I’ve been seeing a lot of fearful people in the last couple of months. “Bitcoins going back to $16,000.” “inflation is sticky.” “the economy is going into recession.” “the banking crisis isn’t over.” “commercial real estate is going to cause a debt crisis”… So the question is, is the bullishness over for now? Well, this may come as a surprise to hear, but the current sentiment might actually be the best look for bulls that we’ve seen since December of 2022.
Getting down to it, the key macro stories of the third quarter have been the resurgence in interest rates and the strengthening of the dollar, oil production cuts causing headline CPI to move back above 4% YoY in August, and the continued steady reduction in global net liquidity.
In line with our expectations, all of the above have resulted in the slowdown of risk assets with stocks pulling back meaningfully and crypto pretty much staying rangebound. So let’s dive into all of this and talk about what’s next for markets.
Treasury Yields and The Fed Funds Rate
The 10-year is continuing to rip higher after breaking 4.3% while shorter-term yields seem to be stabilizing with the 2-year holding below its 2006 high of 5.2%. The likely outcome is that this pattern continues with the 10 year moving towards its 2006 high to catch up with the 2 year.
This pattern of stabilizing short-term yields while long-term yields are moving higher is actually what we want to see. As long-term yields catch up what we get is the currently inverted yield curve starts to steepen again – disinvert. Then once the FED starts cutting rates – which on average happens 8 months after their last rate hike – the steepening will accelerate, getting us back to more normal spreads.
The Elephant in the room still remains, that is, whether or not we will see the recession that everyone has been talking about for the last year and a half. The easiest way to process this question is to simply look at two indicators:
- The Fed funds rate, specifically how often fed hiking cycles cause recessions, and how long it takes from when they finish hiking rates to when a recession occurs.
- The spread between the 10-year treasury yield and the 2-year treasury yield, which historically has been a pretty good indicator for economic recessions.
The first thing you’ll notice is that the fed going through a hiking cycle doesn’t necessarily mean a recession is guaranteed. In fact, over the last 50 years or so, we’ve only seen three recessions as a result of fed rate increases. However looking at the yield curve, we can see that it hitting zero or inverting has signaled a recession three out of the last 4 times.
Note: In the above chart we are discounting the recession in 2020 as it wasn’t caused by the feds tightening cycle and there was little reason to believe that a recession would have occurred had it not been for COVID-19.
So, all of that being noted, if we do see a recession from this hiking cycle when will it be? The answer to this question is actually more straightforward than what you’d probably expect. For one, looking at the yield spread, recessions always occur as the yield curve steepens.
The second way to look at it, is generally a recession occurs on average 15 months after the Fed pauses. As we understand it, this delay happens because it takes about 10 to 12 months for rate increases to actually make their way through the economy.
Investors Are Uncertain and Heavily In Cash
Investors are reacting to the uncertainty of the economy and monetary policy as expected. So, what are they doing? Well, they’re putting their capital into bonds and money market funds at record levels.
There are two key reasons for this. Reason one is that the yield curve being inverted means short-term yields are higher than long-term yields. I’m sure you’re asking what does this have to do with anything?
To answer the question, Banks usually pay out short-term yields to depositors and lend on long-term yields and they profit from the difference. But when long-term yields are lower than short-term yields, they have to pay out a lower yield to depositors than what the market can pay.
So what do depositors do? Well, they can get higher yields by investing in short-duration treasuries. So they take their deposits out of the bank and move them into money market funds. These funds invest in these short-duration debt securities and are currently paying a 4 or 5 percent nominal yield.
Side Note: nominal yield basically refers to the yield not accounting for inflation which is 4% YoY based on the latest report in August. The real yield currently is anywhere between 0 to 1.5% and obviously varies based on the inflation rate.
Reason two, the bigger reason that cash in money market funds is at record levels, is that investors are still scared of risk-on assets. So investors are opting to sit in cash or bonds and collect their 4 or 5 percent nominal yields without taking much risk.
