Spending the long weekend skiing New Hampshire’s trademark blue ice, Bode Miller style, no better place to teach the kids. -10 degrees, gusting to 25mph. “We could do colder than this Dad,” mumbled Charlie through doubled-up neck warmers, hand-me-down ski gear, proud, moments before the chairlift broke down…

In lieu of dusting off an old anecdote, I included Friday’s piece on digital assets from Marcel Kasumovich, our Head of Research (see below). And if you’d like to be added to the distribution for digital thought-pieces and research in the future, email Sebastian Bea, President of One River Digital [[email protected]]. Back next Sunday with full weekend notes. All the best, E

Week-in-Review (expressed in YoY terms): Mon: China reports first community spread of omicron, Richmond Fed’s Barkin says labor market “as tight as it could be at this point”, Turkey drops plans to use bonds to cover possible losses from new FX hedged deposits, Norway CPI 5.3% (5.1%e) / PPI 68.7 (58.6%p), Turkey unemp unch at 11.2%, Italy unemp 9.2% (9.3%e), EU unemp 7.2% as exp, S&P -0.1%; Tue: Powell acknowledges the balance sheet is far above where it needs to be, Johnson faces pressure over reports of a party at Downing street during the peak of the first covid lockdown, Fed’s Bostic says hikes may come in March and balance sheet reduction soon after, N. Korea tests hypersonic missile (3rd such test), Australia ret sales 7.3% MoM (3.6%e), Italy ret sales 12.5% (10.6%e), Brazil IPCA 10.06% (9.96%e), US NFIB Small Bus optimism 98.9 (98.7e), S&P +0.9%; Wed: US CPI 7% as exp / Core CPI 5.5% (5.4%e), Nato/Russia talks begin, Fed’s Brainard supports hikes “as soon as asset purchases are terminated”, Fed’s Bullard says 4 hikes in 2022 now appears likely, Fed’s Mester supports March hike, China PPI 10.3% (11.3%e) / CPI 1.5% (1.7%e) / New loans 1.13T ( 1.25T exp) / M2 9% (8.6%e), EU IP -1.5% (0.8%e), India IP 1.4% (2.8%e) / CPI 5.59% (5.8%e), Russia Core CPI 8.89% (9.05%e), S&P +0.3%; Thur: Russia deputy Fin Min says talks with US and Nato are at a dead end, Lula leads Brazil election polls, US Supreme Court struck down Biden’s covid vaccine mandate for large corporations, McCarthy says he won’t cooperate with Jan 6th commission’s request, UK lawmakers said BoE showed no convincing reason to launch a digital ccy, Japan M2 3.7% (3.8%e), Sweden unemp unch at 3.5%, Turkey IP 11.4% (8%e), US PPI 9.7% (9.8%e) / Core PPI 8.3% (8%e), S&P -1.4%; Fri: BoJ debating how to begin telegraphing eventual interest rate hikes but ready to defend yield curve control until then, CB of Korea hiked rates (25bps to 1.25%) as expected, Biden nominated Lisa Cook / Philip Jefferson / Sarah B Raskin as Fed governors, Fed’s Waller says 3 hikes in 2022 is a good baseline, Blackrock surpasses $10T in assets, Ukraine says Russia behind Wednesdays cyberattack, Australian immigration minister revoked Djokovic’s visa because he is not vaccinated, US senate blocked measure to impose new sanctions on Nord 2, Russia confirmed all troops deployed to Kazakhstan had returned, China’s 2021 crude imports fell for first time since 2005, Argentina CPI 50.9% (51.5%e), Japan PPI 8.5% (8.8%e), China expts 20.9% (20%e) / impts 19.5% (27.8%e), India wholesale prices 13.56% (13.82%e), Turkey home sales 113.7% (59%p), Hungary CPI 7.4% (7.2%e), Sweden CPIF 4.1% (4%e), EU trade balance -1.3b (1.5b exp – first negative print since 2011), Israel CPI 2.8% (2.6%e), Brazil ret sales -4.2% (-5.6%e), US ret sales control grp -3.1% MoM (0%e), US impt prices 10.4% (10.8%e), US expt prices 14.7% (16%e), US IP -0.1% MoM (0.2%e), US UofM 68.8 (70e) / 1y infl exp 4.9% (4.8%e) / 5-10y infl exp 3.1% (2.9%p), S&P +0.1%.

