Bitcoin: Temporary Dip, But Conditions Remain Unfavorable (BTC-USD)

While an ongoing deterioration in leading economic indicators has largely been dismissed in recent months, weak employment data in July has placed the spotlight back on the possibility of recession. This has probably contributed to investors souring on risk-assets, but the sharp decline in asset prices at the start of August likely has little to do with fundamentals.

Bitcoin’s (BTC-USD) drop is more likely the result of investors being forced to unwind highly leveraged positions with no regard for price. As a result, a short-term rebound is likely once this process has been completed. Beyond this, Bitcoin’s price remains relatively high and is likely to decline significantly if macro conditions continue to weaken.

The last time I wrote about Bitcoin, I suggested that based on past halving cycles it could perform well over the next 12 months, but that a sustained upward move would require a supportive macro backdrop and increased demand. While the current dip presented a short-term buying opportunity, I continue to believe that a sustained bull market will likely require a recession followed by a loosening of monetary policy.

The Yen Carry Trade

The Yen carry trade has probably been an important driver of risk assets over the past few years and is the likely culprit for Bitcoin’s recent price drop. The carry trade involves borrowing money at a low interest in Japan, converting it to USD and investing where better yields can be achieved.

The widening gap in interest rates between the US and Japan over the past 2 years, has led to a dramatic decline in the value of the Japanese Yen, supporting the returns created by this trade. With Japan recently raising its policy rate, albeit modestly, and the US likely to begin easing in coming months, the value of the Yen has reversed sharply. Highly leveraged traders have likely been forced to exit their positions by this sudden move, with a flow through impact on risk assets caused by indiscriminate selling.

While forced selling may be done for the time being, it seems likely that the Yen will continue to appreciate in coming months, putting continuous pressure on traders to unwind the carry trade.

Recession Risk

A range of labor market indicators show an ongoing slowdown, and this has now moved beyond just a post-COVID normalization. This has largely been ignored in recent months, probably due to the fact that it has had limited impact on many assets so far.

With the SAHM rule now having been triggered, the state of the labor market, and the economy more broadly, is the focus of attention. Beyond just headline employment / unemployment numbers, there is a range of indicators showing the weak state of the labor market. For example:

• Household survey employment numbers have been flat in recent months
• Private employment growth has been weak
• Employment is increasingly being driven by part-time employment
• Temporary employment has been declining sharply
• Hours worked, and hourly wage growth have been under pressure
• Job openings and the quit rate continue to decline

While data is probably not at a recessionary level yet, this is all very normal in the lead up to a recession. If conditions continue to deteriorate, at some point a negative feedback loop between employment and spending/investment will be created, making a recession unavoidable.

Asset Prices

While economic risk is currently elevated, this isn’t currently reflected in asset prices. In fact, risk-on assets have generally benefited from expectations of looser monetary in recent months, with investors ignoring the possibility of cuts being associated with economic weakness.

While I do not believe that the recent drop in equities was driven by economic concerns, the narrative may be in the process of shifting. Second quarter earnings have been underwhelming so far, and rather than reaccelerating, most leading economic indicators suggest an ongoing slowdown.

Absence of Volatility

The sudden drop in asset prices comes after a period of abnormally low volatility. This low volatility is notable given that asset valuations are generally elevated at the moment and the global economy appears to be stumbling towards a contraction.

It has been suggested that low equity volatility is the result of yield enhancement ETFs and mutual funds. These funds sell covered calls or cash secured puts for income, helping to suppress volatility. Total AUM for these funds has risen six-fold since 2019.

While the drop in asset prices on August 5th is unlikely to be repeated, it is reasonable to expect volatility to generally trend higher in coming months, pressuring levered trades and asset prices.

Conclusion

It is important to note that asset prices are driven by flows, and these flows are often unrelated to fundamentals. For example:

• Passive inflows from retirement funds
• Explosion in option volumes and the associated hedging
• The Yen carry trade
• Volatility suppression by yield enhancement funds

The drop in Bitcoin’s price on August 5th was more likely the result of traders exiting highly leveraged positions rather than anything fundamental. As a result, the decline was rapid and excessive, creating a short-term buying opportunity.

Investors should be careful buying the dip, though. The Yen carry trade is likely to remain under pressure going forward, and weakening economic conditions could result in increased volatility and lower asset prices going forward.

I will probably only become bullish on Bitcoin’s prospects if a recession causes a sharp drop in prices and central banks lower interest rates and inject liquidity into the system, creating a more favorable environment for speculative assets.