Growth equities, digital assets and bonds rallied this month after emergency actions were taken to stem a regional US banking crisis in mid-March. The premise that steep interest rate hikes by the FED, 5% in a year, would not eventually break something in the economy was unfathomable at the start of 2022. However, as this tightening cycle was reaching its apex, a smooth landing/no recession scenario was surprisingly becoming the most probable outcome. March upended that hopeful forecast as mismanagement of duration risk at traditional banks first caused three mid-size to large US banks to shutter and then saw Credit Suisse be acquired by UBS with the assistance (or insistence) of the SNB. US treasury yields spiked lower by 100bps or more across the rates curve in the most volatile interest rate swings since the GFC. The relative stability and subsequent bullish performance of major equity market indices was entirely from mega-cap technology stocks’ positive performance more than offsetting the dismal performance from regional banks and the financial sector. Bitcoin rallied 22.67% in March and 71.68% for the quarter. The performance was driven by its utility as a hedge on the fiat currency system that has returned to (synthetic) QE and as a flight to quality within the digital asset space.
Macro Overview
The improbable economic soft landing can still occur but the odds of it happening and avoiding a recession went markedly lower in March. Banking crises often consist of financial institutions’ solvency being threatened by rising loan defaults, increasing bad debt write-downs, credit spreads widening causing mark-to-market losses on securities, and assets-to-liabilities ratios declining. Contagion from failed lending institutions pose risks to other banks and can destabilize and contract the entire economy. Contagion fears prompted swift emergency measures to be taken by central banks and regulatory agencies in March to stabilize the financial system. The financial sector freezing up could cause market dislocations and lead to a deep recession and further crises. Credit events have been the initial domino of past bank failures, however, central bank policies of prolonged low interest rates and ample liquidity (QE forever!) followed by steep hikes to combat inflation arguably helped break the regional US banking system and added significant turbulence to the hopeful soft economic landing.
A credit event was at the heart of GFC and much of the March 2020 unprecedented monetary and fiscal stimulus was to prevent a similar or worse Covid-triggered credit event. Additional regulatory oversight, enhanced lending reporting, increased capital requirements, higher standards for GSIB designated institutions and other financial market reform legislation have seemingly made the banking sector less vulnerable to a credit crisis during this hiking cycle. The Fed and other regulators have focused on inflation risks to the economy but were less concerned of other risks at non-GSIB banks deemed less systemic. The steep rate hikes may have broken many regional banks that collectively have impact like GSIBs and could cause similar effects of a traditional credit crisis of negative credit growth, spurring a possible severe recession.
Banks borrow from their depositors at lower than short-term Fed Fund rates and lend at a credit spread to the risk-free rate at the relevant tenor. Many regional US banks were managing and avoiding credit risk by investing in US treasury and other government agency securities. When the fed funds rate was near zero and rates curves were upward sloping the spread was positive so banks could borrow at a lower rate than they were lending at (longer dated securities). When interest rates moved higher quickly the yield curve became inverted with higher near-term rates and lower long-term rates. Banks now had to potentially pay higher interest rates on their near dated deposits and had mark-to-market losses on the “safe” longer dated securities they held. The market-to-market losses would only be realized if they needed to sell immediately at market prices when deposit holders asked for their money back.
The depositors of Silicon Valley Bank did just that and caused a “run on the bank”. SVB was quickly seized by the FDIC when it could not meet depositors’ liquidity demands. Silvergate bank was wound up a week earlier and Signature Bank was seized by regulators because of worries about their liquidity. The FDIC, FED, US Treasury and other regulatory agencies stepped in to provide unlimited deposit guarantees for all banks and allowed financial institutions to post UST’s and like securities at par to provide liquidity for those banks without realizing the mark-to-market loss. For unrelated and related contagion reasons, a loss of confidence occurred at Credit Suisse with account holders withdrawing assets and counterparties closing credit lines with them making it difficult to conduct business. The Swiss National Bank assisted UBS in taking over CS to halt the broader contagion.
Interest rates quickly went lower in anticipation that central banks would be forced to cut rates significantly in the next year as probabilities of a severe recession increased. The first chart shows the March change in rates and the second chart shows the MOVE Index which tracks the implied volatilities of the swaption surface and the US 2-year, 5-year, 10-year, and 30-year interest rate moves. The implied volatilities were the highest since the 2008 GFC.
