Why global markets are declining
Strained supply chains, surging inflation, and rising interest rates are the story of the economy this year. But how did we get here? [Image via Paul Teyen]
The global economy in 2022 has been rocky. Both crypto and stock markets are hovering near lows for the year while record inflation is causing your regular expenses to balloon. But why is this all happening, exactly? In this special edition of Coinbase Bytes, we’re diving deep into the key factors — from Federal Reserve policy to market psychology — that are driving the shifting economy, and what you can do about it.
The Federal Reserve and inflation. How the Fed responded to the pandemic, and how it’s now responding to inflation.
The crypto-stock market correlation. And will the two diverge again anytime soon?
Understanding market psychology. What investors should know about market sentiment.
What crypto holders can do during a downturn. And what history tells about market cycles.
FED & COMPANY
How the Fed helped spark the last crypto bull run, and the bear market
Last month, the Federal Reserve hiked interest rates by a half-percentage point, something the world’s largest central bank hadn’t done in over two decades. The reason? To rein in four-decade-high inflation that was driven, in part, by the unprecedented actions the Fed took two years earlier to stabilize the economy during the onset of the Covid-19 pandemic. But how did the Fed make such drastic moves in seemingly opposite directions, just two years apart? And what does that mean for the economy as inflation continues to spike? Let’s take a closer look.
The Fed’s main objectives include maintaining stable prices and maximum employment, while keeping credit flowing in the financial sector. One of its primary ways to manage all this is setting interest rates, which determine how cheap (or expensive) it is to borrow money. In 2020, when the Covid-19 pandemic shut down everything from businesses to schools, the Fed intervened to keep the economy afloat by cutting interest rates to zero, a move that eased lending rates between banks. Resulting low-interest mortgages and loans for things like cars and small businesses meant consumers remained active in the market despite the pandemic’s economic shock.
The Fed also supported pandemic-era financial markets with a process known as quantitative easing, which involved buying Treasury securities and mortgage-backed securities in order to inject liquidity (cash) into markets — a.k.a. printing more money. As a result, the Fed’s balance sheet has more than doubled to $8.95 trillion since early-March of 2020. This abundant liquidity, or “easy money,” ultimately helped buoy the economy, and also boosted riskier assets like tech stocks and crypto with excess consumer cash.
One of the downsides of all that extra cash? Inflation. Amid strong job growth and higher consumer demand, the U.S. Consumer Price Index (CPI) — which measures the annual rate of inflation of key categories like housing and food — jumped 8.6% in May, the biggest spike in 41 years. Economists attribute the surge in prices to several factors: increasingly strained global supply chains; economic fallout from Russia’s invasion of Ukraine and China’s ongoing Covid lockdowns; and the government’s $1.9 trillion Covid stimulus package.
Now, the Fed is focused on quantitative tightening, or withdrawing liquidity from financial markets by shrinking its balance sheet. This month, the central bank has started reducing its pandemic-era Treasury securities holdings and plans to accelerate those efforts in September. Meanwhile, the Fed is targeting interest rates between 0.75% and 1.00% (making borrowing money more expensive), and Fed Chairman Jerome Powell has signaled plans to keep increasing that number this year, perhaps as early as this week. One early indicator on how these efforts are impacting consumers: Mortgage demand has fallen to a 22-year low as home loans grow more expensive and home sales slow.
Why it matters… The Fed’s tightening measures, along with geopolitical concerns, have had a dampening effect on financial markets, pressuring stocks and crypto as investors move away from riskier investments. But some analysts have expressed concerns that efforts to stem inflation could tip the U.S. economy into a recession. So can the Fed pull off its much-referenced, tricky “soft landing?” As the chief U.S. economist at JPMorgan puts it, “The Fed has to thread the needle … We can avoid a recession, but we definitely have an elevated risk of one.”
What’s up with crypto’s growing correlation with stocks?
For the majority of Bitcoin’s 14-year history, crypto markets generally haven’t moved in tandem with equity markets or broader economic trends. In 2014, for example, the S&P 500 jumped 11% while BTC fell 61%. The following year, BTC advanced 35% while the S&P 500 dropped nearly 1%. All of which supported a bit of prevailing wisdom about crypto — that it might be useful hedge against inflation or market turmoil, much like the gold standard of hedges — which happens to be, well, gold. In the current bear market, that hasn’t turned out to be true. In fact, crypto has behaved much more like traditional “risk” assets like tech stocks. Let’s look at some reasons why.
The narrative of BTC as an inflation hedge took hold in mainstream financial markets following the Fed ’s actions and the government’s unprecedented fiscal stimulus. BTC’s limited supply of 21 million bolstered this thesis, as did billionaire investor Paul Tudor Jones when he made headlines for saying he preferred BTC over gold as an inflation hedge.
With extra cash at a time of near-zero interest rates, both retail and institutional investors traded it for riskier investments like tech stocks and BTC. As more investors of all kinds — from regular folks saving for the future to Wall Street giants — added BTC to portfolios, the cryptocurrency’s correlation with stocks began to tighten.
