Bonds May Support Crypto Next Year

This year bear market in bonds has been brutal, but there are signs it may end relatively soon. Given crypto’s historical correlation with real rates, it should provide support for crypto at some point in the future (likely next year).

Are bonds bottoming out?

It increasingly looks like long-term risk-free bonds (US Treasuries) may have bottomed. Better-than-expected US inflation figures published on November 10 sparked rethinking of a mid-term inflation path. Annualized core inflation was as low as 3.3% after 6-9% figures typical in the last 12 months, and details of the CPI report were even more encouraging. Domestic services prices, which are particularly relevant for monetary policy, unexpectedly slowed. That led to a widespread rally, forming a potential double bottom in the long-term bonds.

iShares 20+ Year Treasury Bond ETF (TLT)

The yield curve is now inverted (i.e., yields for the longer term are lower). While it’s not a market timing indicator for buying or selling duration, it does show that current short-term rates may be unsustainably high. Long-term rates are significantly lower than short-term rates because the market believes that short-term rates will be reduced in the future. Current US Treasuries yield is 4.29% for 3 months and just 3.82% for 10 years, and the difference between them is near multidecade lows.

Spread between 10-year and 3-month US Treasuries yield (%)

Shaded area represents recessions

The spread between the 10-year US Treasuries yield, which reflects rates prevailing in the mid-term, and the 2-year yield, which reflects a monetary policy rates path, is the highest since the early 1980s. In relative terms (i.e., divided by the absolute level of rates), the spread is even higher, because in the early 1980s rates were double-digit. The spread suggests that the current monetary policy is extremely tight.

Spread between 10-year and 2-year US Treasuries yield (%)

Shaded area represents recessions

To be clear, there are still a lot of risks for the duration. I think the most significant ones come from the Bank of Japan and deteriorating dollar liquidity. First, there is a last major central bank carrying out a zero-rates policy. If (or when) the Bank of Japan exits from the current loose policy stance, it will likely be a knee-jerk quick and big move up in global rates (and down in terms of bonds prices). Second, there are signs of deteriorating dollar liquidity, pointing to a potential stress event like the coronavirus panic in March 2020. That is probably more relevant for risk assets like stocks, but at least some segments of the US Treasuries market can be vulnerable too.

The Fed to cut rates next year

The Federal Reserve approaches the end of its tightening cycle. There is considerable uncertainty regarding the ultimate high of the policy rate and the timing of cuts, but there is little doubt that the policy rates will peak sometime in the first half of 2023. According to the last-week poll of major bank economists by Bloomberg, “while there is a broad consensus in predicting the Fed will raise its benchmark rate by 50 basis points to a range of 4.25% to 4.5% in December and then to around 5% by March, that is where agreement over the outlook ends”. After March 2023, some economists anticipate fast cuts while others suggest a flatter policy rates path, depending on how the US economy will handle high rates.

Historically, bonds usually bottomed out near the end of tightening cycles. While the exact timing is uncertain, this point becomes more or less close.

Crypto and rates

At the first glance, cryptocurrencies seem to be far from macro variables embedded in the bond market. However, crypto prices reflect available liquidity and a risk appetite for assets without immediate cash flows, making them dependent on long-term rates.

Historically cryptocurrencies had been both inflated and deflated by real (inflation-adjusted) rates. A long period of declining real rates led to Bitcoin skyrocketing from $5000-10000 in 2019 and most of 2020 to $40000-60000 in 2021. Conversely, a real rate uptrend in 2022 deflated Bitcoin price back to about $15000.

Bitcoin (orange, left axis) and iShares TIPS* Bond ETF (blue, right axis)

* TIPS are inflation-protected bonds

From this point of view, a potential bottom of the global bond market is a big positive for crypto. That is a mid-term factor rather than a short-term catalyst, but lower long-term rates and better liquidity prospects should provide support for crypto prices at some point in the future. Now may be too early to make a call for a crypto purchase based on a possible bond bottom, but sometime in the next year, this factor should start working in favor of crypto.

The caveat is that crypto is much more sensitive to real (inflation-adjusted) rates than nominal ones. Falling inflation expectations due to tight monetary policy and a possible recession may increase real rates even as nominal rates decline. For example, nominal bond prices rose more than real ones on the recent inflation news on November 10. That makes real rates lag nominal ones, and so real rates topping out (bottoming out in terms of prices) may take more time than nominal ones.

iShares TIPS Bond ETF (orange) and iShares 7-10 Year Treasury Bond ETF (blue)

Indexed at 100 as of October 21, 2023

Conclusion

It increasingly looks like long-term risk-free bonds (US Treasuries) may have bottomed. There are still risks for the duration, and bottoming is a process rather than a point, but a very tight current monetary policy is likely to reduce inflation a lot, supporting long-duration assets. Given crypto’s historical correlation with real rates, it should provide support for crypto at some point in the future (likely next year).

I would go as far as saying that current high rates lay a foundation for the next bubble, because too tight monetary policy may bring back a deflation threat, forcing the Fed to revert back to aggressive money printing at some point in the future.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.