Hello there,

A fantastic Friday to you as markets flounder seeing off the worst quarter since the pandemic and forcing investors to question many of the assumptions that they've had regarding asset allocation.

In brief (TL:DR)

• U.S. stocks were lower on Thusday with the Dow Jones Industrial Average (-1.56%), the S&P 500 (-1.57%) and the Nasdaq Composite (-1.54%) all down amidst worries over a growth slowdown.

• Asian stocks fell Friday after their worst quarter since the pandemic bear market, buffeted by economic risks from tightening U.S. Federal Reserve monetary policy and Russia’s war in Ukraine.

• Benchmark U.S. 10-year Treasury yields rose three basis points to 2.37% (yields rise when bond prices fall) as traders expect more aggressive interest rate hikes to deal with inflation.

• The dollar held a retreat.

• Oil held losses with May 2022 contracts for WTI Crude Oil (Nymex) (-0.16%) at US$100.12 on the move by the U.S. to release roughly a million barrels a day from strategic reserves to tackle rising energy costs.

• Gold was lower with Jun 2022 contracts for Gold (Comex) (-0.64%) at US$1,941.50.

• Bitcoin (-4.80%) fell to US$45,094 following the path of other risk assets as sentiment soured.

In today's issue...

1. Only Lost 5% this Quarter? Consider Yourself Lucky

2. How should investors respond to a declining dollar?

3. The Options Market May Provide Clues to Bitcoin’s Next Move

Market Overview

Stocks fell Friday after their worst quarter since the pandemic bear market, buffeted by economic risks from tightening U.S. Federal Reserve monetary policy and Russia’s war in Ukraine.

Investors begin a new quarter wondering if the fighting in Ukraine, the isolation of Russia and the Fed’s increasingly hawkish turn will engender more volatility and further losses for stocks and bonds.

U.S. data showed the personal consumption expenditures price index which the Fed uses for its inflation target increased 6.4%, the most since 1982 and continuing with the overarching theme of continuing price pressures.

In Europe, talks between Ukraine and Russia are set to resume Friday.

Russian President Vladimir Putin said Russia aims to keep supplying gas to European customers even as it demands they shift to payment in rubles.

Asian markets were mostly lower Friday with Seoul's Kospi Index (-0.70%), Hong Kong's Hang Seng Index (-0.72%) and Tokyo's Nikkei 225 (-0.37%) down, while Sydney’s ASX 200 (+0.09%) was up slightly in the morning trading session.

1. Only Lost 5% this Quarter? Consider Yourself Lucky

• Data compiled by Bloomberg reveals that the “least bad” performance among U.S. assets was limited to “just” a 4.9% decline in the S&P 500 and high yield bonds, which was bested by a 5.6% fall in U.S. Treasuries and a 7.8% drawdown in the most highly-rated corporate debt.

• Nevertheless, investors can take some comfort in the fact that markets have not quite capitulated, even as 2022 has been futile for investors seeking shelter from the global storm.

Between war, famine and death, it can feel as though the Four Horsemen of the Apocalypse are being brought to bear not just on the markets, but on the world at large.

Investors faced a particularly challenging first quarter, with war, inflation, and the lingering impact of a global pandemic that made the first three months of this year a historically rough one for stock and bond investors and forced a re-think of traditional 60/40 stock and bond portfolios.

Data compiled by Bloomberg reveals that the “least bad” performance among U.S. assets was limited to “just” a 4.9% decline in the S&P 500 and high yield bonds, which was bested by a 5.6% fall in U.S. Treasuries and a 7.8% drawdown in the most highly-rated corporate debt.

Not since the 1980s has the best return among these four categories of assets performed so poorly.

Nevertheless, investors can take some comfort in the fact that markets have not quite capitulated, even as 2022 has been futile for investors seeking shelter from the global storm.

Over US$3 trillion was erased from both bonds and equities in the first quarter of the year, as the U.S. Federal Reserve raised interest rates for the first time since 2018 and even the most ebullient investors had to adjust to a more hawkish central bank.

The dire first-quarter performance has come as a rude shock to investors who typically only park their money in stock and bonds, and particularly bad news for 60/40 stock-bond portfolios that aim to perform well through diversification, a strategy widely used by mutual and pension funds.

Only commodity investors have had reason to cheer, with everything from copper to wheat, experiencing a sharp rally that has been exacerbated by the supply crunch from Russia’s invasion of Ukraine.

Unlike stocks and bonds, the Bloomberg Commodity Index soared by a whopping 25% for its best quarter since 1990.

What happens next for investors has all to do with monetary policy.

The continued uptick in commodity prices which contributes heavily to inflation means that there is growing pressure on central banks to act decisively on interest rates.

Across the rich world, inflation is over 5% in 60% of industrialized economies, from 0% a year ago.

