There is one macro variable, and it alone affects more than 50% of cryptocurrency price fluctuations. What does it mean for the value of your coin wallet? The variable I’m referring to is the dollar.
I compare BTC price and cryptocurrency market cap to a basket of macro factors. The price of the US dollar (represented by the DXY index) has the most obvious correlation with cryptocurrencies.
54% of the time, year-on-year BTC price changes can be explained by DXY alone.
DXY goes up -> cryptocurrency goes down and vice versa.
2018, the arrival of the last cryptocurrency bear market, coincided with a major trend reversal in the U.S. dollar, and as the U.S. dollar began to fall in early 2019, BTC was resurrected from the dead. Which makes you wonder, is the cryptocurrency driven by the BTC halving as they would have you believe, or is it driven by the USD valuation cycle?
You say, the price of cryptocurrencies is in dollars. So, if the dollar rises, of course cryptocurrencies will fall. Or, in your opinion, cryptocurrencies are risk-seeking assets and the US dollar is a risk-averse asset. They should of course be negatively correlated. This doesn’t seem to be a problem?
Indeed, there is also a negative correlation between DXY and commodities, as commodities are mostly traded in USD, and there is also a negative correlation between DXY and the stock market, as stocks are risk-oriented assets.
But DXY explains only 24% of gold price changes and 7% of S&P 500 changes — an order of magnitude more correlated with cryptocurrencies. Why?
This is the product of a combination of various factors. Mechanically, as the U.S. dollar rises, it becomes more expensive to derive benefits from other currencies through stablecoins, reducing demand for cryptocurrencies.
But more importantly, the dollar value is a bellwether for many macro factors, from global risk appetite to monetary conditions to growth prospects to central bank actions, all of which affect cryptocurrencies.
In other words, even though DXY itself does not “cause” a cryptocurrency’s price change, it is a summarizing indicator for many other factors. This is similar to the idea of ”dimensionality reduction” in data science, if you will.
Therefore, if you are wondering how your cryptocurrency wallet might perform in the short to medium term, it is useful to look at the USD valuation trends and their drivers.
Driver 1: U.S. current account
Your college economics textbook says that if a country imports more than it exports (i.e. a current account deficit, roughly), the value of its currency should fall.
In fact, the U.S. current account has been deteriorating since the Covid-19 pandemic, while the value of the dollar has fallen.
But the post-pandemic economic recovery is slowing, with shrinking government spending –> less import demand –> lower annual current account deficits this year –> supporting the value of the dollar.
Therefore, USD Bulls: Score 1; USD Bears: Score 0.
But in reality, the current account has little impact on the dollar compared to other currencies because many commodities are priced in dollars. In an over-financialized world, financial markets have a greater impact on the value of the dollar, which also makes me think:
Driver 2: U.S. capital inflows
The United States is a net recipient of portfolio investment inflows. Inflows to buy U.S. assets –> support dollar demand.
That money is increasingly making its way into the U.S. stock market, which has outperformed most other markets by a wide margin, attracting investors from all over the world.
But as you know, a slowdown may have already begun due to looming Fed tightening, and stocks have been hit hard. A prolonged bear market drives investors to look for wider pastures –> money leaves the U.S. market –> dollar demand falls –> dollar value falls.
Whether we’ll see a general decline in stocks is debatable. But since there is no hard evidence to disprove it, we believe this will happen.
So now: Dollar Bulls: Score 1: Dollar Bears: Score 1.
Driver 3: Fed rate hikes
The prolonged low-interest-rate environment in the U.S. has spurred a variety of carry trades — borrowing dollars to buy higher-yielding foreign assets at low interest rates. This is an important driver of rising foreign assets held by U.S. banks and other financial entities.
Unless your dollar cost of capital goes up, this is a foolproof investment. Higher interest rates –> less carry trade profits –> less portfolio outflows from the US –> dollar demand rises –> dollar value rises –> less carry trade profits –> a self-reinforcing reflex cycle.
