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Connecting the Dots: crypto is leading the macro shift


By the London Crypto Club

US inflation data dominated the macro focus this week and continued to play nicely to our peak inflation, peak rates thematic. Headline US CPI came in at 6.5%, in line with consensus and down from 7.1% the month prior and is the lowest level since November 2021. Core printed at 5.7% Vs 6% prior and month on month inflation came in at -0.1%. Yes, DEFLATION on the month!

This comes nicely on the heels of the previous week’s softer wage numbers as well as the softer inflation prints in Europe.

Global central bank tightening plus supply chain normalisation is starting to bring down inflation and quickly. Indeed, we’ve never subscribed to this “structural inflation” story. Inflation has been the result of a huge pandemic driven fiscal stimulus, stuffing cash directly into people’s pockets alongside massive monetary stimulus, whilst at the same time, global supply chains were severely disrupted.

Maybe it was transitory….

Supply chains have now all but normalised (China reopening adding further to the normalisation) and the monetary “punch bowl” has been taken away). M2 money supply growth has also collapsed and is a good lead on CPI. In fact, it would suggest the pace of disinflation is going to be much swifter than many currently expect and could head sub 2% by Q4. Markets perhaps are just starting to wake up to this reality. “Transitory” is dependent on the time frame of course, but maybe over the two year forecast horizon, transitory will prove the correct classification.

Markets are now pricing in circa 50bps of cuts from June to the end of this year. The talking heads at the Fed of course have continued this week to pour cold water on the idea of any rate cuts this year and remain steadfast in their well worn mantra to keep rates “higher for longer” until they can be confident of inflation returning to target. I expect increased efforts over the coming weeks to talk down markets in the face of “unwarranted easing” of financial conditions, which will induce a little more volatility.

The best economist in the world however is disagreeing with the Fed and you should probably listen to that voice. That voice is of course the bond market and two year yields are telling us that rates have peaked and cuts are likely to follow.

We briefly tested below the December yield lows post the CPI print and maybe our one area of caution here is the reversal amidst the risk-on euphoria last Friday.

Markets still trading the 2022 playbook…

So we’re comfortable that the macro view we’ve been laying out for the past few weeks is playing out according to our framework. This is a HUGE shift in the macro dynamic as markets go from pricing the sharpest Fed hike cycle in history, to pricing the pause and eventually the pivot, whenever those rate cuts come. The market is wildly under positioned for this change and is still trying to trade the 2022 playbook. Yet we’re peak inflation, peak rates, peak Fed. 2022 ≠ 2023

Crypto leading the regime shift…

Arguably, crypto priced the aggressive hike cycle before any other asset class and is perhaps now leading the regime shift with last week’s breakout. Indeed, the macro appears to be the catalyst for the move and comes amidst a backdrop of still negative news flow.

The Gemini/DCG saga continues to play out and is an area of concern should bankruptcy result and drive forced liquidations. However, crypto has advanced warning on this (unlike with FTX!) and appears to be taking it in stride. SEC Chair Gary Gensler meanwhile, never one to miss an opportunity to get his name in lights, announcing that the SEC has charged Genesis and Gemini for the unregistered crypto lending to retail. Note to Gary: It would be helpful if you could get your act together and put these protections in place before the event, rather than opportunistically and retroactively acting. We digress…

Raids too on Nexo offices also casting a further shadow, not to mention continued headcount reductions announced across various crypto firms.

Planting the seeds for full scale adoption…

The lack of reaction in crypto to these events is a positive development. Indeed, post FTX, markets have adjusted to the idea that we require greater scrutiny and regulation to allow this space to flourish. Counterparty and credit risk is now at the forefront of institutions’ trading decisions and compared to previous cycles, we’ve moved past the FUD that the US will “ban crypto” and now it’s about what the regulatory environment will look like which somewhat paradoxically acts to validate crypto as an asset class. We continue to plant the seeds for full scale adoption. FTX may well have been one step back, to take two giant leaps forward.

Speaking of which, the rip higher in BTC and ETH has now recovered the FTX capitulation. Interesting too that ETH lows were in June, despite the Fed getting more aggressive and FTX blowing up.. Clearly post the Ethereum merge, the “supply curve” shift is helping to raise the equilibrium price for a given level of demand and bodes well for price in what should be a better environment in 2023. Risk/reward looks compelling.

What’s behind these explosive crypto moves?

Crypto started the year trading well on this slow macro shift that we’ve been highlighting, getting validation from weaker CPI prints in Europe. Then came the weaker earnings print in the US Non Farm Payrolls and last week’s CPI added to the data momentum. The explosive move higher however happened late Friday and into the weekend and there’s a few key points to note about this rally. Note, we get a bit more technical here.

First, into CPI, huge 27th Jan BTC Call options with 18k and 19k strikes were put on over at Paradigm the institutional liquidity network for trading block size and multi leg crypto derivatives. You can follow their flows in Telegram here

This looked like a play on CPI and ultimately the Fed, taking the most liquid date to trade in and around that event. Second, there were big option expiries rolling off on Friday morning.

This left the market makers (dealers) “short gamma.” Simplistically, dealers typically don’t take a directional view, but are trading just the volatility. When dealers are long gamma, it means to hedge their underlying position and remain “neutral” they have to sell the underlying on a rally and buy on a dip. This tends to keep prices contained. However, when the market finds itself net short gamma, to hedge, dealers are forced to buy rallies and sell dips which acts to exacerbate the breakout moves.

Consequently, dealer short gamma into weekend thinned liquidity, alongside short liquidations helped fuel the explosive move higher.

Why we think this is interesting, is last weekend’s move has not been driven by crypto bro’s quitting their jobs at McDonalds to start ape’ing back into BTC and so running the risk of this positioning getting squeezed out on the short side. Instead, it’s been fuelled by a negative gamma squeeze and short liquidations.

Our sense therefore, is the market remains under positioned for the topside and FOMO is yet to kick in. This in our opinion will be supportive for price and see inevitable pull backs met with solid demand.

Furthermore, alongside the macro, March brings the Shanghai upgrade for ETH (Paradigm flows again show funds starting to position for this with end of March call spreads).

In summary…

Narratives ultimately drive markets and crypto for some time now has lacked a narrative. We’re now getting positive narratives both from the macro as well as idiosyncratic narratives from crypto itself and the market is under positioned with most of the leverage wiped out post Luna, then FTX.

Nothing is certain of course and there’s still a lot to navigate, but as we wrote coming into 2023, there’s a much more positive outlook developing for Crypto which has been severely battle tested in 2022 and is displaying great resilience. This resilience may well form the cornerstone for the next bull run. Maybe it’s started.

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This article does not constitute investment advice. Do your own research or consult a professional advisor.

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