Ecoinometrics - Reasoning by analogy
Bitcoin has never lived through a recession. But that doesn't mean we can't make some educated guess on how it will behave.
Digital assets are relatively new. There is very little data that can be used for historical comparisons. So as we are headed for difficult times in the global economy (if not straight up a global recession) there isn’t much we can learn from the past.
Or is there? With some assumptions we might be able to make educated some educated guess.
The Ecoinometrics newsletter decrypts the place of Bitcoin and digital assets in the global financial system. If you want to get an edge in understanding the future of finance you only have to do one thing, click on the subscribe button right below:
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Reasoning by analogy
Bitcoin was created just as the Great Financial Crisis was unfolding. And until recently it had very little institutional adoption. So it is fair to say that none of the data we have on BTC over the past 13 years corresponds to a period like the one we are living right now.
The key ingredients of the current situation are the following:
We are heading towards a global recession or at least a period of global economic weakness.
The Federal Reserve is raising rates and actively tightening monetary conditions to fight inflation.
Bitcoin trades like a traditional risk assets.
You can argue that Bitcoin has always traded like a risk asset. That makes sense if you consider that Bitcoin is in the early adoption phase of the S curve. For a long time there was very little guarantee that Bitcoin could ever serve as an actual store of value. If you bought BTC in the last 10 years you have been making a growth bet, an adoption bet, not a store of value bet.
In that sense Bitcoin has always been in the category of risk assets.
The difference is that as risk assets goes, BTC has been uncorrelated to the traditional risk assets which are basically led by the US stock market. Only in the past couple of years have we seen Bitcoin being consistently correlated to the stock market. Hence we are in a unique period where BTC trades like traditional risk assets.
Along the same line, this is not the first time the Federal Reserve is raising rates since Bitcoin was created. From the fall of 2015 to the summer of 2019 the Federal Reserve did raise rates. But the economic situation was quite different back then and it was definitely not done as a reaction to the highest inflation rate of the past 40 years. So again it is hard to compare this period to what we are living now.
Finally Bitcoin hasn’t lived through an actual recession.
Yes we had a mini-recession period following the COVID lockdown. But the context for this one was so different than anything we’ve seen before that it can hardly be used to make any conclusion. Except I guess that when the Fed prints trillions of US$ overnight financial assets skyrocket in value…
So yes, taken individually those three ingredients haven’t been present in the market during Bitcoin’s lifetime. Even less all of them at the same time. That means nothing in Bitcoin’s past is of any use to analyze the current situation.
How about we try a different approach then? How about we make some assumptions and see if anything interesting can come out of it?
Bitcoin hasn’t been around long enough to have experience the whole spectrum of financial conditions. But other assets have. And what are the two assets that are the closest to Bitcoin? The stock market and gold.
The SP500 encapsulates how risk assets behave in all financial conditions and it just turns out BTC has been consistently correlated to it since the COVID crash. Thus, assuming a high level of correlation is going to hold in the foreseeable future, understanding how the SP500 is likely to behave in the current condition can be used to extrapolate how Bitcoin will do.
Gold is the store of value of reference. And while Bitcoin and gold show no sign of being correlated it isn’t a futile mental exercise to look at how gold typically reacts to think about how Bitcoin would react if it was to behave like a store of value.
In the current regime Bitcoin clearly behaves more like the stock market than it does like gold. Still, it doesn’t hurt to consider both cases even though the first scenario is the most likely.
Now that our assumptions are clear let’s focus on two questions:
How do the SP500 and gold behave when the Federal Reserve is raising rates?
How do the SP500 and gold behave during a recession?
There have been plenty of recessions and rate hike cycles in the history of the US economy dating back to the 1940s. However it is my opinion that the market structure has changed enough since then that it is worth focusing on the most recent history.
So for this analysis we’ll focus on the period starting at the Dotcom bubble. Not counting the current events that’s still three major rate cycles and three recessions. Certainly this data set is a bit small to do any statistical analysis. But we can look at the charts and try to see if there is any common pattern to those three epochs:
The Dotcom bubble.
