Bitcoin price under macro liquidity modeling

Bitcoin Price under Macro Liquidity Modeling

Original article by Huobi Research

Abstract

2022 was a rough year for bitcoin and the virtual currency market. We saw a lot of capitulation selling, but the market also shattered the expectations of those who wanted bitcoin to fall below $10,000. Bitcoin price changes over this cycle need to be scrutinized to form a reasonable and more robust estimate.

Bitcoin and other virtual currencies, as a kind of risk assets, will be greatly affected by macro liquidity fluctuations. This paper will analyze the main drivers of bitcoin and other virtual currencies based on the macro liquidity model.

This paper is divided into three parts. The first section defines and explains the correlation between the liquidity body (in this case the Federal Reserve's balance sheet) and the broader virtual currency market as a risk asset. The second part examines in detail the drivers of liquidity emanating from the Fed's balance sheet. The third part proposes other important on-chain indicators that can be explained by the liquidity model.

Chapter 1 Correlation between source liquidity (especially the Federal Reserve balance sheet) and risk assets (especially virtual currencies)  

1.1 Excess liquidity on the Fed's balance sheet pours into risky assets

The size of the Fed's balance sheet has grown especially large as the central bank has implemented quantitative easing since the COVID-19 pandemic in 2020. The newly issued money flows into various markets, and the virtual currency market is one of the better performing risk asset markets.

The chart below charts the correlation between risky assets and the Fed's balance sheet. The shaded areas in green are periods of guided growth after large amounts of liquidity have been injected.

1.2 Low interest rates increase economic activity (borrowing and investment)

Another factor contributing to the virtual currency market rally in 2020 is the prolonged low interest rates on U.S. Treasury bonds and the large amount of liquidity in commercial banks.

The light blue shaded areas represent time lines of low interest rates and periods of time when economic activity was stimulated. It is also worth noting that commercial banks are flush with liquidity thanks to the Fed's continued purchases of bonds from these banks. Because interest income is no guarantee of return in such a low interest rate environment, hot money in the market will seek out markets other than money markets that offer better returns, such as equity products. As a result, the proliferation of lending and investment has led to a rapid increase in institutional acceptance of virtual currencies.

1.3 Quantitative tightening has begun quietly before the official announcement of the Federal Reserve

There was confusion at first, because liquidity actually began to dry up in January 2022, more specifically, with the Fed's massive reverse repos. (See 2.1 for a more complete explanation of reverse repos.)

Shaded in red are periods when demand for reverse repos surged. During this period, hot money becomes more risk averse, while its preference for risky assets decreases.

The expression "quantitative tightening has quietly begun in January 2022" aptly captures the nadir in the Treasury general account balance in December 2021. A rise in the US Treasury's general account (TGA) balance means a fall in reserves, and a fall in bank reserves has a fatal effect on economic activity, especially market participation in risky assets. The drivers are detailed in Chapter 2.

Chapter 2 analyzes the Fed's balance sheet and the drivers of liquidity

When analysing the effective drivers of the Fed's balance sheet, it usually looks at three components: total assets, US Treasury general accounts (TGAs), and Reverse repos. Understanding how these three parts affect the market is crucial to analyzing the effective drivers.

2.1 A detailed explanation of the Federal Reserve reverse repo

The Federal Reserve uses reverse repos to cool markets by controlling the federal funds rate and liquidity. The Fed adjusts the effective federal funds rate by raising or lowering the interest rate on reverse repos and the interest rate on reserve balances.

Simply put, when the Fed raises interest rates, it raises the interest rate on reverse repos. As a result, the reverse repo will become more popular with money, and a lot of liquidity will flood into reverse repo trading. No asset is less risky for investors, so the Fed has sucked up a lot of liquidity.

Notably, the amount of reverse repos rose rapidly in April 2021 despite the Fed's continued balance sheet expansion.

(1 Please refer to the following report for the research on the Federal reverse repo: https://medium.com/huobi-research/reverse-repurchase-agreements-as-an-indicator-for-btc-ca8619442890)

Figure 5 captures the time period when the difference between the Fed's balance sheet and reverse repo happened to coincide with the rise in bitcoin prices. Bitcoin prices entered the allocation phase in the Wyckoff allocation model (probably because of illiquidity, when net liquidity first falls and then tries to climb). There is no doubt that there is a negative correlation between reverse repo and risk assets. In this paper, the author created a reverse reverse repo index to present a positive correlation.

A flat reverse repo line usually means loose (less hawkish) available liquidity and the market reacts positively, creating a potential bear market.

Bottom line: A sudden steepening of the reverse reverse repo line will bring risk assets back into the spotlight even more. For now, the reverse repo line is structurally flat, and equity assets should revert to the mean over this period.

2.2 A detailed explanation of the General Accounts of the United States Treasury

The United States Treasury General Account (TGA) is a demand deposit account opened by the United States Treasury at the Federal Reserve. It is used to store all taxes and proceeds from the sale of Treasury securities and to pay all general and other expenditures of the United States government. On the Fed's balance sheet, TGAs, along with bank notes, currency and bank reserves, are liabilities. Since liabilities must be in line with assets, a fall in the TGA balance must lead to a rise in bank reserves, and vice versa. The depletion of bank reserve accounts in 2021 is masked by $3 trillion of asset purchases by the Federal Reserve. As cash flows leave the TGA, bank reserve balances grow, partly boosting lending and investment in the broader economy and markets.

