“Fed Week” is finally here. On Wednesday we’ll get to hear from Jerome Powell and Co. as they set the price of money for the next 2 months. According to the CME’s FedWatch tool, 86% of investors expect a 75 BPS increase and 14% expect a full 100 BPS increase. In other words, the market is effectively pricing in a 75 BPS increase.
It is pretty much a given that the Fed will have to keep raising rates to at least 4% and above (from the current 2.50%) - with investors like Ray Dalio going as far as to say it needs to go to “the upper bound of 4.5 - 6%”.
Similarly, he signals that according to his estimates, if the rates were to go to 4.5%, that would imply a further 20% drop in equity markets.
While the future is unpredictable, there are a few things that are known in this environment. Keeping those in mind could provide an indication of where we could be headed. Here’s a handy list:
- The Fed wants to bring inflation back to 2-3% range
- If the neutral rate is to be slightly above inflation, we can assume that the base rate should be at least 3.5% over the long term
- Because of how CPI is calculated and the data from the trailing 12-months, even if markets stay flat, the earliest inflation readings would show it under 3% would be spring 2023.
4. There is a strong correlation between the size of the Fed’s balance sheet and the value of assets (stocks, real estate and bitcoin)
In other words, the Fed sees the stock market and real estate as drivers of “the wealth effect”. It uses its policies to make people feel wealthier or poorer to drive economic behavior.
- The Fed is decidedly trying to keep the wealth effect, hence markets - in check. This week’s Wall Street Journal article is a clear example of this.
- The Fed has openly stated it is planning to reduce the size of its balance sheet by $95 Billion per month. For context, when it was stimulating the economy it was _buying_ $80 Billion per month in mortgage backed securities and treasuries. In other words, the size of the balance sheet is going down, which should continue putting pressure on markets.
So - what conclusions can we draw from this?
- The Fed does not want asset prices to rally until inflation, or CPI, is back between 2-3%. It will do everything in its power to keep them suppressed until then. This is an effort to keep the “wealth effect” in check.
- The Fed is actively reducing the size of its balance sheet - and will continue to do so until the end of the year. Given the tight correlation between the Fed balance sheet and the S&P 500, this means that it should remain under pressure until then. (This is consistent with point 1).
Translation - investors should expect at least a 75 Basis Point rate increase this Wednesday and a sobering speech from the Fed. At best, it may suggest that future increases are “data dependent” - but Powell will not want to risk coming off too friendly to prevent a knee jerk rally in markets.
Having said this, markets recalibrated to this expectation after last week’s CPI reading. Meaning that it could hold up well on a 75 BPS announcement.
- The earliest we can get to 2-3% inflation, assuming a “happy path” forward is between March-July next year.
- The stock market and other asset prices work with forward-looking expectations.
Translation - investors are keeping a close eye on key market levels as we head into Q4. Many expect the worst in terms of pricing to materialize in the coming months, providing buying opportunities as we head into Q1 2023.
The future is hard to predict - the Federal Reserve isn’t. We also know the data they look at and the tools at their disposal. In the current market conditions, investors like getting paid to wait. Savings Accounts products like Ledn’s let you earn up to 7.5% APY on your U.S. dollar tokens and up to 5.25% APY on your first 0.1 BTC - allowing you to buy and sell between the 2 assets at any time.
With the Fed wanting to keep equity markets in check until at least the end of the year, it is effectively providing an artificial upper “cap” on asset prices. With that as our base case, the 2 remaining outcomes are a sideways progression until the end of the year, or potentially further downside before a recovery. In today’s section we breakdown what could drive potential further downside.
With a “sideways chop” until the end of the year being the base-case scenario, we’ll turn our focus on potential events that could derail markets to go below the lows set in mid-June. While there are many events that could derail this potential outcome, we’ll focus on the big ones:
- A breakdown in the U.S. real estate market
There’s a very simple reason to be worried about the U.S. real estate market, and that is - lending to the U.S. government is yielding close to the same amount as owning and renting a house, with all the pains and risks associated with that activity.
This is a clear-tell sign that the real estate market is about to come under pressure - if nothing else, by selling pressure from real estate investors and not end-users.
Rising mortgage rates may also drive several participants to repay their personal lines of credit or mortgages, draining money from the economy that would otherwise have been spent elsewhere.
- A renewed spike in energy prices
A big driver of the lower inflation trend is the astronomical drop in the price of oil and therefore gasoline. The interesting thing is that this price drop was not natural - it was manufactured by draining the strategic oil reserves of many countries, the U.S. being the main one of them.
As the world looks to its oil producers to demand more production capacity, underinvestment over the years is finally showing its cracks - with capacity constraints popping up everywhere.
OPEC+ has clearly stated that it wants to keep a $100/barrel price - which could put upward pressure on fuel prices from current levels.
If energy prices start rising once again, inflation will remain sticky for longer, meaning that high rates will remain. This could translate to markets selling off if CPI stays above 7.25% by the November meeting.
