The Crypto Circular #3: Fed Up!

1. The Fed
2. The Play
3. The USD
4. Charts
5. Upcoming Risk Events
6. Trade Ideas Update
7. European Reverse Knock-In (ERKI) Options Explainer

1. The Fed

Macro forces have been dominating crypto markets and sentiment is no doubt at its most sour now. Market commentators have been sounding the alarm over the Fed and are now warning of a major market collapse because of the Fed’s impending hikes.

This has led to equities (NASDAQ in particular) having the worst month in April since November 2008 (the height of the GFC).

We highlighted these risks in our 2021 year-end piece and we have been trading on the bearish side for the last 4 months. However, we now find ourselves with a contrarian view.

We’ve possibly reached a short-term peak in fear and we think market bearishness might be slightly over-extended. Could May 2022 be a positive month instead of the usual “sell in May and go away”?

Our view is that the market has priced in rate hikes too aggressively which could then lead to the next few Fed meetings surprising on the dovish side.

It has always been quantitative tightening (QT) and the resultant balance sheet reduction that will send markets lower. However, that will take some time as the Fed has not even started the process (to be announced at their May 4th meeting).

With bearish sentiment at extremes, we could see a potential short squeeze in the near-term. This might be the rally we have been waiting to sell into as the multiple-compressing effects from QT and recessionary pressures from the rate hikes begin playing out in the second half of the year.

2. The Play

Recent Fed actions remind us of a famous central banking playbook: The Maradona theory of monetary policy (as described by retired BOE governor Mervyn King in 2005).

This analogy relates to the 1986 World cup game between Argentina and England, where the late Maradona ran the length of the pitch, beating 5 players on his way to a legendary goal,
all while running a simple straight line.

Just by feinting, Maradona was able to run straight while the English players did all the work for him by trying to anticipate his next move.

And we are seeing the same in the market now as price reactions in anticipation of the Fed are effectively serving the Fed’s goals.

Powell said on 21 April was that he was pleased that markets have reacted to the Fed’s hawkish indications. He was referring to minutes of the March FOMC, released on 6 April. Since then, in just 3 weeks, we have seen some of the largest moves across markets in years (Chart 1).

Notably, market pricing of the Fed’s hiking cycle has steepened significantly with certain meetings even pricing a good chance of a 75bp hike now! (Chart 2)

By anticipating the Fed’s moves, markets have effectively carried out a large part of the Fed’s tightening for them. This gives the Fed more breathing room in their fight against inflation.

The market reaction to the Fed’s posturing has been stalling energy prices, falling raw metal prices, and the surge in the USD. These will all have a dampening effect on inflation over time.

Other possible inflation-reducing catalysts include Treasury secretary Yellen’s suggestion for reducing Trump-era tariffs on specific Chinese goods as well as a de-escalation in the Russo-Ukrainian war.

The war has been responsible for the latest surge in agriculture and energy prices. While it is impossible to predict its outcome, one key thing to note is that all Autocrats like Putin loves anniversaries – and the 9 May annual Soviet WWII victory parade will be an important pivot in whether he chooses to dial down and claim victory in the eastern regions or escalate beyond the current status quo.

Regardless of these events outside the Fed’s control, their tightening has already driven the sharpest rise in mortgage rates since the early 1980s (Chart 3). This will work to arrest the record-breaking house price gains, reduce disposable incomes, and over time pass-through into lower rent, service prices and ultimately wages.

We think that the elusive “transitory inflation” is now finally showing signs of peaking – which would give the Fed some room to do a Maradona-esque “run in a straight line” here, allowing them to cap hikes to their 2022 forecast for 7 hikes and their 2.5% terminal rate at the June projections meeting.

While this week’s meeting is baked in (the first 50bp hike since May 2000), the dovish lean for the meeting would include categorically ruling out any 75bp moves and affirming their plan of getting back to neutral rate (median 2.25%) as quickly as possible before pausing to reassess the effects.

This scenario would certainly force the market to relook its current aggressive pricing of 12 25bp hikes in the next 7 meetings.

3. The USD

The USD has historically been an important factor for crypto price movements. This month we saw the largest monthly USD gain since Jan 2015 (Euro debt crisis).

This time the hawkish Fed and rising US yields have driven the USD significantly higher. The Dollar Index has reached a critical pivot point and its movements from here would have significant impact on crypto prices.