What’s Happening With Stocks
So here’s the deal for stocks, Oil is likely on its way back to 95 or 100 Dollars a barrel and it’s up substantially for September. The expectation is that this will probably mean another ugly CPI report for September. Additionally, the US Dollar strength has been on a tear coinciding with 10-year treasury yields, none of which look great for stocks in the short term.
The S&P 500 will likely trade down and sideways for a bit with a line in the sand at 4200, which is also where the 200-day moving average is currently sitting. Based on historical data we could see an end-of-year rally that takes place in November and December.
However, a rally currently looks unlikely unless we see other factors start to brighten up. If we don’t get a breakout in Q4 then we’re watching for a move back to test all-time highs in the first half of 2024.
It seems like there’s often a lot of talk about recession and with it usually comes a common assumption that it will push stocks to new lows. However, we don’t like watching for a recession as an indicator to buy or sell stocks.
The key reason is that often recessions aren’t officially announced until over a year after they take place. So while there are signs when the economy is in recession, such as negative GDP growth, and/or increased unemployment, you won’t hear an official recession announcement. Trying to time recessions to make trades is a bad move in our view.
What’s Happening In Crypto
So how will all of the above affect crypto?
The key stories from a bitcoin and crypto standpoint have been the SEC’s delay of all Bitcoin spot ETFs. The SEC will probably have to approve all ETFs at the same time. The most likely scenario will be that they are approved in Q1. Which will coincide with the halving taking place in March.
After starting the year in a bullish trend, Bitcoin has flipped into a rangebound pattern. As stated above this is mostly due to the reduction in global liquidity throughout Q2 and Q3 as well as investors choosing to park their cash in bonds and money markets as yields continue to increase.
Bitcoins Short-term holder realized price – which is the cost basis for all Bitcoin bought within the last 155 days – had acted as support for the first half of the year. Unfortunately, in September Bitcoin flipped STH realized price into resistance. This is signaling to us that Bitcoin is pricing in the expectations of continued rangebound or bearish price action.
However, there is a silver lining here. Bitcoin whales – wallets holding over 1000 BTC – have continued to defend their cost basis since February and have done so again recently. Let’s throw it back to 2019 price action and look at both short-term holder realized price and whale realized price.
What we can see here is that if we discount the COVID-19 flash crash, we see very similar action to what we’re witnessing now. After the initial rally dissipated, price moved back below and used STH cost basis as resistance, but whales continued defending their cost basis for the remainder of the sideways market.
The assumption is that had it not been for COVID-19 bitcoin likely would have held STH cost basis and continued to move higher.
Based on the added context of these charts, when we take it back to the technicals, it looks like there are two scenarios that are the most likely moving forward.
1. The first and probably the one we’re betting the most on is that whales continue to defend their cost basis while short-term holders continue selling at theirs. This will basically look like a continued boring range-bound price for most if not all of Q4. If we get the spot Bitcoin ETFs approved in Q1 and then the halving in April, that will probably lead to sufficient capital inflows to move Bitcoin higher.
2. Scenario two which we think is less likely is that the macro gets worse and whales get exhausted. If whales stop defending their cost basis for whatever reason, then Bitcoin will dump to around $20,000 to $22,000. From there we would start to see more opportune buyers step in.
Tying It All Up
In terms of overall market sentiment for risk assets, it’s looking like there’s still a lot of fragility in the market. With all of the uncertainty surrounding interest rates, inflation, and energy prices the bulls look to have completely fled since July.
Have no fear we don’t believe this will be a long-winded pullback that puts us back into bear market territory. One important point to note is that 10% pullbacks while stocks are recovering, such as what we’re currently seeing, are not uncommon.
The simple phrase still holds true, be fearful when others are greedy and greedy when others are fearful. Despite bitcoin being up over 50% on the year and stocks up just over 10%, the majority of the market is still fearful and holding on tight to cash. We said it in January and we’ll say it again, it’s not a matter of if investors will pile back in but when.