But as you can see in the graph below, which estimates the DXY response to a rate shock (data from 2010 to 2021), a rate hike (left graph) has a stronger impact on the dollar’s appreciation than a rate cut (right graph) The impact of a weaker dollar is weaker.
That is to say, the effect is “you ascend and I descend”. This is in stark contrast to the effects of QE/T, as you’ll see in a moment.
For now: Dollar Bulls: Score 2; Dollar Bears: Score 1.
Driver 4: Fed Quantitative Tightening
The impact of Fed asset purchases is similar to a rate hike. QT (quantitative tightening) -> dollar rises, QE (quantitative easing) -> dollar falls. But its impact is stronger because it directly affects market liquidity and the far side of the yield curve.
Historical data shows that the QT (right panel) effect that causes the dollar to appreciate tends to be much stronger than the QE (left panel) effect that causes the dollar to depreciate.
If the above estimates are taken at face value, the impact of QT on the dollar would last for about 10 months before fading. This means that if this year’s QT starts in July, it will push the dollar stronger until May 2023.
Anyway, now we have: Dollar Bulls: Score 3; Dollar Bears: Score 1.
The dollar bulls are winning, in fact since last May, while the power of cryptocurrencies is being eroded. (Dollar rises, cryptocurrencies fall.)
Ukraine gave DXY another boost. At the current rate, this thing is on its way to over 100 — a long-term resistance — within 6 months.
But will its upward trajectory be so smooth in the next few months? I remain skeptical.
Let’s not forget that neither the hike nor QT has started yet. The Fed’s balance sheet growth, while slowing sharply since last May, is still growing, and the market is not at all lacking in liquidity.
However, everyone is trying to get ahead of the Fed. The Nasdaq is down 20% from its December lows to this month, the cryptocurrency is more than 40%, and neither the rate hike nor QT has been justified by actual market conditions.
I expect a strong market rally between now and sometime in July, which should also be the latest QT to start. (A rate hike is a small thing, QT is a big thing.)
This means that BTC dominance is still likely to fall again until June.
Depending on the situation in Ukraine, the QT program may change. Markets would be happy if it was delayed to cushion the blow from oil prices on the economy, but probably not for long.
Anyway, my view is short to medium term market rally with heightened volatility, but by the end of the year, QT has started, DXY has risen further, and cryptocurrencies have fallen further.
But, in conclusion, let’s not lose sight of the big picture. The U.S. dollar has been in a long-term downtrend for over 30 years. Why is this so?
There are many reasons, but it ultimately comes down to supply and demand. If the supply of dollars exceeds the demand, the price is bound to fall. I’m not just talking about the supply of the dollar itself, but also the supply of other things that are in fact substitutes for the dollar, for example, U.S. government securities.
U.S. Treasuries and other debt securities are increasingly viewed by investors as money, a medium of exchange and store of value. This trend is underpinned by volatility suppression by central banks, which helps keep the value of these “quasi-currencies” stable.
This means that the actual money supply should be the statistics of M1, M2, etc., plus the stock of public debt in circulation. This real money supply is now twice the official M2 and growing faster due to the ever-increasing U.S. government debt.
Assuming the demand for money remains stable, to see which direction the value of the dollar is going in the long run, you just have to ask yourself:
1) Will the trend in public debt reverse?
2) Will there be more and more things other than the dollar being used as a global currency?
My answer is: 1) no, 2) yes. Government spending has to increase due to population aging and automation, which means more debt, and thus more quasi-currency issuance. As for global currencies, I don’t know, but I’ve heard there is something called cryptocurrencies.
1/ The value of the US dollar and cryptocurrencies are closely related, the dollar rises -> the cryptocurrency falls
2/ USD should appreciate this year
3/ QT-led dollar appreciation lasts about 10 months
4/ MKT expected to rebound in the short to medium term, but bear market appropriately later in 2022
5/ In the long term, the dollar is in a downtrend