LUCIDA & FALCON: Unveiling the Macro Analysis Methodology of Top Researchers in Crypto

Topic: Unveiling the Crypto Macro Analysis Methodology of Top Researchers

Guests:

Zheng @ ZnQ _626

• Founder of LUCIDA
• Champion of the mixed strategy group in the first season of the 2019 Bgain Digital Asset Trading League;
• April runner-up, May champion, and season third place in the composite strategy group of the 2020 TokenInsight Global Asset Quantitative Competition;
• Season third place in the composite strategy group of the 2021 TokenInsight x KuCoin Global Asset Quantitative Competition;

Vivienna @ VV _ watch

• Research Partner at BuilderRocket Accelerator
• Entered the industry in 2017
• Former investment researcher at a blockchain investment fund under Foxconn
• Former DeFi researcher at Huobi
• Obsessed with macro research

HighFreedom @ highfree2028

• Entered the industry in 2016
• Background in computer science & finance
• Currently a researcher at a brokerage
• Specializes in cycle timing based on dollar liquidity analysis and macro analysis

Albert @ assassinaden

• Quantitative private equity fund manager
• Former quantitative researcher in the foreign exchange market, focusing on statistical arbitrage and relative value strategies
• Specializes in non-delta strategies and macro research
• Emphasizes the ability to respond to cycles and navigate bull and bear markets

Unveiling the Macro Analysis Framework

Zheng @ LUCIDA:

With the development of the Crypto industry, the correlation between market trends and macroeconomics is increasing, making macro analysis an essential part of market analysis. Today, we will specifically discuss macro-related topics. Let's start with the first question: please share your frameworks and methodologies for analyzing the macro economy, as well as the underlying logic behind them.

HighFreedom:

Macro analysis for crypto consists of two parts: the first type is off-chain (non-crypto native) macro, and the second type is on-chain macro (crypto native, primarily focused on BTC on-chain data analysis).

For the first type of off-chain macro, my analysis framework resembles an inverted triangle, divided into three levels.

The first level is various data, such as employment, GDP, inflation, PCE, etc.

The second level is summarizing and synthesizing the data. The data in the first level may seem chaotic, but we can ultimately categorize it into two types: data indicating economic health and data indicating inflation levels. This is because the ultimate goals of the Federal Reserve, which formulates monetary policy (interest rate hikes or cuts, balance sheet adjustments, etc.), and the Treasury, which formulates fiscal policy (how the government spends money, etc.), are to maximize employment and ensure price stability. In other words, the core objective of these two institutions is to ensure a healthy economy with controllable inflation.

The third level is the specific composition of dollar liquidity and its future expectations. The main components of dollar liquidity include bank reserves, the Federal Reserve's balance sheet, the Treasury's balance, and the balance of overnight reverse repurchase agreements. We need to pay attention to changes in these factors, as well as the refinancing announcements released by the Treasury each quarter, to assess the current and future state of dollar liquidity.

Moreover, employment and prices are two core factors that influence each other to some extent. For example, when the Federal Reserve decides whether to cut interest rates or stop tapering, it considers both employment and inflation data simultaneously. Therefore, we need to conduct a comprehensive analysis of these data to more accurately predict changes in dollar liquidity. By analyzing quarterly refinancing announcements and various economic data, we can better understand the operations of the Treasury and the Federal Reserve, thus predicting future trends in dollar liquidity.

These are what we refer to as off-chain factors. Off-chain factors mainly refer to those that are not native to the cryptocurrency market, such as the aforementioned macroeconomic indicators, policy changes, market sentiment, etc. Although these factors do not directly originate from the cryptocurrency market, their impact on the market is significant, as they define the external environment and investor expectations.

The second type is on-chain macro: on-chain macro refers to data and analysis that directly originate from within the cryptocurrency market, primarily focusing on Bitcoin's on-chain data. This data includes the changes in holdings of long-term and short-term holders, profit levels, etc. By analyzing this on-chain data, we can gain deeper insights into the internal dynamics of the market, including investor behavior and market trends.

These two analytical methods each have their own focus; off-chain factors provide us with a macro perspective, while on-chain factors allow us to gain insights into the cycles and rhythms of the crypto market. It is crucial to combine these two perspectives when analyzing the cryptocurrency market, as they together form a comprehensive macro analysis framework.

