Coinbase: Analysis of the underlying reasons for the current “turn from bull to bear” in the crypto market

A macroeconomic recession begins when it becomes apparent that inflation will persist and that central banks will have to change course and end the policies that have driven many assets to new highs.

Original title: The crypto market downturn explained

Compiled by: Hu Tao, Chain Catcher

The financial market is essentially a giant information processing machine because it influences the decisions of millions of individual buyers and sellers. Or as Benjamin Graham said - "In the short run, the market is a voting machine." As of June 2022, the U.S. stock market has fallen by about 20%, and about $10 trillion has evaporated. However, for American stockholders, the sell-off still does not seem to have reached a historical low, which means that the severity may further intensify.

Meanwhile, cryptocurrencies have fallen nearly 60%, or $1.7 trillion, but that drop pales in comparison to the 2017 bear market, which saw an 87% drop in total market value after the peak of the 2017 bull run.

BTC, ETH, and the Nasdaq all peaked in November, and the S&P 500 peaked in late December, so what has changed in the economy over the past two months? To understand this market downturn, it’s best to start at the beginning of the historic bull run that stocks and cryptocurrencies have experienced in 2020.

In 2020, Bitcoin rebounded from the 2018/19 crypto trough, rising from $7,500 to nearly $10,000. At the same time, both the S&P and Nasdaq indices hit record highs.

Then, the COVID-19 pandemic hit.

March 2020: COVID shock

On March 12, 2020, the World Health Organization declared the coronavirus a pandemic and governments around the world would have to go into lockdown. As COVID-19 broke out, it became clear that the global economy was not adequately prepared for the shock, causing panic in almost all markets.

The S&P and Nasdaq both fell by about 30%, and the crypto market was hit even harder (in absolute terms), with BTC falling below the $4,000 mark at one point and its market value shrinking by more than 60%.

In short, the COVID-19 pandemic caused panicked investors to sell, leading to a sharp drop in all liquid markets.

Then the Fed stepped in.

The Fed’s response

As the central bank behind the world's largest economy, the Federal Reserve plays a unique role in financial markets, and of course, their main task is to control the supply of the world's reserve currency, the U.S. dollar.

Money printing and interest rates are the Fed’s primary tools for supporting the economy during times of extreme turmoil—

• By printing money and purchasing financial assets such as bonds from financial institutions, the Fed can introduce newly created money into the economy.

• By lowering interest rates, the Fed makes it cheaper for other banks to borrow money from the Fed, which also introduces newly created money (in the form of credit) into the economy.

In the wake of COVID-19, the Federal Reserve cut the cost for banks to borrow money from the central bank, known as the federal funds rate, to essentially zero, which in turn enabled banks to make it cheaper for customers to borrow money. Cheap loans are then available to finance households, businesses, spending and other investments.

By printing more money and buying Treasury bills and other securities from financial institutions (known as quantitative easing), unprecedented amounts of dollars were introduced into the economy. Over the next two years, the Fed printed nearly $6 trillion in new money, increasing the broad supply of dollars by nearly 40%. Financial institutions, flush with cash, competed to lend out this new money, forcing them to lower interest rates to remain competitive. Again, the availability of cheap credit encourages borrowing, which ultimately supports the functioning of the economy.

The Fed is not the only one doing this. The European Central Bank, the Bank of Japan, and the Bank of England have all cut interest rates to near (or even below) zero and are printing money at historical “risk-controlled” levels. In total, the world’s four largest central banks have issued an additional $11.3 trillion, a 73% increase since the beginning of 2020.

On top of that, the US government has injected over $5 trillion of “stimulus” into the economy by assuming the debt of public, private, and foreign entities. Likewise, China has injected another $5 trillion into its economy through the same method.

Basically, the world is now awash in cash.

Don't fight the Fed

“Don’t fight the Fed” is an old investor mantra, meaning that given the Fed’s outsize influence, one should invest in lockstep with whatever direction the central bank pushes financial markets. In the wake of the COVID-19 outbreak in 2020, this mantra has become a reality.

With U.S. dollars being printed at record levels and U.S. interest rates close to zero, all that money and credit needs a place to go. On top of that, when interest rates are low, conservative instruments like bonds are less profitable, pushing money into higher-yielding assets. As a result, in the wake of COVID-19, these forces have led to massive inflows into stocks, cryptocurrencies, and even NFTs, helping to push asset prices to new heights.

From the COVID-19 panic-induced bottom, the S&P 500, Nasdaq, BTC, and ETH would surge 107%, 133%, 1,600%, and 4,200%, respectively.

The result of printing a lot of money: inflation

When the system is awash with money and assets are rising, everyone feels richer. People can spend more and companies can pay their employees more. When spending and income grow faster than the production of goods, there is "too much money chasing too few goods" and prices rise or inflate.

There are fewer goods in the economy due to supply chain shocks caused by COVID-19. More money chasing fewer goods leads to one result: more inflation, which began to become increasingly apparent in May 2021.
Take the Consumer Price Index (CPI), which measures changes in prices consumers pay for goods like gas, utilities, and food—from March to May 2021, the CPI had already surged from a healthy 2.6% to 5%. By March 2022, inflation had reached 8%, the highest in more than 40 years of records.

Inflation makes everyone poorer because people's money no longer buys as much as it used to, so the Fed has to step in again, and to combat rising inflation they first use the tool of backstopping financial assets.

The Fed is ready to reverse

As we explained, low interest rates and newly printed money provide support for maintaining economic development and asset prices. But when this tool is used excessively, it can also lead to inflation. Once this happens, the Fed flips the switch, raising interest rates and withdrawing money from the market, thus reversing the process.

