How to make money in the cycle (2): Looking at the flow of funds from the perspective of the Federal Reserve's monetary policy and stablecoins

I. Overview

In the previous article, we covered the Bitcoin halving cycle and how to use the Merrill Lynch clock, and in this article, we will look at the inflow and outflow of funds from the perspective of the Federal Reserve’s monetary policy and stablecoins, so as to be aware of the stage of the cycle. The Fed’s monetary policy determines where money goes, and changes in the market value of stablecoins reflect whether money goes to the crypto market. Whether there is a continuous inflow of funds in the crypto market is the main basis for judging whether a bull market is coming.

Second, the Fed’s monetary policy perspective

The cryptocurrency world is heavily dependent on capital spillovers, and the Fed’s interest rate decision will determine where liquidity goes, so it is important to understand the Fed’s monetary policy.

1. Introduction to the functions of the Federal Reserve

The Federal Reserve is the central bank of the United States, and its full name in English is The Federal Reserve, abbreviated as the Fed. It was established to create a stable, flexible monetary and financial system for the country. The Fed’s primary responsibilities include: monetary policy setting, regulation and oversight of the banking system, maintenance of financial stability, and clearing and payment systems.

The monetary policy of the United States is set by the Federal Reserve, and the so-called Fed interest rate hikes and interest rate cuts are adjustments to the federal funds rate in the United States. The Fed adjusts interest rates by a minimum of 25 basis points at a time, say 25 basis points at 2.25%-2.50%, which becomes 2.5%-2.75%, and the adjustment decision is announced through the Federal Open Market Committee (FOMC) meeting.

2. The Fed’s motivation for raising interest rates

• Prevent the economy from overheating. **When the economy is on the upswing, it is easy for the economy to overheat, and the Fed is likely to raise interest rates to cool the economy. In this case, the impact of interest rate hikes on domestic and foreign financial markets is smaller. For the United States, the impact of interest rate hikes on the real economy is less due to the economic expansion period, corporate profitability is rising, financing resistance is smaller, and for other countries, the negative impact of capital outflows due to rising interest rates is offset by the positive impact of economic growth and increased imports in the United States.
• Reducing the level of inflation. **Although the economy may be at a standstill or in a downturn, the Fed will also choose to raise interest rates in order to curb high inflation. For the United States, rising interest rates will slow the recovery of the U.S. economy, making it more expensive for companies to raise financing, further affecting business growth, and for other countries, exacerbating capital outflows, incurring higher debt-servicing costs, and reducing exports **The need for monetary policy adjustments. **Even if there is no significant overheating and inflation, the Fed may raise interest rates as part of monetary policy adjustments. For example, after a long period of zero interest rates and quantitative easing, the Federal Reserve embarked on a new round of interest rate hikes in 2015 to return to normal monetary policy.

The reason for the Fed’s interest rate hike this time is to reduce high inflation. In the wake of the pandemic, the Federal Reserve has implemented extraordinary fiscal and monetary policies. Factors such as the overheating of the domestic economy, the rise in international commodity prices caused by the Russia-Ukraine conflict, and the sluggish global supply chain under the impact of the epidemic have caused inflation in the United States to soar. In addition, the Fed misjudged the severity and persistence of high inflation, and the tightening policy was not introduced in a timely manner, resulting in it having to resort to overkill measures to deal with high inflation. The Fed’s current goal to reduce inflation is to bring the CPI (Consumer Price Index, which represents the level of inflation) below 2%, which has fallen to 3.7% but has rebounded slightly in the first two months.

3. Historical analysis of the Fed’s interest rate hikes

Since July 1954, the Fed has gone through a total of 13 rate hike cycles, with the most recent full rate hike cycle being from December 2015 to December 2018.

