Crypto in Context of US Debt Ceiling Drama
The recent news has been dominated by the US debt negotiations and the risk of the US default. How does it affect crypto, and how to trade it?
US CDS Rises
The US will soon hit a national debt limit, and that makes a case for a traditional standoff between the current administration and the opposition. This time the standoff is even hotter than usual, as the opposition Republican party seems to be determined to reduce government spending by almost any means. Donald Trump went as far as suggesting a US default if the current administration does not concede.
On the back of this news, the US CDS (credit default swap, i.e., default insurance) rose to the highest ever, far surpassing its previous high of 2011, when a similar standoff triggered a US credit rating downgrade.
1-year US CDS
1-year US CDS now implies higher default risk than 5-year CDS of many emerging market counties. (I compare 5-year CDS with 1-year CDS because of data availability; 5-year CDS are generally more liquid, but not for the US). The US seems to be riskier than Mexico.
| Country | CDS (bp) |
|---|---|
| Brazil | 228 |
| Morocco | 186 |
| United States | 178 |
| Oman | 177 |
| Mexico | 124 |
| Algeria | 148 |
| Bulgaria | 144 |
| Greece | 123 |
** 1-year CDS for the US and 5-year CDS for other countries. Source: Bloomberg
However, I note that the specifics of a CDS payout calculation overstate the actual US default risk in the current situation. An actual CDS payout is determined via an auction when a CDS holder supplies a defaulted bond and gets 100% of the bond's nominal value. It may be a physical settlement of bonds or a payment agreed upon by both sides. The specifics of the current situation are that long-term US Treasuries trade much below nominal values because of higher rates. That is not related to any credit risk and is purely explained by the macro factor of a tighter Fed policy. For example, let’s consider the 30-year US Treasury bond issued on May 15, 2020, with a 1.25% coupon and roughly the same yield. That was perfectly fine in May 2020 because of ultralow rates, but now the bond yield skyrocketed to 3.85% and its price plunged to about 56% of a nominal value.
Yield to maturity of T 1¼ 05/15/50 UST bond*
Most US Treasuries trade near nominal values, but long-term securities issued in the low-rate era are deeply discounted because of higher rates. That makes the current situation very unusual because a possible payout in the case of the US default is artificially inflated by the presence of some securities, which can be bought much below nominal value and sold at a potential CDS auction at 100% of nominal value. For most insolvent issuers, there is no differentiation between their bonds, which trade at roughly the same prices (as % of a nominal value).
Effect on Liquidity
I think that the effect on markets of the US debt ceiling drama is very counter-intuitive. The current standoff is positive for liquidity and so for the markets (including crypto) because the US Treasury spends money from its account (TGA) at the Federal Reserve. “The U.S. government runs most of its day-to-day business through the TGA - managed by the New York Fed and into which flow tax receipts and proceeds from the sale of Treasury debt.
When citizens or businesses receive a government cheque, they deposit it at their commercial bank, which presents it to the Fed. The Fed then debits the Treasury’s account and credits the bank’s account at the Fed - increasing its reserve balance. The TGA sits on the Fed’s balance sheet as a liability, along with notes, coins, and bank reserves.” – Reuters explained in 2021. By the way, the TGA decrease mentioned in this Reuters article was a primary factor behind a liquidity increase and the rally of both crypto and broader markets in 2021.
Debt resolution may actually be negative for liquidity, the markets, and crypto (maybe after a short rally) because the Treasury will increase the TGA, reducing liquidity. The TGA's current level is already low and will further decrease until the debt ceiling is raised, but the Treasury will increase the TGA back to a more normal level after this.
TGA (U.S. Treasury General Account, week average, USD billion)
The last time the TGA rose a lot was in the first 4 months of 2022. The Treasury took about $900 billion from the markets during this period, driving the markets much lower. Of course, Russia's invasion of Ukraine during this period was a major negative factor for the markets, but I believe that such a large liquidity outflow should have caused havoc regardless.
Thus, I think a likely resolution of the current debt standoff may be a perfect short-term opportunity to sell most assets, including crypto. Both crypto and broader markets may be supported until the crisis resolution, and the resolution as a positive event may be accompanied by a very short-term market rally (likely days at most), providing a good entry point for sellers.
What if US Defaults
An actual US default is a very unlikely but possible scenario. It may look like a technical delay of selected bond payments for a few days. It’s hard to make a blueprint for such an extreme scenario, but the credit rating downgrade episode in August 2011 is the closest example. At that time, the US Treasuries rallied, and gold shined. Stocks sharply fell but later recovered.
Performance of gold (yellow), long-term US Treasuries (green), 7–10-year US Treasuries (blue), and S&P 500 (black) in 2011*
In the case of a default, dollar cash is the safest asset, but on a time frame longer than a few days, the US Treasuries and gold are likely to perform well too. Given the relatively low implied volatility in the equity market, I think S&P 500 puts and VIX calls seem a perfect hedge for such a scenario.
For crypto, the question is whether it would behave more like some kind of digital gold or like technology stocks. Breaking previous historical correlations, during the recent banking crisis, Bitcoin performed like levered gold rather than technology stocks, and so I think Bitcoin should do relatively well in the default scenario. In the first few days of the possible default, crypto may be suppressed by a liquidity squeeze like most other assets, but after that, it may rally like gold in August 2011. Bitcoin is likely to outperform other crypto in this scenario.
Conclusion
The US CDS rose to the highest ever, but the specifics of a CDS payout calculation overstate the actual US default risk in the current situation because long-term US Treasuries trade much below nominal values due to higher rates. That is not related to any credit risk and is purely explained by the macro factor of a tighter Fed policy.
The effect on markets of the US debt ceiling drama may be very counter-intuitive. The current standoff is positive for liquidity and the markets (including crypto), because the US Treasury spends money from its account (TGA) at the Federal Reserve. Debt resolution may actually be negative for liquidity, the markets, and crypto (maybe after a short rally), because the Treasury will increase the TGA, reducing liquidity in markets. I think that a likely resolution of the current debt standoff may be a perfect short-term opportunity to sell most assets, including crypto.
*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.