Albert:

I would like to add that, in addition to the influence of the Federal Reserve and Treasury policies, we should also pay attention to microeconomic factors such as bank deposits. For instance, ordinary investors may choose to deposit funds in banks to earn interest when faced with high interest rates, which can also impact market liquidity. Historically, after the banking crisis in the 80s and 90s, the growth rate of deposits significantly slowed. Similarly, after the SVB incident in 2023, we saw a similar situation where bank deposits decreased while the stock market and other asset markets began to recover. Additionally, international liquidity, such as the yen-dollar arbitrage trading by the Bank of Japan, also brings extra liquidity resources to the market.

During high interest rate cycles, people tend to deposit funds in banks to earn interest. However, when banks face operational risks, investors may shift their funds to the stock market or other assets, such as short-term government bonds. Currently, the yield on short-term U.S. government bonds is close to 5%, attracting many investors. At the same time, investors may also choose to invest in stocks, derivatives, or ETFs to seek higher returns.

Of course, when investors face a banking crisis, they may reassess the safety of depositing funds in banks. They might choose to invest in the stock market or other assets to seek relatively safe returns. This situation has occurred in the 90s and in 2019. Additionally, the performance of money market funds can also serve as an indicator of liquidity. Since 2023, the growth rate of money market funds has reached a new high in over 20 years, reflecting the market's demand for liquidity.

Ideally, we should consider all possible factors that could affect the market, including the liquidity conditions of other countries. However, in practice, due to the complexity, we may not be able to incorporate all factors into our analysis. For example, carry trades in Japan and Europe affect the market but are difficult to quantify. We usually focus primarily on the U.S. while considering the impacts of other countries as secondary factors. Nevertheless, we cannot ignore the influence of the offshore dollar market.

Vivienna

On Twitter, I published an article exploring the impact of U.S. liquidity on cryptocurrency prices. I mainly focused on domestic factors rather than the overseas dollar market, as the latter's data is difficult to quantify. When analyzing Bitcoin prices, I categorized the influencing factors into three types:

The first is observable indices: including the federal funds rate, treasury yields, the dollar index, and gold prices. These indices form the basis of market expectations, but their relationship with the prices of risk assets is not directly linear. For example, interest rate hikes typically lead to tighter market liquidity, which is unfavorable for the rise of risk assets, while rate cuts have the opposite effect. However, this influence is affected by the complex interplay of the monetary policy transmission mechanism, economic, financial, and sentiment cycles, and does not directly impact market liquidity at the moment monetary policy is implemented.

The second is liquidity indicators: such as the Federal Reserve's balance sheet, reverse repurchase operations, and Treasury accounts. These indicators directly affect dollar liquidity, thereby influencing the prices of growth-oriented risk assets like Bitcoin. For instance, an expansion of the Federal Reserve's balance sheet, a reduction in reverse repos, or the Treasury's consumption of the TGA account would increase market liquidity, benefiting risk assets.

The third is sentiment impact indicators: including dot plots, speeches from Federal Reserve officials, labor market data, and inflation data. These data have a short-term impact on market expectations and sentiment, influencing the smaller cycles of trading. However, it is important for traders to focus on changes in expectations rather than the data itself.

How Macro Factors Affect the Crypto Market

Zheng @ LUCIDA:

So how do you apply your macro analysis frameworks to the crypto market? Or how do these frameworks guide your trading and help you make money?

HighFreedom:

I believe we can understand the ways to make money from three angles:

The first is making money from the big direction: This means buying and holding spot when the market trend is clear, without frequent trading, and maintaining patience.

The second is making money from volatility: This usually involves quantitative trading, utilizing market volatility for buying and selling, without focusing on the specific direction of the market.

The third is making money from liquidity: During a bull market, investing funds into the market and lending to traders in need to earn high interest.

Personally, I believe macro factors primarily influence the cryptocurrency market through two aspects: liquidity and penetration rate. Liquidity determines the amount of funds in the market, while penetration rate refers to the proportion of funds allocated to cryptocurrencies like Bitcoin.

In terms of operations, I tend to be fully invested in spot during bull markets, especially in mainstream currencies like Bitcoin. This aligns with what I just mentioned: making money from the big direction.

