The Breakdown - Why Bitcoin and Crypto Are Crashing

Starting point is 00:00:00 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexo.io, Abra, and FTX, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, January 6th. Welcome back to the breakdown. If you're enjoying the show, give it five stars, leave a rating, or join the Discord community. It's been growing very quickly recently. There's a lot more discussions going on. You can find that address in the show notes,

Starting point is 00:00:40 or you can go to bit.ly slash breakdown pod. Bitley slash breakdown pod. Also, as always, as they're now a sponsor, I do marketing at FTX, so that is a disclosure. So to today's topic, just a few days in, and we've got our first big crypto macro Fed show. The markets have been brutal for the last 24 hours,

Starting point is 00:01:03 but hopefully this show helps you put them in context. So let's do a little primer on the Fed and markets in crypto, just for those of you who might be joining us for the first time or who are still new in this journey. So, the Fed's relationship with markets, if you can't already tell, it's a little Pavlovian, right? When the Fed signals cheap money, lower interest rates, more support in terms of asset purchases, more liquidity, financial market actors respond positively. And part of what the accumulation of that is is that they feel like they can take

Starting point is 00:01:36 more risk. That benefits all risk assets, of course, but it certainly benefits the riskiest the most because some additional number of actors or percentage of the market feels like they can move even farther out on the risk spectrum. Indeed, in the extreme, they feel like they have to. This is sort of the story of the last, I don't know, 15 years or so in market history. As the yields from safe assets have gone down, institutions of all stripes have had to move farther and farther out onto the risk spectrum. That's why you see so many more types of previously extremely risk-averse organizations getting into asset classes like venture capital or more recently crypto. This has been the story for the last decade for sure, between the great financial crisis,

Starting point is 00:02:19 and certainly this was supercharged over the last couple of years. Remember, the dominant meme of 2020 was Money Printer Go Burr. And the genesis of that meme and that attitude was retail traders who were completely convinced that the Federal Reserve would not let markets struggle based on COVID shutdowns and would come in riding on their monetary policy horses with all of the capital injections that the markets needed. Now, 2020 was complemented by fiscal stimulus, which is different than what the Fed does, and led to what has been a booming last couple of years. Now, for all of this, though, the Pavlovian reaction works in both directions. And so, when the Fed signals tightening, raising rates, withdrawal of asset purchases, or even balance sheet reduction, quantitative tightening,

Starting point is 00:03:03 markets go in the other direction, risk off. And sometimes they go that way even more than they should. The most dramatic historical example of this was the so-called taper tantrum in 2013, when markets reacted extremely poorly to the very idea that the Fed would withdraw support from its quantitative easing program. So we have a Pavlovian response between the Fed and markets in both directions, In fact, some folks like Jeff Snyder think that the cultivation of that Pavlovian reaction, the ability to influence markets via statements and media, rather than through actual action, is at this point the Fed's chief tool in its toolkit. But what about crypto and the relationship between crypto and the Fed?

Starting point is 00:03:46 A big thing you see a lot of people talking about over the last six months is crypto's correlation to stocks. There have been a number of folks in FinTwit who have tried to show Bitcoin charts versus Equities charts in a way to somehow diminish Bitcoin or say it's not actually an uncorrelated asset, yada, yada, yada. Now, my basic explanation for the relationship between crypto and stocks is super simple. For the first eight years or so of its life, Bitcoin was not in the mainstream. It attracted a totally different type of investor than traditional equities markets. There's a lot that we could get into on that, on how much it was ideological, how much it was international, yada, yada, yada. The point was there wasn't ultimately that much overlap.

Starting point is 00:04:25 And even in 2017, when that whole bull market happened and the ICO boom happened, it was dominated by retail investors, not traditional Wall Street types. We've now spent the last four years or so lobbying Wall Street to get in, and over the course of the last 18 months, it worked. Wall Street now has huge investment in exposure in Bitcoin and starting to be in other crypto assets as well. And this happens at both an individual and institutional level. We're talking about Wall Street institutions and traditional finance institutions coming in, as well as traditional traders who have hung up their priors and decided to just make their allocations into Bitcoin.

