Market View
This was an eventful week for both tradFi and crypto markets but for very different reasons. Carry trades in traditional currency markets were upset by the Bank of Japan’s decision (on July 28) to raise the hard cap on its 10-year bond yield (signaling a transition from its yield curve control policy). While some media characterized it as a tweak, we think the broader policy implications are much larger. Despite the change in its rates regime, the BoJ has simultaneously been curbing sharp rises in the yield by offering to buy long-end Japanese government bonds (JGBs). Due to low rates in Japan, the JPY has historically been the base currency in many carry trade pairs, so intervention has created instability across different pockets of the FX market.
At the same time, we’re starting to see the higher interest rates in some price currencies come down, as evidenced by the surprise decision by Brazil’s central bank this week to cut its benchmark SELIC rate by 50bps (compared to expectations of 25bps).
Separately, in the US, the yield curve steepened significantly this week following the rally in Treasury bonds only two weeks ago, as the US Treasury Department announced an increase in the size of its debt issuance plans. (Note that ratings agency Fitch also cut the US debt rating from AAA to AA+ due to their concerns on the fiscal outlook, but we think the impact of this on bond yields was actually fairly limited.) Nevertheless, yields tend to track rate expectations more so than supply pressures, so a ~25bp move in the US 10y yield is meaningful. US stock markets reacted poorly due to concerns of liquidity drain, though the upcoming week’s higher-than-expected US$103B of issuance (an increase from $96B) is mostly just rolling over the government’s maturing debt.
What’s important for crypto is that the US dollar is more sensitive to front end rates, and the 2y yield seems to be well anchored. That is, current macro conditions suggest we may see a temporary pause in the recent strong USD trend, which should be supportive for the digital asset market. But we’re concerned that crypto performance may recouple with US equities in the short term, which may cap the upside on digital assets as we think it’s more likely stocks could retrace due to stretched valuations. For the moment, the correlation coefficient between these factors signal almost no relationship – see chart 1.
Meanwhile, the exploit of four liquidity pools on Curve (July 30) didn’t help risk appetite in the crypto space but neither did it sustainably accelerate the downtrend that’s been ongoing since mid-July. In a recent report, we discussed the potential implications of the event on the decentralized finance (DeFi) landscape. Our main takeaway is that the actual systemic risk associated with the exploit is limited by mitigating factors that offset some vulnerabilities of the attack. While the situation is still fluid, we believe that this is not evidence of DeFi’s weakness but rather highlights the system’s antifragile properties. That is, DeFi’s inherent visibility helps to recognize and confront problems, which may ultimately improve its resilience.
