Arthur Hayes: Predicts a sharp decline in cryptocurrency this March, followed by a rise

Author: ARTHUR HAYES

Compiled by: Deep Tide TechFlow

Arthur Hayes published his new article on January 5, mainly expressing his views on the early market trends before 2024 and his trading strategies. Deep Tide has compiled the full text.

(The views expressed below are the author's personal opinions and should not be used as a basis for investment decisions, nor should they be understood as recommendations or advice for participating in investment trading.)

In the snowstorm of Hokkaido, the trees provided me with navigational direction, just as central bankers and politicians guide me in investing in global capital markets. While no trader can predict the future, we can observe the market and assign probabilities to the outcomes of events. If the market's probability of an event differs from our own calculations, there exists a trading opportunity.

The cryptocurrency bull market is in its early stages, and we must control our enthusiasm. Just as Bitcoin produces a block every 10 minutes, the current dirty fiat financial system will meet its predetermined disgraceful end. However, while I am certain of this ultimate outcome, the path to that future is unknown. We must remain vigilant and invest accordingly.

In short, I have deployed sufficient capital for this cycle phase, namely selling fiat currency and buying cryptocurrencies. I am preparing for a sharp decline in all cryptocurrencies this March, with various events leading me to foresee this happening. I will outline my reasoning and the turning points I will observe that will give me confidence to use Bitcoin put options to heavily short the cryptocurrency market, then sell U.S. Treasury bills (T-bills) and acquire more Bitcoin and other cryptocurrencies.

Variables

There are three conflicting variables in March presented in the form of questions.

When will the Reverse Repo Program (RRP) balance approach zero?

By reducing the RRP balance, liquidity is injected into the financial markets. When this number approaches zero, I define it as $200 billion in liquidity, and the market will want to know what the next step is, requiring another source of dollar liquidity to sustain the market's euphoria.

To understand more about how the decline in RRP balance injects liquidity into the system, please read my article "Bad Gurl."

This is a chart of the RRP balance since its inception. The horizontal white line represents $200 billion.

I believe that by early March, the reverse repo balance will reach $200 billion. This estimate is based on the rate of decline from different starting points in 2023.

Will the Bank Term Funding Program (BTFP) continue?

On March 12, bankrupt banks must find cash to swap with U.S. Treasury securities and other eligible bonds they have repoed to the Federal Reserve. Ultimately, this is a decision for Yellen (the U.S. Treasury Secretary). The market will begin to wonder weeks in advance whether the Bank Term Funding Program (BTFP) can continue.

The initial BTFP process involves banks offering $80 worth of U.S. Treasury securities in the open market but receiving $100 in cash. When the program ends, banks must return the $100 before receiving their original U.S. Treasury securities. If the cash is given to fleeing depositors, how will banks obtain cash without selling more equity or issuing high-yield bonds?

To understand the reasons for creating BTFP and its impact on the speed and amount of fiat currency depreciation, please read my article “Kaiseki.”

Will the Federal Reserve cut interest rates?

The Federal Reserve's March meeting will conclude on the 20th of this month. Currently, the market expects the Fed to cut rates for the first time since it began raising them in March 2021, with a reduction of at least 0.25%.

This is a table indicating the probabilities of future Fed rate hikes as implied by Fed fund futures. As you can see, as of January 3, the market expects a 75% chance of a 0.25% rate cut.

These variables are interdependent. The sequence of events is important as it will affect the market's assumptions about how much dollar liquidity the Fed and the U.S. Treasury will or will not provide in the future.

If my predictions are correct

Now we must assign probabilities to different event paths and predict the market's reaction.

The speed of reverse repo reduction

If the reverse repo approaches zero by early March, the financial markets will begin to decline. Remember the surge in U.S. Treasury yields that coincided with the stock market crash? The only reason was that the Treasury bonds rebounded significantly starting November 1, as the quarterly Treasury debt management report was released that day (Note: These documents aim to provide transparency regarding government borrowing needs and strategies, informing investors and the market about upcoming auctions, types and sizes of securities issued, and any changes in debt management policy. They are crucial for financial markets as they affect interest rates and investment strategies.)

This report confirmed that the U.S. Treasury would shift more borrowing to the short end of the yield curve. As the supply of T-bills increases and yields rise, money market funds (MMFs) will be economically incentivized to use cash held in RRP to purchase T-bills. All else being equal, a decline in the RRP balance increases system liquidity; this is why global bond and stock markets surged significantly.