The sudden onset of the banking crisis did not deter the FED from raising interest rates 25bps at the March FOMC meeting nor from guiding the market to the possibility of one more hike later this year and no expected cuts until 2025. The implied rates surface in Chart 2 shows markets believe peak rates are here and the increased probability of a recession will create the need for substantial cuts over the next two years. Data releases that include March will have extra weight to see the extent of the banking crisis impact on inflation, corporate profit expectations and the macro-economic environment.
While rates and commodities prices signaled recession expectations increasing, equity market indices rallied. The MSCI world equity index was up 3.16% for the month and the S&P 500 up 3.51%. Mega Cap Tech reacted to the emergency banking measures as a return to QE and continued the year-to-date rally with the up almost 14% for the month and up 36% this year. The dispersion in returns is best shown in the varying performances of financials versus large tech companies. Chart 3 shows the US regional bank index, the UBS mega cap tech index and the MSCI world return
The headline equity index returns are presenting a much more optimistic picture than other asset classes. Long duration assets are benefitting from both the sharp reduction in interest rates and the flight to quality assessment that now sees Apple and Microsoft as a safe store of value compared to some government securities. The equal weighted return of the S&P 500 compared to the capitalization weighted return shows less optimism on the broad economy and the skew of the tech performance.
The banking sector stabilized at the end of March and “no further headlines” was seen as good news. The emergency measures the regulators instituted will no doubt require greater oversight and controls over risk taking at banks. The government’s unlimited deposit guarantee makes US Banks quasi-government institutions and more like public good utilities. Banks’ ability to lend in the coming year will be constrained by both the expected enhanced regulation and the recessionary fears of tightening credit standards. The expansion of the FED’s balance sheet appears to be a reversal of QT and back to QE but there is uncertainty around how effective this synthetic QE will be. The banks may not use the added liquidity to increase economic activity through their normal lending practices. An ineffectual QE may increase the FED’s balance sheet without any positive growth pulses. In the current inflationary environment this may be desired but that might change if economic conditions worsen. If the last rate increase is a policy error and the recession is inevitable, the tools the FED may employ could look like the 2021 cycle all over again.
The alternatives to USD hegemony are limited and have equal or greater issues (EUR, JPY, CNH). The Bitcoin origin story was a reaction to the 2008 GFC and Bitcoin is again gaining momentum as a financial system hedge during this crisis and may provide a parachute if the turbulent landing gets rougher.
Digital Asset Overview
The ETH/BTC ratio, a proxy for the market’s risk appetite, was down 8% in March further driving the distinction between Bitcoin and “crypto”, with the leading digital asset’s hard money characteristics yet again pushed into the spotlight by the macro uncertainties described above. Bitcoin was born out of the GFC, and we are once again reminded of the message Satoshi left in the first Bitcoin block, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”.
In addition to the backdrop of failing banks and the return of expansionary monetary policy, we have seen confluence between holder behaviour and other network metrics which further support the investment case for Bitcoin. We can assume that the two key drivers of price action are Bitcoins intrinsic value, and speculative trading on the likelihood of greater adoption. Arguably, these two drivers are most clearly represented by Bitcoin’s realised price and the variation of the open market price from this measure. Simply put, realised price is the average cost basis for all market participants, and, as can be seen in Chart 5, seems to present a long-term, consistent upward trend coinciding with the network halving cycles (marked in grey). Market price, on the other hand, has driven the better-known history of meteoric rises and devastating crashes that have spent the last decade dancing around the slow, steady ascent of realised price. As opportunity lures more participants across the knowledge chasm, galvanising fresh Bitcoin die-hards by the day, so too has capitulation cleared the decks of any speculators
Additionally, separating the long-term holder (LTH) from the short-term holder (STH) realised price is a useful metric to show the transition from bear to bull markets. As shown in the charts below, in previous market cycles following a period of STH realised price sitting below LTH realised price, STH’s begin regaining confidence and historically a crossover of STH>LTH has been a good indicator of a transition to a longer-term bull market.
In addition to the above metrics, network statistics such as hash rate (computational input) of the Bitcoin network continue to increase, as market price drives more miners to switch previously dormant machines back online. The networks total input currently sitting above 300 exahash – one exahash equalling one quintillion hashes. Bitcoins hash rate can be directly attributed to the security of the network, and the fact that hash rate has continued to grow despite a near 80% drawdown in the underlying asset price last year, highlighting the increasing number of mining organisations investing in the future of the network. Trovio expects this trend to persist as Bitcoin mining also becomes an accepted demand response program, helping to balance supply and demand whilst increasing grid efficiency.
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