Every Dog Has Its Day?

TLDR:

1. US Markets make a round trip to end the week slightly lower, while crypto continues to make new highs.
2. Yen is at the highest in months despite BoJ’s affirmation of an ultra easy policy.
3. Germany struggles to decide whether to supply Ukraine with its Leopard 2 main battle tanks.

I did not expect my last week’s predictions to play out so soon. Perhaps it is still premature but on 2 key points:

1. Crypto has definitely been outperforming traditional assets last week
2. Germany is now being put in the difficult position of sending top-tier military equipment to Ukraine and dragging their feet.

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Source: Yahoo Finance

How will this play out for the coming weeks to month though? Let’s dig in!

Crypto Outperformance

To be honest, my belief about the recent outperformance of crypto is less about any specific catalyst, but more about extremely unbalanced positioning which meant that any random event could precipitate a “short squeeze”, but it’s hard to predict “when” it would happen.

The case in point is the chart above. We can see the supply of Bitcoin has been dropping across exchanges, yet the price has continued to trend down prior to january. This is akin to piling up a lot of tinder and waiting for a random passerby to simply drop their cigarette into the pile.

Since the beginning of the year, the tinders were:

• Pro-crypto Silvergate Bank released earnings this week and has taken a major hit, but will survive and continue to service the sector.
• Coinbase continues to slim down and gun for more profitability and seems in no immediate danger of failure
• Genesis Global Capital, one of the biggest crypto lending desks, has finally filed for bankruptcy. This eases concerns that contagion will spread to its parent company DCG, or its sister company Grayscale, which runs the Bitcoin, Ethereum among many other closed-end funds.

None of these are direct positive catalysts, but for those that have been paying attention to the underlying “business” of crypto, which has been to supply permissionless compute power, here’s an interesting chart:

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Source: ultrasound.money

The chart shows the transaction fees paid on the Ethereum blockchain since the beginning of the year. All fees above the horizontal line causes some amount of ETH to be burned, thereby making Ethereum deflationary, hence the “ultra-sound” money moniker. Usage has gone up, and the chain is now consistently deflationary, generating approximately 4-5% income for those that stake their capital to keep the chain in operation.

This is a very small big deal despite net deflation of around 0.1% per year. Why? Because traders care a lot about carry. Carry trades are those that generate consistent income for those that hold the trade. It’s one of the biggest drivers in FX for those trading against the Yen and can cause violent swings when central bank policies change interest rates. 

Central Banks Throwing In The Towel?

What’s lighting the fire in markets is the expectation that the end of the major central bank rate hikes are over. With BoJ declining to raise rates, and the ECB considering a slower pace of hikes despite 9%+ Euro area inflation, markets have been green light across the globe.

The BoJ has the reverse problem of the Fed. Japanese companies have historically been reticent in raising wages since they have experienced nearly unabated deflation in the last 3 decades. The concern is that wage inflation will not keep up with inflation, thereby causing it to crash down again without jolting firms into action.

In contrast, the US has a much more flexible and competitive labor market and the Fed is concerned that wage increases will be persistent, thereby making it difficult to push down inflation once these expectations have been set.

Despite these two camps, measures of inflation pressures have been dropping fast. Perhaps energy will resurface as a concern this year, but the amount of investments in alternative energy sources have been expanding dramatically.

Oddly enough, interest has been growing but from a decidedly different front.

War Tactics

As we detailed last week, there is a fine dance that the US and Europe will have to do to minimize the risk of an all out war against Russia while supporting Ukraine. The latest disagreements revolve around providing modern main battle tanks to Ukraine. 

Germany has been dragging its feet on direct support but have stated they would permit partner nations already in possession of Leopard 2 tanks to supply Ukraine.

These are powerful enough to create meaningful tactical advantages for Ukraine given that Russia's fleet of T-90s are anecdotally more powerful than 3 outdated tanks from Ukraine.

Beyond supply, as we look into the future, both Europe and the US are looking to boost output of new firepower. The unlikely benefactor of this may be nuclear power. The US Navy has been exploring newer types of weaponry that would require higher energy intensity, the likes of which can only be provided by nuclear power. This would indirectly benefit investments in newer small-scale and scalable nuclear reactors, which would be both safer but also provide ample civilian applications.

Ivan’s Take

Sometimes it’s better to do nothing. While things have been chugging along, I see nothing that is likely to derail market sentiment. Other than earnings that will trickle in the coming weeks, expectations have been dropping, and for better or worse, it sets a lower bar for the future.

The Fed will be meeting next week, and markets are expecting a 25 basis points hike. Any mention of a changing stance towards a more balanced outlook would be a boost for markets, but unchanging rhetoric about being tough on inflation has already been priced in. So it seems that the risks are asymmetric to the upside.

That’s all for now, see you next week!

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