BitMEX founder: My expectations for Ethereum price

In this Bidding, Max Bidding

By Arthur Hayes, founder of BitMEX

Block chain & NBSP;  

Since late last year, markets have been waiting for the Fed to shift its policy focus from taming inflation to supporting economic growth. On July 27th the Fed issued a statement saying it would shift its policy focus to supporting growth if growth falls short of expectations. This paper demonstrates the need to resume monetary expansion by showing the rapidly deteriorating US economy.

If you think my argument is correct, then the next step is to think about which assets might do best if the money supply expands again. It would be irresponsible to squander the period of transition from monetary tightening to monetary easing, which is an excellent opportunity for a substantial increase in financial assets, so we must choose the right assets carefully.

Should I invest in stocks, bonds, real estate, commodities, gold, or crypto? Obviously, you all know that I'm advocating crypto assets as the star of the show, so when it comes to liquidity, which Token should we favor? There is a presupposition here that we should prefer centralization over decentralization during the transition period of monetary policy. As a concentrated bet, ETH will deliver the best returns in the second half of this year.

expectations

Over the next eight months or so, there are two potential events that could play out, and whether they go smoothly is crucial to my conclusion.

· Will the Fed change its policy focus and restart the printing press for the economy?

· Will the ETH merger succeed?

Investing is a work with a time horizon, so I have to set a time limit for these events to be completed (or not completed). The time limit is March 31, 2023.

Two events each have two outcomes, meaning there are four future scenarios.

Scenario 1: Fed pivot + ETH merger is successful (my favorite scenario).

Scenario 2: Fed's focus does not change + ETH merger succeeds

Scenario 3: No shift in Fed focus + ETH merger unsuccessful

Scenario 4: Fed pivot + ETH merger unsuccessful

For each scenario, I provide a price target and assign a 25% probability. I will then calculate the average of all the results to arrive at the expected ETH/USD price on March 31, 2022. If this expected return is positive, then I will feel comfortable increasing my ETH long position. If it is negative, I will not add ETH for the time being.

This analytical structure is demonstrated in the following paragraphs.

Whether the Federal Reserve policy changes

Over the past few decades, as financial services matured, banks began to finance more residential real estate. Banks want to lend excess reserve balances provided by the Fed to low-risk asset classes. The safest loans a bank can make are for hard assets, and houses are high on that list. If you don't honor your mortgage, the bank can repossess your home and (hopefully) sell it for more than the value of the remaining loan. Over time, banks began pouring more and more of their free capital into home loans.

The wide availability of housing finance and the willingness of banks to accept extra risk have made it possible for more and more people to buy homes through mortgages. At some point, the price of a home doesn't matter. The only thing that matters is whether borrowers can afford their monthly mortgage payments with their disposable income. As a result, the housing market has become entirely dependent on the cost of funding, which is largely determined by central banks by setting short-term risk-free interest rates (more on how that works later).

Us National House Price Index (white) versus US CPI index (yellow)

The chart above starts in 1985 with an index of 100 for each data series. As you can see, over the past four decades, housing prices have risen 75 percent faster than inflation as measured by the government. If everyone just paid cash for their homes, prices would be much lower. But if you can afford the monthly mortgage payment, you can afford to buy a more expensive house, and the willingness of banks to extend credit to home buyers is driving prices up.

70% of U.S. GDP is consumption. Starting in the 1970s, the United States transitioned from a manufacturing powerhouse to a financialized service economy. Essentially, anything that can be used as collateral for a loan is eligible for financing. Most Americans live paycheck to paycheck, which means their entire lifestyle is dependent on monthly loans.

"PYMNTS research found that 61 percent of U.S. consumers were living paycheck to paycheck in April 2022, up 9 percentage points from 52 percent in April 2021."

The rate of return that banks earn when they dole out money is called interest on excess reserves (IOER), and the IOER rate is between the lower and upper limits of the Fed funds rate (set by the Fed at its meetings). This is one of the tools the Fed uses to translate its policy rate into the actual rate observed in the market.

If a bank takes your deposit and pays you 0%, it can turn around and immediately earn a 2.40% risk-free return by lending to the Fed. Given that the market is competitive, if Bank A offers A 0% deposit rate to consumers to earn A 2.40% spread, Bank B can offer A 1% deposit rate to steal business from Bank A and still earn A 1.40% spread. As a result, banks will compete by offering higher and higher deposit rates until they closely match the IOER offered by the Fed.