At the same time, I will appropriately use part of my funds for coin-based long positions but avoid frequent long and short operations during bull markets. I believe the key is to identify market highs and lows, which requires considering various information sources, such as miner costs, market heat, borrowing rates, funding rates, etc.

The market performance in the second half of 2021 showed that the high point of Bitcoin prices was sequentially related to the highs of the Nasdaq index and dollar liquidity. This indicates that when liquidity peaks, risk assets may need to prepare to exit. Therefore, I closely monitor liquidity indicators to assess whether the market is approaching a top or bottom.

I also believe in information orthogonalization, which means forming a comprehensive market judgment by widely collecting information from different angles. This method helps us more accurately grasp market highs and lows, allowing for more reasonable trading decisions and minimizing the likelihood of operational errors. I will also adjust my risk control strategies based on market conditions to ensure that I can protect my investments during market fluctuations.

Vivienna:

I recommended a book on Twitter titled "The Principles of Professional Speculation," where the author Spolandi proposed two basic principles for market analysis and forecasting: one is that market trends are the result of fundamental economic forces at work, which are influenced by political systems and policy activities; the other is that the psychological state of market participants determines the manner and timing of price movements.

Macro analysis should focus on these two points. First, we need to understand the basic principles of politics and economics, such as economic indicators, production and consumption cycles, investment and savings behaviors, and technological innovation development paths. Second, predicting the psychological state of market participants is more instructive for trading. Macro analysis is often questioned because many people overly focus on economic and financial data while neglecting changes in expectations. Successful trading requires not only analyzing the current situation behind the data but also paying attention to how expectations change and how market games unfold.

Soros once pointed out that economic history is built on false lies rather than truths. The way to make big money is to analyze erroneous trends, act in accordance with them, and exit before being exposed. This reflects the aforementioned principles, as discerning erroneous trends requires first knowing what is correct. For example, if the government implements high interest rate policies during an economic recession or attempts to stimulate the economy through monetary policy adjustments, failing to understand the transmission mechanisms of these policies makes it impossible to judge their consequences or to exit before most participants realize the issues.

Albert:

Regarding how the macro analysis framework influences the cryptocurrency market and our trading strategies, I will break it down into the following points:

First, since 2020, we have discussed a long-standing theory—the liquidity chain theory. According to risk analysis, we rank different assets such as commodities, foreign exchange, stocks, etc., along a chain. At the top of the chain is cash, which serves as the foundation for all assets, with very low risk, almost zero except for inflation. If cash itself becomes risky, it indicates that the global market may face a reset.

The second layer of the liquidity chain consists of bonds, especially government bonds, which are considered low-risk fixed-income assets. The third layer includes corporate bonds and stocks, as they offer relatively higher returns. The fourth layer is commodities, which have higher volatility and risk. The final layer is cryptocurrencies, as they are at the end of the liquidity chain, exhibiting the highest volatility and risk.

This theory also explains the underlying reason for the phenomenon mentioned earlier by HighFreedom, where "the high point of Bitcoin prices is sequentially related to the highs of the Nasdaq index and dollar liquidity."

When liquidity is released, it first affects the foreign exchange market, then the bond market, followed by the stock market, commodity market, and finally the cryptocurrency market. Conversely, when liquidity tightens, the withdrawal process is reversed. This order of liquidity flow has a significant impact on the market.

As traders, we utilize this framework to guide our trading. For example, when we see liquidity beginning to tighten or release, we can predict the market's reaction and adjust our trading strategies accordingly. We closely monitor interbank rates and bond futures, as these are the first responses of the market to policy changes. Then, we analyze the options market, as option prices reflect the market's expectations for future volatility.

Our trading strategies are primarily based on these macro expectations. For instance, during a rate hike cycle, market sentiment tends to be bearish, and we will allocate put options when volatility is low. At the same time, we will adjust our options portfolio based on market sentiment and expectations to profit from volatility regression.

Our strategy relies on volatility regression, especially near-term volatility. Long-term volatility may remain high for a period and not regress immediately. Therefore, we are typically buyers in the long term, obtaining value through cross-period allocations. Our portfolio strategy involves holding both near-term and long-term options to profit from the value differences between them.

