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Daily Analysis 1 July 2022 (10-Minute Read)

Hello there,

A fantastic Friday to you as markets continue to flounder primarily on recession concerns and that central banks will overdo tightening, exacerbating any economic pain.

In brief (TL:DR)

  • U.S. stocks marked another day of declines on Thursday with the Dow Jones Industrial Average (-0.82%), S&P 500 (-0.88%) and the Nasdaq Composite (-1.33%) down more strongly on instantaneous GDP numbers suggesting that the U.S. economy marked zero growth in the past quarter.

  • Asian stocks were mostly lower on Friday, with the sole bright spot Australia where expectations of China's reopening buoyed sentiment.

  • Benchmark U.S. 10-year Treasury yields fell to 2.985% (yields fall when bond prices rise) as the prospect of a recession saw investors flee to safety.

  • The dollar edged higher in Asian trading.

  • Oil rebounded with August 2022 contracts for WTI Crude Oil (Nymex) (+0.23%) at US$106.00 on optimism over a possible Chinese reopening, but remained under pressure on expectations of a global recession.

  • Gold fell with August 2022 contracts for Gold (Comex) (-0.11%) at US$1,805.40 on a stronger dollar.

  • Bitcoin (+1.04%) made a surprising rebound to US$20,246, after falling to as low as US$19,000 at one stage overnight, due mainly to further liquidations of other positions in centralized crypto lenders and those associated with the fallout from Three Arrows Capital.

In today's issue...

  1. Could Wall Street's Great Inflation Trade be Over?

  2. It's All About the Oil when it comes to Rates

  3. Cryptocurrency Deleveraging is Bitter Medicine

Market Overview

As goes America, so goes the rest of the world, at least when it comes to the global economy.

With China still teetering on the brink of its own slowdown, there are growing signs that the U.S. economy may have clocked zero growth over the past quarter, with China in no shape to fill that gap or make up for the shortfall in global demand.

The once lucrative inflation trade appears to have been overbought and there are signs that commodity prices are beginning to recede, which is putting downward pressure on sentiment and asset prices.

Asian markets were mostly lower on Friday with Tokyo's Nikkei 225 (-0.88%), Seoul's Kospi Index (-0.92%) and 200 Hong Kong's Hang Seng Index (-0.62%) down, while Sydney’s ASX (+0.27%)was up marginally in the morning trading session.

1. Could Wall Street's Great Inflation Trade be Over?

  • Bets on higher inflation are waning against a backdrop of dour economic data.

  • More than an outside chance that U.S. Federal Reserve may pause rate hikes as soon as September, meaning smaller increases like 25-basis-points as opposed to the larger hikes that the market has continued to brace itself against.

With inflation bets on Wall Street coming down from their record highs, the U.S. Federal Reserve may be able to claim a provisional victory as economic indicators suggest that the much-feared commodities supercycle was not to be.

Bond-acquired expectations for price growth over the next few years are declining, together with the reversal of a breakout from value stocks and easing of commodity prices.

There are signs that this year’s once-profitable inflation trade has peaked, creating an environment which threatens cross-asset trading.

The Fed’s policy tightening is beginning to yield tangible easing of price pressures, which should help businesses plan their next phase with a higher degree of certainty.

Speaking with Bloomberg, Chief Global Strategist at Principal Global Investors Seema Shah suggests that “US inflation is likely close to peaking,” adding that consumers are shifting away from consumer goods and consuming more services amidst a slowdown in overall demand, hence “core goods price pressures are becoming more deflationary”.

Since March, a slew of commodities has tanked to their lowest levels in months, and US$1.9 billion Invesco DB Agriculture exchange-traded fund is facing its largest cash withdrawal since 2008, with US$235 million pulled from the fund.

There are growing signs that the U.S. economy may already be in a recession, with GDP growth over the past quarter likely to come in at zero and a more than outside chance the inflation print for June will come in lower than the white-hot CPI of 8.6% in May.

If inflation indeed moderates, then any further tightening in July may not necessarily usher in a fresh correction in risk assets, because it’s likely that this quarter will see the U.S. economy actually shrink and indeed, it’s entirely possible for the Fed to “pause” rate hikes in September.

But pausing rate hikes isn’t necessarily cutting interest rates, merely slowing the pace of increases and that has implications for all manner of risk assets on the upside.

2. It's All About the Oil when it comes to Rates

  • U.S. Federal Reserve is narrowing the distinction between headline inflation and core inflation, to consider more volatile food and fuel prices when it comes to setting policy.

