is, the past 2 years bubble sponsored by the Fed allowed for billions of dollars to transit to crypto, getting to the hands of investors and builders, who now have the keys to keep the engine running.
The crypto 2020–2022 bubble was, by definition, a good bubble. A bad bubble is built on top of no foundation. It is a speculative mania that relies on zero fundamentals and thin air. Admittedly, there is a bit of thin air in crypto which needs to be washed out. This correction will take care of it and the strong will prevail. A good bubble on the other hand, can pop but still has foundations to rely and rebuild on. The crypto space as a whole definitely falls in the category of good bubble. From the amount of interest amongst sophisticated investors (the real ones) that have their eyes on crypto because of the vision and disruption the tech will inevitably provide, and the talents joining the space to build the future, it is clear that the industry is in good hands. We can picture good bubbles with the parallels of the automobile, or more recently the internet. Going back in time, the first cars were shitty. They broke down easily, were loud, uncomfortable, ugly and inefficient. In fact, distractors and non believers thought automobile would never succeed, thinking it was a bubble, and that horses were doing to same job without the flaws early cars had. But the idea was brilliant, and the vision of freedom it provided encouraged early believers to explore areas for improvement. Although the first cars didn’t work well, the foundations were built. The road system was being built, factories and supply chains in place, while millions of jobs created. Automobile was here to stay. The same can be said of the internet bubble in the late 90s/2000s. There were tons of new websites and services popping out of nowhere, most of them were crap, people were getting hyped, valuations were going through the roof, and the bubble eventually popped. But while the bubble was growing, the entire internet network infrastructure was being built in the meantime, thus guaranteeing that the space was here to stay. The trick part was to identify the good projects from the bad. Those who got it right made fortunes and more importantly, lessons were learnt for future generations.
What’s next?
Now that billions in wealth have been wiped out regulators will be more than happy to put their hands in the crypto mud and launch their “customer/consumer protection” crusade. It is about time that the space finally gets the regulation it deserves. And I insist on “it deserves”. Blockchain technology and cryptocurrencies are part of a disruptive industry that needs its own set of custom regulations. I do not believe that copy pasting traditional finance regulation to crypto would be productive as the innovation potential is limitless and we are yet to explore what the tech is capable of, and how it can genuinely improve current issues.
In terms of price action, the direction is down. “Bitcoin is back to its 2018 high, it’s $19K, it’s cheap” is not a valid argument. 2017 was a crypto market specific bubble pop. This is the first time crypto is going to experience a macro bear market. If you’re not provided with a fundamentally good reason to buy, then it’s not a good buy, regardless of the price.
I do not see this ending until the Fed lowers rates to fight the recession they themselves designed. And I don’t think trying to anticipate a Fed pivot is a good idea in an attempt to catch the bottom. Front runners will get trapped and punished. I would not try to jump start the Fed’s go. There is always a good 3 to 6 months between the time they start talking about it, and the moment they actually act. This was true for the hawkish pivot and will be for the dovish. Tom Loverro’s take on the crypto market is spot on in my opinion:
In terms of which monetary policy will be adopted after QT, I believe that some sort of QE will kick start the initial boost markets need before concluding to a more long term, sustainable policy which would be in my opinion yield curve control. I expressed my arguments for yield curve control implementation in my previous article.
So to conclude, crypto is here to stay. There will be some painful headwinds to face in the coming months but the space will rise from its ashes after the dust settles. The key to make it to the next bull run is to survive the temporary pain, which heads up, could take a couple years. We shall in the meantime not give up and pay attention to new trends and developments. In these periods of time, cash is king, and the more you’ll stack under the mattress the more comfortable you’ll be buying the fucking dip.
