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Daily Analysis 12 May 2022 (10-Minute Read)

Hello there, A terrific Thursday to you as markets continue to take a turn for the worse amidst hotter than expected inflation data. In brief (TL:DR)

  • U.S. stocks fell Wednesday with the Dow Jones Industrial Average (-1.02%), S&P 500 (-1.65%) and the Nasdaq Composite (-3.18%) all lower as investors digested inflation data.

  • Asian stocks fell Thursday after elevated U.S. inflation bolstered the case for aggressive monetary tightening and sparked a slide on Wall Street.

  • Benchmark U.S. 10-year Treasury yields declined three basis points to 2.89% (yields fall when bond prices rise).

  • The dollar was little changed.

  • Oil held onto a rally on plunging U.S. fuel inventories with June 2022 contracts for WTI Crude Oil (Nymex) (-0.57%) at US$105.11.

  • Gold edged higher with June 2022 contracts for Gold (Comex) (+0.22%) at US$1,857.70.

  • Bitcoin (-3.84%) continued to fall to US$27,330 (at the time of writing) a level which appears to be holding as the cryptocurrency markets muddle through the challenges facing the algorithmic stablecoin TerraUSD.

In today's issue...

  1. U.S. Inflation Remains Elevated

  2. One of China’s Biggest Real Estate Companies Just Defaulted

  3. The Crypto Winter is Finally Here

Market Overview

U.S. inflation moderated but topped expectations at 8.3%, signaling persistent price pressures. Traders raised bets the U.S. Federal Reserve will roll out another half-point interest-rate hike in September - following similar increases in June and July. Russia’s war in Ukraine and China’s Covid lockdowns are creating shortages and stoking costs of everything from natural gas to wheat. Asian markets continued to fall Thursday with Tokyo's Nikkei 225 (-0.99%), Hong Kong's Hang Seng Index (-1.19%), Seoul's Kospi Index (0.07%) and Sydney’s ASX 200 (-0.73%) were all down in the morning trading session.

1. U.S. Inflation Remains Elevated

  • The surprise inflation numbers surprised markets in a bad way and sparked a sharp selloff in bonds and equities, led primarily by tech.

  • With the annual inflation figure coming down from 8.5% to 8.3%, there are signs that even if inflation is not coming down, it’s not running out of control.

The good news is U.S. inflation isn’t rising any faster than it already is, but the bad news is that it’s still elevated. According to the U.S. Labor Department, consumer prices measured by the Consumer Price Index, rose at an annual pace of 8.3% last month, above economist expectations of 8.1% but a step down from the increase recorded in March of 8.5%. The surprise inflation numbers surprised markets in a bad way and sparked a sharp selloff in bonds and equities, led primarily by tech. Consumer prices climbed another 0.3% in April, but that was slower than the rise recorded in March of 1.2%, fueled primarily by soaring energy and food costs associated with Russia’s invasion of Ukraine. Housing, food, airfare and new vehicle costs all helped push up CPI data last month, but the moderating rise in oil prices, because of concerns over Chinese demand from that country’s Covid-zero lockdowns, helped contain overall inflation. More importantly, stripping out volatile food and fuel prices from last month’s data, core-CPI rose by 0.6%, compared with 0.3% in March. Long story short, the CPI data will provide yet another data point to confirm the U.S. Federal Reserve’s hawkish pivot and ahead of next month’s policy meeting, investors can well expect that the central bank will hike rates by another 0.50% as promised. There is a silver lining to the CPI data though, because it could represent the beginning of a peak in the post-pandemic inflation surge in consumer demand coupled with supply chain bottlenecks. Many economists expect that the pace of consumer price growth will moderate further from these levels as the immediate price shocks caused by the war in Ukraine start to subside and that timing could dovetail with when the Fed has suggested it would lower its rate hikes. The Fed has indicated earlier that it intends to hike by 0.50% at the next two meetings, the idea being to frontload rate hikes now and then provide bite-sized hikes in the latter half of the year on the assumption that inflationary pressures will ebb. With the annual inflation figure coming down from 8.5% to 8.3%, there are signs that even if inflation is not coming down, it’s not running out of control. But investors will need to be wary of several other policy moves on the horizon outside of rates – with the Fed commencing its balance sheet reduction in June, a reliable buyer for U.S. Treasuries would have exited the market, increasing the risk that yields will soar and providing yet another fresh headwind for risk assets.