If banks have to pay a deposit rate close to the IOER, they will have to charge a higher rate than the IOER when making loans. The higher the Fed's risk-free rate, the higher your mortgage rate will be.

Us 30-year fixed mortgage rate (white), Fed funds cap (yellow)

The chart above clearly shows that the higher the rate set by the Fed, the more Americans pay to finance their homes. This is extremely important for the health of the US consumer because monthly mortgage payments take up a large proportion of the median household's disposable income.

Mortgage rates, which were around 3% at the start of the year, are now just over 5%. As a result of this change, the median household balance sheet has deteriorated by more than 10%. The bigger problem is that loan volumes continue to grow faster than inflation. Looking back at the above graph of home prices versus inflation, imagine what it would be like if the price of the median home were reduced to match the 75 percent inflation rate since 1985. The household balance sheet would look something like this.

In this case, households would have a greater proportion of their income set aside for other necessities. The more stretched the median household's finances are by the cost of financing a mortgage, the more likely they are to turn to other consumer finance tools, such as credit cards, to pay for life's other necessities.

U.S. household debt as a percentage of GDP

Outstanding consumer credit in the US

The charts above clearly show that households have increasingly resorted to the use of credit to finance their survival.

The Gross merchandise value (GMV) figure in the chart above is basically the outstanding loans to customers of top BNPL (New form of credit) fintech companies. As you can see, almost $70 billion of GMVS were financed this way in 2020. Old people use credit cards, young people use BNPL, different form, same essence.

The United States is a nation of cars, and for Americans earning an average wage, owning a car is a requirement for getting from home to work. The family car is another asset that has to be financed because of its high price. According to Kelley Blue Book, the average car price is now $48,043, a record high. If you make $50,000 a year and the average car price is $48,000, then you have to fund that mother car!

American commercial Bank auto loan

The data set from the Fed goes back to 2015. Outstanding auto loans have jumped 44 percent in the past seven years.

Homes and cars are two examples of life-critical assets that American households must finance. Determining the monthly interest rate that Americans must pay for these necessities is directly affected by the federal funds rate. So when the Fed makes money more expensive by raising interest rates, it directly makes the vast majority of American households poorer.

The Fed's impact on household balance sheets is directly related to the amount of loans those households hold. If the price of the average home or car suddenly drops 50 percent, then raising interest rates by a few percentage points by the Fed won't make much difference to households, because while they will pay a higher interest rate on their home or car, their net monthly payments will likely be lower. Yet we are at the end of more than 50 years of intensive financialisation of the US economy, which has fuelled an exponential rise in the price of any asset that can be lent.

If you can't afford your monthly payments, you can't buy a house, car, or other durable items. If the buyer can only pay less, the seller must sell at a lower price. Then at the margin, the entire stock of houses, cars and other financing assets becomes even less valuable. Given that these assets are financed by debt, this becomes a problem for banks that lend against this type of collateral, since they will seize assets worth less when their lenders fail to pay.

As asset prices have fallen, banks have become more conservative about who and what they lend to. At this point, the price of the asset must fall to a level where the buyer can afford the monthly payment at a higher cost of financing. Although prudent, this actually reduces the entire stock of bank loans to American households. This is a circular, reflexive process that leads to the dreaded deflation of debt-backed assets.

As I have said many times, the goal of central banks is to ensure that asset deflation does not occur, because the commercial banking system cannot survive asset deflation. Thus, the Federal Reserve or any other central bank must act immediately if it believes deflation is imminent, a lesson taught to anyone and all in economics classes. Most of the academic staff at the Fed (or any other central bank) who wrote papers on and studied the Great Depression believe that the Fed erred by not printing money, not supporting asset prices, and not fending off deflation in various advanced economies in the 1930s.

The implication of this entire section is that the health of the American consumer is directly linked to the federal funds rate. If interest rates continue to rise, the economy will suffer. If interest rates fall, the economy will boom.

A choice

The phrase became famous in China when e-commerce giant Alibaba was accused of forcing merchants to choose between Alibaba or its competitors to sell their goods on one platform and not allowing them to co-exist with other platforms.