Bitcoin's Position Among Major Assets

Zheng @ LUCIDA:

The next question is relatively easier, and we have indirectly touched on it in our previous discussions, which is Bitcoin's position among traditional assets. I remember in 2019, especially in the first half, the market generally viewed Bitcoin as a safe-haven asset. During that time, due to some geopolitical crises, gold prices soared, and Bitcoin also rose, with increasing market recognition of this viewpoint.

However, with the bull market cycle from 2020 to 2021 and the situation in 2022, the public gradually accepted that Bitcoin is a riskier asset compared to traditional risk assets. I would like to know if everyone agrees with this positioning or if there are other descriptions regarding Bitcoin's position among major assets.

HighFreedom:

I think this description is quite accurate. I believe Bitcoin is undoubtedly a riskier asset in the medium to short term. However, in the long term, I am confident that Bitcoin can develop into a safe-haven asset. Currently, we are in the process of Bitcoin growing into a safe-haven asset. I believe that safe-haven assets need to meet several basic criteria, and we can discuss whether these are necessary conditions:

The first is that the market size must be large: The market size of the asset needs to be sufficient for large funds to enter and exit freely.

The second is that volatility must decrease: Although Bitcoin has historically exhibited high volatility, it has significantly decreased and is now close to or sometimes even lower than gold's volatility.

The third is the rationality and stability of market participants: As market participants transition from insiders to more traditional and rational financial institutions, the market may become more stable.

When these conditions are met, Bitcoin may become a mature safe-haven asset with a large market size and low volatility, similar to gold. At that time, even significant events would only have a slight impact on prices.

Vivienna:

I believe the comparison of Bitcoin to digital gold is widely recognized, and the logic behind comparing it to gold is well-accepted. Bitcoin's total supply is fixed, similar to gold's scarcity, and it can serve as a store of value and a means of payment, which aligns closely with gold's characteristics.

However, the pricing of gold is a complex issue. During times of heightened risk aversion, such as wars, gold's safe-haven characteristics become particularly evident. If the market's underlying liquidity is not tight, but war factors are significant, Bitcoin may follow gold's trend, as the primary factors affecting gold prices are risk aversion sentiments. Correspondingly, Bitcoin prices will also be influenced by risk aversion sentiments.

However, if the market's underlying liquidity itself is insufficient, for example, during a global or U.S. economic recession or when there are expectations of recession, even if risk aversion sentiments are high, it may not drive trading volume. This explains why, during certain intense geopolitical conflicts, other markets do not respond significantly. In such cases, it is the underlying liquidity that determines the price floor, and Bitcoin is closer to a risk asset.

Therefore, the correlation between gold prices and Bitcoin prices primarily depends on the underlying liquidity of the market at that time and the market's perception of Bitcoin's attributes. Most of the time, Bitcoin prices are highly correlated with U.S. stocks. During economic contractions, investment shrinkage, and deleveraging processes, Bitcoin tends to react first, and during economic recoveries and investment returns to leverage, it also tends to react in advance, with greater acceleration.

Gold holdings in global asset management companies are typically controlled within 5% because the factors influencing gold prices are highly uncertain. Although gold has practical applications, it is more influenced by speculation and sentiment, lacking fundamental analysis. This makes it difficult to explain to LPs (limited partners) why they should invest in gold, relying solely on predictions of future economic recessions or risks, which is very subjective and lacks persuasive power.

Bitcoin faces the same issue, making it difficult to persuade capital companies and LPs to allocate funds to this asset. Although gold is viewed as a safe-haven asset, its ability to combat inflation is primarily reflected in the long term. Bitcoin may be similar; its status could be very high in the future, especially as the difficulty of Bitcoin mining increases.

If more traditional financial asset management companies enter the Bitcoin investment space, the investment ratio of Bitcoin may align more closely with that of gold.

Albert:

From a macro perspective, both gold and Bitcoin have multiple attributes; they can be both risk assets and safe-haven assets. This phenomenon may seem contradictory at first glance, but it actually has its inherent logic.

First, both gold and Bitcoin serve as safe havens for funds during times of crisis. In times of war or other turmoil, asset transfers are restricted, and liquidity seeks a safe harbor. Investors tend to move funds into easily transferable assets like gold and Bitcoin, leading to significant price increases for these assets during crises.