In terms of the timing of interest rate hikes, among the 13 interest rate hike cycles, the shortest is only 4 months, and the longest is 69 months, with an average duration of no more than two years. The current rate hike began on March 17, 2022, and it has been 19 months since then;

In terms of the magnitude of interest rate hikes, the maximum rate hike is 15.25%, the minimum rate hike is only 1.37%, and the average rate hike is 4.74%. In this round of interest rate hikes, the federal benchmark interest rate has increased from 0.25% to 5.5% now, and the rate hike has reached 5.25%;

In terms of the pace of interest rate hikes, the 1980 rate hike was the steepest, with an average monthly rate hike of 2.63%. The pace of rate hikes was the slowest in 1963 and 2015, averaging 0.04% and 0.06% per month, respectively. The rate hike has averaged 0.28% per month, from 0.75% at the beginning, to 0.5%, and then to 0.25% at the most recent time.

Summary: Judging from the data of this round of interest rate hikes, the time and magnitude of interest rate hikes have exceeded the average of previous years, and the pace of interest rate hikes is also slowing down, which indicates that this round of interest rate hikes has come to an end. But the end of the rate hike does not mean that the rate will be cut immediately, and the most likely thing is to keep the interest rate high for a while, after which the Fed will adjust according to macroeconomic data such as CPI, PCE, non-farm payrolls, etc.

4. How does monetary policy affect the inflow and outflow of funds in the crypto market

• Impact of interest rate hikes: Increase the speed of capital outflows. Interest rates are constantly rising, and the withdrawal of funds from the crypto market is accelerating, flowing into the dollar market.
• Stop raising interest rates: Continued high-speed outflows. During the period of maintaining high interest rates, funds also maintained a high outflow.
• Rate cuts: The pace of outflows slows, but they continue to flow until outflows are reversed.

The growth of the bull market in the crypto market depends on the spillover effect of funds, which is first reflected in the U.S. stock market, where funds flow into the U.S. stock market, resulting in a bull market in the U.S. stock market.

We can have an intuitive understanding of the strength of the US dollar through the US dollar index, so as to judge whether funds flow from the risk market into the US dollar market. As a direct result of the Fed’s interest rate hike, funds poured into the dollar market, resulting in an outflow of funds out of the risk market, resulting in the fall of a risky asset like bitcoin, and how to measure the strength of the dollar requires the use of the dollar index (DXY). Because the U.S. dollar index is negatively correlated with Bitcoin, we can judge the future trend of Bitcoin through the U.S. dollar index.

Source: MacroMicro

3. Stablecoin Market Value Perspective

In the definition of a bull market in the first part of the cycle series, we talked about the continuous entry of incremental funds as one of the criteria for judging a bull market, and in this part we will introduce how to determine whether incremental funds enter the market from the perspective of stablecoins.

1. Why does the market value of stablecoins represent the amount of stock funds?

First of all, the concept of funds needs to be clear: funds are money that can be used, and money is money. Only stablecoins pegged to fiat currencies meet this point, and other cryptocurrencies fall under the category of assets. Many people are accustomed to the fact that the crypto market does not need fiat currency as a medium of exchange, and are guided by the name “XX coin”, so they feel that “XX coin” is capital.

Of course, not all stablecoins can represent existing funds, and all decentralized stablecoins secured by crypto assets are not included. The reason is that decentralized stablecoins cannot be directly exchanged for fiat currency because their collateral is a volatile asset. Therefore, decentralized stablecoins do not represent the entry of incremental funds, it is just another manifestation of assets.

On behalf of the incremental funds, the method of entering the market is to use fiat currency to purchase centralized stablecoins, and the issuer of stablecoins will issue additional stablecoins on the chain, and the market value of stablecoins will rise. In the trading market, stablecoins always flow from one person to another, and the total amount of stablecoins is constant, what changes is the price of volatile assets, so as long as funds do not enter or exit, the market value of stablecoins will not change.

As a simple example, let’s say A has 3 BTC, B has 10 USDT, and C has 15 USDT. B buys 1 BTC from A at a price of 10 USDT. Later, C also wanted to buy BTC, but at this time, A raised the BTC price to 15 USDT, and the price of BTC came to 15 USDT, and the market value of the stablecoin in the market did not change, and the price of BTC increased. Later, newcomer D wanted to enter the market and bought 20 USDT from the stablecoin issuer Tether, and due to the increase in demand, BTC was traded at the price of 20 USDT, at which time the market value of the stablecoin increased from 25 USD to 45 USD, and the BTC price also increased, which is the “price increase brought by incremental funds” mentioned earlier.