The Fed faces a similar "one or two" dilemma. They can choose to fight inflation, or they can choose to support America's financialized economy. They cannot do both. Fighting inflation requires raising the price and reducing the quantity of money, but a "healthy" American economy needs the exact opposite prescription.

In March 2022, as inflation began to surge, the Fed decided to stomach higher interest rates, raising the federal funds rate by a quarter for the first time since 2018. However, the chart below shows that the U.S. economy is in recession.

U.S. real GDP growth percentage

Remember, the Fed's first rate hike came in March, and the first negative GDP growth also came in the first quarter of this year, which is a real coincidence.

Americans are more pessimistic about the economy today than they were at the peak of COVID, which has killed millions in the United States, but people are more desperate today.

Consumer sentiment at the University of Michigan

Even so, however, inflation shows no sign of abating. By this measure, the Fed has failed.

At home, the Fed is crashing the economy (it's in recession), but inflation is still grabbing more and more purchasing power from ordinary people who will be heading to the ballot box in a few months. What to do? What variables should the Fed optimize?

If the Fed wants to keep lowering inflation, then it must keep raising its policy rate. You could argue that the Fed needs to be more aggressive because the ceiling on its policy rate, at 2.5%, is still 6.6% below the latest inflation reading of 9.1%.

If the Fed wants to grow the economy, then it must buy bonds again, which will reduce monthly payments for homes, cars and other durable goods for 90 percent of American households.

Market expectations for policy

A big rate hike is certain at the September meeting. Markets are currently pricing in a 50 basis point hike in September. What is now in play is the follow-up suspension of the November meeting. That's what the market cares about. With short-term interest rates at 3 percent by the end of September, those monthly payments will be very unaffordable for Americans.

The Fed raised rates 0.75 per cent at its June and July meetings, while expectations for a rate hike at the Fed's September meeting were little changed. The September 30, 2022 fed funds futures contract was at 97.53 on June 17 and 97.495 on July 27.

The expected interest rate is 100 minus the futures price, and if the curve moves up, that means the market expects the interest rate to go down, and vice versa. The market is clearly still pricing in a rate hike over the next six months.

However, my macro risk asset indicators all rebounded after the Fed meeting and held gains into Friday's close. Risk markets held on to their post-Fed meeting gains, but forward-looking money market derivatives indicated no change. Who is right? I believe the negative growth story will trump continued high inflation as economic data continue to deteriorate and higher credit prices further constrain financial activity. Powell said the Fed has reached neutral and now they need to see the impact on the broader economy.

Market expectations for a change in the policy rate at the September meeting are well established. However, the Fed will have two additional CPI data points between now and then (July CPI, released on August 10, and August CPI, released on September 13). I'm no data sleuth, but it's likely that the pace of price increases will slow, which will provide Powell with the rationale he needs to backpedal to easing monetary conditions.

Given the data, we are almost certain that the Fed will raise rates by 0.5% to 0.75% at the September meeting. That makes the December meeting the decisive one for the rest of 2022. I expect the steady climb in the federal funds rate between now and the December meeting to do absolute harm to ordinary Americans.

With the election out of the way, the Fed will get back to business - reducing the amount of money Americans pay each month by easing monetary policy. While the top 10% have benefited disproportionately from the rise in financial asset prices, given that every aspect of American life is financed and civilians need low interest rates to afford their lifestyles, everyone is hooked on the cheap money offered by the Fed.

We should now be prepared for forward expectations of Fed policy to point towards easing. So it is likely that the market for risk assets has bottomed out and will now trade.

Check whether the ETH merger is successful

Will ETH network be updated to Proof of Interest (PoS) as planned? That's the question you have to ask yourself. Before I give a reason why the ETH merger is extremely bullish on ETH prices, let me explain why I am more confident today than ever that the merger will actually happen.

In 2018, I wrote an article titled "ETH, a Two-digit junk Coin," in which I predicted the price of ETH would fall below $100. I was wrong.

I became convinced in 2020 when I came across a chart somewhere depicting how ETH's market cap was lower than the combined market cap of all the Dapps it supported. I firmly believe that DeFi offers a credible alternative to the current financial system - and that ETH is now poised to power the world's financial computer.