While Europe may be constrained in its ability to hike rates – its economy is slowing owing to its proximity to the Russian invasion of Ukraine, the U.S. has far more room to hike rates, and that could tip the scales towards a recession.

At stake is the resolve and credibility of the U.S. Federal Reserve, which will be under political pressure to do more on inflation in a year that could see both houses of Congress shift from the Democrats to the Republicans.

2. How should investors respond to a declining dollar?

• While countries are seeking to diversify their reserves out of the dollar, that pace has been glacial at best, with the dollar’s share of reserves going from 70% to 60% over the past two decades.

• An unexpected beneficiary of a possible decline in the dollar’s dominance could come from digital finance, from cryptocurrencies to stablecoins, or even central bank digital currencies, suggests Gopinath.

While many have cheered (and rightfully so) the unprecedented breadth and depth of Western sanctions against Russia for its invasion of Ukraine, it also raises uncomfortable questions about the dollar’s centrality to the global financial system.

According to Gita Gopinath, the IMF’s Deputy Managing Director, the sweeping measures imposed by Western countries on Russia, including restrictions on its central bank, would encourage the emergency of small currency blocs based on trade between smaller groups of countries.

And some of these countries may not even be that small.

Take China for instance, the world’s second largest economy.

Till date, Beijing has refused to condemn Russia’s invasion of Ukraine and U.S. officials report that China has remained open to providing both financial and military support to Russia as it finds itself excluded from the rest of the world.

In an interview with the Financial Times, Gopinath suggested,

“The dollar would remain the major global currency even in that landscape but fragmentation at a smaller level is certainly quite possible.”

“We are already seeing that with some countries renegotiating the currency in which they get paid for trade.”

One of those countries “renegotiating” has been Russia, with Moscow threatening to cut off gas supplies to Europe if these contracts are not paid for using Russian rubles.

For years, Russia has sought to reduce its dependence on the dollar, a campaign that accelerated in earnest after U.S. imposed sanctions in retaliation for Moscow’s annexation of Crimea in 2014.

But weaning the world off the dollar isn’t as straightforward as it may seem – Russia still had roughly a fifth of its foreign reserves in dollar-denominated assets even on the eve of its invasion of Ukraine.

And China is just behind Japan in terms of its holdings of U.S. Treasuries, with just over a trillion dollars in U.S. sovereign borrowings on Beijing’s books.

Even Gopinath concedes that in the medium term, dollar dominance is unlikely to be challenged given its backing by strong and highly credible institutions, deep markets and free convertibility.

And while countries are seeking to diversify their reserves out of the dollar, that pace has been glacial at best, with the dollar’s share of reserves going from 70% to 60% over the past two decades.

Much of that decline has been due to the growth of the Chinese yuan in international transactions – but that continued growth cannot be assumed.

China still lacks full convertibility of its currency, nor does it have open capital markets or the institutions to support them, something which may never arrive as it would require independent institutions and checks and balances, in a country where the Communist Party exerts its grip and influence on every aspect of life.

An unexpected beneficiary of a possible decline in the dollar’s dominance could come from digital finance, from cryptocurrencies to stablecoins, or even central bank digital currencies, suggests Gopinath.

3. The Options Market May Provide Clues to Bitcoin's Next Move

• After a rally during the Ides of March, bullish call option demand has rallied alongside demand for Bitcoin.

• According to cryptocurrency derivative analytics firm Genesis Volatility, the 180-day Bitcoin call option implied volatility is now trending higher relative to bearish put options, reversing a 2-month trend.

The Bitcoin rally was unfortunately short-lived.

Having breached the important resistance at US$45,300, Bitcoin has now given up some of those gains to return to US$44,500 at the time of writing (GMT 0400) but investors charting the next course for the benchmark cryptocurrency may need to look beyond the tips of their noses to smell what’s coming next.

After a rally during the Ides of March, bullish call option demand has rallied alongside demand for Bitcoin.

According to cryptocurrency derivative analytics firm Genesis Volatility, the 180-day Bitcoin call option implied volatility is now trending higher relative to bearish put options, reversing a 2-month trend.

Short-term options which had been bearish are also now tending towards a more neutral market while appetite for leveraged long exposure in futures has increased.

Since January, the Bitcoin options market’s skew has been negative, meaning that premiums for bearish put options (the right to sell at a predetermined price) has been higher than premiums for bullish call options (the right to buy at a predetermined price).

But on Wednesday, this skew turned positive for the first time since January, suggesting that traders are now hedging more in terms of the upside – where the price of Bitcoin rallies.

Depending on how traders use options, whether to hedge risk or generate returns, that positive skew for Bitcoin options suggests that traders are now more concerned about a further rise in Bitcoin’s price, having rejected a capitulation below US$40,000.

Traders who are bearish on Bitcoin would still want to have options to cover them in case the cryptocurrency should rally hard and the rising premiums for bullish call options seems to reflect that the recent pullback in Bitcoin’s price rally could be temporary.