There’s no doubt that the hype around cryptocurrencies is powerful.
The trend has led investors to believe digital tokens will dominate the future. There’s even speculation that digital assets will eventually replace national currencies.
All of this makes for a very compelling sales pitch – all you need to do to secure a piece of this utopian future is to buy crypto now.
Meanwhile, critics claim that the entire crypto space is little more than a bubble looking for a pin – its value based on thin air.
Either side might turn out to be right. But, for now, there’s nothing either one can do to stop crypto’s volatility.
And right now, we might be heading into a period of extreme volatility…
Crypto’s Incidental Cousin
Consider for a moment just how widespread crypto has become…
The market cap of cryptocurrencies is now $1.8 trillion. Even today, that’s a lot of money. That sum represents the savings of many people and institutions. They all want to have both a store of value and an appreciating asset at the same time.
However, few people ask where all the money comes from to support that valuation. And so far this year the answer has been, surprisingly, Wall Street institutions.
In August, MicroStrategy was the first publicly traded company to swap a portion of its cash reserves for bitcoin – to the tune of $250 million. Other high-profile companies like Square and Tesla have followed suit with their own bitcoin purchases. And asset manager Grayscale has been buying up various cryptocurrencies to offer clients by way of publicly traded products.
So as institutions have piled their free cash into the crypto sector, and crypto has taken on the characteristic of a “risk-on” asset, it has become highly correlated with the stock market.
That’s important. It means cryptocurrencies are now more influenced by institutional money flows… And ultimately, it’s these flows that lead to big upticks in price for crypto.
More importantly, it means that cryptocurrency is now vulnerable to the same macro risks that now face the broader stock market. And in today’s essay, I’ll show you why I see imminent headwinds for both sectors due to a key macro factor – and what you should do if you have heavy exposure in either.
What Do Bonds Have to Do With Crypto?
During the Fed meeting on Wednesday, Chairman Jay Powell said that rising inflationary pressures are not going to last very long. But the very next day, the bond market sold off heavily, pushing interest rates higher.
Since the price of bonds and yields moves inversely, this means bond yields kept running higher.
Bonds are long term investments, and the return is fixed years in advance of maturity. If inflation rises before maturity, the amount you receive will be worth less than what you paid for it. That’s why bonds are so sensitive to perceptions about future inflation.
And when bond yields rise, it increases the cost of financing for all borrowers. In the same way that mortgage rates have risen recently, so have the costs for capital-hungry growth companies.
Companies who haven’t turned a profit yet rely on access to cheap capital to fund their operations. When yields rise, it’s like a roadblock for innovation.
The Nasdaq is loaded with these kinds of growth companies. That’s why it’s been underperforming both the S&P 500 and the Dow recently.
It’s no secret many stocks in the Nasdaq are down big. Tesla, one of the Nasdaq’s biggest movers, is down about 26% in just two months.
Many investors have lost money lately. And when investors take losses in one part of their portfolio, they sell some of their winners to balance out their profit and loss. As losses mount from the decline of popular assets like the ARK Innovation ETF – which is heavily focused on the types of growth stocks facing headwinds right now – people will begin to take profits in other assets.
A dynamic like this affects the entire market. As losses worsen across the board, investors will salvage what they can from their profitable position, driving those prices lower as well.
The thing is, bitcoin and the other cryptocurrencies are not immune from these factors. Many people have been investing in the sector because of the growth potential and the promise of a rosy future. That’s the same reason the ARK Innovation ETF has been so popular.
To me, this all culminates in a warning that volatility lies ahead. Anyone who isn’t a true-blue crypto bull will be tempted to take profits at these levels – I know I am. However, this does nothing to question the long-term growth potential of the sector, since nothing rises in a straight line.
The simple fact is that all kinds of innovation projects, like crypto, prosper when money is free – or close to it. As the cost of borrowing rises, the barrier for success rises with it. That means it will be more difficult for innovative candidates to raise the financing they need to market their ideas.
Eventually, the Fed will intervene to stop the advance in yields. The last time that happened was in late 2018. Back then, the stock market pulled back by 20%.
Since the S&P 500 hit an all-time high on Wednesday, it’s unlikely the Fed will act until prices are well below the peak.
When prices do fall enough to scare the Fed into action, it will create a buying opportunity for both the growth and crypto sectors alike.
All the best,
Co-Editor, Market Minute