A Game of Chicken?

TLDR:

1. PCE shows inflation continues to run hot
2. Crypto is charting it’s own path
3. Coinbase releases its own blockchain

Last time people listened to the Fed about transitory inflation, we got to 10% inflation prints. Not entirely the Fed’s fault, but it is being extra cautious not to repeat such a blunder this time. The message has been steadfast and consistent. We’ll hike as much as needed to bring down inflation.

Markets hope otherwise, yet since the NFP print at the beginning of the month, most measures have been consistently pointing to higher inflation for longer.

Mr. Market is playing a game of chicken with the Fed. People used to say: Don’t fight the Fed. Markets got ahead of themselves in January, and the Fed has pushed back. Has the bearish sentiment run its course?

PCE Runs Hot

PCE says no. Not only have revisions come in higher (Dec revised to 5.3% vs 5% previously), but January also came in at 5.4%, well above expectations of 5%.

The biggest concern that the Fed has been harping on has been services. And unfortunately, that has not only been high, but it’s been going the wrong way and accelerating.

And the worst part about services inflation is that it is fairly persistent, people expect wage growth of X% a year, and while it was painful during low inflation years, it will probably be worse during times of high inflation.

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Naturally stocks and bonds have taken a beating in the last week, but not all is doom and gloom…

Crypto Holds Strong

We stressed last week that correlation between asset classes have turned negative between stocks and bonds. This has also been the case for crypto vs stocks.

This is a big change. As you can see on the bottom blue section, correlation between S&P and Bitcoin has been positive for nearly all of 2022. So a correlation change means idiosyncratic factors are supporting crypto above and beyond the risk-on move implied by stocks. Last time this was the case was during the FTX blow up, which rightly indicated a state of distress unique to crypto.

So why is it happening? There’s no smoking gun anywhere, but I have a few guesses.

1. Hong Kong’s crypto reforms: There is a lot more speculation than substance at this point since activity will be permitted only for a select few residents and requirements are not easy for exchanges to satisfy to address such a small market.
2. ETH Shanghai Fork: Ethereum will become a fully functional proof-of-stake chain following the second part of the Merge upgrade which will come soon and allow pre-upgrade stakers to withdraw their ETH.
3. Tail Inflation Hedge: While many have argued that crypto can serve as an inflation hedge in the apocalypse/uncontrolled inflation hedge scenario, that hasn’t played out in the last few years. However it is something to monitor as many citizens in Argentina, Nigeria among others lose faith in their own countries ability to administer a stable currency, there’s some anecdotal evidence of many of them buying crypto.

So perhaps a lot of it is hype, but builders are going strong. The most notable development last week was…

Coinbase Launches a Blockchain

The Base blockchain is an open source layer-2 blockchain based on Optimism. It derives its security from the underlying Ethereum chain, and has the benefit of faster processing times, gasless transactions and additional developer tools. It aims to be the gateway for developers to make building dapps “easier, cheaper and safer”. 

What’s groundbreaking is not the blockchain. It’s the fact that Coinbase, known for its compliance-first approach to crypto, has come up with a way to build a blockchain while pacifying its team (army?) of lawyers.

While Binance, an international competitor, has long had its own (not 1, but 2 blockchains), it is quite another for a US based company to launch one post FTX.

For better or worse, Coinbase now serves as one of the few bulwarks defending the interest of the crypto industry. If adoption picks up steam, it could mean the beginning of another phase of broad adoption.

Ivan’s Take

While the bulls and bears fight it out, one clear winner in all of this is Ethereum. It’s become quite clear that while it’s not the fastest kid on the block it will form the foundation for higher level applications that will bootstrap its chain for security.

Furthermore, its native asset ETH benefits from accelerating deflation since the beginning of the year. Is that good enough to support its $200B market cap? Time will tell.

As for the correlations, everyone is holding their breath. Ten year treasuries are close to the critical 4% level while short term yields are almost 5%. How long can this hold as inflation continues to run? That’s this week’s trillion dollar question.

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My hunch is that we are close to the breaking point. A couple more higher-than-expected prints and pandemonium can ensue. See you next week!