Weekly Close: S&P 500 -0.3% and VIX +0.43 at +19.19. Nikkei -1.2%, Shanghai -1.6%, Euro Stoxx -1.0%, Bovespa +4.1%, MSCI World -0.1%, and MSCI Emerging +2.6%. USD rose +0.6% vs Russia. USD fell -3.8% vs Bitcoin, -3.7% vs Ethereum, -2.4% vs Turkey, -1.9% vs Brazil, -1.2% vs South Africa, -1.2% vs Yen, -1.1% vs Chile, -0.7% vs Canada, -0.6% vs Sterling, -0.5% vs Mexico, -0.4% vs Euro, -0.4% vs Indonesia, -0.4% vs China, -0.4% vs Australia, -0.3% vs Sweden, and -0.2% vs India. Gold +1.1%, Silver +2.3%, Oil +6.2%, Copper +0.2%, Iron Ore +3.1%, Corn -1.7%. 5y5y inflation swaps (EU +1bp at 1.87%, US -7bps at 2.40%, JP -4bps at 0.60%, and UK +1bp at 3.97%). 2yr Notes +11bps at 0.97% and 10yr Notes +2bps at 1.79%.

YTD Equity Indexes (high-to-low): Turkey +9.3% priced in US dollars (+11.6% priced in lira), Chile +8.6% priced in US dollars (+4.1% in pesos), Hungary +8.1% in dollars (+3.9% in forint), Saudi Arabia +7.2% (+7.1%), Poland +6.7% (+4.7%), Greece +6.4% (+6.3%), India +5.8% (+5.2%), South Africa +5.4% (+2.1%), Singapore +5% (+5.1%), Israel +4.4% (+4.7%), HK +4.4% (+4.2%), Austria +3.5% (+2.7%), Czech Republic +3.5% (+1.3%), UK +3.1% (+2.1%), Colombia +3% (+1.5%), Norway +2.4% (+2%), Brazil +2.3% (+2%), Spain +1.8% (+1.1%), Mexico +1.5% (+0.9%), Italy +1.5% (+0.7%), Philippines +1.4% (+1.9%), Taiwan +1.3% (+1%), Indonesia +1.3% (+1.7%), Thailand +1.3% (+0.9%), Canada +1.3% (+0.6%), Argentina +1.3% (+2.4%), Germany +0.8% (0%), Ireland +0.6% (+0.4%), France +0% (-0.1%), Finland -0.2% (-0.9%), Euro Stoxx 50 -0.5% (-0.6%), UAE -0.7% (-0.7%), Malaysia -1.2% (-0.8%), Belgium -1.4% (-1.5%), Venezuela -1.4% (-0.3%), Japan -1.4% (-2.3%), Netherlands -1.7% (-1.8%), Australia -1.7% (-0.7%), MSCI World -1.8% (-1.8%), Korea -1.9% (-1.9%), S&P 500 -2.2%, Sweden -2.3% (-2.5%), Portugal -2.5% (-2.6%), New Zealand -2.7% (-1.9%), Switzerland -2.7% (-2.7%), China -3.2% (-3.3%), Russell -3.7%, NASDAQ -4.8%, Russia -7.3% (-5%), Denmark -9.4% (-10%).

BOTTOM LINE (by Marcel Kasumovich, Head of Research, One River)

Macro narratives are driving digital asset sentiment, from asset swings to regulatory decisions. This alone speaks to a maturing ecosystem – investors want the macro story. But digital asset volatility has been mostly uncorrelated to other macro markets in the recent past. It is more about a shift in investor behavior.

1/ As digital assets enter the mainstream, market commentary focuses on price. And in a world where exchange rate volatility is near all-time lows, attention has naturally shifted to digital assets where volatility against the US dollar is breathtaking by comparison. The megatrend towards the digitalization of finance will not be defined by the shorter-term gyrations. The innovation happening more behind the scenes will dictate the secular formations. Recent advancements in the Lightning Network illustrate the quiet determination to digitalize finance.

2/ The Lightning Network was proposed in 2015 as a way of scaling smaller payments, able to accommodate billions of transactions in a second (here). It addressed the tiring argument of Bitcoin’s inefficiency head-on. And after a slow start, user adoption surged last year with a 3-fold rise in network capacity (Figure 1). It is also integrating into the regulatory mainstream. This week, Bottlepay, a payment provider built on the Lightning Network, was approved by the UK Financial Conduct Authority. These new technologies can hold up to regulatory standards including anti-money laundering (here). It is a powerful example of technologists and regulators working together to encourage innovation in a complacent legacy system.