However, during stable market periods, the attributes of gold and Bitcoin differ. Due to its high volatility, Bitcoin tends to behave more like a risk asset. Its price fluctuations are correlated with the stock market, partly because there are many leveraged tools in the Bitcoin market and numerous market participants, leading to sharp price fluctuations.

In stable environments, investors tend to pursue robust investment portfolios, avoiding significant asset price volatility. Therefore, they may prefer to allocate to traditional assets like gold and other commodities. Gold, due to its long history and stable value, is typically controlled within 5% of investment portfolios.

Additionally, the prices of gold and Bitcoin are also influenced by market expectations. When liquidity is ample, investors may seek higher-yielding assets, while during liquidity tightening, they may revert to traditional safe-haven assets.

Finally, the status of Bitcoin and gold as safe-haven assets also depends on the market environment and the phase of the macroeconomic cycle. In specific situations, they may exhibit safe-haven characteristics, while in others, they may reflect more as risk assets.

What Are the Grasping Points of Macro Analysis?

Zheng @ LUCIDA:

Next, let's discuss a question regarding the data sources you typically rely on when analyzing the macro economy. Do you collect data yourself, or do you have some non-traditional analytical tools? Are there any more exclusive information sources you can share?

HighFreedom:

I wrote some code on TradingView to create a dashboard for continuously monitoring and analyzing macro liquidity. These tools are no different from the data provided by the Federal Reserve and Treasury's official websites; I just integrated them into a single interface for easier ongoing observation. Additionally, I follow some analysts on Twitter, especially a blogger from Taiwan who aggregates some interesting data, such as borrowing rates from different exchanges. This data can reflect the operational trends of large and retail investors, as well as their sequence of actions. I find this data very valuable, but I have not yet successfully applied his tools.

I have also been looking for data on U.S. Treasury bonds, particularly the daily net issuance of short-term and medium-to-long-term bonds (net issuance refers to the amount of bonds newly issued on that day minus the amount of bonds maturing on that day). This data is crucial for understanding and judging the current and upcoming market liquidity. Currently, I can only manually download data from the U.S. Treasury's website and process it myself. If anyone knows of better data sources, please recommend or contact me.

Albert:

I would like to add some macroeconomic data sources we focus on. Since I primarily focus on risk commodities, the data services I use include Spotgamma Menthor Q, which provides comprehensive data on U.S. stocks, bond markets, and other commodity options.

Additionally, for the U.S. stock market, there are services like GR that provide real-time data at relatively low prices. If deeper data is needed, such as gold or interbank market data, it may require relying on industry internal resources.

For the cryptocurrency market, the first recommended data source is Amber Data Derivative, which has very comprehensive options data and clear advantages. Additionally, this service provider offers real-time data from exchanges like CME.

We also need to pay attention to data from some exchanges, especially those where institutional trading volume is significant, such as Deribit, where 80% of their trading volume comes from institutions and 20% from professional individual investors. Such data can reflect market expectations at the institutional level and have a significant impact on the market.

Moreover, exchanges like Bitfinex can be viewed as the interbank market for cryptocurrencies, and their short-term borrowing rates can reflect the market's risk-free rate, which is crucial for calculating the risk premium in the crypto market.

Compliant exchanges, such as Coinbase, and their large trader transaction data are also important, especially dark pool trading data, which may impact the market.

Overall, while we can obtain a wealth of market data, the final trading decisions still rely on our own risk management capabilities. Our goal is to avoid losses or achieve small profits in most cases while aiming for significant gains in a few instances.

Review and Outlook of This Cycle

Zheng @ LUCIDA:

Let's turn to the final question regarding views on the future market.

I will share my perspective first: the market generally expects that the Federal Reserve's interest rate cuts in the second half of this year or next year will bring significant liquidity, coupled with favorable factors like Bitcoin halving, leading many to anticipate a replication of the 2021 bull market. However, I hold a very pessimistic view of this widespread optimism, as historically, highly consistent market expectations often come with significant potential risks.

Especially regarding U.S. public funds and other institutional investors, although they belong to the long-term holding type, they also adjust their investment decisions based on market conditions and will not blindly "chase highs."

