What happened leading up to now
In 2020 and 2021 banks like Silicon Valley Bank saw a huge influx of deposits. This was due to the drastic increase in money printing done by the U.S. government while the FED was simultaneously dropping interest rates to essentially 0 and injecting massive amounts of liquidity into the financial system.
The job of banks is to take deposits and then lend that money out to generate a return, part of this strategy is buying Held To Maturity assets (HTM) – a debt security that pays back its face value to the holder on its predetermined maturity date – such as US treasury bonds and mortgage-backed securities (MBS).
Due to the extremely low-interest rate environment in 2020 and 2021, generating a yield on short-duration debt securities was almost impossible, so banks started buying more long-duration assets in order to generate higher yields.
Now here’s where the problem arose, let me explain.
Generally speaking, short-term interest rates are lower than long-term interest rates, so the business model of banks is to essentially profit from this spread between short-term and long-term interest rates, I.E. they borrow on the short end and lend on the long end.
All of the money printing and low interest rates in 2020 and 2021 created a spike in inflation. And in order to “restore price stability” the FED started reducing their balance sheet and increasing interest rates at an unprecedented pace in 2022.
Here’s where understanding the situation might get a little tricky, so allow me to paint a picture.
Lets say in January 2021 the bank bought a 10 year HTM asset that was yielding 1.9%, that’s a pretty good yield when interest rates are less than 1%.
However, in 2022 the FED started aggressively raising interest rates, the result of this was that now you could buy a 2 year duration bond that was yielding something like 4%, this meant that the 10 year 1.9% bond was now way less valuable marked to market – if it were to be sold on the market – because who wants to buy that bond when they can buy one that’s higher yielding and shorter duration?
So now, because these long-duration bonds are way less valuable, banks have a significant amount of unrealized losses on their balance sheets – meaning the price of the asset is down but the asset hasn’t been sold therefore the loss has not been realized.
This sounds alarming, however, because most of these are Held To Maturity assets, the banks never have to realize the losses if they just hold the assets to maturity.
Unless, for some reason, they are forced to crystalize those losses in the event of a liquidity crunch – an increase of depositors pulling their money out and the bank not having enough cash on hand to fulfill those withdrawals.
This leads us into yet another issue, remember we mentioned that banks profit from the spread between short and long-term rates – also commonly known as the yield curve.
When the FED raised interest rates it created an inversion of that interest rate spread, meaning that now short-term interest rates are actually higher than long-term interest rates.
This hurts the bank’s profitability, so what do they do? They suppress how much yield they pay to depositors in order to still profit, but this increases their risk of depositors pulling their money out because they’re now sort of competing with other risk-free savings vehicles.
As you can see over the last year or so bank deposits have been declining, some of this has possibly been due to less saving and more spending. But it’s mostly due to people moving their cash out of banks and into US treasuries and money market accounts in order to generate way higher yields than what the bank is willing to pay.
– Which is at a basic level what happened to Silicon Valley Bank –
The issue is: due to so much contagion and FUD – Fear Uncertainty and Doubt – people started rushing to move more money out of the smaller regional banks into the large “systemically essential” banks – the too big too fail banks – where their money is safer, hence exacerbating the problem.
So Far There has been 5 Banks that’ve failed or had significant liquidity issues:
- Silvergate
- Silicon Valey Bank
- Signature Bank
- First Republic
- Credit Suisse
And Now Deutsche Bank is also reportedly having issues.
One last thing to note here is that most of these banks were exposed to more risk than many other banks which is why they’ve been having more issues.
Crisis Or No Crisis?
The big question here is whether or not this bank liquidity crunch will spiral into a bigger economic or financial crisis. Here’s what we’ve found to further analyze that possibility.
To figure out what could come of this situation moving forward we want to find signs of broader systemic risks in the banking system that demonstrate whether or not we might be facing something greater than just a few banks having some liquidity issues.
First off the bat there’s one silver lining we’ve found here that certainly differentiates the current state from the great financial crisis. That being bank leverage is much lower than it was in 2008, which raises our hopes that “this time is different”.
Another significant difference between now and 2008 is that in 2008 the percentage of bank balance sheets that were NonPerforming Assets (NPAs) was much higher – NPA is a debt asset that the borrower has not been paying the interest on, meaning the lender is not generating a return.
ALLL is Allowance for loan and lease losses, and it essentially reflects the estimated credit losses within a bank’s portfolio, which is the number of loans that the bank probably won’t be able to collect on.
While ALLL is currently lower than it was, it has started to tick up in 2022, were this to continue it would probably pose a bit more of a threat to the banking system. It also could be used as an indicator for broader economic health, because it demonstrates the number of people and businesses that are unable to pay the interest on their debts.
One last financial stability indicator we want to highlight is nonperforming loans as a percent of gross loans. This particular chart gets cut off at 2009, so for reference, in 2007 it was at 1.4% and in 2008 it was 3%. Currently, it’s sitting in the 2004 to 2006 range of 0.7 to 0.8 percent.
While everyone is freaking out, the data is showing a more promising story that this liquidity crunch is going to blow over, and we’ll also continue to see recovery in risk-on assets in 2023 into 2024.
An additional chart that suggests this is how much money is sitting in money market funds. Yes as we mentioned before this is partially due to people moving money out of banks in an effort to generate higher yields. However, another significant reason for it is that investors are still sitting on the sidelines waiting to deploy capital.
This bearishness and uncertainty is also being reflected in investor sentiment which is still sitting at over 40% bearish and just over 20% bullish. We love this scenario! Generally speaking when data is showing one thing and market sentiment hasn’t caught up to that reality yet, it’s the perfect storm, whether it’s bullish or bearish, and this time it’s looking to be very bullish.