Since 2015, Vitalik has been talking about the need to eventually move to a PoS consensus mechanism. I don't have the technical skills to assess whether an ETH core developer can succeed, but having a group of ETH network stakeholders definitely hinders the likelihood of success. These are the current ETH miners.

Miners who spend billions of dollars on GPU graphics cards and related capital expenditures can only earn income under proof-of-work (PoW) systems. Kraken wrote a great blog post explaining the difference between PoW and PoS systems. When the merger occurs and ETH transitions from PoW to PoS, miners' income will fall to zero and their equipment and facilities will become virtually worthless unless they can find another valuable chain that provides the same marginal revenue as mining. I highly doubt this possibility as ETH is the second largest cryptocurrency by market capitalization and there is not another PoW blockchain with a market capitalization of hundreds of billions of dollars that can be mined using Gpus. Thus, it is fair to speculate that consolidation is a real possibility when miners begin to voice their opinions on the negative effects of consolidation.

Bao Erye is aligned with the ETH mining community in China. I have known him for many years and I do not doubt his determination to do so.

After reading the tweet, I reached out to some of my other contacts in the Chinese mining community. I asked them if there was any real momentum behind a potential airdrop or hard fork to form a POW-based ETH chain. One person said "absolutely" and added me to a wechat group where serious people were discussing the best way to achieve this reality. Another friend said it was an absolute failure and that Bao Er Ye had reached out to him.

Similarly, after the merger, ETH miners' machines will become worthless overnight unless they can mine on another valuable chain. I seriously doubt that the ETH PoW chain will be viable in the long run, but let's assume for now that it will exist for a few months with a significantly non-zero market cap. The more important point is that miners would not have embarked on the journey and spent valuable political capital in their communities if they did not believe the merger would go ahead on schedule.

So if the merger is likely to happen sometime in the third quarter of this year, or at the latest in the fourth quarter, the question is - has the market priced in the merger ahead of time?

The Amber Group has a great article on the merging of everything. Here are the key points:

The market expects the merger to occur on or around September 19, 2022.

The merger will reduce ETH issuance per block by 90%, making ETH a deflationary currency.

ETH pledged on the beacon chain will be locked for another six to 12 months.

Amber thinks a merger would be akin to a "triple halve" :

On the supply side, ETH is currently incentivizing miners (under PoW) and verifiers (under PoS). Seigniorage is paid to miners to generate new blocks at each 2ETH, and the reward is also distributed to the verifier on the beacon chain. After the merger, incentives for miners will cease, reducing ETH's issuance rate by about 90%. That's why mergers are also colloquially known as "triple halving" -- a nod to Bitcoin's halving cycle.

Demand for ETH is also expected to increase after the merger due to a number of factors. First of all, the pledge reward for the proband will be increased immediately. The verifier will receive the transaction tips currently available to PoW miners and may increase the APR by approximately 2-4%. In addition, they will also start earning MEV (maximum extractable value) since they will be able to reorder transactions. According to researchers at Flashbots, a research and development organization that studies emergent behavior in MEVs, the verifier yield could increase by an additional 60% due to MEVs (assuming 8 million pledged ETH). Thus, if a merger were to occur today, the verifier would expect to receive an APR of around 8-12% due to all the above factors.

Most, if not all, of the information hasn't changed in many months. What has changed is the credit-driven crash in cryptocurrency prices. The market dislocation caused by Luna/TerraUSD and the Three Arrows led to many forced selling, and many hedge funds that had piled into DeFi took a hit.

Given all the forced selling that took place during the market decline and the poor financial position of most crypto investors, the merger does not appear to be priced in - we have an excellent opportunity to increase ETH positions at very attractive levels.

Thus, now that the dust has settled, the remaining loyalists among us -whether they hold ETH or fiat currency-must determine how much of a factor we think the merger will have on prices, based on expected market conditions and/or other contributions.

Let me share a simple example of why I think the merger will have an incredibly powerful impact on ETH prices.

Many of you trade stocks and understand at a fundamental level that stocks are a claim on a company's future profits. But a company doesn't pay you dividends in additional shares -- it pays you in fiat currency. In addition, to use a given company's services, you don't have to pay in the company's own stock, but in fiat currency.