As Figure 7 shows, the green shading is the period in which the Fed spent $1.6 trillion of TGA accounts to almost zero, offsetting the sudden increase in reverse repos and filling the net liquidity that helped the Nasdaq rally.

2.3 Combine Treasury bills and bond issuance with liquidity projections for the Fed balance sheet, fiscal general account, and reverse repo analysis

The net liquidity model worked very well between 2020 and 2022, until the recent peak in Fed debt.

The Fed's debt ceiling of $31.4 trillion means the Treasury cannot issue bills and bonds until TGA balances are exhausted; At the same time, when the full TGA balance is budgeted and used to support government spending, the debt ceiling can only be increased by submitting a formal request to Congress for approval. Especially when TGA balances are used to pay for government spending, the demand for short-term Treasury bills falls, but does not affect issuance of long-term bonds much. Demand for Treasury bills will inevitably seek other targets (perhaps because institutions need to satisfy end-investor returns). However, this demand should not be channelling into virtual currencies and other risky assets in such a bear market, leaving reverse repos as the only safe option. As a result, reverse repos, including offshore reverse repos, will play a bigger role in the Fed's liquidity model than TGA accounts in the coming months.

So it's important to watch the first quarter of 2023 for Treasury bills and other debt issuance. If the Treasury were to issue fewer bills, demand for those bonds would shift to reverse repos; If the U.S. Treasury issues more short-term bills, reverse repos will decline and other risky assets may recover. So it is also worth paying attention to the extent of reverse repos.

(2 data see: https://home.treasury.gov/system/files/221/Tentative-Auction-Schedule.pdf)

2.4 Basis of liquidity model

True net liquidity combines TGAs, reverse repos and newly issued debt issued by the Treasury and is used to track the movement of risky assets.

2.5 US Federal Funds Rate forecast

Above is a forecast of the likelihood of a Fed rate hike. The general trend is in favour of a cut in 2024, while also pointing to the base rate remaining at the target rate of 5.25% through 2023.

Therefore, in the environment of high interest rate, investment will decline. At this time, hot money will prefer lower risk investment targets, so the investment in risky assets will not flourish. In such an environment, it will be hard to see anything like the exuberance of 2020.

However, this is not the end of the virtual currency, because the market is always evolving and moving forward, not to mention the market has been due to respond to the Fed rate hike. The following bitcoin pricing model suggests that the current virtual currency market may have entered a "value range" that smart money will enter. If there is no major negative news coming out of the market recently, virtual currencies should have bottomed out by now.

Chapter 3 Bitcoin Pricing Model  

3.1 Bitcoin basic holding fee model

The above multi-base model reflects that the market has entered a cyclical capitulation sell-off every four years. According to CVDD, the selling price floor range is likely to be $13.5K-16K. The grey shading is the time when the cost base of long-term holders is higher than that of short-term holders, a phenomenon that occurs every four years and is indicative of a classic capitulation period.

3.2 Realized gains/losses

Realized losses have begun to abate in the recent capitulation sell-off, and subsequent capitulation sell-offs are accompanied by minimal realized losses, which portends the aversion that mostly occurs in bull markets.

3.3 Stablecoin supply ratio model

When the stablecoin supply ratio crosses the lower standard deviation threshold, it is a very effective way to determine the market bottom range. Recently, the ratio has hovered near the boundary, suggesting that the purchasing power of stablecoin may have reached a point where it is about to rise.

3.4 Bitcoin vs bond interest income

Bond returns remain on an upward trend. The dollar index is showing signs of recession. Bond returns and risky assets are negatively correlated, so when bond returns are trending downward, they are a sign of a bull market. High bond returns will also dampen DeFi's growth. Unless bond returns are lower than DeFi's current interest rate returns, it will be difficult for DeFi's TVL to return to previous levels.

3.5 Bitcoin cycle comparison

Finally, when viewed over a four-year period, bitcoin prices have recently been trading in a historic "value range." This interval starts on the 700th day of the previous interval and usually lasts for 2-3 weeks. Within this range, capitulation selling flows in, often accompanied by FUDs. The virtual Currency Fear and Greed Index is now 27/100. If you look at the bitcoin cycle after each bitcoin halve, the interval typically begins on day 850 and lasts for three months.

Chapter Four Conclusion  

4.1 Bitcoin enters historic value range after massive capitulation selling

All of these indicators suggest that bitcoin is now undervalued. It is likely that bitcoin will return to its pre-FTX fair value, but breaking above $30,000 will still require significant macro liquidity and support from more positive investment sentiment towards VCS.

4.2 Although the reverse repo line remains flat, risk assets are under less downward pressure

The true net liquidity indicator and reverse repo line should be observed at all times to confirm the continuity of the trend. That is to say, only these two indicators show a strong trend, the virtual currency market can continue to prosper.

This article is from submissions and does not represent the views of BlockBeats.    

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