HighFreedom:

My view is quite similar. The main upward trend in the market began in November last year, particularly after the January spot ETF trading, leading to significant market volatility. Liquidity and penetration rates increased in the first quarter, but primarily due to retail participation, true institutional investors have not yet entered on a large scale. For example, in the inflow of funds into the spot ETF, 80%-85% came from retail investors. In the second quarter, liquidity decreased, and penetration rates stagnated. My outlook for the third and fourth quarters is to hope that liquidity remains stable, while penetration rates can improve with further participation from institutional investors.

I believe that interest rate hikes or cuts do not immediately change liquidity but rather alter market expectations for future liquidity. My question is whether we can still see a fiscal and monetary policy environment as loose as in 2021; currently, this possibility seems low. Therefore, I hold a cautious attitude toward the future performance of the market, hoping not to see overly optimistic expectations.

In the short term, the market may not experience significant changes; liquidity expectations may see 4 to 5 rate cuts in the next 15 months, providing a stable outlook for the market. However, true liquidity release will be slow and unlikely to see large-scale rapid changes. Unless a severe economic recession or crisis occurs, it is unlikely that we will see a return to a loose fiscal and monetary policy environment.

So, unless a severe economic recession occurs, this round of rate cuts is likely to be what we call "asymmetric rate cuts." Previous rate hikes and cuts were symmetric; for example, if the federal benchmark rate took about a year to rise from a low to a high, the reverse process of dropping from high to low would also take about a year. This round of aggressive rate hikes started from 0-0.25 in March 2022 to 5-5.25 in May 2023, taking just over a year. However, this round of rate cuts may follow an asymmetric path, with the rate-cutting process being prolonged and gradual.

Vivienna:

My conclusion is relatively simple and aligns with everyone's views. From July and August this year to the end of the year, the market may face less optimistic liquidity conditions. Even if rate cuts occur, there may only be one, which, while providing positive expectations for the market, will not fundamentally change the situation.

The current economy has not fallen into recession, and the stock market may continue to rise. People's lives seem to be largely unaffected, with deposits and dividends still filling household savings and promoting consumption. However, if inflation continues to rise, it may trigger trading expectations for a stagflation cycle. If high interest rates are maintained next year, and in some cases further rate hikes are needed, while the Treasury does not loosen policies, this could lead to tighter liquidity next year. For markets like Bitcoin that rely on liquidity, this is certainly not good news.

As for the desire for institutional investors to enter the market on a large scale, I believe this is more of an expectation than a reality. In the current environment of poor underlying liquidity, insufficient understanding of cryptocurrencies in the market, and high volatility, institutional investors are unlikely to build large positions or heavily invest. This expectation may be overly idealistic, and the actual situation may not unfold as we wish.

Albert:

Currently, short-term market expectations lean bearish, especially for Bitcoin. Although market volatility may increase in July due to factors like options expiration, in the long term, the asset allocation cycle may drive prices up. However, for the market to rise, it may need to rely on two factors: significant allocations from institutional investors and further improvement in investor sentiment. However, this sentiment-driven rise may not be healthy, as high capital costs and high volatility are difficult to sustain in the long term.

My view is that the market's rise will be a slow process, as the entry of market participants is a gradual process. The use of derivatives and leverage is unlikely to drive the market in the short term. In this case, the operations of market makers may become an important factor influencing market price direction. The macro factors of the market may only serve as one factor driving market makers' hedging behaviors, rather than directly affecting prices. This may lead to the market appearing more irregular, increasing the execution difficulty of strategies like CTA.

Overall, the market is unlikely to experience large-scale crashes or rapid rises in the short term; rather, it will be a slow and prolonged process. Liquidity will not see drastic fluctuations unless a severe economic recession occurs. Investors should remain cautious and pay attention to the allocation trends of institutional investors and changes in market sentiment.

About LUCIDA & FALCON

Lucida (https://www.lucida.fund/) is an industry-leading quantitative hedge fund that entered the Crypto market in April 2018, primarily trading strategies such as CTA/statistical arbitrage/option volatility arbitrage, currently managing $30 million.

Falcon (https://falcon.lucida.fund) is a next-generation Web3 investment infrastructure based on a multi-factor model, helping users "select," "buy," "manage," and "sell" crypto assets. Falcon was incubated by Lucida in June 2022.

For more content, visit https://linktr.ee/lucida_and_falcon