  • Move by the Fed to include fuel prices in its consideration may result in unintended consequences as monetary policy is a blunt tool to use on rising energy costs.

At the most recent U.S. Federal Reserve meeting, Chairman Jerome Powell highlighted that the Fed is reducing its focus on distinguishing between headline and core inflation and the metrics matter because they affect policy.

So-called “core inflation” strips out volatile food and energy prices but is also misleading because they form an essential component of what actual Americans pay for their cost of living.

Whereas most traders look at the Consumer Price Index, which includes fuel and energy prices, the Fed has long preferred the Personal Consumption Expenditures index and has also often distinguished between perceived durable goods costs versus food and fuel.

To be sure, food and fuel prices can change daily, whereas the price of say a washing machine will only change every so often and in that regard, the Fed has at times focused on the price inflation of the latter when convenient.

Part of the reason of course is optics, but the other is also practical – tighter monetary policy can’t grow more wheat or extract more barrels of oil and so it’s somewhat redundant to attempt to use policy measures to cater for those prices as they are a blunt an ineffective tool for that purpose.

But politics has made it necessary now for the Fed to adopt a slightly different tack and blur the lines between inflation and core inflation and why the price of oil may have an outsized role in the determination of rates.

Because fuel prices hit the driving culture of America the hardest, policymakers may be minded to tighten, with Americans looking at pump prices as an indicator of the Fed’s success in taming inflation.

Conversely, if fuel prices decline, there is sufficient headroom for the Fed to “pause” rate hikes and to that end, there may be some signs a decline in fuel prices is indeed possible.

Oil has already come off its most recent highs and front-month contracts are hovering around US$110.

The increase in fuel prices has Americans driving less, or opting for electric vehicles, which has dampened demand for oil to begin with.

China’s slowing economy has dampened demand for oil as well, as the world’s largest importer of oil continues to struggle with rolling zero-Covid lockdowns and other measures to crackdown on its economy.

3. Cryptocurrency Deleveraging is Bitter Medicine

  • Nansen report suggests that one-way bullish bets and numerous levels of hypothecation of cryptocurrencies used in decentralized finance led to the contagion from the fallout of TerraUSD and Luna.

  • Complete unwinding of leverage and counterparty failure will take weeks if not months to trickle through the entire cryptocurrency ecosystem.

A recent report published by blockchain analytics company has started to shed light onto possible reasons that led to the fall of some of the biggest crypto firms such as lender Celsius Network and hedge fund Three Arrows Capital.

According to Nansen research analyst and report author Niklas Polk, “a lot of the selling pressure stemmed from the TerraUSD collapse” which created a domino effect on crypto lenders, firms and institutions which had treated TerraUSD as the equivalent of a dollar.

The Nansen report suggests that many whales (large holders) may have exacerbated the contagion through the crypto markets by leveraging high-yielding derivatives of Ethereum which would have come into contact with TerraUSD.

Under most circumstances, Ether doesn’t generate a lot of yield from staking, but by hypothecating Ether to other derivatives, whales with large amounts of Ether can leverage up bets and generate higher returns through a variety of delta-neutral strategies.

With the collapse of Terra-Luna large holders of Luna were badly affected, including Three Arrows Capital, which is believed to have had up to US$500 million worth of Luna at its peak, only to be worth US$604 after the collapse.

Because of Luna’s collapse, Three Arrows Capital and Celsius Network were forced to dump some US$800 million worth of Lido Finance’s staked Ether or stETH, a derivative of Ether that is “locked” until Ethereum completes its software upgrade, to an already illiquid market.

According to Nansen, Between May 12th and June 18th, investors liquidated US$4 billion worth of stETH holdings which sent Ether plunging by around 29%, but saw stETH, which till then had been assumed to be worth 1:1 to Ether, falling by 31%.

Making matters worse, as Celsius Network depositors called on their Ether deposits, the crypto lender was forced to withdraw 50,000 stETH tokens as collateral between June 8th to 9th as it utilized other crypto assets to “either add collateral or repay debt”, as stated by the report.

But as the equivalent of a run on the bank occurred for Celsius Network, its liabilities exceeded its assets and the lender was unsurprisingly forced to freeze withdrawals, and a crisis of confidence spread throughout the crypto lending industry.

Lenders like BlockFi and Babel Finance were dragged into the fray, and both had to freeze withdrawals, as well as smaller outfits like Finblocks.

While the deleveraging of the crypto industry as a whole is welcome, it will take some time for markets to regain normalcy, as litigation inevitably ensues, opportunistic buyers pick up assets at cents on the dollar and the market resets itself.

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