3/ Innovation may drive the megatrends, but investors are still left to manage and explain portfolio volatility from digital assets. And just as digital innovation is garnering more institutional attention, so too are the narratives around the volatility of digital assets. Investors are looking for macro thematic narratives, including the sharp downturn since November and the abrupt decline to start the year. Explanations center on the downturn in inflation expectations, the Fed pivot toward faster rate hikes and balance sheet normalization, as well as the decline in growth stocks tied to the rise in real interest rates. The high correlation of bitcoin returns to inflation expectations last year (56%) reinforces a desire to put a tidy macro narrative to the digital ecosystem.

4/ But the analytics tell a different story. We run a simple empirical exercise to evaluate bitcoin returns as explained by three macro factors: market-based inflation expectations (5y5y inflation swaps), the inflation-adjusted terminal policy rate (5y5y overnight interest rate swap less 5y5y inflation swaps), and Nasdaq 100 equity returns. These factors only explain 10-45% of the variation in bitcoin over the past two years and with various representations of the data. More importantly, there is almost no relevance of these factors in explaining the bitcoin downturn since November. Those factors would imply a bitcoin price of 50-60k, much higher than the current price.

5/ What does that mean for investors? Digital assets volatility has been largely independent of macro factors in the recent past. To be sure, the independent volatility that most investors hope for is skewed to the upside. But in assets where volatility expectations have ranged from 55% to 158% in the past two years, there will be plenty of periods where idiosyncratic moves detract from a portfolio. The test for any investor is asking about the structural trends. What tokens will prosper with the digitalization of finance? How broad will token pluralism extend? If the answers to the structural questions are positive, then downside volatility should be met with programmatic rebalancing into digital assets.

6/ Of course, idiosyncratic volatility is not satisfying. It is a polite way of saying we need to dig deeper for an explanation. What is behind the swings in digital assets if the macro narrative falls flat? The hunt for the explanation is partly a process of elimination and partly identifying new patterns of behavior. There are three key elements of the market microstructure of interest.

7/ First, the bitcoin forward yield curve has been stable, indicating leveraged trading is not a source of downside volatility. Figure 2 illustrates the one-month annualized yield implied by bitcoin futures on the Deribit exchange, where leverage is more readily available to traders. A rise in speculative demand leads to higher forward bitcoin prices and higher implied yields (vice versa). In periods of excess leverage, forward prices fall more than spot as speculative traders forced to close positions at unfavorable prices. Last May, one-month yields fell to an annualized –75%, reflecting a costly, steep inversion of the forward curve to speculative long traders. On this downturn, the compression in yields is barely visible.

8/ Second, option markets have decoupled from previous correlations to spot prices, with declining volatility expectations. The one-week implied volatility on Ether is 70%, near the lows of the past year (Figure 3). Ordinarily, declines in spot prices, particularly severe ones, would have seen a surge in volatility expectations. However, volatility is low despite a sharp decline in spot prices. The same pattern is evident in 25-delta put-call volatility skew. The one-week skew in Ether options is only marginally positive, near the average of the past year. This is strongly counter to past downturns in spot prices, where option skew spiked well above 40%! Again, leveraged trading is not the source of the recent price weakness.

9/ Third, a rise in the dispersion of digital asset prices hints at a change in investor behavior. We illustrate this point with a unique parsing of the data based on the last two downturns: May 8, 2021 and Nov 9, 2021. Dispersion is measured by the median difference between the individual returns on the 12 assets of our Core Index and bitcoin returns. When Index asset returns are evenly dispersed around bitcoin returns, the measure is zero. The one-month dispersion in the latest downturn measures near-zero (–0.4%). This is vastly different from May 2021, where the one-month dispersion index measured –9.1%. Index assets exhibited higher beta to the bitcoin downturn. No doubt, two cyclical periods don’t make a trend, but it does call for attention.

10/ Market behavior is bifurcating. It is evident in futures markets, where the decline in yields has been greater in regulated markets (CME) than in unregulated ones (Deribit). It is evident in active supply, where the percentage of longer-term holders has dropped alongside a more-than 20% fall in large-value bitcoin addresses (greater than $10mn). It is evident in the surge of interest in venture applications (here). Investors focused on macro narratives have mattered more than leveraged traders. And it is these ebbs and flows that should remind investors that we are at the very early stages in the digitalization of finance. It is precisely in those imperfect, inefficient early stages where megatrend assets are most additive to a portfolio.

Figure 1 – Lightning Network Capacity Surge, Adoption Rising

Figure 2 – Bitcoin Futures’ Yield Stable, No Sign of Speculative Excess

Figure 3 – Ether Volatility Low Despite Declining Prices

If you’d like to be added to the distribution for digital thought-pieces and research in the future, email Sebastian Bea, President of One River Digital [[email protected]].

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.