From the above example, it is not difficult to see that the increase in prices is not necessarily caused by the inflow of funds, the price is determined by supply and demand, but only the price growth without the inflow of funds is unhealthy.

2. Examples illustrate the impact of stablecoin inflows and outflows on the market

On May 12, 2022, the Luna thunderstorm officially started the current round of bear market, that is, since then, stablecoins in the cryptocurrency circle began to flow out in large quantities and never returned.

On June 15, 2022, Three Swords Capital thundered, and the stablecoin in the currency circle started the second wave of large-scale outflow, and it also never returned.

On November 12, 2022, FTX declared bankruptcy, dealing the final blow to the precarious cryptocurrency circle and completely dragging the cryptocurrency circle into the abyss of a bear market.

Looking at the data, we can see that since then, the total market capitalization of stablecoins has been declining, without a decent rebound, and the crypto market has also been hit significantly.

It should be noted here that due to the opaque capital information of centralized stablecoins, stablecoin issuers are likely to over-issue, and there are certain limitations in the way of looking at the funds on the floor based on the market value of stablecoins.

3. Does the big market necessarily need incremental capital inflow?

From a practical point of view, the big market does not necessarily need the inflow of incremental funds. Although the inflow of incremental funds has played a positive role in the subsequent market, the crypto market has also risen well in the context of the outflow of stablecoins this year. In the first part of the cycle, we summarized the bear market as follows: the bear market is a game of stock funds. In this year’s long-short game, it is obvious that the multiple armies are constantly attacking cities and seizing land in this battle.

4. How to identify the participation of funds in the market

Due to its good trading depth and high liquidity, centralized exchanges are the main places for large funds to trade, so the net inflow of stablecoins in centralized exchanges reflects the participation of funds in the market to a certain extent. The larger the net inflow of stablecoins, the higher the activity of the funds in the market, and the greater the role of driving the price.

From the chart, we can see that in the course of the last round of bull market rise, stablecoins continued to net inflow into CEXs, indicating that capital activity is high and traders are bullish, and in the process of falling in the bear market, the net outflow of stablecoins continues to expand, indicating that funds are gradually cooling, activity is decreasing, traders are not optimistic about the future market, and the desire to trade is weakened.

Looking at the data, the maximum market cap of stablecoins is $180 billion, and the peak of total cryptocurrency market cap is $3 trillion. The current total market cap of stablecoins is $120 billion, and the total market cap of cryptocurrencies is $1 trillion. The market capitalization of stablecoins has shrunk by 33%, and the total market capitalization of the crypto market has shrunk by 67%. This suggests that the shift in the market is related to the inflow and outflow of stablecoins. However, the market value of stablecoins has not fallen as much as the total market value of the crypto market, indicating that some of the funds attracted by the last round of bull market have not left the market and are on the sidelines.

At the same time, it also shows that poor liquidity is a false proposition, and liquidity does not need to be considered in a completely free market. If no one buys it, it is okay to reduce the price, and when the price drops, someone will naturally buy it, and then there will be liquidity. Illiquidity, reflecting a manipulated market. The price itself is overestimated, and if you don’t want to reduce the price and want to protect the disk, you can only maintain a state of high price and low liquidity.

Fourth, Summary

The Federal Reserve controls the flow of funds, and the market capitalization of stablecoins is the Kanban of the flow of funds in the crypto market. If you want to profit from the cycle, you must always pay attention to the Fed’s policy movements, which not only affect the direction of the market in the long run, but also have a huge impact on the sentiment in the short term, which is easy to cause short-term sharp fluctuations in prices. After the Fed cuts interest rates, will funds necessarily flow to the currency circle? Not necessarily, so we need to look at the changes in the market value of stablecoins.

After reading the money of the cycle (1) and (2), I believe that everyone has a basic understanding and judgment of the bull and bear cycle in the currency circle. In the next article of the series, we’ll give you a brief look at the stimuli for a bull market. **

References:

1. Why should we care about the Fed’s rate hikes

2. Exploring the relationship between cryptocurrencies and U.S. stocks: Is the correlation between Bitcoin and U.S. stocks a piece of paper?