The Great Financial Crisis.
The post Great Financial Crisis world.
We are looking for anything that could help us navigate the current market conditions.
Let’s start with the Dotcom bubble. From 1999 to 2000 the Federal Reserve raised rates from 4.6% all the way up to 6%. Then the Dotcom bubble popped and recession ensued.
Looking at the timeline of events, the rate hike is what popped the bubble and probably increased the odds of a recession.
Gold did well during that period. However it is important to note that this happened in the lead to the launch of the physical gold ETFs. So some of the upside could be attributed to the anticipation of those products. Regardless this is a win for gold.
Meanwhile despite the Federal Reserve slashing rates after the peak of the Dotcom bubble, the stock market continued to move lower for a long period of time. As a matter of fact the SP500 bottomed only in the middle of 2002, long after the US was technically out of the recession.
Next stop, the Great Financial Crisis. Same chart as above. Take a look and tell me if you see any similarity.
What I see is that again the Federal Reserve is raising rates until something breaks. This time around it was the housing bubble. And past peak rates the stock market rolled over while the US economy headed straight into a long and painful recession.
Gold sold off at the beginning. But that’s exactly what you expect during a liquidity crisis. Investors get liquidated out of their positions and need to face margin calls. In that situation they will sell everything they can to raise cash. The result is usually that everything gets correlated until things settled down. After the initial selloff gold did very well as the rates were slashed to zero.
So as in the aftermath of the Dotcom bubble, gold played its role of a safe asset.
By comparison the stock market suffered during the whole recession. It only found a bottom in 2009 and was on a path to recovery only after the economy exited the recession.
Actually that’s not far off what we happened during the Dotcom bubble.
Last stop, the post Great Financial Crisis era. Except for the extremely brief COVID recession, this whole period isn’t characterized by any major troubles in the US economy. However we did get a rate hike cycle. Take a look.
Here the Federal Reserve decided it was finally time to get the Fed Funds rate away from zero. At some point the stock market decided that was too much tightening and dipped significantly. Only after the Federal Reserve promised they were going to reverse course did the SP500 rise again.
At the same time gold started its ascension, months before COVID really appeared on the map.
If you remember, before COVID we witnessed an inversion of the yield curve. We talked about it here. Usually this is a sign of an incoming recession. Now of course this inversion of the yield curve did not predict COVID. Instead it shows that the US economy was already weak before this whole COVID sequence.
The Federal Reserve slashing rates to zero and injecting trillions of liquidity to deal with the pandemic probably only delayed a recession that was already baked into the market.
So are there lessons to learn from those three periods?
It always starts the same way:
The US economy has some underlying weakness.
The Federal Reserve is raising rates.
The weakness is thus exacerbated to the point where the financial markets roll over and the economy enters a recession.
What comes after that depends on whether you look at gold or the stock market.
The stock market (representing all the risk assets) typically has it worst. The double whammy of higher rates and a recession generate a long and large correction. Only after the worst of the economic recession has passed do risk assets recover.
If Bitcoin continues to track the stock market closely this is bad news.
The Federal Reserve is once more on a path to raise rates until something breaks. And a recession is baked in the economic data. So in that case you’d expect that Bitcoin and the stock market have not seen the worst yet. You’d also expect that depending on the severity of the recession the recovery will be long.
For gold things are different. Typically gold suffers less than risk assets during these kinds of events and also recovers or even thrive much earlier. That’s ultimately what you’d want from Bitcoin if it behaved like a store of value.
But my take is that Bitcoin is still in the middle part of the adoption curve. That means it is more likely to behave like the stock market than it is to behave like gold in the near future. That means more pain before things get better.
That being said, I also think Bitcoin is cheap at the current price. So you don’t need to time try to time the bottom as long as you have a long investment horizon. Simply be ready to endure difficult conditions. If you can survive the storm, asymmetric returns are waiting on the other side.
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