Could it rain on the next Crypto parade? (Recession)

It’s no secret to many investors that an inverted yield curve has long been regarded as a reliable indicator of an impending economic recession. It occurs when short-term interest rates surpass long-term rates, reflecting investors’ pessimism about the economy’s future prospects. In this article, we will explore the concept of an inverted yield curve, its significance as a harbinger of recession, and its potential impact on the next crypto bull run.

Understanding the Inverted Yield Curve

The yield curve is a graphical representation (see below green line) of the interest rates on debt for a range of maturities. Typically, longer-term bonds yield higher returns than short-term bonds, reflecting the higher risk associated with holding assets for an extended period. However, when economic conditions hint at a recession, investors rush to purchase long-term bonds, driving up their prices and lowering their yields. Simultaneously, short-term bond yields may increase as the central bank tries to stimulate the economy through monetary policy. This results in an inversion of the yield curve, where short-term rates surpass long-term rates.

The Inverted Yield Curve as a Recession Indicator

The inverted yield curve has proven to be a reliable indicator of impending economic downturns. Historically, most recessions in the United States have been preceded by an inverted yield curve. The reasoning behind this phenomenon lies in investors’ expectations of a weaker economy, leading them to seek the safety of long-term bonds. Moreover, it can signal that the central bank is trying to curb inflation (which is happening in 2023) and stimulate economic activity by reducing short-term interest rates, which are typically higher during strong economic periods.

Previous Inverted Yield Curves

Let’s first look at past yield curve inversions before comparing them to today. The green line in the above chart shows the 10-year treasury returns minus the 3-month returns. When it goes below zero, the curve is inverted. The chart shows the last 4 inversions put in parallel with the US Stock Market (S&P500 Blue Line).

• In 2000, the curve inversion preceded the dot-com bubble and stock market correction of 54%.
• In 2006, the curve inversion preceded the global financial crisis and stock market correction of 56%.
• In 2019, the curve inversion preceded the Covid Pandemic and stock market correction of 33%.

Looking at the data, we can also deduce two other elements. First, the consequences of the inversion on the stock market usually start to appear when the inversion goes back to zero or above. Second, there is some correlation between the depth and time of the inversion and the impact on the stock market. If the inversion is deep and/or long, the impact on the stock market is higher. Several other past inversions also corroborate this deduction.

What About Today?

In 2022, the curve started to invert, but the stock market is still rallying… for now… Is this time different? Before we can conclude that “this time it’s different,” it would be prudent to first wait for the curve to come back to zero and then wait for another 12 months before considering this inversion did not signal a market correction. Why so long? Because the depth of the inversion and the time inverted are both unusually deep and long.

As seen in the above chart, the current inversion is at the same level as the 1928 inversion that led to the Great Depression in the US. But as the chart also shows, in 1975 and in 1980, two deeper inversions also led to stock market corrections, but the economic consequences were not as bad as in 1975.

But Aren’t Cryptos Supposed to Rally in 2024?

In short, yes. The Crypto parade or Bull Run is expected to gain full steam after the next Bitcoin halving in April 2024. A lot of technical indicators show that the crypto asset class could be headed towards an impressive rally led by Bitcoin.

Considering the price of Bitcoin is derived from offer and demand (if there is more demand than offer, the price goes up) and looking at supply, we can see it’s going down. The available supply on exchanges (meaning easily tradable) is following a negative trend, which is a first since the inception of Bitcoin. Read our article on Bitcoin supply on exchanges here.

If you add to the fact that the available supply on exchanges is going down, the consequence of the upcoming Bitcoin halving (supply creation reduced by 50%) in an environment where demand for Bitcoin is factually increasing (number of transactions and the number of wallets holding Bitcoins), you can understand why a lot of people expect the price to increase significantly in 2024/2025.

So Why Are We Talking About Rain?

Because Bitcoin and Cryptos are considered “risk-on assets,” just like the stock market. And they both move in tandem (highly correlated) when impacted by macroeconomic events (COVID was a good example). The reality is we don’t actually know how Bitcoin and Cryptos would behave in a deep recessionary economy because besides the “flash covid recession” of 2019, they have never gone through one.

Could Cryptos decouple from the Stock Market and become an edge on the recession? In theory, yes, but in practice, it’s unlikely. The reason is very simple: in a deep recessionary environment, a lot of people start to lose their jobs and need money. Therefore, they sell stocks and cryptos to pay for everyday necessities. Read our article on the correlation between unemployment and cryptos here.

A Game of Probabilities

Ultimately, there are no certainties, and the biggest unknown remains when do the consequences of that deeply inverted yield curve start to show? The curve has been inverted since September 2022, almost a year. Historically, the longest gap between an inverted curve and a market correction has been 18 months. We also know that when the consequences start to materialize, they can take up to two or three years to settle.

So, if we put two and two together and consider that there is a high probability that Crypto stays macroeconomically correlated to the stock market. And that there is also a high probability that, this time again, the inverted yield curve signals an economic downturn, we can conclude that there is a high probability it could rain on the 2024/2025 Crypto parade.

The one-million-dollar question is when. If those economic consequences materialize early in 2024, they could make the next bull run look very weak. If they materialize at the end of 2024 or even 2025, they could simply mark the end of the next Crypto Bull run.

In any case, having a clear strategy and exit points should help crypto investors through what could be their first deep economic recession.

 

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