Perennial tug-of-war forces

September 7th, 2022

Life forces animate vitality. All forces come in pairs, such that for every action there is an equal and opposite reaction. The greater the tension of opposites, the greater the potential energy for creative or destructive resolution along the path of least resistance. This tug-of-war cycle repeats to the rhythm of the perennial beat of life.

Markets are also animated by opposing forces. At the very core, the human forces of fear and greed translate into economic forces of supply and demand that ultimately determine the clearing market price. As the destructive force of fear subsides, greed stimulates demand that is matched by the constraining force of supply and the balancing tension of price. The balance of price reflects the friction or inertia of each opposing force.

All market participants, including US Federal Reserve, are mere players who are subject to the same perennial tug-of-war forces. The rhythm of opposing forces varies in frequency, amplitude and duration. These main economic forces are productivity, debt cycles and inflation, which are managed through a mix of fiscal and monetary policy tools. The Fed is perpetually attempting to balance the opposing dual mandate of price stability and full employment through the adjustment of the friction of US dollar liquidity.

The issue arises from the global distribution of the US dollar-denominated liquidity, with the foreigners holding over 30% of US national debt and the Eurodollar market eclipsing the domestic US dollar deposits. Fed’s resolution of the domestic dual mandate tensions via higher policy rates, inadvertently creates significant orthogonal economic and geopolitical tensions.

These external imbalances are reflected in falling global FX rates, rising import prices, domestic inflation, and most importantly food shortages that expose inherent tension of wealth disparity. The most likely resolution is along the destructive path of least resistance through radical political change, as the pendulum swings back along the axis of political freedom and economic equality. This tug-of-war cycle of social and economic change repeats to the rhythm of the perennial forces of our biological impulses.

Summary

Fed hawkish guidance and thin liquidity profit-taking weighed on sentiment
The global crypto market cap decreased 10% to $1.0 trillion in August
Pull back was led by BTC down 14%, with ETH falling by 8%
BTC futures volume hit a 21-month low in August, as ETH volume surged
Fed lack of policy pivot weighed on risk, despite expected CPI pull back
Resilient US labour market emboldens Fed's QT guidance
Risk off spilled over to digital assets, with profit-taking dominating
Ethereum merge narrative closed the Bitcoin performance gap

Fed’s Stealth Qualitative Tightening

As we know, US Fed sets the rules for US Dollar liquidity that ultimately determine all risk asset prices and investors’ return on capital. Cash is trash, but only when the liquidity is flush. As the Fed drains the bank cash reserves, using monetary policy and macroprudential tools, asset prices decline and liquidity premiums rise. If pushed far enough, a liquidity squeeze may quickly escalate to a full-blown solvency crisis (e.g. 2008 GFC and 2019 repo spike). This would cause the Fed to reassess its tightening strategy and once again flood markets with new US Dollar liquidity, setting the stage for the next asset price rally. For every action, there is an equal and opposite reaction.

In September, Fed is expected to accelerate the reduction of its Herculean $9trn balance sheet, from $47.5bn to $95bn per month, as well as raise its benchmark rate to 3-3.25%. Despite the US inflation of 8.5% YoY and unemployment rate of only 3.7%, these actions are intended to reinforce Fed’s hawkish guidance. However, the drain of net US Dollar liquidity has been ongoing since January 2022 on the back of the Fed’s growing reverse repo facility and to a lesser extent the Treasury general account balance. This qualitative tightening is equivalent to over $1tr balance sheet reduction, by soaking up bank reserve liquidity and weighing on risk asset prices.

Investor’s flight to liquidity and short-duration assets, in light of rising long-term rates, is exacerbated by the tight supply of US Treasury bills on the back of US government’s preference for longer-duration bonds and tax income windfall. As a result, we see a persistent trend of multi-trillion dollar money market funds rebalancing into the Fed’s reverse repo account, further reducing commercial bank reserves and market liquidity

Draining Bank and Non-Bank Liquidity

The impact of qualitative tightening is most evident in the $1trn decline in US commercial bank reserves held with Fed. Lower reserves will ultimately impede banks’ ability to purchase risk assets and provide liquidity in the interbank market, further constrained by post-GFC Basel 3 capital reserve and asset quality requirements. The contraction in liquidity is also reflected in bank deposit growth slowdown for non-bank clients that do not have access to Fed’s reserve facility. The liquidity trickle-up is in full effect.

Despite the market liquidity reduction and asset price pullback, the real economy is still riding the corporate and consumer credit growth wave, fuelled by a tight labor market and delayed contraction of the housing market. In addition, the prospect of higher inflation along with rising living expenses are undoubtedly pushing more consumers towards higher long and short-term bank borrowing. However, the laws of debt gravity and forces of the credit cycle dictate an inevitable return to the long-term mean productivity growth trend. Higher rates and declining property prices will be the resolving forces in stemming future credit creation.

