As above, so below

October 10th, 2022

In markets, history rhymes. Everything that needs to be said has already been said, but since no one was listening, everything must be said again, again and again.

The market macrostructure reflects its microstructure, and the same events are bound to repeat across both time and space. This law of correspondence is driven by the perennial forces that shape incentives and contribute to a repeating pattern of building tensions and their resolutions. Like clockwork.

The cross-market structure correspondence is well revealed by the rise and fall of crypto DeFi products. In DeFi, the rapid pace of innovation and unencumbered flow of capital result in a perfect microcosm of market structures, reflective of archetypal macro market forms. Any system fragilities of the above are quickly exposed on the DeFi level below.

As we know, inflation is always and everywhere a monetary phenomenon. The recent collapse of Terra Luna has served as a sober reminder of this immutable law, which holds true across all market plains. The same fate has been shared by the Turkish Lira, albeit over a longer time horizon. Given the multitude of failures across DeFi microcosm, one can be assured of encountering similar fragilities in the TradFi macrocosm. The law of correspondence will always prevail.

Summary

Successful Ethereum merge offset by hawkish monetary policy headwinds
Market risk sentiment weighed by elevated CPI and Fed’s QT guidance
The global crypto market cap decreased by 2% to $0.9 trillion in September
The pullback was led by ETH down 15%, with BTC falling by 3%
US Fed’s rate hiking haste exposing domestic and global market fragility
Soaring overnight reverse repo rate scooping domestic US dollar liquidity
Strong US dollar testing global central banks’ patience amid rising yields
Ethereum technical de-risking paves the way for institutional adoption

Fed’s Haste Rattling the Markets

One who is in a hurry always arrives late. After a decade of accommodative monetary policy, the Fed is on its second attempt to reign in the build-up of excess leverage. This time, the Fed’s hand is being forced by the runaway inflation, resulting from late monetary policy response to the post-Covid fiscal demand boost. Their haste is evident in the record pace of the rate hiking cycle, as compared to the first 6 months of the previous tightening cycles. The risk stems from a lack of temperance, similar to the previous loose monetary policy imbalance that can sway the pendulum in the opposite extreme, thereby exposing the market structure's fragility and excess leverage build-up over the past decade. In this hurry, down the rabbit hole one falls.

Domestic Pressures Abound

The pain from the Fed’s tightening on the US internal market microcosm is self-evident.

In response to the hawkish path, we are seeing a rapid deterioration in domestic US Dollar liquidity as illustrated by the elevated overnight financing rate and ballooning repo market balance. In effect, the Fed’s actions incentivise commercial banks to forgo real economy lending and credit creation by inducing elevated rates in a risk-free repo deposit. In truth, the Fed can only estimate the minimum level of banking reserves required for the functioning of the US real economy. Given the rapid pace of change and levels of the key domestic US Dollar liquidity indicators, the microstructure capacity for additional Fed tightening appears limited.

The limit of the Fed’s additional tightening capacity is also evident in the rapid tightening of the US broad financial conditions (money markets, debt and equity), to the levels approaching March 2020 market sell-off. In parallel, we see significant equity price pressure, along with elevated implied volatility risk premium. This creates a significant issue, given that most US pension funds are less than 70% funded, with a total of $1.3tr in unfunded future liabilities. Therefore, any market pain and drawdown must be transitory to ensure pension fund solvency.

Mounting Global Pressures

Zooming out, the external economic pressures in the global macrocosm are also building.

The enduring dominance of the US Dollar in global trade and financial infrastructure comes at a high cost in periods of economic deleveraging and rising demand for US Dollar liquidity. The rhyme of history reveals a cyclical pattern of major adverse global economic events coinciding with rapid US Dollar appreciation. Admittedly this process is reflexive, as major economic stress increases safe-haven US Dollar demand and retrenchment of US capital. In parallel, the coinciding deprecation of local currencies reduces the key affordability metrics of outstanding US Dollar denominated debt. Thereby creating a vicious cycle that typically resolves through debt restructuring and coordinated US Dollar devaluation against foreign currencies and more importantly real assets (commodities and real estate). The story of the macrocosm is once again approaching this resolution.

