Ecoinometrics - Dollar Strength

November 17, 2021

Nov 17, 2021

Here is something I see thrown around pretty regularly: “watch out for Bitcoin, the US Dollar Index is on the move!”

On the surface that seems logical. The US Dollar is getting stronger, so that means Bitcoin should be getting weaker no?

Actually no. It isn’t that straightforward...

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Dollar strength

I’m sure many of you know that already, but there is no reason to think that the strength of the US Dollar as measured by the US Dollar Index (DXY) has anything to do with the price of Bitcoin.

Let’s back off a minute. What is the US Dollar Index?

The US Dollar Index simply measures the exchange rate of the US Dollar against a weighted basket of currencies. It is made of:

57.6% of Euro vs USD
13.6% of Japanese Yen vs USD
11.9% of Pound Sterling vs USD
9.1% of Canadian Dollar vs USD
4.2% of Swedish Krona vs USD
3.6% of Swiss Franc vs USD

Interestingly some major trade partners of the US aren’t represented in the Index e.g. Mexico and China.

But my point is that, as you can see, this Index is just a mix of exchange rates between the US and a number of its trading partners.

So what the “strength” of the dollar reflects is the balance between the macroeconomic forces that govern those exchange rates:

Differential in monetary policies.
Relative deficits.
Trade balance.
…

As an example back at the end of 2014 it became clear that the Federal Reserve and the European Central Bank were going to have divergent policies when it comes to money printing.

The Federal Reserve was going to keep their balance sheet flat for the foreseeable future while in contrast the ECB was ramping up their assets purchase program.

That meant comparatively the Euro should get devalued against the dollar. And what did we see? The DXY jumped from 80 to 95. That makes sense given that the Euro weighs more than half of the basket.

Now by what mechanism would a change in the DXY influence the price of Bitcoin (in USD)?

Hmm…

Honestly I don’t see any direct path between the DXY and BTC.

To be fair there could be something. But it is indirect. Bear with me.

For the most part, the price discovery that happens on the exchanges involves stable coins that are stable against the US Dollar. That means there is an indirect relationship that goes like local currency to stable coin to Bitcoin.

So if the DXY is stronger that means some currency in the basket is getting a smaller purchasing power of USD stable coins… and at the end of the day this is supposed to make Bitcoin cheaper.

Right, I’m not convinced. It could have some effect for sure, however I doubt it would be anything major.

But we can still look at past data to see if there is something.

In the chart below you can see the price of Bitcoin broken down by year where each day is coloured by the value of the USD Index. Blue means low range of the index, red means high range.

If there is any significant effect you’d expect to see:

Bitcoin rises when the DXY moves from blue to red.
Bitcoin drops when the DXY moves from red to blue.

Take a look.

If you stare long enough at the chart you can find all possible scenarios. BTC rising when the DXY is rising. BTC dropping when the DXY is rising. BTC rising when the DXY is dropping. BTC dropping when the DXY is dropping.

So at least when it comes to long term trends you shouldn’t worry too much about the DXY.

CME Bitcoin Derivatives

What’s new in the world of the CME Bitcoin Derivatives? Well, not much. Let me recap what has happened over the last six months:

Bitcoin lost 50% of its value and that triggered two things.
The demand for BTC futures contracts coming from the retail crowd crumbled.
As a secondary effect, the premium of the futures contract over the spot market diminished as well. That resulted in hedge funds being less active on the carry trade.

That basically created a reset of the conditions on the CME back to the levels of October 2020 before the real Bitcoin bull market got started.

Ok, so far so good.

Then we got this nice recovery where Bitcoin reclaimed its all time, signifying that this bull market isn’t over despite what the bears have been screaming since April.

But now the dynamic is a bit different on the CME. The reason is that we have a new kid in town i.e. a Bitcoin future ETF.

First of all, what stays the same?

Hedge funds. If it ain’t broke don’t fix it. That’s what the hedge funds guys would tell you about running the same old futures to spot arbitrage.

There is again more demand for Bitcoin futures. As a consequence the premium is rising and you can see that hedge funds are once more record short BTC since they sell this premium.

But you can also see that asset managers are now record long Bitcoin. They basically went from flat to 4,000 contracts long in one month.

Of course that corresponds to the futures ETF entering the arena. Currently BITO is long approximately 4,300 BTC contracts.

That’s basically the entirety of the long positions attributed to asset managers by the Commitment of Traders report.

Which means the red line on the chart above tracks more or less the inflow to the ETF over the past few weeks. Indeed the way it works is that:

Investors purchase shares of the Bitcoin ETF.
The Bitcoin ETF goes to the CME and buys some BTC futures contracts in proportion to the inflow.

At the end of the day though we are missing one important piece of information: what kind of investors are buying those ETF shares? Is it institutional investors who prefer to be long BTC through an ETF? Or is it the retail crowd?

That’s something we cannot read directly from the CME data so we’ll have to find some way around it.

One thing is sure though, the introduction of the Bitcoin futures ETF hasn’t increased the trading activity on the CME significantly. Yes the open interest has jumped, but if you look at the volume there is nothing to write home about.

What will be interesting to see is how the dynamic of the rollover is affected by BITO.

Right now they hold the equivalent of 20k BTC on the November contract vs 3,000 on the December contract. If there is a lot of volatility around the end of the month things might get spicy.

You know what’s not spicy? The options market.