Higher interest rates ripple through the entire economy. Since this makes it more expensive for banks to borrow money from the central bank, they in turn charge their customers more to borrow money. In addition to it becoming more expensive for everyone to borrow money, the price you pay for money you already borrow also goes up (think if your credit card interest rate goes from 5% to 10%).

While quantitative easing involves pumping money into the economy by purchasing securities from financial institutions, quantitative tightening does the opposite. First, the Fed stops buying securities while letting existing securities mature, and eventually begins selling them on the open market. This ultimately results in less money in the economy. Due to simple supply and demand, less money being loaned out causes interest rates to rise.

As borrowing costs and servicing existing debts become more expensive, everyone slows down the spending that caused inflation in the first place. With less money pumped into the economy through asset purchases, there is less money chasing inflationary goods, and in theory prices should normalize. There is also less money chasing investments, which leads to falling asset prices - something that the investment market veterans know all too well.

In the summer of 2021, the U.S. inflation rate hovered around 5%, and the Federal Reserve said at the time that the inflation rate was "temporary" or non-permanent.

On November 3, 2021, the Federal Reserve said it would begin to slow the pace of asset purchases, but would remain patient on any interest rate hikes while continuing to monitor inflation.

On November 10, 2021, the United States announced that the CPI in October reached 6.2%. It is clear that inflation is not under control and the Federal Reserve will have to intervene. Although the first rate hike will not come until March 2022, the powerful information processing machine of the market seems to have responded at the beginning, indicating that market changes are coming.

Don’t fight the Fed again, because BTC and ETH peaked on November 8, respectively, Nasdaq peaked on November 19, S&P peaked at the end of December, and even some NFT floor prices and DeFi lock-up volumes continued to hit new highs - so we should be very clear about what will happen next.

in short

Basically, in response to the COVID-19 pandemic, intervention by central banks and governments around the world helped maintain record low interest rates, printed a lot of money, and introduced a number of stimulus measures. These loose monetary policies ultimately helped push stocks and cryptocurrencies to all-time highs and then led to inflation.

A macroeconomic recession begins when it becomes apparent that inflation will persist and that central banks will have to change course and end the policies that have driven many assets to new highs.

Although it may seem like everything started in early 2020, the era of loose monetary policy by central banks began after the financial crisis of 2008. Of course, 2008 was also an era that saw the birth of cryptocurrencies and a historic run for stocks.

Faced with inflation not seen in 40 years, central banks have signaled beyond a reasonable doubt that the era of easy money is over. Previous frameworks for valuing companies and assets no longer apply in this shift, and everything is being “revalued”, a downturn we have all experienced over the past six months.

When interest rates rise, bonds become more attractive investments. Meanwhile, "growth" stocks, or companies that are expected to pay dividends many years in the future, are hit hardest. As money tightens, investor preferences shift toward investments that can generate cash flow immediately, rather than looking far into the future.

Then, the technical sell-off came.

Cryptocurrency sell-off

Some people may think that cryptocurrency should not be an inflation hedge tool? Actually, not necessarily.

If you bought Bitcoin in May 2020, you are still up over 200% and well ahead of inflation. However, if you bought Bitcoin after inflation started to pick up, the story might be completely different.

Still, even with these sharp price declines, Bitcoin and ETH are still up 500% and 1,000% from their peaks at the start of the pandemic. Long-tail assets haven’t fared much better by comparison, and it’s hard to deny that cryptocurrencies are becoming increasingly correlated with stocks — especially tech stocks.

Tech stocks have always been viewed as risky assets. Given the correlation, it’s fair to say that most people still view cryptocurrencies in a similar way. Risk assets have higher upside risk and higher downside risk, and when there’s a monetary tightening, which is what happens when central banks tighten money, risk assets are usually the first to be sold off.

In conclusion, the above are the main reasons for the recent downturn in the crypto market.

While cryptocurrency prices are also affected by Fed policy, they have been one of the best performing asset classes in the last market cycle. Loose monetary policy encourages speculation, which has always been associated with paradigm-shifting technologies such as personal computers, the internet, smartphones, and even railroads in the 1800s.

Bitcoin and its fixed supply of 21 million stands in stark contrast to the Fed’s money printing press. History tells us that the Fed’s money printing will eventually fail due to massive inflation caused by poor economic management. In contrast, cryptocurrencies further verify that decentralized systems have no unilateral control risks. Although cryptocurrency prices will still be affected by the Fed’s policies in the short term, in the long run, cryptocurrencies and Web3 remain more attractive than ever.

Looking ahead

If this is your first crypto market downturn, the current plunge in the market will surely feel scary.

In fact, cryptocurrencies were declared “dead” in 2018, 2015, and 2013, but ultimately, they emerged stronger after each setback.

Like the internet before it, crypto innovation will continue to advance regardless of market cycles.

From our perspective, cryptocurrencies are more important than ever.

• Bitcoin has been adopted globally and is held by institutions, corporations, countries and millions of individuals.

• DeFi lays the foundation for an internet-based financial system that no single party controls.

• The foundation for Web3 and a user-owned internet has been laid.

• NFTs have already spawned multi-billion dollar industries in art and gaming, with a wide variety of use cases emerging in the process.

• The DAO already has nearly $10 billion in assets under management, and it’s only just getting started.

• 9 of the 10 largest central banks in the world are exploring digital currencies

• Analysts at JPMorgan Chase called cryptocurrencies the “alternative asset class of choice.”

• Facebook becomes Me ta , Twitter, Spotify, TikTok and Instagram are integrating NFTs, while Google and Microsoft are both involved in Web3.

Time will tell us the answer.