The current story antagonist reveals itself as the global inflationary pressures that target the structural fragility of the global bond markets. After a decade of loose monetary policy and suppressed real yields, the bond market investors were pushed into leveraged long-duration asset exposures to meet fixed-income obligations. However, the surprise entrance of the inflationary antagonist and the haste of the Fed’s response caught these investors off guard, leading to a record bond price sell-off (down 20% YTD) and significant portfolio losses. As pressure mounts, we expect to see additional signs of bond market fragility that will inevitably be met with local central bank intervention, as was the case in the UK.

The central bank of tea and crumpets is not alone in feeling the pain of the US Dollar liquidity squeeze. The Bank of England is in the good company of the central banks of Japan and China, the biggest international holders of US Treasury securities. We are seeing both countries reducing their Treasury holdings to support rapidly depreciating local currencies, which reduces export competitiveness and fuel import price pressures. This self-reinforcing loop is expected to persist until we see either a coordinated USD Dollar devaluation or the Fed signaling a pause in its tightening cycle. Absent this, the Treasury selling pressure will likely escalate and force Fed to extend US Dollar swap lines to selected central bank partners. In addition, the geopolitical tension from the Taiwan dispute further adds to the downside bond price narrative.

Temporary Relief On the Horizon

As the law of correspondence in structural market weaknesses and mounting economic pressures holds across microcosm and macrocosm realms, the range of probabilities is once again shifting towards softening of hawkish guidance and the associated bear market relief rally. At this stage, given the extreme negative investor sentiment, the path of least resistance is up.

Looking at the historical bear markets in Nasdaq and Bitcoin, one should not be surprised to see a 30 to 50% price rally in the event of market short positioning caught offside. So far, we have seen two shallow Nasdaq relief rallies of 12% and 24% in March and July respectively, four months apart. The catalyst for this move will most likely come from market pricing of peak US inflation and rates in Q1/Q2 of next year combined with extreme current short investor positioning.

In addition, the passing of seasonally negative Q3 and the start of historically positive October BTC performance creates positive sentiment tailwinds. The September underperformance stems from lower liquidity as European banks tend to shore up capital for quarter-end regulatory snapshots. The historic October outperformance reflects both a relief rally and the need for investors to deploy risk into the new quarter. The seasonal positive reflexivity also points to a near-term upward path.

Successful Ethereum Merge

Macro forces aside, the underlying fundamentals of the most popular Ethereum blockchain network are steadily improving post a flawless mid-month merge to Proof-of-Stake consensus layer. Despite the build-up and anticipation, the PoS transition was mainly a non-event, thereby more than delivering on its promise of seamless upgrade. The plane engine was changed to a more energy-efficient one, with the plane still flying safely in mid-air.

The improvement in Ethereum fundamentals is most evident in the pullback of short ETH derivative positions after the merge, reflected by the normalization of the perpetual contract funding rate. This pullback in funding rate is mostly indicative of technical ETH de-risking, and a small implied premium from ETH Proof-of-Work (PoW) distribution for hedged ETH spot positions. With technical event risk out of the way, Ethereum is on a solid footing for future user adoption and investor participation.

As expected, the ETH tokenomics also improved significantly post-merge. Although the net issuance of new ETH has yet to become truly deflationary, it has nonetheless declined more than 95% as compared to the PoW. Given the low level of current on-chain activity and the associated low ETH burn rate, one can expect a meaningful pick-up in the future that will inevitably result in deflationary net issuance. In addition, the removal of PoW miner selling supply pressure is expected to provide further fundamental tailwinds.

On the demand side, we see Ethereum maturing into an institutional ESG-compliant alternative asset with a clearly defined utility value and a sustainable expected yield (4.2% APR). The PoS upgrade has established ETH as a bond-like instrument with a significant upside price optionality that can be hedged away in a growing derivatives market to meet investors’ risk appetite and return objectives.

Finally, despite the macro headwinds the underlying Ethereum developer ecosystem is continuing to grow, with steady application improvements and innovative protocol launches. As the fundamental value of any network is ultimately driven by the variety and quality of the user-facing applications, the current positive on-chain microcosm momentum paves the way for future value accrual to macrocosm ecosystem participants. As above, so below.

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Thank you,

OX1 Team