TheChek News Flow

1/ As digital assets enter the mainstream, market commentary focuses on price. And in a world where exchange rate volatility is near all-time lows, attention has naturally shifted to digital assets where volatility against the US dollar is breathtaking by comparison. The megatrend towards the digitalization of finance will not be defined by the shorter-term gyrations. The innovation happening more behind the scenes will dictate the secular formations. Recent advancements in the Lightning Network illustrate the quiet determination to digitalize finance.

2/ The Lightning Network was proposed in 2015 as a way of scaling smaller payments, able to accommodate billions of transactions in a second (here). It addressed the tiring argument of Bitcoin’s inefficiency head-on. And after a slow start, user adoption surged last year with a 3-fold rise in network capacity (Figure 1). It is also integrating into the regulatory mainstream. This week, Bottlepay, a payment provider built on the Lightning Network, was approved by the UK Financial Conduct Authority. These new technologies can hold up to regulatory standards including anti-money laundering (here). It is a powerful example of technologists and regulators working together to encourage innovation in a complacent legacy system.

3/ Innovation may drive the megatrends, but investors are still left to manage and explain portfolio volatility from digital assets. And just as digital innovation is garnering more institutional attention, so too are the narratives around the volatility of digital assets. Investors are looking for macro thematic narratives, including the sharp downturn since November and the abrupt decline to start the year. Explanations center on the downturn in inflation expectations, the Fed pivot toward faster rate hikes and balance sheet normalization, as well as the decline in growth stocks tied to the rise in real interest rates. The high correlation of bitcoin returns to inflation expectations last year (56%) reinforces a desire to put a tidy macro narrative to the digital ecosystem.

4/ But the analytics tell a different story. We run a simple empirical exercise to evaluate bitcoin returns as explained by three macro factors: market-based inflation expectations (5y5y inflation swaps), the inflation-adjusted terminal policy rate (5y5y overnight interest rate swap less 5y5y inflation swaps), and Nasdaq 100 equity returns. These factors only explain 10-45% of the variation in bitcoin over the past two years and with various representations of the data. More importantly, there is almost no relevance of these factors in explaining the bitcoin downturn since November. Those factors would imply a bitcoin price of 50-60k, much higher than the current price.

5/ What does that mean for investors? Digital assets volatility has been largely independent of macro factors in the recent past. To be sure, the independent volatility that most investors hope for is skewed to the upside. But in assets where volatility expectations have ranged from 55% to 158% in the past two years, there will be plenty of periods where idiosyncratic moves detract from a portfolio. The test for any investor is asking about the structural trends. What tokens will prosper with the digitalization of finance? How broad will token pluralism extend? If the answers to the structural questions are positive, then downside volatility should be met with programmatic rebalancing into digital assets.

6/ Of course, idiosyncratic volatility is not satisfying. It is a polite way of saying we need to dig deeper for an explanation. What is behind the swings in digital assets if the macro narrative falls flat? The hunt for the explanation is partly a process of elimination and partly identifying new patterns of behavior. There are three key elements of the market microstructure of interest.

7/ First, the bitcoin forward yield curve has been stable, indicating leveraged trading is not a source of downside volatility. Figure 2 illustrates the one-month annualized yield implied by bitcoin futures on the Deribit exchange, where leverage is more readily available to traders. A rise in speculative demand leads to higher forward bitcoin prices and higher implied yields (vice versa). In periods of excess leverage, forward prices fall more than spot as speculative traders forced to close positions at unfavorable prices. Last May, one-month yields fell to an annualized –75%, reflecting a costly, steep inversion of the forward curve to speculative long traders. On this downturn, the compression in yields is barely visible.

8/ Second, option markets have decoupled from previous correlations to spot prices, with declining volatility expectations. The one-week implied volatility on Ether is 70%, near the lows of the past year (Figure 3). Ordinarily, declines in spot prices, particularly severe ones, would have seen a surge in volatility expectations. However, volatility is low despite a sharp decline in spot prices. The same pattern is evident in 25-delta put-call volatility skew. The one-week skew in Ether options is only marginally positive, near the average of the past year. This is strongly counter to past downturns in spot prices, where option skew spiked well above 40%! Again, leveraged trading is not the source of the recent price weakness.