Starting point is 00:05:01 So it follows from that that if some meaningful percentage of Bitcoin holders are now Wall Street types, things that impact Wall Street are going to impact Bitcoin. And this is especially true for these nibly little short-term things like moves between risk-off and risk-on. There was a whole different conversation to be had about how far this correlation really goes, and how much it undermines core arguments for Bitcoin, which, spoiler alert, it doesn't, but that's for a different show. Nexo is a trusted and easy-to-use crypto platform where you can buy cryptocurrencies at the touch of a button and start earning up to 17% annual interest that is paid out daily. They support all of the major assets on the market and even allow you to swap one asset for another

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Starting point is 00:07:06 That's FTX.us. But that brings us up to now, and the Super TLDR on last year, as it relates to Fed and the markets is that there were three phases that I saw. Phase one was the Fed insisting that growing inflation was in fact transitory. It was transitory because it was caused by disruptions and supply chains and the general mismatch between demand post lockup, which was huge, not only the normal demand, but the demand for things that people hadn't bought while they were stuck in their homes during the first phase of COVID, meeting a lack of supply. A lack of supply because manufacturers, supply chains had to turn off the rails as shutdowns happened. All of that would be worked out and

Starting point is 00:07:52 things would move on. And this is important because the Fed doesn't want to use monetary policy to try to fight a supply chain dislocation that just doesn't make sense. But the markets never really believed, at least in my eyes, that the Fed was going to be able to keep its dovish stance for as long as it wanted to. Phase two was this sort of nebulous in-between phase where Powell and the other members of the Fed started to acknowledge that maybe this inflation wasn't so transitory. They thought that it was probably still largely due to supply chain disruptions and that supply demand mismatch, but it kept persisting and it kept lingering longer than they thought. What's more, it was getting harder and harder for them to justify keeping such dovish policy

Starting point is 00:08:34 because so many people had dropped out of the workforce, and that was leading to challenging calculations around the other side of their mandate, which is maximum employment. Phase three, which I believe really started around Powell's renomination, was the we will fight inflation phase. It was an end to the whole transitory talk. It was an acknowledgement that this could go on a lot longer. And it was an acknowledgement that there were political ramifications because the U.S. population was seeing consumer prices rise. And it was a commitment that this group of people had the tools and was going to use the tools to make sure inflation wasn't an ongoing concern. That got us to the last FOMC meeting of the year, where the Fed's

Starting point is 00:09:12 signal that there could be three rate hikes in 2022, and that tapering would wrap up faster than anticipated. Now, this was quite a hawkish turn. In the September meeting, there was only one anticipated rate hike in 2022, and there wasn't even full universal conviction around that. However, the tone of the presser afterwards with Jerome Powell very much signaled that he was not going to be on some sort of anti-inflation crusade, and so the markets largely sloughed it off, actually responding well to having a little bit more clarity around what they could expect in 2022. However, yesterday, the meeting notes from that December FOMC meeting were released, and there were a couple new things that market actors honed in on. First was the timing. Many took the minutes as a signal that, as Neil Dutto,

Starting point is 00:09:54 head of U.S. Economics at Renaissance macro put it, the Fed is on a glide path to a March rate hike. Most people were expecting these rate hikes to be the second half of the year. March was a little earlier and March made it possible to see a fourth rate hike in 2022 depending on how things went. The second and much bigger discussion was around the balance sheet. In December, after the FOMC meeting concluded, the discussion was all around the speed of the taper and interest rate hikes, but it didn't get into discussions of the balance sheet. Notes, however, show that there was a briefing from staffers relating to the normalization of the now $8.8 trillion balance sheet. And by the way, this new term balance sheet normalization used to be called quantitative tightening,

