Why are crypto markets rebounding?

So far, blue-chip crypto assets including Bitcoin (BTC) and Ethereum (ETH) have performed very well in 2023, with BTC up nearly 40% since the new year and ETH up more than 30%. There are growing reasons to believe that the crypto market has "bottomed out," with some macroeconomic data suggesting that this year will be much better for the crypto industry than the spate of scams and disasters in 2022.

This may be the most persuasive argument for a crypto bottom: The bad actors and the consequences of their sprawling leveraged behavior have been eliminated. On an emotional level, of course, getting rid of industry “pests” like Alex Mashinsky , Do Kwon , Three Arrows Capital , and Sam Bankman-Fried feels like rebirth.

Crucially, the crypto education wave and enthusiasm driven by the COVID-19 pandemic began, and the fraud incident ended the last bull run, but the new beginning is based on a more solid bottom. Bitcoin hit a local low just below $16,000 on November 9, 2022, and despite a sharp pullback from its late 2021 high, it is still 66% higher than its September 2020 price.

This is a very worthy lesson to learn - crypto assets have maintained a steady but volatile growth trend for more than a decade. Despite some major regulatory risks this year, this basic trend seems to be continuing after the frenzy peak and fraud cases in 2021.

A soft landing for America (maybe?)

Still, while getting rid of the scammers should mean we’ve cleared some major downside tail risk, it hardly constitutes a case for a new crypto bull run. Instead, what matters most over the next year is how macroeconomic conditions, especially inflation and interest rates, affect crypto and other risk assets. (Though, as we’ll discuss, that dynamic itself could be a path to disappointment.)

The global inflation situation is complex, but the current rise in BTC and ETH seems to reflect a growing awareness that the United States is not only slowing inflation, but may even be heading for a "soft landing," that is, stopping inflation without destroying employment.

Observers in 2022 seem to have completely given up on the “transient inflation” thesis that Chairman Jerome Powell and the Fed tried to disprove in 2021. But it can be said that in retrospect, inflation has proven to be quite transient, at least in large part driven by supply-side disruptions to the monetary supply chain and commodities. US inflation has now fallen for six consecutive months.

The month-over-month data for December was particularly positive, with the Consumer Price Index (CPI) actually falling 0.1% for the month. Some household staples even fell below the Fed’s 2% inflation target, with grocery prices rising just 0.2% month-over-month and gasoline prices falling 9.4% month-over-month. This isn’t enough to eliminate the sharp inflation we’ve seen over the past year or so, but it does bring us closer to a new stable baseline.

This has led to widespread expectations that the Fed will soften its rate hike agenda. Four consecutive 0.75% rate hikes in 2022 would be historically aggressive, but the market has now fully priced in a modest 0.25% rate hike in February, and there may be no rate hikes at all in the second half of the year.

While continuing to aggressively raise rates may seem surprising given the cooling in monthly inflation data, another positive data point still supports the move, namely that employment data remains strong, with the latest report keeping the unemployment rate at a historic low of 3.5%, but wage growth has slowed, and the Fed still needs to keep up the pressure.

This is an almost “Goldilocks” macroeconomic scenario, showing the real possibility of the fabled “soft landing”, that is, controlling inflation without catastrophically stalling the economy and putting workers on the streets. This, in turn, is good news for risky speculative assets such as cryptocurrencies.

European and Chinese markets

The situation in Europe is more mixed, as former CoinDesk research director Noelle Acheson examines in the latest edition of her newsletter, “Crypto is Macro Now.” European manufacturing and services indexes beat expectations in January, suggesting the region’s economy returned to positive growth for the first time since June.

But a soft landing in Europe may be less likely than in the United States, as the European Central Bank appears to still be concerned about inflation and has signaled it will continue to raise interest rates more aggressively in the coming months.

That’s still much better than China, the third largest axis of global economic activity. COVID-19 infection rates have now fallen sharply since full reopening, but more damaging surges cannot be ruled out.

It’s also important to note that China is still facing an ongoing housing crash that threatens the foundations of its still-evolving financial system. After a crackdown on indebted and corrupt developers in 2020, house prices continued to fall – in fact, the pace of decline accelerated in December. This could be catastrophic because, according to the Federal Reserve, housing accounts for 45% of Chinese household wealth, compared with a more typical 25% in the United States, which means that falling house prices are very, very bad for Chinese consumption.

Mainland China has made crypto activities illegal, so its impact on the crypto market is not direct, but its position in the global economy means it has huge downstream effects. These effects may include supply chain disruptions, which will continue to disrupt manufacturing and may worsen global inflation. On the other hand, a real estate-driven recession in China may ease global price pressures - but it will also drag on global growth and economic enthusiasm.

Anti-speculative impulse

Having discussed interest rates and price pressures, I feel it’s important to point out the problems inherent in this focus. Crypto investors who worry about central bank rates are implicitly concerned about speculative drivers of crypto prices, including increased competition for the U.S. dollar from safe investments like Treasuries.

But it may be time to move away from that mentality. One version of the 2020-2022 crypto narrative is that the early pandemic led to a large number of new participants learning about cryptocurrencies during the 2020 COVID stay-at-home period, which in turn created a speculative frenzy in 2021 and then an explosion in 2022.

In a perfect world, we’d have sustained curiosity and real user adoption, without frenzy or implosion. Enthusiasts expecting huge returns often hype speculators as charismatic “wunderkinds” with exciting new tokens and promises of massive returns. 2022 has been a sobering lesson in the extreme risks of following these ethos — just ask anyone who held LUNA or FTT this time last year.