Crypto currencies experience another weekend sell-off

Just when the ice was thawing and the flowers appeared to bloom for cryptos, another volatile weekend of trade has raised the question of whether this crypto winter is over. Indeed, it could all be just a function of what is a volatile and immature market trading during an illiquid period. Nevertheless, as a sentiment barometer, it’s an opportunity to dig into what could be going on in the crypto space. In this week’s article, we’ll discuss some of the factors that drive crypto prices - and have a look at the price action of IG’s Crypto 10 Index.

Three drivers of crypto assets

• Are yields getting too real?

When it comes to the investment community, Bitcoin and its smaller counterparts are treated as a high-beta (that is: especially volatile) alternative asset. Investors allocate ‘risk-capital’ to the asset-class, somewhat like they do with equities. When a relatively risky asset like a stock or a crypto is offering a very attractive return versus a relatively safe asset like a bond, then it’s more likely an investor will put marginally more capital into the risky asset.

Much of the calculus depends on what’s on offer in safer assets. When a safe asset is delivering low or even negative yield, then taking risks in other assets becomes more appealing. However, when a safe asset is delivering a relatively high yield, investors will opt out of taking risk in favour of the safer asset. More important than the nominal yield is the ‘real yield’, which is the nominal yield minus actual or expected inflation.

One of the major reasons for the sell-off in stocks, crypto and other riskier assets is that as the US Federal Reserve started raising interest rates, real yields began to skyrocket. In fact, they went from deeply negative – so an investor loses money if owning a bond – to positive, with the real yield for the benchmark ten-year Treasury around 0.4% currently. This has pushed money away from riskier investments and is one of the major reasons that crypto assets have plummeted in the past ten months.

• Has the US tech recovery fizzled?

As we discussed here in the past, crypto assets (and Bitcoin in particular) have traded at times in a tight correlation with the NASDAQ. Although that correlation has weakened in recent weeks, it remains that corners of the crypto market are linked to technology stocks - perhaps in part because of the perception of their speculative, growth-like characteristics. The NASDAQ has surged over the past 2 months and volatility has fallen, with many investors questioning whether the move in the index is a bear-market rally, or something more sustainable. Friday’s trade saw a drop in tech stocks, igniting fears of another drawdown in the market. Crypto-assets, and particularly Bitcoin, have been swept up in selloffs in US tech - and even acted as a forward-looking indicator for the stock market.

• The problem with financial conditions

Ultimately, the situation with the bond market and the equity market all feeds into the most important factor at all driving the swings in crypto assets: financial conditions. Financial conditions are what the US Federal Reserve is trying to manipulate when increasing interest rates. The stronger the financial conditions are, the more supportive policy is for growth and stoking inflation. The weaker the financial conditions are, the more restrictive policy is for growth and stifling inflation.

With inflation running at a 40-year high, the Fed has been trying to weaken financial conditions so that economic activity slows and inflation cools. For the most part, it has been successful. However, with the markets expecting a significant slowdown in growth next year and subsequent interest rate cuts from the US Federal Reserve in 2023, financial conditions have loosened again, supporting the run-up in stocks, the drop in real yields, and the rally in crypto assets.

While looser financial conditions may appear like a positive thing, it throws up a potential dilemma for the US Federal Reserve and financial markets. If conditions improve so much that it runs the risk of stoking economic activity and inflation again, the Fed might have to double down to crush financial conditions, so they don’t feed this dynamic. As crypto assets in the short-term are so heavily dependent on financial conditions, a more hawkish Fed could drive another drop in prices.

A look at IG’s Crypto 10 Index

The Crypto 10 Index is made up of the 10 largest tokens and can be traded on the IG Platform. It also gives a good representation of the overall strength and weakness of the crypto market. With the weekend sell-off, the index has broken through the lower boundary of a short-term trend channel, to renew its primary downtrend. Momentum has also rolled over, with the daily RSI turning lower and indicating downside momentum.