HashKey Jeffrey: The interest rate cut cycle begins, what is the reason for the volatility in the crypto market?

The cryptocurrency market, in addition to new narratives, sees U.S. monetary policy as a key factor influencing market trends. Especially after the approval of ETFs, with BTC and ETH gradually entering the asset allocation of mainstream institutional investors, the market's capital structure, attributes, and investment methods are undergoing significant changes. Cryptocurrencies are increasingly resonating or diverging with other major asset classes such as U.S. stocks, U.S. bonds, and gold.

Recently, the market has been oscillating repeatedly amid expectations of interest rate cuts, recession fears, and election anticipations. This essentially corresponds to the intertwining and mutual influence of three factors: liquidity, fundamentals, and regulation. The most direct impact comes from interest rate cuts and expectations of cuts. To some extent, within a short cycle, expectations of interest rate cuts are more important in trading than the cuts themselves. Therefore, clarifying the upcoming interest rate cut in mid to late September is particularly crucial.

1. Why Cut: Tightening Arises from High Inflation, but Rate Cuts Stem More from a Slowing Labor Market

The leverage differentiation under high inflation in the U.S.: the government is increasing leverage while households are deleveraging, supporting the resilience of the U.S. economy. There is little disagreement in the market regarding the causes of high inflation; the overly aggressive fiscal policy in recent years is the core reason. While aggressive fiscal policy has injected a large amount of liquidity into the market, the Federal Reserve has rapidly expanded its balance sheet, and government deficits have significantly increased. However, on the other hand, the debt levels of households and non-financial corporations have not significantly increased; rather, they have improved.

Chart: Leverage Rate Differentiation Among the Three Major U.S. Sectors, with Household Leverage Rate Declining

The differentiation in leverage further explains that although the yield curve inversion of the 10-year and 2-year U.S. Treasury bonds, which serves as a leading indicator for recession, began in July 2022 and lasted a total of 26 months— the longest in history— by August of this year, the labor market slowed, and expectations of interest rate cuts led to a decline in short-term rates, thus resolving the inversion, yet the recession has not yet arrived.

Chart: The Current Round of Rate Hikes Has Resulted in the Longest Yield Curve Inversion, Heightening Market Concerns

Data does not support a recession, but the slowdown in the labor market and the deterioration in data quality have reinforced expectations for rate cuts while also raising concerns about a recession. In terms of inflation, the current PCE (2.5%) and core PCE (2.6%) have not reached the Federal Reserve's target of 2%. However, Wall Street traders generally expect the Fed to cut rates in September. In addition to Powell and other Fed officials continuously sending dovish signals to the market, an important background is that in the Fed's monetary policy framework established in 2020, the original inflation target regime was changed to an average inflation target regime. Meanwhile, although employment and inflation remain the Fed's main dual objectives, employment and the labor market have significantly taken precedence. In other words, the Fed is more inclined to tolerate short-term high inflation to ensure the robustness of the labor market.

The change in the monetary framework is also further reflected in each FOMC meeting and in the management of market expectations. Each release of data such as non-farm payrolls and unemployment rates triggers repeated oscillations in the market, with U.S. stocks and cryptocurrencies being particularly volatile. Describing the current market as being on edge is not an exaggeration. The market's heightened sensitivity, in addition to speculating on the extent of rate cuts, is also compounded by concerns about a recession and the sustainability of the AI narrative represented by Nvidia.

From the data perspective, the current U.S. economy has not fallen into a recession zone, but the slowdown is faster than expected, and the quality of employment is not high. Judgments about a recession have always been varied, and a simple and effective indicator is the Sam Rule, which defines that when the three-month moving average of the U.S. unemployment rate rises by 0.5 percentage points or more from the low of the past twelve months, it indicates that the U.S. has entered the early stages of economic recession. According to this indicator, the U.S. has entered a recession since July of this year (the Sam Rule recession indicator for July was 0.53%, and for August it was 0.57%). However, mainstream institutions, including the Federal Reserve, do not believe that a recession has begun.

Using the more authoritative NBER recession indicator, currently, whether it is GDP, employment, or industrial production, there has been a slight pullback, with a three-year pullback of less than 2%, far below the historical recession range of 5%-10%.

Chart: NBER Recession Indicator Still Has Distance from the Recession Zone

The pressure from the slowdown in the labor market is greater. The most critical indicator in U.S. employment data is the NFP data (non-farm payroll data), released by the U.S. Bureau of Labor Statistics (BLS). Over the past three months, the sub-data shows significant drag from the manufacturing sector, primarily supported by the service and government sectors. Additionally, the U.S. Department of Labor has revised previous data downwards in August and September, with the magnitude of the revisions surprising the market. According to the revised data, from January 2024 to August 2024, the average new non-farm jobs is only 149,000, significantly lower than the 2019 average of 175,000.

Chart: Significant Slowdown in Non-Farm Employment Over the Past Three Months

Further examining the types of employment, there is also a clear differentiation between full-time and part-time jobs. Full-time positions in the U.S. have continued to decrease both month-on-month and year-on-year, while part-time positions have increased both month-on-month and year-on-year. The increase in part-time positions somewhat masks the overall decline, but it also reveals that the quality of employment data is not high.

