How US Recession Can Boost Crypto

Cryptocurrency prices might rise if the US economy continues to deteriorate and the Fed's tightening stance is moderated, creating more favorable US financial conditions.

Despite expansion, crypto is resilient. 

The US economy contracted at an annualized rate of 0.9 percent in the second quarter, significantly missing median analyst estimates for a small gain, according to figures on US GDP growth published this Thursday. After the economy contracted at an annualized rate of 1.6 percent in the first quarter, it represented the second consecutive quarter in which the US's GDP growth was negative.

It's common knowledge that the primary indicator of an economy's state of recession is two consecutive quarters of negative GDP growth. In light of the continued strength of the job market, US Treasury Secretary Janet Yellen claimed on Thursday that the US economy wasn't truly in a recession in the first half of 2022. In a recession, the job market often becomes worse.

However, with a rise in weekly initial unemployment claims in recent weeks, the labor market has begun to moderate somewhat. Additionally, although consumer confidence has been at an all-time low and consumer spending has been stagnant when adjusted for inflation for some time due to the bite of rising inflation, other indicators are also flashing warnings of weakness elsewhere in the economy.

According to PMI statistics issued last Friday, the dominating US service sector probably shrank in July. Although Yellen might claim that the US wasn't in a recession in the first half of the year, the outlook for the second half of the year is not promising.

In spite of growing skepticism over the US economy in recent weeks, bitcoin prices have increased. Bitcoin is now trading almost 35% higher from its June lows in the $17,500 region, at values around $23,800. Ethereum, on the other hand, is almost up 100% from its June lows of $880 per token at current prices around $1,700.

Why have bitcoin prices been able to rise if the economy is doing so poorly?

Financial conditions improving and boosting speculative risk assets

Because US financial conditions have eased dramatically over the last several weeks, crypto and other highly speculative risk assets like select US tech/growth companies have been able to perform strongly.

Despite mounting signs that the US is either approaching or is already in a recession, there is rising hope that the sky-high inflation rate has peaked. Bets that the US Federal Reserve won't have to be as aggressive with its rate rises in the coming quarters, which the bank is executing in order to try to drive inflation back to its 2.0 percent long-run objective, are rising along with confidence about a more benign inflation forecast.

In fact, Fed Chair Jerome Powell sounded a touch more dovish at this week's Fed meeting, as the bank raised interest rates by 75 bps for a second consecutive meeting, returning to approximately in line with the so-called neutral rate of 2.25-2.50 percent that neither boosts nor slows the economy. He declined to support more disproportionate rate rises at the Fed's future sessions in light of the current downturn in the economy and signs that US pricing pressures may have already peaked.

Thus, wagers on tightening for the remainder of 2022 and in 2023 have been muted in the money markets, which may be seen as the market's assessment of where the Fed would take interest rates. The market's base case now seems to be for a 50 basis point rate increase in September, followed by a series of 25 basis point rate increases in the remaining months of 2022 and early 2023, which would bring interest rates to just under 3.5 percent.

The rest of 2023 will see the Fed lower rates down to around 3.0 percent, according to the money markets. The rates on US bonds that compensate for inflation have dropped significantly as a result of the Fed's recent softening of tightening bets. In comparison to prior monthly highs, the 5-year TIP yield concluded the week at around -0.09 percent, down over 70 basis points. The 10-year TIPS yield was recently at 0.11 percent, around 60 basis points lower than previous monthly highs.

Real rates close to zero have a neutral effect on the economy, whereas real yields in positive territory, as they were earlier this month, are seen by analysts as being limiting to the economy. In other words, it may be said that the current state of the economy has returned to being rather neutral.

Historically, easier financial conditions have increased the value of risky speculative assets like cryptocurrencies and US tech companies. This is so that investors are compelled to invest in riskier asset classes as a result of easier financial circumstances that make holding bonds with lower yields less appealing.

Given the above, a further deterioration in US economic circumstances may increase the price of cryptocurrencies if it helps keep inflation under control and lowers Fed tightening bets. As inflation begins to decline, speculators may increase their bets on the Fed cutting interest rates in the second half of 2023 and beyond.

A significant boost for cryptocurrency might arise from a further easing of financial conditions if the Fed begins to support such wagers by coming off as more dovish at its last sessions in 2022.