The Current Threats To The US Economy and Markets
While all of this is happening, another substantial risk to take note of if you’re in the US or you hold USD or USD-denominated assets, is the threat to the Dollars dominance.
While the US is currently looking weak, China has recently been making moves to start increasing the usage of the Chinese Yuan globally in replacement of the US dollar.
Additionally, recent reports have surfaced that Saudi Arabia has stated that its open to the idea of using other currencies such as the yuan for energy exports and some other countries are recently following suit to move away from the US Dollar.
A loss of the petrodollar could be absolutely detrimental to the USD and thus the united states as a whole. The Best Hedge against a loss of dollar dominance would likely be BTC in our view, but that’s a topic for another day.
Economy and Stock Market
A credit crunch might mean higher standards and more conservative lending by banks which could put a crimp on the economy.
That being the case, there’s a good probability that we will see a bit of a recession in 2023 or 2024 – if we haven’t already been in one – as a result of increased lending standards and a crimping of credit lines.
That being said, keep in mind that on average the official announcement of recession from the National Bureau of Economic Research (NBER) is usually about 12 to 20 months after the recession occurs.
Additionally, stocks are a leading economic indicator, so they generally bottom and begin their recovery before the recession is officially over, so we aren’t concerned about a recession pushing risk assets to new lows.
If we take a quick look at the S&P 500, we have broken out of the lower highs and lowers lows trend, we retested the 200-day moving average and proceeded to shift into a more bullish trend with a couple of higher highs and higher lows.
Watching Bitcoin
Bitcoin has been making moves in 2023 up over 70% for the year, which historically speaking is not surprising. But why is it moving? And has it bottomed?
Prepare yourself because we’re about to drop charts galore on you!
There are a few trends we can look at to better rationalize how, why, and when Bitcoin moves.
Historically Bitcoin moves in 4-year cycles with the halving – the halving is when the Bitcoin supply growth gets cut in half, which programmatically happens every 4 years.
Currently, we have about 1 year before the halving takes place again, which is historically an accurate indicator of growth. Mathematically this makes sense because when demand stays the same and supply growth gets cut in half, the price has to go up – economics 101.
In our view, the last 6 years or so have demonstrated a pattern of Bitcoin trading:
- With global and domestic liquidity.
- As a hedge against inflation
- Inverse to interest rates (because it is still looked at as a risk on asset.)
There’s a huge debate about whether or not Bitcoin is a hedge against inflation and monetary debasement.
What some may argue is that bitcoin moves ahead of inflation. If we’re looking at bitcoin as an inflation hedge, it trades based on future expectations. As you can see it priced in inflation before the inflation was here, and then it priced in the fall of inflation.
The interesting thing here is that Bitcoin priced in much more disinflation than what we got, now after the recent crisis in banking, the market is realizing that the Fed might not be able to keep tightening until they get to their inflation target of 2% without drastically breaking something. Upon this realization, Bitcoin is starting to correct its exaggerated expectations.
There’s more to this story though, the other factor that plays a part in Bitcoins movements is interest rates, here you can see that Bitcoin for the most part has an inverse correlation with interest rates, making recent Bitcoin price action make even more sense.
The other – maybe most – prominent factor in this equation along with interest rates, is Bitcoins correlation with Liquidity, here you can see how Bitcoin has moved in relation to the Feds balance sheet.
This Makes alot of sense because the feds monetary policy – Interest rates and balance sheet – is kind of the most prominent indicator of liquidity in the financial system and risk on assets move very much with global liquidity.
More simply put, most asset prices are just dictated by what central banks and governments are doing from a fiscal and monetary policy standpoint.
Has Bitcoin Bottomed and What’s Next?
As we’ve previously stated, our thesis is that while most people are still hesitant or fearful, the data is showing that “risk is back on the menu” and risk assets will sneakily outperform expectations in 2023, bar any black swan, and crypto will continue to be a beneficiary of that upside.
The indicator that accurately marked the last 3 bottoms in Bitcoin before substantial 200% + moves has also just flashed bigger and brighter than we’ve ever seen.
This is Bitcoins put/call ratio, now if you’re not overly familiar with options, a simple way to look at the put/call ratio is as a market sentiment gauge. When it spikes that means alot of people are bearish and when it dips that generally means alot of people are bullish.
The put/call ratio is a widely watched indicator in the stock market as well. And it has just perfectly signaled Bitcoin’s recent bottom.
Additionally Bitcoin has recently smashed through the 200 week and 50 week moving averages, and has been consolidating in the 27k to 28k range.
As we said a few weeks ago we’ve been watching for a catalyst to push Bitcoin out of the sideways pattern that its been in since june of 2022, and it looks like we got it.
Now, this doesn’t mean Bitcoin can’t fall back into that 18k to 25k range, but until further notice, the bullish market structure seems to be holding up.
We’re watching 29,000 and 25,200 if bitcoin doesn’t break through 29,000 then we’ll be watching for a retest off of that $25,200 level. But its current short-term pattern is suggesting a potential breakthrough up toward $32,000.
Last but not least Bitcoins net entity growth – which is the measure of new user growth on the network – 14-day moving average, is way higher than it was during the bottom of the last market cycle in late 2018 and early 2019. This could be a signal for a bigger move higher than what we saw back then although nothing is guaranteed in this macro environment.
Bringing It All In
There’s been a lot to unpack here from what has happened over the last few years, to what we see happening in the near future. Hopefully, from a macro standpoint, we start to see better news as we move through the summer and into the second half of the year.
For now, crypto still have some issues as it pertains to regulation but on the long end we’re seeing a lot of great signs. Based on history there’s no guarantees that this year will be too exciting for crypto prices. However we maintain a positive yet level-headed outlook for the future.