X Marks the Spot

BTC, ETH, and broad risk ran out of steam in a somewhat perplexing week, lacking a clear driver. Flows consequently dominated, and unexplained persistent selling of BTC triggered long liquidations and a full unwind of the prior week's well-won gains. Indeed, Wednesday saw the biggest long liquidation event this year, according to Coinglass, with circa $262.5 mio positions liquidated👇.

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Consolidation then, with BTC and ETH having failed to gain momentum over 30k and 2,000, respectively, and the lethargy supporting a drift lower.

Bubbling Bank Stress 👀

The favorable macro tailwinds also faded somewhat over the past week. Persistent hawkish rhetoric from Fed officials alongside a seemingly becalmed banking sector seeing markets price out the aggressive rate cuts for 2023, although the June/Dec Eurodollar interest rate contracts suggest 70bps of cuts are still priced. A 25bp hike for May is also now pricing around 90% probability, and markets are pricing in a 25% probability for an additional hike in June, challenging my expectations for “one and done.”

The Fed balance sheet also contracted $17.6bn this past week. China reported strong GDP at 4.5% YOY on the quarter, up from 2.9% prior, dampening expectations for continued credit pumping (worth noting Total Social Financing in Q1 was equal to nearly 51% of the GDP recorded - this patient still relying on the intravenous credit drip!)

Interestingly, the Fed emergency loans to banks rose for the first time in 5 weeks, with the discount lending facility up at $69.9bn Vs. $67.7bn and the Bank Term Funding Programme (BTFP) up to $74bn Vs. $71.8bn the week prior. US bank deposits also resumed outflows, falling $69bn to the lowest levels since April 2021. Underlying financial stress remains, and I suspect the longer the Fed rates stay up here, it’s a matter of when not if we have another bank failure. The Fed balance sheet may have given back a little in recent weeks, but the liquidity support will continue to be needed indefinitely. The financial system is addicted to low rates and liquidity. The higher the rates, the more liquidity will be required to offset, which is why the Fed’s balance sheet has expanded so far in 2023, despite reducing treasury holdings via QT.

Credit Crunch

Underscoring the real economy impacts of these banking strains, the Fed Beige book suggested the expected credit crunch is underway, as lending standards tightened “notably” with “several depository institutions opting to reduce loan volumes.” Take a look at some of the summary comments from regional Feds 👇.

New York Fed: “Conditions in the broad finance sector deteriorated sharply, coinciding with recent stress in the banking sector. Regional banks continued to report widespread declines in loan demand, ongoing credit tightening, and modestly rising delinquency rates.”

Philadelphia Fed: “Banks reported tighter lending standards. Expectations were subdued as sentiment remained cautious.”

St Louis Fed: “Banking contacts reported slowing loan growth and a decline in deposits.”

Kansas City Fed: “After tightening credit standards over the past several weeks, many contacts reported expectations for further tightening or more strict pricing related to credit risks.”

Dallas Fed: “Credit standards and terms tightened sharply, and marked increases in loan pricing were noted. Banking outlooks continued to deteriorate, with contacts expecting a contraction in loan demand and business activity and an increase in nonperforming loans over the next six months.”

JPow has alluded to the possibility that a tightening in credit conditions would work like rate hikes, and that tightening looks to be well underway. However, this slow-moving credit crunch keeps me comfortable that May’s hike will be the last of this cycle 👊.

Whilst the comprehensive data has thrown up some mixed signals, the general pulse is weak, encapsulated by the latest Conference Board Lead Economic Indicators, which fell by 1.2% in March and the lowest levels since mid-2020. The weaknesses in the index were widespread and pointed towards a recession starting mid-2023 👇.

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In this context then, the move higher in US yields this week looks wrong, with 2yr yields up 8bps and 10yr 5bps higher on the week. Oil, juxtaposed, reflecting the weak growth outlook, down 6% on the week and almost closing the post OPEC cut announcement spike. This does not look like a “reflationary” world for markets to start pricing in a higher rate profile 🤔.

X-date looming

Muddying the waters this past week has also been the US tax repayment deadline which may, in and of itself, have weighed on broad assets as they get sold to raise the cash to make payment. However, tax receipts were also disappointing and have brought forward expectations that the “X-date” (when the US government runs out of money) will be reached by June. This has driven a significant move in 1-month yields down to 3.35%, Vs. 3 month at 5.11% as investors seek to avoid the risks of a potential stalemate in the debt ceiling negotiations and subsequent default. Indeed, US sovereign risks, as measured by 1yr CDS prices are at a record high.

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Of course, the US will not nominally default (they default by stealth through inflation and currency debasement), and as with any negotiation, time is the most significant point of leverage and so an agreement will be reached, but only in the eleventh hour. The Treasury Cash balance held at the Fed currently stands at circa $250bn and will be the number to watch as that depletes.

Whilst I’m not concerned then about default as the “debt ceiling” will be perpetually raised (they should call it a debt target, not a debt ceiling!), the biggest concern is as it relates to liquidity. When the debt ceiling gets lifted, the US Treasury will be able to issue debt once again to raise cash and rebuild the cash balance (TGA) held at the Fed and subsequently drain liquidity from our markets.

Perhaps the sell-off in BTC this past week is in anxious anticipation of that moment coming close. Of course, there are many moving parts to these things and potential off-sets, but this will be the biggest challenge to my bullish view of crypto in the short term and something we will monitor closely.

Ironically, in the bigger picture, this debacle only once more highlights the value proposition for Bitcoin as the US can only survive on yet more debt, which eventually finds its way back onto the central bank balance sheet and will continue to debase the value of fiat. From a purely narrative point of view, the short-term liquidity-draining impact of increased debt issuance could well be offset by this realization, as BTC is the ultimate hedge against the credit-based fiat system's failure and unsustainability. The long-term bull case for crypto continues to strengthen 💪.

Heading into this week, I expect the US rates to retrace and yields to move lower, which should put a floor under BTC and ETH. Clearly, after last week's liquidations, long positioning is cleaner and allows for some length to be added.

After the initial scramble to add downside protection on the spot break lower, we also started to see some decent buying of May bull risk reversals to take advantage of the flippening in skew towards puts in the front end. ETH skew is now trading for puts over calls out to 90 days as the positive post Shapella momentum fades.

With the positive spot/vol correlation seeing vols drip lower, we expect to see demand to buy topside wings return which will provide some comfort that the broad direction of travel for crypto remains higher. Still, as always, we remain on the lookout for any significant change to the pattern and structure of flows from the client base.

For now, nothing to signal any significant change in sentiment, just some position management as we consolidate and await the next catalyst. This consolidation looks healthy in the context of a new bull market, which, I think, crypto is now in.

Sincerely,
David Brickell 💜