Tightened

As the bond market begins to price in the end of the monetary policy tightening cycle, it’s tempting to think that the crypto winter is also over, and a new, longer-term bull trend will emerge.

Why It Matters for Crypto

The crypto winter was caused primarily by large-scale tightening of the US monetary policy. Facing higher-than-expected inflation, the Federal Reserve .hiked the rates by a whopping 525 basis points (bp). The key Fed funds rate soared from 0-0.25% in 2021 to 5.25-5.50% now, pressuring virtually all assets. Crypto was particularly sensitive to expectations of tighter monetary policy as Bitcoin plunged by about 4 times from high to trough, fully erasing its 2021 rally.

Bitcoin (Black, Left Axis, Usd) and Fed Fund Rate (Blue, Right Axis, %)

The Cycle Turns

Now, the bond market perceives the end of the tightening cycle, so it’s tempting to think that the crypto winter is over too.

In the last several months dollar bond yields rallied (effectively increasing rates for the economy without further Fed rate hikes), the labor market cooled somewhat and, most importantly, inflation slowed more than forecasts. The last-week data showing lower-than-expected inflation was a key factor that forced the market to price an end of the tightening cycle. After the news, the market became sure that the Federal Reserve is done hiking rates, dismissing the odds of further rate hikes and pricing more rate cuts next year.

Implied Fed Funds Rate Path and Number of Hikes/Cuts Priced In

As of the end of October, the market was pricing a 25-30% chance of a hike in December, January, or March, having doubts about when the cycle will end. Now these doubts are gone.

Implied Fed Funds Rate Path and Number of Hikes/Cuts Priced in (As of October 31, 2023)

Compared with a month ago, the yield curve flattened for 6 months and moved down, particularly for longer maturities. Yields dropped by 40-50 bp for 5 years and more.

US Yield Curve (Current and 1 Month Ago)

Guess a Landing Type

As the tightening cycle nears an end, few scenarios are possible. The markets are pricing a soft landing, when inflation declines with only a moderate slowdown of economic growth. The current consensus forecast for the US economy suggests that inflation (as measured by the core PCE deflator preferred by the Fed) will continue declining from 3.9% in Q3 2023 to 2.3% in Q1 2025. Real GDP growth is expected to slow from 4.9% in Q3 2023 to about 0.5% in the next 3 quarters, remaining in positive territory and implying no recession. That allows the Fed to cut rates while the economy escapes a recession. The soft-landing scenario is obviously beneficial to both crypto and most other assets as the economy will remain resilient and liquidity will improve.

Current Consensus Forecasts for the US Economy

The issue with the consensus forecast is that soft landings are historically rare. In my view, a soft landing is more like a unicorn than a real thing. Given that the current cycle is unusual due to coronavirus effects, a soft-landing probability may be higher than usual but it’s still low.

The most obvious alternative to the consensus soft-landing scenario is a recession. As a bulge bracket investment bank recently wrote in a macro note, “Every hard landing begins by looking like a soft landing, and our concern is rising that a more significant slowdown is coming”. Indeed, a hard landing (recession) seems to be the most logical scenario for the next year due to the delayed effect of higher real rates and a lower fiscal stimulus. I believe that the primary reason for US economic resilience this year has been a huge budget deficit, which has started to decrease (albeit modestly). If there is a recession, risk assets will likely fall, but crypto increasingly trades more like gold than stocks and so may benefit from safe-haven flows. However, even gold usually falls during major risk-offs, so crypto resilience in such a scenario depends on how deep a recession will be. A mild recession looks positive or neutral for crypto, but a severe one would likely be negative for most assets except dollar cash and the safest bonds.

The third alternative is a no-landing scenario. The US economy may continue defying the gravity of high rates for some more time and/or inflation may rise further, forcing the Fed to tighten even more. That does not seem particularly probable from a pure macro view, but I fear that some kind of a supply-side shock (like an oil price spike from a possible Middle East war) may again worsen inflation prospects. In such a case, it would be 2022 all over again for most assets, including crypto.

Frankly, the probability of the third scenario may be not very small (although it’s still the least probable among the three scenarios), as the bond market is more than usually uncertain about the future. The implied volatility of US Treasuries is still very elevated compared with the last decade and remains near COVID-era levels.

Implied Volatility of US Treasuries (ICE BofA MOVE Index)

Conclusion

Following last week's news that inflation was lower than expected, the market became convinced that the Federal Reserve has finished hiking rates, dismissing the odds of further rate hikes and pricing more rate cuts next year.

As the tightening cycle nears an end, few scenarios are possible. The markets are pricing in a soft landing, which is beneficial to both crypto and most other assets. The problem with the consensus forecast is that soft landings are historically rare, and a recession seems to be the most logical scenario for the next year due to the delayed effect of higher real rates and a lower fiscal stimulus. Crypto resilience in such a scenario depends on how deep a recession will be. The third and least probable (although still possible) alternative is a no-landing scenario with sticky inflation, further rate hikes, and likely 2022 all over again for most assets, including crypto.

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