9/ Third, a rise in the dispersion of digital asset prices hints at a change in investor behavior. We illustrate this point with a unique parsing of the data based on the last two downturns: May 8, 2021 and Nov 9, 2021. Dispersion is measured by the median difference between the individual returns on the 12 assets of our Core Index and bitcoin returns. When Index asset returns are evenly dispersed around bitcoin returns, the measure is zero. The one-month dispersion in the latest downturn measures near-zero (–0.4%). This is vastly different from May 2021, where the one-month dispersion index measured –9.1%. Index assets exhibited higher beta to the bitcoin downturn. No doubt, two cyclical periods don’t make a trend, but it does call for attention.

10/ Market behavior is bifurcating. It is evident in futures markets, where the decline in yields has been greater in regulated markets (CME) than in unregulated ones (Deribit). It is evident in active supply, where the percentage of longer-term holders has dropped alongside a more-than 20% fall in large-value bitcoin addresses (greater than $10mn). It is evident in the surge of interest in venture applications (here). Investors focused on macro narratives have mattered more than leveraged traders. And it is these ebbs and flows that should remind investors that we are at the very early stages in the digitalization of finance. It is precisely in those imperfect, inefficient early stages where megatrend assets are most additive to a portfolio.

The first two weeks of the year have reinforced the key message from our 2022 Strategy Outlook – the policy training wheels are indeed coming off, and fast! The hawkish shift in the minutes of the FOMC’s December meeting, reinforced by the rhetoric from a number of Fed officials, signals policy tightening through more hikes. They are coming sooner than expected, and the timeline between the first rate hike and the beginning of balance sheet runoff will be compressed. Our economists now expect the Fed to deliver four 25bp hikes this year, at its March, June, September,and December meetings, in addition to an August start for the balance sheet runoff announced last July. Market pricing already reflects this hawkish shift, with the March liftoff nearly fully priced in along with 3-4 hikes in the subsequent 12 months.

Given the size of the Fed’s balance sheet (US$8.2trillion, consisting of US$5.6 trillion in Treasuries of varying maturities and US$2.6 trillion of agency MBS), the runoff has important market implications. However, quantifying its impact is far from straightforward. One could look to the balance sheet expansion in the post-GFC years with the view that if the buildup lowered interest rates, the runoff should have the opposite effect. A rule of thumb (with a lot of handwaving) suggests a 4-6bp change in the 10-year interest rate from a US$100 billion change in the balance sheet. However, we would argue that the market effects are unlikely to be symmetric and a simple sign reversal between the buildup and the runoff ignores the complexity of the modalities. We expect different impacts for Treasuries and agency MBS, given the different ways they were acquired during the buildup and the share of the Fed’s holdings in their respective markets.

During the balance sheet buildup, Treasury securities were predominantly acquired through the US Treasury’s new issue process. The Fed consciously decided how much duration to take out of the market by picking securities with varying maturities. In contrast, we expect the balance sheet runoff to be implemented by allowing securities to mature without reinvestment. That means the impact on the yield curve depends on how the Treasury responds to its increased issuance needs as the Fed decreases its Treasury holdings. Our interest rate strategists estimate that US Treasury issuance needs will rise by ~US$850 billion by the end of 2023and ~US$1,300 billion by the end of 2024. If we assume that the Treasury follows the advice of the Treasury Borrowing Advisory Committee, the optimal targets for increased issuance would be at the 7-year and 10-year points of the yield curve. Consequently, our strategists now forecast 10-year rates to reach 2.30% by the end of 2022.

