Onto Next Year
Our last weekly strategy note of the year is going to be a brief one. I want to thank everyone for turning to us for timely and actionable research on crypto throughout this year. It was undoubtedly a trying time for the industry. We witnessed a period of reckoning that will leave the space better off over the long term. We will be back in the new year with our outlook for 2023, and perhaps a surprise that we think will help our clients and subscribers manage crypto risk much more effectively.
Now for a few interesting insights worth paying attention to heading into year-end, most of which suggest we are on the brink of finally resolving this year-long plunge downwards.
Volatility on the Decline
If you merely paid attention to equities over the past week, you might be surprised when you shifted your view back to crypto, only to see that the coins had not budged, despite substantial swings in major equity indices.
Below we can see that annualized 30-day realized volatility has fallen off a cliff since the FTX-driven liquidations in early November. Conversely, SPX volatility has steadily climbed higher, continuing a trend that began over a year ago.
Low BTC Volatility Relative to Equities Precedes Substantial Moves
The reduction in volatility relative to equities has historically pre-dated substantial near- and intermediate-term moves.
Below we created a ratio of BTC to SPX volatility using rolling 30-day annualized volatilities. We used a lookback period starting in 2016 since this was when correlations with macro began to take consistent shape. A ratio below 1.0 means that bitcoin’s volatility is lower than the S&P 500’s volatility. Very few instances have occurred where the market observed a ratio below 1.0. However, the most recent period within this territory was relatively recent – just before the collapse of FTX and the subsequent plunge in asset prices.
To be clear, we are not currently below this level, but if current trends continue, we will be in no time. Based on the chart below, this churn in volatility can resolve in either direction in the near term. In both November 2018 and November of this year, we saw volatility get crushed relative to equities, and this was followed by a severe drawdown. Meanwhile, in 2016 and 2020, prices resolved to the upside.
One important variable worth noting is the monetary regime in which each of these instances of volatility decline occurred.
The cases of decreasing volatility that transpired during periods of Fed tightening (highlighted below) were followed by steep drawdowns. Those that occurred during loosening or flat monetary conditions resolved to the upside.
To put the near- and long-term returns into perspective, of the six instances highlighted in the chart above, returns over the ensuing 365 days were impressive. The returns over the ensuing 30 days were mixed.
Broadly speaking, removing the comparison to equities, we have seen that instances in which volatility has wholly vacated the market are great times to increase exposure.
Visually, we can see that each time realized volatility had reached this level, near-, medium, and long-term returns are impressive.
The Path of the Dollar
This was a year in which the Fed, despite being late to respond to clear inflationary pressures, was resolute in its quest to tighten monetary conditions since Q1 this year. As we approach the new year, having witnessed a continuously strengthening US dollar, we are reminded of the critical relationship between the USD and bitcoin. Broadly, this correlation speaks to bitcoin’s better performance in looser monetary regimes.
Now we are faced with a scenario in which the Fed has set inflation on the proper trajectory, and has admitted that it is likely time to slow rate increases or pause them to let the hard data catch up to the changes in policy.
We are also finally starting to see the Fed pass the ball to other central banks, which, up until now, have been more hesitant to raise rates due to their respective economic situations. However, these dovish stances are shifting.
Last week, the ECB surprised many with a hawkish tone in the face of persistent inflationary pressures, and this week, markets were floored by the decision from Japan’s central bank to raise its target 10Y yield from 0.25% to 0.50%. This was a massive signal that the country famous for its persistent deflation would also start tightening monetary conditions.
While there remains an argument that appetite for risk remains constrained in a globally tight monetary regime, we think a declining USD coupled with decreasing or flat terminal Fed Funds rate is of paramount importance relative to the monetary conditions in Europe or Asia. In short, a peaking USD would be constructive for bitcoin’s price in the coming year.