For ETH, the revenue earned by the pledge -- paid in ETH, and you must pay in ETH to use the service. The pledgers must also pledge their ETH to generate revenue, which requires them to lock up the money and effectively remove it from the market. The more ETH a pledgee pledges, the more revenue they receive. Thus, it is safe to assume that most of the pledgers will take the ETH they earn and lock it in. Add to this the impact of users having to pay an ETH fee to use ETH (which has been removed from circulation) and the fact that the rate of ETH issuance will be reduced by about 90% per year under the new PoS model, and we will quickly look at reducing ETH supply. The more the network is used, the more of the network's own currency must be used to use it - so as the network becomes more popular (assuming it provides useful services), the number of ETH taken out of circulation will only increase. Of course, it's important to note that the per-transaction fees paid by users are expected to go down under the new PoS model, but even so, when you combine all these factors, they should still drive ETH prices exponentially higher.

A good metric to use is the total locked value (TVL) in DeFi applications (that is, the amount of money that users deposit or "pledge" on the DeFi platform from which they earn revenue). I believe DeFi will provide a credible alternative system to our current financial cards that pay trillions of dollars a year in economic rent. As you can see, TVL soared after 2020, using this lock-in collateral application to pay ETH fees to the network. The larger the DeFi, the more deflationary ETH. It becomes an extreme problem, but we're not close to that yet.

Before proceeding, let's review my assumptions again.

1. I believe the merger will happen by the end of this year due to increased noise from ETH miners, who may lose a significant portion of their revenue in the PoS world.

2. The recent market rout has broken the soul of the bulls who shone on ETH and DeFi this cycle, turning them into a bunch of indiscriminate sellers.

3. There will be no "buy rumors, sell news" phenomenon after M&A. Since prices have fallen sharply in the past month, anyone who might have sold has probably already done so.

4. The merger means ETH becomes a deflationary currency, and usage is expected to continue to grow as DeFi spreads -- increasing the rate of deflation.

5. Although there are other L1 smart contract network competitors, many of them already have some version of the PoS consensus algorithm. ETH is currently the only major cryptocurrency transitioning from PoW to PoS.

Expectation value calculation

This is the most important part of this article, because even if my arguments are sound and you believe them, there is a good chance that I am wrong. With that in mind, let's take a quick look at the price forecasts for all combinations of potential outcomes.

Unless otherwise noted, the prices I quote in this section are from Bloomberg.

Scenario 1: Fed pivot + ETH merger success (i.e. what I guess will happen, and the best case for ETH)

In November 2021, the Fed started printing money, shankcoins soared, and attention began to shift to the bullish narrative surrounding the upcoming 2022 ETH merger. Therefore, I will use $5,000 as my price target in this scenario. I believe this is a conservative estimate because structural changes in supply and demand dynamics are never fully priced a priori - just like how bitcoin halving consistently generates positive returns even when we have a good idea in advance of when they will occur.

Scenario 2: Fed's focus does not change + ETH merger succeeds

From the dark start of the three Arrows, which saw a number of pre-eminent crypto lenders and hedge funds forced into liquidation, ETH has rebounded from a low of around $1,081 to $1,380 - a return of nearly 30% in a few weeks. Between the Fed meeting on July 27 and the close on Friday, July 29, ETH gained 25% in absolute terms and 9% versus bitcoin.

If the Fed doesn't turn the printing presses back on, then the base case is to get back to where the markets were before the Fed turned. To be conservative, let's assume ETH prices return to the June 17 market low ($1,081), but also retain any price movements experienced from the June 17 low to July 26 (the day before the Fed fulcrum was proposed), that is, we can strictly attribute to expectations of a successful merger. To isolate the movement of ETH prices over this time horizon driven solely by merger expectations, let us assume that any near-term performance of ETH versus BTC is entirely driven by expectations of merger impacts. This would allow me to separate the speculative impact on the timing and outcome of the merger from the impact of dollar liquidity on the broader market.

From June 17 to July 26, the value of ETH increased by 25.46% relative to BTC - so if the Fed fulcrum is removed, we can assume that the price will fall to $1,081 (June 17 low) * 1.2546, resulting in $1,356.