A higher USD will ultimately be a drag for crypto from here – bringing back the old correlations where an overly strong USD turns into a headwind for crypto (Chart 4).

At this point the USD is sitting on a massive pivot testing 20-year highs, and will be a key market barometer – of whether we start a new multi-month appreciation cycle (bearish assets), or this turns out to be one of the largest head-fakes in recent times (bullish assets).

The remainder of Q2 shall be the determining factor to conclude this.

4. Charts

i. USD (DXY Index)

• Picking bottoms (or tops) is always tough – but the USD is sitting on a massive pivot here.

• On a monthly chart going back to the start of the GFC in 2008 and QE1, 2, 3; we are retesting the bottom of the
broken parabolic trendline that has held multiple times over the last 15 years.

• Together with the triple trendline top from 2016, and a monthly TD 9 – we have a confluence of technical signals that could undermine this fundamental rally in the most reflexive way.

ii. BTC

• The Fibonacci retracement from the Mar 2020 lows at 3,858 to last year’s 69,000 all-time highs yield two key support levels – the 50% retracement at 36,429 and 61.8% retracement at 28,742.

• These levels correspond exactly to last year’s lows as well as this year’s closing lows – and are the two main levels we’re watching to hold on the downside. These are also levels where we look to sell longer-term puts on BTC.

• In the near-term we have a channel developing defining the range for this year (Red trend channel), as well as a trendline support that connects all the lows of 2021 and 2022 (Orange trendline).

iii. ETH

• The trend channel beginning at the start of the exponential rally last year is still in-play – with immediate support coming in at 2,500, in-line with the 2d TDST support level.

• 2,300-2,500 is our key near-term support on the downside, while 3,600 on the topside is our new bull/bear pivot. A close above this level is needed to see an abating of bearish pressures and resumption of the uptrend.

• Below the 2,300-2,500 support zone, we have 1,720 which will see good bidding support too.

5. Upcoming Event Risk

The key event risk in the next month is the FOMC rate decision on Star Wars Day – May the 4th. But outside that there is the chance for a temporary Ukraine ceasefire into 9 May (huge impact on food & energy inflation), and the next CPI reading on 11 May (the first of two before the June FOMC projections meeting).

6. Trade Ideas Update

1. We closed our Downside Risk Reversals last month expecting that the lows of the range would hold, but kept the
short call legs which have decayed nicely.

• We still think there will be decent support at 30,000 in BTC and 2,000 in ETH and we’ve held off re-initiating
any fresh downside risk reversals (buy put, sell calls), rather choosing to let all the calls in the portfolio continue
to decay.

2. Our main open trade now is the long BTC Jun 40k Call with 50k ERKO.

• The ERKO was an excellent way to cheapen the trade, and the topside KO level has decayed nicely in this selloff,
setting the long call leg up for a potential post-FOMC rally into the Jun expiry now.

• Breakeven for the trade is 41,580 BTCUSD.

3. For a tactical trade we add a short ETH SEP 2k Put with ERKI* at 1.5k.

• We like scaling into longer-term ETH puts to accumulate ETH.
• However in still uncertain market, instead of selling a put outright, we give up a small portion of the premium for
additional insurance protection provided by the ERKI. In this case, ETH spot price would have to expire below
1.5k for the 2k put to be exercised.

7. European Reverse Knock-In (ERKI) Options

With ERKIs, selling options comes with an additional protection against expiring in-the-money for a small fraction of the total premiums earned.

What is an ERKI?
An ERKI option has an additional knock-in level. A call option may only be exercised if the spot fixing is above this
knock-in level at expiry. A put option may only be exercised if the spot fixing is below the knock-in level at expiry

Example:
Underlying:           ETH/USD
Expiration:            30SEP22 2000 UTC
Call/Put:                PUT ETH
Strike:                    2,000
Knockin:                1,500
Settlement:           Cash or physical
Premium:              4.5% ETH

Scenarios
At expiry:
Spot rallies to 3,200               Option is out-of-the-money and not exercised
Spot drops to 1,700                Option is in-the-money but above the knock-in level, not exercised
Spot drops to 1,400                Option below the knock-in level and exercised. Client buys ETH at 2,000

Short Put ERKI vs Outright Short Put Option
Spot ref 2,794 ETHUSD