Particularly, the 2020-2021 crypto bull run differed from past surges in that it saw a wave of institutional adoption from giants like Tesla, Visa, JPMorgan, and hedge-fund billionaire Ray Dalio. The emergence of the first-ever bitcoin-futures ETF last October meant that institutional buyers had indirect, but easy access to crypto markets, strengthening the correlation between the two worlds. But the involvement of more institutional players — who trade multiple assets — also resulted in BTC being increasingly more susceptible to macro influences.
Since November’s price peaks, the NASDAQ has seen losses as steep as 30%, while BTC and ETH have seen 60% drops. And last month, The Wall Street Journal found that three-month correlation between BTC and ETH and the major U.S. stock indexes had reached a record — more than triple the average from 2019 to 2021.
Why it matters… While the easy money era that helped drive crypto and other volatile assets to new highs is currently in the rear mirror, there are still reasons to be hopeful for a crypto recovery. Among the expected events in the second half of the year are possible regulatory clarity from the Biden administration and Ethereum’s transition to a proof-of-stake consensus mechanism. As David Duong, Head of Research at Coinbase Institutional, puts it, the end of the hype cycle has the potential to “draw more attention to the benefits of some crypto as a store of value" and “open up more opportunities for crypto in [the second half of the year.]”
How markets measure investor sentiment and why it matters
Market sentiment refers to the overall attitude investors have about an asset or an entire market, and it plays a crucial role in influencing and reflecting investor behavior. So how do you do a vibe check for the S&P 500 or the broader crypto market? Several indicators attempt to provide a composite picture of consumer attitudes and expectations. Let’s take a look at some of the best-known tools.
The Crypto Fear and Greed Index measures how investors feel about crypto markets. Compiling various data — volume, volatility, social media trends — the index ranges from 0 to 100, with the former indicating extreme fear and latter suggesting irrational euphoria. The reading on June 9 registered an 11 — extreme fear.
The CBOE Volatility Index (the VIX) is the stock market’s most widely referenced fear gauge. The index shows expectations for market volatility based on S&P 500 options for the upcoming 30 days. Higher readings on the VIX reflect expectations of market volatility, while lower readings imply an environment of greater risk taking. The VIX has climbed about 50% this year while the S&P 500 has declined about 13%, signaling bearish conditions.
The Conference Board’s index of consumer confidence uses surveys to assess American consumers’ optimism (or pessimism) about purchases, job seeking, business hiring, and spending. This spotlights some of the financial behavioral trends of Americans, indicating whether more money will potentially flow into the economy. The latest reading for May showed the index dipping from the prior month, reflecting diminished confidence about the economy’s present and future conditions.
Why it matters… Given crypto’s correlation with stocks, sentiment narratives in the broader economy and the financial sector matter more than ever, shaping trends and inclination for risk across markets. As long as this coupling persists, the effects of downbeat sentiment and elevated stock market volatility are likely to ripple across crypto markets.
LET’S GET CYCLICAL
Tips for navigating crypto down cycles
While a growing number of economists are concerned that we’re headed for a recession (typically defined as two consecutive quarters of contracting gross domestic product, or GDP) — it’s not a foregone conclusion. Anthony Crescenzi, portfolio manager for fixed-income giant PIMCO, thinks the Fed can pull off a soft landing, and the U.S. will avoid a recession. And Goldman Sachs Chairman Lloyd Blankfein recently said the risk of recession is high, but it’s not “baked in the cake.” But whether we’re in for a sustained crypto winter or a temporary gulf, smart investors will tell you that bear markets are inevitable — and are often when fortunes are built. Here’s a little perspective.
Keep your emotions out of it. It’s okay to feel anxious, but don’t let anxiety dictate financial choices. Emotional trading can lead to badly-timed trades, like selling when prices are lowest or buying at a peak due to FOMO.
Instead of trying to time the market, consider dollar-cost averaging (DCA), in which you buy a smaller amount of an asset every week or month no matter what prices are doing. This is a smart strategy if you believe that crypto prices will generally trend upward over a longer time horizon. Although DCA is a popular way to buy crypto, traditional investors have been using this strategy for decades to weather stock market volatility. Anyone with a Coinbase account can quickly set up recurring buys for any listed asset.
Use the time and mental space afforded by the down market to learn how to DYOR — crypto speak for “do your own research.” Spend a few minutes a day learning the basics, reading crypto news (including major financial newspapers and dedicated outlets like The Block and Decrypt); diving into the whitepapers of projects you’re interested in; and digging into analytics (via sites like Messari, DappRadar, Dune Analytics).
Never abandon common sense. No matter how exciting a new DeFi project is or what you learn while researching, there’s no such thing as returns or yield without risk — so if you see double-digit interest rates when banks are offering fractions of a percent, only invest what you can afford to lose.
Why it matters… It’s important to zoom out and see the big picture. Crypto is still very much in its infancy. Historically, BTC prices have reached new peaks during each bull run. The uptrend in 2013 saw Bitcoin surpass $1,000 for the first time; four years later it almost reached $20,000, and the most recent cycle topped out at $69,000. The most important thing you can do right now is set yourself up for success for the next up-cycle. And if you have any questions or concerns in the meantime, reach out to a trusted and certified financial advisor.
What is a bear market?
An environment where supply is greater than demand
The opposite of a bull market
A period when market value drops by at least 20%
All of the above
Find the answer below.
All of the above