Starting point is 00:10:36 so keep your eye on that sort of marketing shift as well as we talk. Now, during the last rate hike cycle, which came in the 2010s, the Fed waited two years after lifting rates to begin trimming their assets. This time, from the notes, quote, participants judge the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the committee's previous experience. End quote. And also quote, that some participants judge that a

Starting point is 00:11:01 significant amount of balance sheet shrinkage could be appropriate over the normalization process. So this is what really has markets going baddie, so let's look at some of the reactions. Mack 10 Suburban Drones points out that this shows a pattern. This is the third month in a row the Fed has escalated their hawkish policy stance. In November, they were on a single taper. December brought double taper. Now per the FOMC meeting, they're talking about balance sheet reduction. Lisa Abramowitz tweets, the Fed had a hawkish tilt in the December meeting. the meeting minutes show that members were even more inclined to remove accommodation than many expected, especially given the extensive discussion of the balance sheet. Scott Minard, everyone's favorite

Starting point is 00:11:40 person to ignore his Bitcoin predictions and the CEO of Guggenheim said Fed minutes much more hawkish than I'd expected. Fed seems intent on raising rates and shrinking the balance sheet simultaneously, clearly the recipe for a financial accident. Ross Gerber tweets Fed causing a taper tantrum. They did this before. We expect them to change their tone with all the issues from Corona. A Fed induced recession would be a disaster. Yellin needs to take Powell for a walk. The Fed isn't going to solve things by creating a recession. We'll have stagflation with this recipe. Powell did this in 18 and it was a bad year, hence the sell-off. CNBC showed a chart with their polling suggesting that 40% of respondents thought it was likely to see a fourth rate hike in December, something that no one was

Starting point is 00:12:24 really anticipating before these minutes were released. Alex Kruger tweets, markets may be overreacting short-term, but looking beyond, hard to overestimate how hawkish the Fed minutes were. QE reduction plus three hikes okay, but three hikes plus accelerated quantitative tightening was not on anyone's radar. And the Fed is likely to deliver unless inflation subsides faster than expected or credit markets collapse. There's, of course, a political dimension to this as well. Luke Groman said, today we got more evidence that the Fed is no longer operating a dial. It is operating a switch, global economy on and global economy off. If the Fed keeps this up, Dem strategists may want to start asking what polls better in November

Starting point is 00:13:04 midterms, 6% inflation or U.S. recession. Zero Hedge tweets. Has someone explained to Biden what the Fed crashing the market will do to his polls? And the six poppy says, if the Fed crashes the market this year, combined with the handling of the pandemic, this is going to be the biggest political massacre we've ever seen for Dems come midterms this fall. But there is a different perspective as well. So let's look to a slightly more sober and different take from Mark Dow, who writes, Fed's barking to buy time to try and get a better handle on how much inflation is likely to come down on its own. They don't want to hike only to find out they've overestimated overheating part of inflation story, but still want to be in a position to hike enough if need be.

Starting point is 00:13:44 So this goes back to that Jeff Snyder argument that I mentioned at the beginning. Dow is basically saying, by showing off and surprising the market with extra hawkishness, actually getting into the QT quantitative tightening balance sheet normalization discussion earlier than expected, it buys the Fed some time to actually see how things play out in the markets without having to actually do anything. He reinforces exactly this, saying barking about quantitative tightening is a freebie for the Fed. Easiest way to dampen sentiment without hiking. Reverse placebo effect. Give them more time to see how soon and how much supply-constrained prices increase in some prices start to decline. I actually think there's something to be said for this perspective, that there's a lot of value for the Fed in trying to throw the market in one direction based on what they might do to give themselves more time to actually let markets resolve without them having to do anything at all.

