Tightening financial conditions put an end to Luna-cy

May 13, 2022

Stablecoin Terra UST collapses while broader growth concerns continue to build as consumer demand is impacted by the cost-of-living squeeze.

Headline US CPI dipped lower in April, but markets were disappointed at a relatively strong +0.6% month-on-month gain in core prices, which suggests that underlying inflation pressures remain uncomfortably elevated. However, Treasury yields were little moved by this data and turned lower during the week, as tightening financial conditions continued to weigh on risk assets.

Sentiment in equity markets has soured with many of those assets with the highest levels of retail investor participation coming under the most pressure. Buying the dip has worked as a strategy for a long time, but it seems that this investor base is learning that the Fed is not necessarily their friend during a rate hiking cycle.

The notion of a ‘Powell put’ to support prices still seems some way out of the money, while if equities should rise and financial conditions ease, so the Fed may return to more hawkish rhetoric, effectively creating a ‘Fed call’ in terms of the upside in stocks.

Meanwhile, a collapse in the Terra UST stablecoin attracted attention this week, with Yellen voicing her concern at the lack of regulation covering stablecoin assets, whose value is notionally pegged versus the USD. In particular, algorithmic stablecoins, whose value is backed by the arbitrage on the cryptocurrencies they relate to, are seen as subject to a potential death spiral should falling prices trigger liquidations that depress prices yet further.

In this sense, such stable coins, which have no hard assets to back them, may exhibit a binomial return distribution, in which either they are stable at a fixed USD1 price or else risk being worth absolutely nothing at all.

Arguably, those attracted to invest in the 20% returns offered by UST, which was tied to the Luna coin, seem to have overlooked this point. Notwithstanding any tweets from founder Do Kwon, it has long been true in the history of financial economics that once confidence in a currency is lost, then it is near impossible to restore it.

Although this may seem of limited relevance to those outside of digital assets, the unwind we’re witnessing can still impact sentiment on a broader scale, noting that UST and the associated Luna token were top-10 global coins by capitalisation until earlier this week.

Similar substantial losses have also been seen in previous ‘hot’ investments, such as special purpose acquisition companies, or SPACs, which appeared all the rage just a short time ago. However, with banks now distancing themselves from those entities, it seems that the tide has turned and many such vehicles are nursing losses in excess of 50% from their highs. We suspect that the same magnitude of price moves have been seen in many other private assets held in private equity (PE) funds.

Anecdotally, it appears that PE firms have been inclined to chase ever-higher IRRs in the context of the bull market, meaning that a disproportionate amount of flow was allocated towards tech entities trading at highly elevated multiples to sales.

Locked-up investment vehicles are not marked to market and so this pain has not been felt more widely at this point. But it seems likely that the need to refinance will ultimately be a cause of concern for many private equity and debt funds, at a time when there has been an unprecedented wave of money chasing opportunities in the space, given that public market assets have appeared to offer far less compelling returns, particularly in fixed income.

However, just as it appears the investment outlook is starting to darken for private market assets, so we are seeing value start to return to public market fixed income. For example, US high yield was offering investors a paltry 4.5% at the beginning of this year, but index yields are now well above 7%. From that point of view, there seems less of a need for investors to rush into private markets to achieve their target return levels, and so 2022 may mark an inflection point with interest in private assets having peaked.

Elsewhere, growth concerns have continued to build as consumer demand is impacted by the cost-of-living squeeze and business sentiment is negatively impacted by evidence suggesting that China is sliding into recession as it implements restrictive lockdowns to preserve its zero-Covid strategy. We think that Beijing policymakers are failing to realise that as soon as curbs are relaxed, Omicron will quickly resurface. This suggests a trajectory of activity which will be stop/start at best.

On a relative basis, the European economy is more heavily exposed to downside risks. Germany remains in a sense of angst at the demise of an economic and political model that has relied on cheap Russian energy imports in order to manufacture goods to be sold to China, under the security support provided by the US. Europe continues to wake to a new reality and with war on its doorstep, it is easy to see how risks continue to be skewed to the downside.

We are inclined to believe that the ECB will have much less scope to tighten policy than the 200bp that the market currently expects before the end of 2023. It is likely that the ECB will end asset purchases in June and raise rates to 0% in Q4 this year. However, we only think that rates will rise modestly in 2023 as a result of weak growth and muted inflation pressure, cumulatively delivering only around half of the tightening that markets currently discount.

Conversely, we are more hawkish in the UK. At the end of 2022, we think that US and EU inflation will be below 4% but in the UK it is likely to be closer to 10%. This disparity in the trajectory of prices highlights how UK inflation expectations are likely to continue to de-anchor and that the UK economy could experience more pronounced stagflation than will occur in other major economies.

From this standpoint, we retain a negative view on UK assets and the pound and think the Bank of England is potentially risking the need that rates will have to rise by much more later this year by adopting a dovish stance in the interim. From that point of view, we would push back on the notion that high inflation can be the cure for high inflation.

Looking ahead

It strikes us that the Federal Reserve (Fed) is particularly focused on financial conditions indices (FCI) as it conducts policy and seeks to guide markets with its comments. Such measures have tightened materially over the past two months, albeit from ultra-accommodative levels. FCI are now not far from their long-term average and we suspect that the FOMC is quite content with this.

However, it is probably wary of much further tightening in these indicators in the near term; in the past week we have seen both the Fed’s Waller and Bullard seek to reassure markets a little. This suggests to us that we could be close to seeing a period of stabilisation in the coming weeks, absent adverse data or further shocks.

With US inflation having now peaked, we think the Fed can proceed along the path it has communicated without needing to induce further tightening of financial conditions. In that context, we are inclined to see Treasury yields in more of a trading range. Should this be the case, then sentiment in equities should also stabilise. In turn, this suggests more stability in credit markets in the weeks to come.

This is leading us to adopt a more constructive view on spreads, but we would note that it will be difficult for markets to retrace too much, as any easing in financial conditions could see central banks become more hawkish.

The macro landscape remains uncertain. Should bearish sentiment in equities continue to build, then it is very possible that prices could move materially lower on a loss of confidence. Lost confidence certainly seems to be a narrative in digital asset markets for the moment.

Arguments that cryptocurrencies are a good portfolio diversification trade seem to have been blown out of the water of late and it is also hard to think of these coins as a form of ‘digital gold’ at a time when volatility is so extreme and even supposedly ‘safe’ coins can end up as a very poor store of value.

Pain among retail investors could well lead to increased regulation, and it appears that even some of the most ardent supporters of the crypto ‘asset class’ may view many of the coins, tokens and NFTs that are trading today as little more than hyped-up Ponzi schemes. Meanwhile, further losses at exchanges such as Coinbase appear to suggest that even trading platforms are failing to make money, notwithstanding high transaction fees and plenty of turnover. In short, it has been nothing less than a Terra-ble few days in the space.

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