The ebb of liquidity triggers a currency disaster, and the myth of Bitcoin’s “digital gold” fades


June 18, 2022

Reversing the inflation cycle for the Fed would require raising the federal funds rate to 6%, well above the current market consensus. The volatility of risk assets is likely to intensify, gold is still expected to be a stabilizer to reduce the volatility of the investment portfolio, and the shrinking of the market value of cryptocurrencies may continue.

When the liquidity feast came to an end, not only did U.S. stocks fall into a technical bear market, but the currency circle also felt the chill.

Bitcoin, which was once hailed as "new gold" or "digital gold" by insiders, has had a bleak trend recently. The all-time high of $69,000 fell more than 70%. The decoupling crisis of the third-largest stablecoin "algorithmic stable coin" USDT and the U.S. dollar that broke out in May has also dented confidence in the cryptocurrency market, causing many institutions to teeter on the brink of bankruptcy.

Joseph Carlson, the former chief economist of AllianceBernstein, recently published an article arguing that the Federal Reserve needs to raise the federal funds rate to 6% to reverse the inflation cycle, far exceeding the current market consensus. The volatility of risk assets is likely to intensify, gold is still expected to be a stabilizer to reduce the volatility of the investment portfolio, and the shrinking of the market value of cryptocurrencies may continue.

More than 70% down from the all-time high

As of the close of last Friday (June 17), the international gold price was reported at $1,841.9 per ounce. As of 14:10 on the 19th, Beijing time, the price of Bitcoin was reported at $18,299.

According to CoinGecko statistics, among the top 100 cryptocurrencies by market capitalization, 72 have fallen by 90% or more from their historical peaks. Specifically, cryptocurrencies with larger market capitalizations have seen relatively small declines. Among the top ten cryptocurrencies by market value, 9 currencies fell by less than 90%. The price of Bitcoin fell by 70% from the peak in November last year, and the price of Ethereum fell by about 78% from the historical peak.

Under the expectation of aggressive interest rate hikes by the Federal Reserve, cryptocurrencies have suffered a "bloodbath" in the past week, and the total market value has fallen below the $1 trillion mark. As the May U.S. inflation data (8.5%) released a few weeks ago exceeded expectations, the Federal Reserve announced a 75 basis point (BP) interest rate hike on the 16th, and the S&P 500 officially entered the bear market region in the past week, from January 3 this year. The all-time high fell 24% to 3,667 points.

The agency expects that the Fed will continue to raise interest rates by 75BP in July, then raise interest rates by 50BP in September, and raise interest rates by 25BP in November and December, thus accelerating the return to the neutral interest rate of 3.25%~3.5%. The Fed also predicts that the interest rate level at the end of 2022 will be 3.4%, that is, it will raise interest rates by 165BP this year. The Fed also expects interest rates to be 3.8% in 2023, which is roughly the same as market expectations (4%). At the same time, since June, the Federal Reserve has begun to shrink its balance sheet, and it will gradually reach a monthly shrinking scale of 95 billion US dollars in the future.

"Affected by the sell-off in US stocks, Bitcoin fell by more than 10% on Friday (17th), and under rumors of tight liquidity on the major cryptocurrency platform Celsius, Bitcoin fell nearly 25% this week (13th to 19th). There are also unconfirmed reports that Three Arrows Capital, a $10 billion crypto fund, missed a margin call and is now insolvent. Bitcoin needs support at 20k U.S. dollar to prevent a further pullback to the $13,880 level in June 2019,” City Index senior analyst Sica Moore told reporters. However, Bitcoin has now fallen below the above-mentioned key support level.

Cryptocurrency institutions liquidate their positions

As early as May, the decoupling of the “algorithmic stablecoin” USDT from the U.S. dollar triggered a “currency disaster”. This turmoil has still shocked the market so far and may exacerbate market volatility in an environment of tight liquidity.

Cryptocurrency hedge fund Three Arrows Capital is exploring options, including selling assets and seeking a bailout from another company, the media said on Friday. Companies like Coinbase, Gemini, Block, and have laid off thousands of employees as investors sell risky assets in an environment of rising interest rates; on Thursday, it was reported that Three Arrows Capital Can meet margin call requirements.

In May, the cryptocurrency market was rocked by the collapse of USDT and its sister token LUNA after the stablecoin USDT could no longer be pegged to the US dollar. It is reported that Three Arrows Capital invested about 200 million US dollars in LUNA.

At that time, USDT and LUNA suffered a "death stampede". USDT should have been anchored at 1 US dollar, but it plummeted to 26 cents, and there was only a pitiful less than 0.09 cents left in the following week. After LUNA’s currency value evaporated by 99%, the largest stablecoin “guaranteed stablecoin” USDT fell below the US$1 that should have been anchored, and once fell to 95 cents. At that time, the price of Bitcoin was also pushed down to a new 16-month low.

On May 10, the Federal Reserve released the latest Financial Stability Report, which also emphasized the risk of running on stablecoins. In fact, the market value of USDT is small and the overall impact is controllable, but if, for example, USDT is exposed to the same risks, it will have a relatively large impact on financial stability.

USDT uses assets such as U.S. dollars or U.S. bonds as a reserve to support stablecoin prices. Most of the USDT is issued in the form of tokens on the Bitcoin blockchain through the Omni Layer protocol. Each issued and circulated USDT is pegged to 1 US dollar, and this part of the US dollar is stored in Tether, the issuer of USDT. At the time of redemption, USDT holders can exchange USDT for fiat currency or bitcoin.

Questions about "secured stablecoins" have never been interrupted, especially since Tether has never publicly proved that for every stablecoin issued, there is a corresponding $1 mortgage. In addition, Tether was established in the British Virgin Islands by Bitfinex's chief strategy officer and financial director. In other words, investors who hold USDT continue to "buy it" because they believe in Bitfinex's ability to redeem as the world's largest bitcoin exchange. But once this "consensus" is broken, the value of the "guaranteed stablecoin" is obviously no longer stable.

The gold preservation function is highlighted

The tide of liquidity has receded, and the "new gold" has been retreating. The more risky assets are volatile and inflation is high, the more prominent the value of gold seems to be.

On the 16th, the S&P 500 index fell to around 3,666.67 points, the lowest closing level this year, and a drop of nearly 24% during the year. However, the international gold price is still around $1,840 an ounce, and it has still made positive gains since the beginning of the year.

In the future, inflation will be the most critical variable to determine the direction of monetary policy, and the upward trend of food and crude oil prices will be difficult to end in the short term. Standard Chartered believes that risk asset volatility will increase, and gold will be an effective tool to reduce portfolio volatility.

It is worth mentioning that against the backdrop of rising real yields and interest rate hikes this year, the price of gold for non-interest-earning assets remains firm, which seems to contradict historical logic. The outside world believes that this also comes from the expectations of global central banks for the diversified allocation of reserve assets. According to data from the World Gold Council, in the first quarter, the official gold reserves of global central banks increased by 84 tons, and the net purchase of gold more than doubled from the previous quarter. The market expects the trend of diversification to accelerate after "restrictive measures" were imposed on some of Russia's central bank's foreign exchange reserves in March.