Until Something Breaks

As investors in both bonds and stocks are reaching for cash by selling their assets, driving further asset price declines, the Fed is achieving its goal of demand contraction and eventual inflation easing. In doing so, the Fed risk depleting bank liquidity below the minimum level required for real-economy operations. As a result, we may see a repeat blowout of the repo funding rate similar to the September 2019 attempt at QT, where the Fed effectively broke the repo market and was forced to step in with new liquidity measures. The current repo rate is similar to the 2019 levels, and given the larger size of the US economy as well as outstanding debt, it warrants significant caution. To keep the economy moving, the Fed must grease its wheels.

The Merge Is Upon Us

Liquidity concerns aside, we are finally approaching the anticipated Ethereum merge (13/15 September) to a more energy-efficient Proof-of-stake (PoS) consensus chain. While the upgrade will not result in immediate scaling improvements, as the speed and cost of transactions will remain mostly unchanged, the net effect is expected to be positive as it paves the way for increased user adoption. In addition, the ESG compatibility of the post-merge Ethereum chain along with its well-defined staking yield attribute will undoubtedly increase its institutional investor demand. Higher ecosystem investment will seal Ethereum’s role as the dominant Layer 1 chain.

The dominance of Ethereum is evident in its recent outperformance against competing PoS chains (Avalanche, Solana, and Fantom). Despite initial excitement and fun fair, all these competing Layer 1 chains sold off as DeFi value flowed back to Ethereum and early investors ‘rebalanced’ their portfolios. Interestingly, although lacking on-chain smart contract activity Bitcoin performance stayed almost at par with Ethereum, with liquidation-induced BTC outperformance reversed over the recent months. This reaffirms the non-competing and divergent use case for leading digital assets, further reinforced by Ethereum’s transition to PoS.

Balancing Forces of Supply & Demand

So what does the merge mean for Ethereum’s fundamentals going forward?

On one side, we have the constraining force of the new ETH token supply. The pre-merge net daily supply was determined by a combined issuance rate of PoW rewards and the burning of network fees (EIP-1559). The high cost of securing PoW decentralised network led to c. 13K ETH daily issuance, while the declining network activity and the associated burned fees led to significant inflationary pressures.

The merge upgrade is expected to reduce daily ETH rewards by over 90%, as PoS validators require fewer real-world energy resources to secure the network and thus demand lower compensation. Thus a significant sell pressure will be removed. Even if one assumes no pick-up in the user activity, the current burn rate is almost sufficient to offset the lower 1.6k ETH daily rewards. We are more likely to see a pick-up in burn rate due to the reflexive nature of Ethereum price and activity.

On the opposite side, we have the pulling force of ETH token demand. It is no secret that current network activity is low and the on-chain ETH token demand is not directly impacted by the upcoming merge, apart from the speculative investor demand. Looking under the hood, we can see NFT and DeFi protocols as the main forces behind ETH demand, with the current activity levels down c. 80%. So for any meaningful recovery in demand, we would need to see a volume pick up on cornerstone protocols such as OpenSea (NFT) and Uniswap (DeFi). We may also see a merge of NFT/DeFi narratives that will undoubtedly drive up network utilization and native cryptocurrency demand.

In light of this, one can be forgiven for dismissing the extent of web3 innovation amidst declining market price sentiment. However, history says otherwise. Each consecutive price rally captures the attention of the brightest and most ambitious developers, who are attracted by the technical challenge of decentralized problems and the freedom of permissionless protocols. As a result, network value creation and the inevitable native token demand follow the forces of the evolutionary rhythm.

Barbarians at the Gate

As a closing thought, it is worth mentioning the merit of Ethereum’s transition from PoW to PoS. At the very core, we are moving from a digital asset network secured by fungible real-world energy resources to one governed by ownership rights not dissimilar to the conventional equity model. The degree of decentralisation and neutrality can be measured along multiple dimensions, one of which is the dispersion of voting and economic shares of its participants. It is not looking good.

Most notably, the vast majority of on-chain value is controlled by a handful of centralised stablecoin custodians. These entities are subject to increasing regulation and hold enormous economic power in the future evolution of the Ethereum network, with the ability to freeze and reallocate digital asset resources at will. Their power is amplified by the increasing concentration of staked ETH through a single service provider Lido (90%), which although decentralised still poses significant network censorship risks.

While recognizing the benefits of PoS transition, we maintain our unwavering focus on the fundamental benefits of true decentralisation, supported best by PoW. Time will reveal the path of ecosystem evolution post-merge, but one thing is certain the minute you establish an organization it starts to decay. As discovered by Trojans, sometimes it is worth looking a gifted horse in the mouth.

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Thank you,

OX1 Team