2. One of China's Biggest Real Estate Companies Just Defaulted

  • It may be possible to miss small pieces of news which may have huge repercussions – like the recent default of Sunac China Holdings, one of China’s largest real estate developers.

  • If Sunac falls, it will likely take a whole bunch of other large real estate companies with it, even those that up till several months ago were considered “safe” borrowers.

There are signs of stress everywhere in the global economy. From soaring inflation to slowing growth, tightening monetary policy to Russia’s invasion of Ukraine, it seems that there is no shortage of news to turn bearish. Which is why it may be possible to miss small pieces of news which may have huge repercussions – like the recent default of Sunac China Holdings, one of China’s largest real estate developers. On Wednesday, Sunac missed a dollar-bond coupon payment and has said that it doesn’t expect to make payments on other notes, becoming one of the biggest Chinese property firms to renege on its obligations amid a record-breaking wave of defaults. Part of the reason of course is that Sunac and other Chinese companies are finding it increasingly difficult to raise finance in the high-yield bond market, as global money managers balk at extending credit to Chinese borrowers as lockdowns weigh on the economy. And refinancing concerns are flaring as defaults mount with central banks globally raising interest rates to stave off inflationary pressures. In a filing with the Hong Kong stock exchange, China’s fourth-largest developer Sunac, acknowledged that its ability to access new financing has remained difficult and compounded by recent coronavirus outbreaks in the country that have deepened an industry sales slump. More telling, Sunac revealed that it has appointed legal and financial advisers to help assess the firm’s capital structure and liquidity – typically a precursor to a restructuring or capitulation-type scenario. If Sunac falls, it will likely take a whole bunch of other large real estate companies with it, even those that up till several months ago were considered “safe” borrowers. As recently as February, some of Sunac’s dollar bonds were indicated above 80 cents on the dollar, but have since fallen below 30 cents. Unlike the far more high-profile China Evergrande Group, Sunac was considered to have been more conservative and therefore a “safer” bet and if it should fall, could trigger a broader malaise in the Chinese economy that risks spilling over to the entire world. So far China has been able to avoid Evergrande becoming its “Lehman” moment through a combination of corporate chicanery and subterfuge – offshore dollar-denominated bond holders were stiffed, while onshore lenders were repaid. Preferential payment by Evergrande sets China on a difficult path forward, especially if it wants to ever woo global investor monies again, many uncomfortable questions over respect of the rule of law remain when it comes to commercial transactions. In the first three months of this year, global investors yanked some US$6 billion from Chinese equities, a figure which would be far larger by now. Against a backdrop of Covid-zero lockdowns, crackdowns on various sectors of its economy from tech to afterschool education and a refusal to pump stimulus back into the economy, China is increasingly looking like a typical emerging market basket case, but one that risks taking the rest of the world down with it.

3. The Crypto Winter is Finally Here

  • It’s probably safe to say that that dreaded season for digital assets has finally arrived and no, it’s not because of the price of Bitcoin.

  • And in the case of TerraUSD, Anchor Protocol and LUNA, the last 72 hours was the final straw on the camel’s back.

