Bitcoin and cryptocurrencies are poised for further gains as stocks look to extend their recent gains

The long-awaited recession and resulting resumption of the bear market in 2022, which many expected, has so far failed to materialize in 2023. In fact, most assets caught the bid, with the NASDAQ hitting a 52-week high on July 12.

How is this possible and will the rally continue?

Michael Burry of Big Short fame said in January that the US could be in recession by the end of 2023, CPI lower and Fed rate cuts (note that today’s CPI print was much lower than expected, further supporting the recent recovery). This, in his opinion, would lead to another sharp rise in inflation.

Recently, independent macro and crypto analyst Lyn Alden explored this topic in a newsletter published this month.

In the report, Alden examines today’s inflation environment by comparing it to two similar but different periods: the 1940s and the 1970s. He concludes that the US economy is likely to stall or experience a mild recession while experiencing some level of persistent inflation. This could mean that the markets will continue their uptrend until an official recession hits.

The Fed’s inflation battle continues

An important difference between the two periods involves rapid bank lending and large monetized fiscal deficits, which Alden says are fundamental factors driving inflation. The former occurred in the 1970s when baby boomers began buying homes, while the latter occurred during World War II as a result of financing the war effort.

The 1920s are more like the 1940s than the 1970s, yet the Fed is running a 1970s monetary policy playbook. This could prove to be quite counterproductive. As Alden explains:

“So as the Federal Reserve raises rates, federal interest costs rise and the federal deficit ironically widens at a time when deficits were the primary cause of inflation in the first place. It risks being like trying to put out a kitchen grease fire with water, which makes intuitive sense but doesn’t work as expected.”

In other words, today’s inflation has been primarily driven by the creation of new federal debt, or what some may call government money printing.

Raising interest rates to calm inflation can work, but it is designed for inflation that has its roots in the expansion of credit tied to bank loans. While higher rates curb such inflation by making borrowing more expensive, thereby reducing private sector credit creation, they exacerbate fiscal deficits by increasing the amount of interest owed on these debts. The federal debt today exceeds 100% of GDP, compared to just 30% in the 1970s.

Federal Government Interest Payment Expenditures Vs. effective federal funds rate. Source: Lyn Alden

While the Federal Reserve cooled parts of the economy by raising rates by 500 basis points in just over a year, the root cause of the current inflationary environment remains unresolved. And with a much higher debt-to-GDP ratio than the US had 50 years ago, the situation is only getting worse at a faster rate. However, markets remained resilient, including tech stocks and cryptocurrencies, even as the correlation between the two broke.

That way, the Fed may be using a tool that is inappropriate for the situation, but that hasn’t stopped the markets, at least for now.

Big Tech Defies Recession Forecasts and Drives Stocks

Despite the Fed’s fight against inflation and market participants’ expectations of an inevitable recession, the first half of 2023 has been relatively bullish for stocks, with the rally extending into July. While bonds sold off again, pushing yields to highs in 2022, risk assets such as technology stocks rallied.

It’s important to note that this rally was primarily led by just 7 stocks, including names like Nvidia, Apple, Amazon, and Google. These stocks make up the NASDAQ’s disproportionate weight:

Related: Bitcoin Mining Stocks Outperform BTC in 2023, But Chain Data Shows Potential Stagnation

Bonds down, crypto and tech up

The rally in tech, fueled largely by AI-driven hype, and a handful of large-cap stocks also caught a tailwind from the release of bond market liquidity.

Alden notes how it started late last year:

“But then at the beginning of Q4 2022 some things started to change. The US Treasury began releasing liquidity back into the market to offset the Fed’s quantitative tightening and the dollar index fell. The S&P 500 found a bottom and began to stabilize. Liquidity in the government bond markets started to decrease. Various liquidity-driven assets like Bitcoin have bounced back.”

A July 11 report from Pantera Capital made similar observations, noting that real interest rates also have a very different story compared to the 1970s.

“Traditional markets can struggle – and blockchain can be a safe haven,” in part because “the Fed needs to keep raising rates” as real rates remain at -0.35%, according to the report. They also conclude that “there is still a lot of risk in bonds.”

They further note that while most other asset classes are sensitive to interest rates, cryptocurrencies are not. Bitcoin’s correlation with stocks during 2022 was due to the collapse of “over-indebted centralized entities”. Today, this correlation has reached an almost zero level:

Bitcoin Correlation with S&P 500. Source: Pantera Capital

Among the key takeaways here may be that risk assets appear to be underbid for now. However, this trend could easily reverse by the end of the year.

Dan Morehead of Pantera Capital said it well when he stated that:

“After trading 35 years of market cycles, I’ve learned that markets can only go down for so long. Only so much pain investors can take… From TerraLUNA/SBF/etc. a whole year has passed. There was enough time. We can gather Now.”

Bitcoin price trend and year-over-year returns. Source: Pantera Capital

With a split just around the corner and a view of a spot bitcoin ETF on the horizon, catalysts for cryptocurrencies seem poised to break through in almost any situation.