The white line represents the 10-year Treasury yield, while the yellow line represents the difference between the 10-year and 2-year Treasury yields. As you can see, yields peaked at the end of October, showing a bearish trend, meaning both the white and yellow lines rose simultaneously. A fierce short squeeze in bonds began in early November, causing yields to plummet.

Without another new source of dollar liquidity, I believe that bonds, stocks, and even cryptocurrencies will be hit hard. I will elaborate on this later in the tactical trading section, but I will be buying a large position in Bitcoin's put options at this time.

We cannot know in advance the speed at which the reverse repo will decline. Therefore, I will closely monitor the rate of change. If it deviates significantly from my predictions, I will adjust my trading strategy accordingly. In any case, I purchased a large amount of cryptocurrencies in the second half of 2023, and I do not believe that now until April is a good time to be bullish on cryptocurrencies.

Bank Term Funding Program (BTFP)

2024 is an election year in the U.S., and ordinary Americans are tired of bank bailouts. Therefore, I believe Yellen will not extend the BTFP to showcase the strength of the U.S. banking system. However, once a few sufficiently large non-TBTF banks (TBTF means "too big to fail") are forced to take over due to equity nearing zero, the necessary regulatory capital will also disappear. U.S. Treasury Secretary Yellen will inevitably inject more liquidity into banks in the form of a new version of BTFP.

Due to the lack of liquidity flowing out of reverse repos and the inability of printed money to cover bond losses on non-TBTF banks' balance sheets, global financial markets will be severely impacted. The market will hit hard on holders of financial assets, forcing the Fed and the Treasury to reintroduce liquidity. This is correlated. All assets, including cryptocurrencies, will decline together as the market becomes anxious about the prospect of the free market once again functioning and clearing insolvent banking institutions from the system.

March FOMC Meeting

The BTFP will expire on March 12, and the Fed's interest rate decision will be announced on March 20. There are six trading days between these two critical decision points. If my predictions are correct, the market conditions during this period will lead to some bank failures, forcing the Fed to cut rates and announce the restoration of BTFP.

Technically, the U.S. Treasury cannot lend to banks; that is the Fed's job. But suppose the Fed incurs losses by accepting collateral worth less than the dollars provided; these losses will flow to the Treasury and ultimately to U.S. taxpayers, as the Treasury must borrow more money to fund the Fed's losses.

Bitcoin will initially plummet sharply along with the broader financial markets but will rebound before the Fed meeting. This is because Bitcoin is the only neutral reserve currency that does not become a liability of the banking system and trades globally. Bitcoin knows that when things get worse, the Fed will always inject liquidity in response. It may be called by a new name to confuse those getting news from TikTok, but rest assured, Bitcoin knows that regardless of the disguise, printed money is always printed money. Therefore, before and after the Fed ultimately yields to restart the printing press, Bitcoin will rise significantly.

If my predictions are wrong

If my predictions are incorrect, the following will happen:

• The Reverse Repo Program (RRP) will decline slowly, and liquidity will continue to support financial markets until the end of the second quarter.

• Yellen will clearly indicate before March 12 that the Bank Term Funding Program will be extended.

• The Fed's March meeting decision will become irrelevant. Whether they cut rates, keep them unchanged, or raise them, based on any of these outcomes, combined with the Fed and Treasury increasing dollar liquidity in other ways, the net effect will still be stimulative.

If the RRP declines more slowly than expected, I will not establish my put option positions in early March. Additionally, the date Yellen communicates that BTFP will be extended will be my moment to exit the non-trading zone. I will resume selling U.S. Treasury securities and buying Bitcoin and other cryptocurrencies.

Trading Strategy

Let’s return to my prediction: RRP will be exhausted in early March, BTFP will be canceled on the 12th, but will be restored by the 20th, and the Fed will cut rates. Now I will discuss my trading plan.

Bitcoin Put Options

As many of you know, I have a diversified cryptocurrency portfolio. My largest positions are in Bitcoin and Ethereum, accounting for about 70% of my portfolio. The liquidity of the other cryptocurrencies I hold is much worse, especially the liquidity of these cryptocurrency derivatives. Therefore, if I want a macro cryptocurrency hedge with strong liquidity, I must use Bitcoin derivatives. I use the term "hedge"; this is a trading position, and the trading setup I describe only needs two weeks to resolve. Since this is a trade, I will use options, which allow me to know my maximum loss in advance: the premium paid for the put options. An additional benefit is that I do not have to monitor the liquidation levels as I would when trading perpetual swaps or futures contracts.