Despite the mercury rising as the summer draws nearer, it’s probably safe to say that the Crypto Winter is here as the nascent asset class freezes over. After holding off for some time in declaring a “Crypto Winter” because after all, I’m not Punxsutawney Phil, it’s probably safe to say that that dreaded season for digital assets has finally arrived and no, it’s not because of the price of Bitcoin. At its heart, cryptocurrencies were intended to form the backbone of a “trustless” financial ecosystem – a new dawn where value could be sent across thousands of miles without having to rely on intermediaries exacting their pound of flesh. Counterparties could execute contracts without ever having seen each other, certain in their completion. But trust is a tricky thing – it can take a lifetime to earn, but just hours to lose. And in the case of TerraUSD, Anchor Protocol and LUNA, the last 72 hours was the final straw on the camel’s back. Investors who had been drawn to Anchor Protocol for its insane stablecoin yields of close to 20% soon discovered where those yields were coming from – other investors. Time will ultimately reveal the incestuous relationship between LUNA, Anchor Protocol and TerraUSD for what it was, an ill-conceived algorithmic stablecoin that had all the hallmarks of a Ponzi scheme, even if that was unintentional. “Money for nothing and your chicks for free,” may have been the lyrics to a popular Dire Straits song, but they also reflect the promise that the LUNA, Anchor Protocol and TerraUSD trifecta were promising – outsized stablecoin returns that looked “risk free.” Unfortunately, these returns were anything but “risk free” because the risk was baked into the entire ecosystem. The relationship between UST / LUNA in a nutshell:

  1. TerraUSD (UST) is an algorithmic stablecoin, meaning it’s not backed by dollar deposits in a bank or anything.

  2. To keep UST’s peg stable, it’s backed by another token, LUNA, whose price is allowed to float freely.

  3. 1 UST is always convertible to $1 worth of LUNA and vice versa, so if LUNA’s price is $4, 1 LUNA can be swapped for 4 UST.

  4. LUNA’s supply is used to keep the UST peg stable, 1-to-1 with the dollar. If 1 UST > $1, LUNA is “burned” (taken out of circulation) by converting it to UST and as the supply of UST increases, it should return back to its peg. On the flipside, if 1 UST < $1, UST is “burned” by converting it to $1 worth of LUNA.

  5. Presumably, arbitrageurs will constantly work at the peg to earn off these spreads and keep UST’s peg 1-to-1.

So what happened? Because UST is one of a multitude of stablecoins (algorithmic or otherwise), to attract users, it used Anchor Protocol to offer sick yields (close to 20%) to get investors buying UST. Anchor Protocol is a DeFi platform that facilitates lending and staking and is “coincidentally” owned by the same people who issue UST and LUNA, i.e. Terraform Labs. Unfortunately, the only “real” demand for UST was in order to deposit it on the Anchor Protocol to generate 20% yields. But remember, everything on the blockchain is transparent, and it was clear that as demand for those sweet, sweet, yields rose, the smart contracts that paid out these yields from the reserves started depleting, and fast. At this juncture, a decision could have been made to reduce Anchor’s yields, to stem the bleed, but that would also have seen interest and confidence in UST fade, so Terraform Labs took the path of least resistance, find new investors to pay off the existing ones. Because the Anchor Protocol Reserve was bleeding, Terraform Labs announced a US$1.5 billion BTC injection to shore up the reserves, making matters worse. With investors now thinking that these 20% yields were “backed” or “sustainable,” more poured in, and in the meantime the price of LUNA skyrocketed. But as with any house of cards, the writing was on the wall from day one and regardless of which conspiracy theory you subscribe to, the long and short of it was that investors soon lost faith in UST and it broke its peg. As UST broke its peg, UST would be converted to LUNA to reduce its supply. But what happens when you add more LUNA into a market where LUNA’s price is already falling? A self-perpetuating feedback death spiral, which is exactly what happened. To shore up confidence in UST, Terraform Labs took to raising more capital from fresh investors to shore up the reserves – pouring good money after bad, but opening a different can of worms – why would an algorithmic stablecoin even need to raise reserves? Because none of the tokens in the entire “Terrable” ecosystem have any intrinsic value or use case outside of speculation or earning unsustainable yields, in one fell swoop Terraform Labs has tanked the cryptocurrency markets by robbing it of the one commodity it wasn't supposed to need – trust. And that’s why the cryptocurrency markets should brace themselves for a “Crypto Winter,” because trust takes a time to rebuild, how long however, is anyone's guess.

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