Starting point is 00:14:34 But let's shift over now to the Bitcoin side. I gave me two cents before about why Bitcoin is more correlated than it was before and why that correlation shouldn't seem unexpected. And I'm also quite sure I don't need to get into prices, as you've no doubt been checking them on the way down a little bit more than a lot. healthy. But as we sit here under 43,000 currently, let's again look at some community reactions. Alex Kruger again points out a funny foible in 2020. Investors buy Bitcoin as they worry about inflation. 2021 and 22, investors sell Bitcoin as they worry about the Fed worrying about inflation. This reinforces to me the idea, the reality that will help you understand Bitcoin that it exists as both a risk asset and a flight to safety asset at the same time in different

Starting point is 00:15:20 timelines and four different people. You have Bitcoin holders who view it just as a speculative game, the farthest thing out on the risk spectrum, who are going to flee at the first sign of trouble. You also have an ever-growing set of hoddlers who view it as a lifeline in whatever storm is to come next. And then, frankly, you have a lot of people in the middle who have long-term conviction, but who are working with personal or institutional mandates that force their hand in short-term movements. Anyway, moving to more reactions, there have been a lot that I've seen with conviction that the Fed is just going to have to reverse course. Dylan LeClair tweets,

Starting point is 00:15:54 honestly, would love to see Bitcoin inequities continue to grind down over the next month. Max's opportunity is when, not if, the Fed blinks and reverses course. It's anyone's guess when that comes. There's also a lot of sentiment out there that people, i.e. the Fed, shouldn't have this much power,

Starting point is 00:16:10 reinforcing the fundamentals of Bitcoin for so many. Dennis Porter from the Smart People's shit podcast tweets, even rumors that the Fed will raise rates causes massive panic selling across the globe. A seven-member board of humans shouldn't have this much power over our lives. We need a monetary policy that is predictable and controlled by code. There are some who are pointing out that although the market is tanking, people aren't really freaking out.

Starting point is 00:16:34 Checkmatey from GlassNode posted a tweet showing the divergence between Bitcoin's illiquid supply and its price and said thanks for the cheap stats anon. Bitcoin sent straight to cold storage just like all of these coins. Love me a good old divergence. let it run as hot and as deep as you want, the reversals will be swift and powerful, have seen this movie before. And of course, what he's referring to is the fact that more and more Bitcoin is leaving and has been leaving exchanges even with recent turbulence. Bitcoin leaves exchanges when people have long-term conviction, and it moves back onto exchanges

Starting point is 00:17:08 when they're getting ready to sell. The fact that the market is going down while the illiquid supply of Bitcoin, i.e. the supply of Bitcoin not on exchanges is going up, suggests that nothing has changed ultimately in terms of hoddler conviction. Still, not everyone is convinced that this is going to be an easy time for all crypto assets. Adam Cochran wrote a great thread, and I'm going to read the back half of it. Hopefully, it's a market over spook and the Fed does this softly, but clearly pressured to move faster than even suggested last month. In my personal view, this is bearish overall, very bearish on growth,

Starting point is 00:17:40 but outperform on value in havens. If we do slip into a macro bear, it will be interesting to see how a lot of new sectors that didn't have scale last bear out like NFTs. Now, as we wrap up, even though there seems to be pretty universal acceptance of the notion that this Bitcoin move is macro-driven, right, Fed-driven. It's worth noting that this week, Kazakhstan shut off the internet, and with it, they're 18% of the Bitcoin hash rate. This is obviously something that we need to be paying attention to and something

Starting point is 00:18:10 that I'll be getting into later this week. For now, the next thing to watch is inflation numbers on Friday and the market's reaction there. And going forward, I believe it will be increasingly important to keep track of the domestic U.S. political landscape as it relates to markets and the midterms. But we'll wrap there for today. I want to say thank you again to my sponsors, nexo.io, Abra, and NFTX. And thanks to you guys for listening and hanging out. Until tomorrow, be safe and take care of each other. Peace.

The Breakdown - Why Bitcoin and Crypto Are Crashing

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