With rising U.S. treasury yields after last week’s inflation reading, the U.S. dollar has sucked the air out the room and the wind from under the sails of asset prices. Last week gold finally broke down below the important $1,700 level that we’ve been watching, and the future looks grim until the end of the year.
This sentiment is shared by TD Securities’ commodity analysts, who in a note to investors last Friday stated that they were adding to their tactical “short gold” position, as they expect prices to dip to a target of $1,580 between now and the end of the year.
On the DeFi space, a bloody week for ETH closing at -15.06% against BTC despite the successful Merge upgrade occurred in the early morning of September 15th EST.
ETH's price suffered a sharp sell-off after the long-anticipated transition to PoS, reaching $1280 during the weekend, trading currently around $1350 - figures not seen since mid-July.
In what appears to be a major "sell-the-news" event (at least from a short term perspective) for the second biggest cryptocurrency in market capitalization, the DeFi Index also outperformed ETH finishing the week +10.68% against it.
The successful Merge was broadly celebrated within the community and among the core contributors:
The Merge impacted ETH's inflation substantially, reducing in 95% the daily issuance to the validators. The supply change compared to ETH PoW is estimated to be nearly 60.000ETH in just fews days.
Although still theoretically an inflationary asset, the severe reduction in emissions post-Merge allied with the EIP1559 (burns ETH dependent on the demand for Ethereum network in simple terms) that was already in place, could in fact turn the asset to become deflationary if the demand for blockspace continues to scale.
There is an interesting tool where you can check these inflation & economics information about ETH supply and simulate future projections:
As an example, considering the current 30-day avg demand for blockspace on Ethereum network, in a 2 years period from now we could have 116.5M ETH as total supply, instead of the current 120.5M ETH.
The transition to Proof of Stake also expects to reduce in 99.95% the electricity consumption by the network as estimated by the Ethereum foundation and was also widely covered by the mainstream media sourced with interesting information from the main contributors:
Despite the bearish price action, ETH holders are still hopeful of a recovery from its recent losses against BTC to potentially re-test the highs from the last 2017/2018 cycle.
At Ledn we had a very smooth period during the upgrade with practically no impacts to our users and operations. We will monitor the developments on the ecosystem and as usual keep you informed.
During the past months of Bitcoin's sideways price movement, we've covered how miners' profit margins have been suppressed for multiple reasons, including surging energy prices globally. Which is forcing some miners around the world to look for cheaper power elsewhere.
In Europe for example, Norway and Sweden attracted Bitcoin miners for long periods of time thanks to their abundant energy sources. With the war between Russia and Ukraine still upon us, rising energy bills coupled with fears they might be regulated out of the market has made a group of miners evaluate the Arctic Circle's cheap energy sources as an alternative.
In Australia, the first Bitcoin mining farm powered by solar was installed. Operated by Lumos Digital Mining in the city of Whyalla, the site could mine around 100 BTC a year. It's remarkable how use cases like this one show the exact opposite of what is sometimes stated in the headlines (e.g. "Bitcoin generates too much carbon emissions").
The last thing we'd like to cover in this week's mining section is the rising share of US Bitcoin mining out of all global mining activity. Since the China Mining Ban, the US has become the #1 country in terms of hash power, bringing US' mining share from 3.5% all the way up to 38%; in just two years. No wonder the White House is now further investigating how PoW can impact the country's energy industry.
All eyes will be on the Fed meeting this week Wednesday at 2 PM EST where investors expect a 75 BPS increase. Last week the Ethereum Merge went smoothly, and once again the old “buy the rumour, sell the news” wall street saying proved to be true.
The price relationship between bitcoin and ethereum is once again in the mid-range of its historical level. Checking in on the chart that we shared last week, the reversion to the mean trade into the merge played out favorably for bitcoin.
In bitcoin terms, Ethereum dropped ~10% since our report last week. This shows that - while excited by the merge, the event was unable to draw in net new buyers for Ethereum at the current levels.
If economic and developer activity returns to Ethereum in droves during the coming weeks, the upper bound of the relationship might be tested. Conversely, if we remain in a risk-off environment, it is possible that Ethereum loses even further ground relative to bitcoin, as many investors consider it to be further out the risk spectrum than bitcoin.
Here’s what you can expect for the week ahead:
12.30 PM EST - Federal Reserve FOMC Meeting - Interest Rate decision
09:00 AM GMT - Bank of Japan meeting - Interest Rate decision
07.30 AM GMT - Swiss National Bank - Interest Rate decision
11.00 AM GMT - Bank of England meeting - Interest Rate decision
It's a big week coming up, and as always, we'll keep you posted on any relevant news throughout the week right here and from our Twitter account.
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About the author
Mauricio Di Bartolomeo
Mauricio is the co-founder and Chief Strategy Officer of Ledn.io. He grew up in Venezuela where he and his family learned about Bitcoin. Now based in Canada, Mauricio holds HBA and MBA degrees from the Richard Ivey School of Business in London, Ontario in Canada.