I expect that regardless of what price Bitcoin reaches in early March, it will experience a 20% to 30% adjustment. If a spot Bitcoin ETF listed in the U.S. has already started trading, the washout could be even more severe. Imagine if hundreds of billions of fiat currency flow into these ETFs in the future, then Bitcoin would break through $60,000, approaching the historical high of $70,000 in 2021. Due to the sudden withdrawal of dollar liquidity, I can easily see a 30% to 40% pullback. This is why I cannot buy Bitcoin before these March decision dates pass.

I consider myself a focused trader. I will attempt to track the market top in late February and then buy a substantial put position. I will purchase put options expiring on June 28. I do not want to choose options expiring on March 29 because I will be entering my position in early March. High negative theta could overwhelm any delta, gamma, and vega gains and losses. Longer expiration periods will be more expensive, but since the expiration time exceeds a quarter, the premium decay will not be as rapid.

I will set my maximum loss, which will be quite significant relative to my standard trading position, and then purchase put options. To achieve some substantial gains on these put options, I will select a strike price that is 20% to 25% out of the money based on the current June quarterly futures contract price.

Exiting Positions

Many traders, especially options traders, excel at entering the market but make mistakes when exiting. Because the returns on options are path-dependent, you may correctly judge the market, but if you wait too long to close your position, you will still incur losses. Every day I hold these put options, I am losing money. If my predictions are correct, the market will begin to correct significantly around March 12. Between the 12th and the 20th, I need to try to exit my position at the market low and hope to profit. If I am correct in my policy judgment but Bitcoin holds or rises, I must immediately close my put option position.

Bull Market Continuation

By the end of March, we will be back on track. Yellen and Powell will once again confirm that they will spare no effort to maintain the fiat solvency of the peaceful financial system under U.S. governance. As this brief market turbulence passes, cryptocurrencies can soar again under the anticipated impact of the upcoming Bitcoin block reward halving. Therefore, I will resume selling Treasury securities and buying Bitcoin and other cryptocurrencies.

Unexpected Variables

This article focuses entirely on the decisions of the two managers of the American financial system. However, there are other key players in the fiat financial system that cannot be ignored.

China

The Taiwanese elections may lead to a pro-China candidate winning, after which the Chinese government will turn on the RMB printing press. A continuous influx of RMB credit into the global market will overwhelm any issues with the U.S. banking system. Even if the RRP is exhausted and BTFP is not extended, cryptocurrencies will rise. Therefore, I may choose not to buy put options but instead turn to purchasing more cryptocurrencies.

Japan

The Bank of Japan is currently allowing Japanese Government Bond (JGB) yields to rise slowly. If JGB yields continue to rise, this will financially incentivize Japanese corporations, pension funds, insurance funds, and households to repatriate capital. They will sell U.S. Treasury securities and buy JGBs because domestic yields are better. If this trend strengthens, I will certainly write a detailed article describing this phenomenon for my readers. Given that Japan is the largest holder of U.S. Treasury securities and the largest international creditor (based on its net international investment position), actions by the Japanese private sector could exert significant upward pressure on yields of U.S. Treasuries with maturities of 10 years or more.

This is data from the International Monetary Fund, estimating Japan's net international investment position at a positive $3.3 trillion.

This pressure may manifest before early March and force the U.S. to take more printing measures. If so, I may not even have the opportunity to execute this trade, as Yellen may have already renewed BTFP and introduced a novel way of injecting liquidity before mid-March. One candidate solution is a new U.S. Treasury plan to buy existing long-term U.S. Treasury securities by issuing more short-term bonds. This is a mild form of yield curve control, which she refers to as a repurchase plan. There was an explanatory article about this last year, which you can read here if you're interested.

In Conclusion

With the arrival of the new year, central banks are printing money in various forms, and with the anticipated listing of spot Bitcoin ETFs in the U.S. and Hong Kong, risks are skewing to the downside. It is not difficult to be bullish now. I like to buy well-performing stocks when the market perceives situations that seem impossible as likely to happen. From a trading perspective, taking non-consensus views using these signposts representing binary outcomes offers better risk-reward. I may ultimately be wrong. But if I am correct based on expected value, my gains will be much larger than following the crowd.