The story with agency MBS is quite different. Agency MBS were purchased in the secondary market,and we expect their runoff to come through paydowns resulting from prepayments and amortizations of the underlying mortgages. Since the Fed has been a non-price-sensitive and programmatic buyer, the Fed's portfolio of agency MBS would have received faster-prepaying mortgages (cheapest-to-deliver, in mortgage parlance). In addition, Fed holdings constitute a much larger share of the outstanding agency MBS market than of the Treasury market, hence the runoff will have a greater negative impact on agency MBS. In 2021, the Fed bought US$575 billion of agency MBS versus net issuance of US$875 billion, resulting in US$300 billion of MBS that the market absorbed. Our agency MBS strategists project that in 2022 the runoff will remove US$15 billion from the Fed’s balance sheet against projected net issuance of US$550 billion, implying that the market needs to absorb US$565 billion in mortgages, the largest amount of mortgages the private market would ever digest. What’s more, the market will have to find a more price-sensitive buyer for the cheapest-to-deliver mortgages. Putting it all together, the balance sheet runoff clearly will have more impact on agency MBS than other asset classes.

Of course, the markets have already begun to price in some of these effects,as mortgage spreads have widened about 20bp in the last two weeks. Still, our agency MBS strategists have advocated being short the mortgage basis for some time,and they think there is still room for modest widening (~10bp) in the mortgage basis from here, with mortgage rates rising towards 4%.

Do not underestimate the effects of liquidity withdrawal. The mammoth balance sheet the Fed has built up was a key determinant of liquidity across markets. As balance sheet runoff is put into motion, the withdrawal of liquidity will have profound impacts. Determining how it plays out is far from straightforward and will be determined by a variety of factors. Understanding the details matters. So hold on tight – there’s volatility ahead.

After two months of brutal, constant pain for crypto longs on the back of fears the Fed is about to yank the punchbowl and drain enough liquidity to end the party (at least until the next recession and market crash, when the Fed will double-down on easing, launch NIRP, buy equity ETFs and upgrade helicopter money to tactical money ICBMs, finally sending all cryptos to the moon and beyond), the tide may finally be turning at least according to the options market.

After bitcoin suffered its biggest drop since May 2021 as it tumbled more than 40%, sending the price to the most oversold level since the covid crash - traditionally a failsafe bullish indicator...

.... the world’s largest cryptocurrency rebounded this week after falling below $40,000 for the first time since September on Monday and has bounced as much 10%, just as we said last weekend it would.

In short, Bitcoin appears to have stabilized, and options activity suggests investors believe the test of $40,000 - a critical support level below which Mike Novogratz said last week is where he would buy more (and appears to have done just that)...

... is over, and more upside is ahead, according to Genesis Global Trading including Noelle Acheson.

For one, the skew - or difference in implied volatility of bullish and bearish bets - has recently dropped from double-digits to near zero, and revealed a decrease in investor demand for put options and an increase for call options, Genesis data show.

“That shift in preference may be bullish for the price of BTC, all else equal,” Acheson added, and indeed a look at the option-implied probability cone shows an upside target just shy of $10,000..

It's not just option traders and billionaire investors who see $40,000 as a bottom- it is a view echoed by many analysts in the famously optimistic world of crypto. Quoted by Bloomberg, Martin Gaspar and Katherine Webb at CrossTower said in a Friday note that Bitcoin’s reserve risk, a measure of confidence of long-term BTC holders, is currently lower than it was at the coin’s last bottom in July 2021, and now stands in the “buy” zone, which could give “more weight to the indication that this is a bottom.”

The $40,000 level “has been the key pivot point,” said Bloomberg Intelligence’s famously bullish crypto analyst, Mike McGlone. Up next, $50,000 comes into play before Bitcoin resumes its upward trend toward his forecast of $100,000, he said.

“Demand and adoption are increasing and supply is declining,” McGlone said. “Something has to reverse the increasing Bitcoin adoption trend or the rules of economics point to higher prices. I expect demand and adoption trajectories to remain favorable.”

McGlone isn’t alone in his calls for Bitcoin to more than double from current levels. According to Bloomberg, Jonathan Padilla, co-founder of Snickerdoodle Labs, a blockchain company focused on data privacy, expects Bitcoin to hit that level by the end of 2022, and also said that $40,000 is likely a floor, given the level of institutional capital he expects to flow into the market this year.