Chart: Changes in Full-Time and Part-Time Employment in the U.S. Indicate Low Quality of Employment Data

Regarding the unemployment rate, with the labor force participation rate remaining stable, the unemployment rate has risen to 4.3% but has slightly retreated, while the Sam Rule index continues to rise. Notably, within the unemployment rate data, the U6 unemployment rate (a broader measure of unemployment, closer to the true unemployment rate of the entire market) has risen to 7.9%, the highest level since the pandemic. Additionally, looking at job vacancies, the number of job vacancies has unexpectedly declined, and the vacancy rate has also continuously decreased.

Chart: JOLTS Non-Farm Job Vacancies Have Continuously Decreased

The consecutive two months of cooling in the job market, combined with the previous downward revisions of employment data, have significantly strengthened market expectations for rate cuts, with the focus solely on 25bp/50bp ; on the other hand, concerns about a recession are beginning to rise.

2. How to Cut: The Market and the Fed's Game, but Data Remains Key

After the non-farm data was released on September 6, the market's performance vividly showcased the mixed data and the divergence in market consensus; risk assets fluctuated, but ultimately returned to weakness. The CPI data for August released on the evening of September 11 showed a year-on-year decline to 2.5%, below expectations, but the core CPI increased by 0.3% month-on-month, higher than market expectations. Overall, inflation continued its previous structural differentiation, with goods, food, and energy continuing to decline, while services still exhibited strong stickiness. After the data was released, market expectations for a 50bp rate cut significantly decreased, and the stickiness of service inflation indirectly indicated that there is currently no risk of recession.

Chart: CPI Sub-Data for July-August Reveals High Stickiness of Inflation and Slowing Decline

Concerns about a recession persist in the market, combined with the decline in inflation. The interplay of these two factors has led to a market that is quite "conflicted" about rate cuts, primarily due to the current inability to unify market consensus and the presence of contradictions. If a 25bp cut occurs, on one hand, the pricing is already quite sufficient, providing limited support for risk assets, and it cannot completely alleviate market concerns about a recession; if a 50bp cut occurs, then concerns about a recession will significantly increase, which in turn will hinder the boost to risk assets. In either case, the direct impact on the market is a significant increase in the sensitivity of risk assets.

From the Fed's perspective, its regulatory methods mainly consist of market expectation management and monetary policy management. The former relies on communication, while the latter relies on concrete policy tools. Currently, although the Fed has not implemented substantial rate cuts, through continuous communication from Powell and other officials, it has already formed a loose expectation in the market. Both U.S. Treasury yields and domestic credit rates have already reacted in advance, forming substantial easing.

Chart: Decline in U.S. Bank Credit Tightening Ratio and Narrowing Credit Spread

The above chart illustrates that the tightening ratio of U.S. banks has significantly decreased, and the credit risk spread has also been declining since August 5, indicating a clear easing trend in the market.

Based on the current slowdown in inflation, the unexpected slowdown in the labor market, and the substantial easing environment, the possibility of a 50bp cut starting on September 18 has begun to decrease, while the probability of a preventive rate cut of 25bp has increased. Furthermore, in the absence of clear data proving that a recession has arrived or that inflation has significantly decreased beyond expectations, a soft landing remains the baseline scenario for current trading, and the market will continue to oscillate amid data fluctuations related to recession, rate cuts, and elections.

3. What Impact: Boosting Crypto Risk Appetite, but Adjustments Are Inevitable

Even though there is a general expectation that the FOMC meeting on September 18 will initiate a rate cut cycle, risk assets may not immediately show a rally, especially as we enter 2024. With the listing of Bitcoin and Ethereum ETFs in the U.S. and Hong Kong, the compliance process for cryptocurrencies has allowed mainstream capital to begin allocating crypto assets, which has also weakened the independent market for crypto assets. Crypto assets are significantly influenced by fluctuations in major assets such as U.S. stocks and U.S. bonds. In terms of the transmission of rate cuts, the direct impact is on the risk-free treasury market, which in turn affects risk assets (MAGA7, Russell 2000, SP500, crypto assets).

Historically, during turning points in cycles, increased asset volatility is normal, primarily due to the game of expectation differences. If the market prices in advance, any change in data will affect the pricing effect, subsequently impacting asset fluctuations.

In terms of different types of rate cuts, past preventive rate cuts typically lead to a response in risk assets that first decline and then bottom out, followed by a recovery rally (whereas if it is a relief-style rate cut, the probability of asset declines is greater). The bottoming process usually takes about one month.

Chart: Preventive Rate Cuts Typically Lead to Risk Assets First Declining and Then Rising

For crypto assets, as high-risk assets, they are increasingly correlated with U.S. stocks. In a scenario where rate cuts are relatively certain and a soft landing is anticipated, the market's risk appetite should gradually increase. However, as analyzed earlier, the market is currently in a stage of divergence before forming a new consensus, making oscillation inevitable, whether for U.S. stocks or crypto assets.

Chart: Crypto Assets and U.S. Stocks Show Highly Consistent Volatility Directions

From a long-term perspective, the probability of an increase in crypto assets remains high, but in the coming month, volatility will closely follow U.S. stocks, maintaining oscillation, especially around the time of the rate cut. Additionally, it is still worth paying attention to the impact of the U.S. elections, as the election results directly influence the government's stance, including that of the SEC, towards cryptocurrencies, which will in turn impact the market.