Now we need to add the expected price impact of a successful merger. As I mentioned earlier, the merger is expected to drive the "triple halving" event due to the structural impact it will have on the ETH network. To predict how this might affect the price of ETH, we can look at how Bitcoin behaves between halving dates. The table below shows the price appreciation that occurred between each bitcoin halving date.

Bitcoin is a decentralized currency. ETH is decentralized computing power. If Bitcoin keeps going up after halving, it is reasonable to assume that ETH will also go up. So if we apply the smallest 163% increase in price after halving to $1,356, we arrive at an expectation of $3,562.

Please note: The 163% price performance after the merger is very conservative, as the total bitcoin supply continues to increase per block after each halving, while ETH supply after the merger, given current usage trends, should shrink.

Scenario 3: No shift in Fed focus + ETH merger unsuccessful

Taking us back to the dark Ages, that would be the recent low of $1,081 - here's my price forecast for this scenario.

Scenario 4: Fed pivot + ETH merger unsuccessful

If the merger fails or is delayed, the ETH network will still work as it does today. Many people may be very disappointed, but the value of ETH will not go to zero. Solana, the ninth largest counterfeit coin -- with a market value of $13.5 billion -- has stopped working for hours several times over the past 12 months, but it's still worth well over zero. Even if the merger does not go as planned, ETH will still be fine.

To calculate the impact of this scenario on ETH prices, let's use the BTC/USD price performance between June 17 and July 26 as a liquidity Beta to determine what ETH prices would have been before the Fed's possible fulcrum, And there is no merger-related upside to push prices higher -- while still including any price movements that we believe are strictly driven by recent dollar liquidity conditions.

BTC gained 1.72% against the dollar between June 17 and July 26. As a result, we can estimate that ETH prices would also have increased by 1.72% over that time frame in the absence of merger-related excitement -since we assume again that the merger was the only factor driving ETH over BTC. Thus, a failed or delayed merger would take us back to $1,081 (ETH low on July 17th) * Liquidity Beta (1.0172), or $1,099. But in this case, too, we can experience the euphoria of more money printing. DeFi will continue to gain ground on TradFi. If the past is any indicator, ETH will suck fiat money into its orbit as the Fed expands the money supply again. ETH is up nearly tenfold from its low in March 2020, when the Fed expanded US dollar global liquidity by 25% in a year. To be conservative, I predict ETH will only recover to its current level of $1,600.

I assign an even probability to each of the four outcomes. Obviously, you can use this basic model at your discretion, but it's an easy starting point. I then calculated the return from the current level to the expected price in each case, weighted those expected returns by probability, and averaged them together - to get the expected value.

With expected future values 76% higher than today, our March 31 ETH/USD forward price is $1,600 (current spot price) * 1.7595, or $2,815.

I believe I was very cautious about the outcome of Scenario 3, so this is a very conservative estimate. With expected returns well above 0%, I can confidently add to ETH.

Specific operation

Let's evaluate our options for participating in this opportunity.

The spot

This is the most straightforward option. ETH is currently trading 76% cheaper than my model, and I am willing to buy ETH now. And I get a bonus because I get the same amount of ETH from the PoW ETH fork. Once ETH_PoW is online on the centralized spot exchange, I can sell these forked ETH_PoW.

futures

Today (August 4), the March 31, 2023 ETH/USD futures contract on Deribit is trading at $1,587. My model futures price is $2,815, so the futures market looks undervalued by 44%. Therefore, I would go long.

Call options

Given that our model suggests a fair value of $2,815 for the March 31 futures contract, I should buy a call option with an exercise price of $2,800.

Deribit's March 31 $2,800 ETH/USD call option traded at 0.141 ETH on Aug. 4. Each contract is worth 1 ETH. Using their option pricing model, the important parameters are as follows:

Delta: 0.37. Implied volatility: 98.3%.

I wanted to take more risk on the timing of the merger and the potential upside, so I bought a December 2022 option contract with a $3,000 exercise price. A shorter maturity means I pay less time value, which is expensive given the high level of implied volatility. My strike price is far from the current market price, which reduces the price of the option, but on the other hand, since the term structure exhibits a smile curve, I will pay more for volatility.

As I develop my trading strategy in response to the merger, I will most likely buy more spot ETH and participate in other financing transactions to maximize the opportunity for market mispricing. Such opportunities abound, as they did during Bitcoin's fork in 2017.

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