“The institutional nature is dramatically different from the primarily retail focus in 2017, 2018,” Padilla said. “That shows the strength of institutional buying and the demand from the long-term perspective.” Of course, this cuts both ways, because when institutions are deleveraging, they dump those assets first that have outperformed in 2021 - such as cryptos - which is also why crypto's correlation to risk assets has exploded as institutional adoption has grown.

David Tawil, president of ProChain Capital, was ready to watch the $38,000 level in this past week’s sell-off. But, he hoped to see U.S. tech stocks start to rebound, which signals to him that “the bottom is in” for Bitcoin, he told Bloomberg’s “QuickTake Stock” broadcast.

“This is a pretty good buying level, especially if we go ahead and just retrace the losses -- you’re talking about a 50%-plus gain from a year,” Tawil said.

A surprising view comes from some of the biggest crypto skeptics around - JPMorgan, and specifically their clients, who have recently initiated a new target price for Bitcoin for this year of 2022. In a recent report, America’s largest commercial bank asked its clients where they see Bitcoin by the end of 2022. Based on the results, nearly 41% of clients believe that Bitcoin could be trading at $60,000 or above by the year-end, or about 50% higher than the current levels and more than what other asset classes can offer.

Others are less bullish. Another 23% of JPMorgan clients believe that BTC will be available at a 50% discount from the current levels i.e. $20,000. While another 20 percent believe that Bitcoin will be trading flat at $40,000. Only a mere 5% believe that Bitcoin will be trading above $100,000 levels.

Marko Papic, chief strategist at Clocktower Group, is another skeptic - he warns that Bitcoin’s correlation with the S&P 500 remains at one of its highest readings in the past 12 months; this is happening just as tech names have swooned amid fears of a hawkish Fed. In this environment, “you don’t really want to own high-beta risk assets,” he said. “You want to own things that are much more sensitive to value, much more sensitive to global growth and cyclicals, and that’s why I don’t think crypto and Bitcoin are going to really do great over the next three to six months.”

In his latest Crypto Keys note (available to professional subs), UBS FX strategist James Malcolm has turned quite bearish on crypto, writing that the recent drop in bitcoin prices is the result of disappointment with the SEC not approving ETFs, as well as three other reasons: 1. It's not better money; 2. The technology may prove subpar; 3. Regulation is a rising hurdle. While we disagree with all of these points, UBS does point out something notable: whales now own more bitcoin than ever before.

Meanwhile, as debates rage what's next for crypto, one thing that is certain is that China's attempt to crush the largest cryptocurrency last year when it banished all crypto miners has now failed (and backfired) spectacularly:

Bitcoin’s hash rate has returned to all-time highs despite losing a key hash rate contributor. Meanwhile, amid lackluster price action, Block CEO Jack Dorsey confirmed the creation of an open Bitcoin mining system. according to CoinTelegraph, while Kazakhstan, the network’s second-most important BTC mining country, experienced an internet blackout last week due to civil unrest, the hash rate faltered no more than 13.4% before regathering to reach all-time highs.

As shown in the data below from Glassnode, with the price checking into the $42,000 range on Thursday, the mean hash rate hit 215 million terahashes per second.

Said otherwise, Bitcoin miners continue to show resilience, and as Fidelity Digital Assets observed, the network is even “more widely distributed around the world.”

As testament to this, Jack Dorsey's Block confirmed it would develop open-source Bitcoin mining systems in 2022. In the Twitter thread, Thomas Templeton, a general manager at Block, addressed issues relating to the availability, reliability, performance and products pertaining to BTC mining. In sum, Block’s goals for BTC mining are the following:

Building a BTC mining system “out in the open” and alongside the community is no mean feat. Econoalchemist, an established home BTC miner and BTC magazine contributor, tweeted that developing products in open source would “build trust where no reputation exists currently and also might shift consumer expectations in that direction.”

Ultimately, Block’s mining solutions may pave the way for more DIY miners to enter the space.

Ultimately, it seems the sky’s the limit for Bitcoin’s hash rate, at least until the next 2,016 blocks, when the network difficulty resets.