Uptober Off to a Good Start

Macro Update

The narrative in macro-land skewed negative this week until a strong jobs report on Friday morning.

• JOLTs data showed a big surprise to the downside, as job openings declined 10% in August. A job opening total of 10 million was materially lower than the 11 million consensus estimate and was the most significant 1-month decline since the start of COVID. Fewer job openings suggested a softening labor market.
• ISM Manufacturing PMI fell abruptly to 50.9 in September, significantly below market expectations (52.2), and signaled that the economic expansion witnessed in the preceding 28 months is slowing faster than expected. It appears that companies are starting to prepare for reduced economic demand.
• Despite the JOLTs data rolling over, the economy registered an unemployment rate of 3.5%, below a consensus estimate of 3.7%, as the total nonfarm payroll increase of 263k was above the consensus estimate of 250k. However, of note, fewer jobs were created in September than in both August and July. Ultimately, the market interpreted this as a signal of a persistently strong economy.
• From a narrative perspective, international markets continue to be disproportionately affected by the Fed’s current tightening endeavors. Australia showed the first sign of central bank capitulation, raising their interest rate benchmark by 25 bps, below market expectations. We also saw the UN signal caution against central banks tightening too much too fast. In a similar spirit, the IMF expressed their concern that the decisions by the Fed could lead to global recessionary pressures.

On balance, crypto and equities will finish the week higher, but not without some volatility. We think the takeaways from the macro headlines this week are:

• Demand and the job market are softening. However, some metrics are not progressing as fast as investors have priced in.
• Outside of actual CPI numbers, bad news (JOLTs and PMI) is still good news, and good news (jobs report) is still bad news.

Now our attention will turn to next week for the release of the September CPI figure. The Fed nowcast data shows headline CPI continuing to roll over but at a much slower clip (forecasting a decline from 8.3 to 8.2) and Core CPI accelerating this month (forecasting an increase of 6.3 to 6.6).

The consensus forecasts released prior to the hot August CPI print were rather optimistic. Our take here is that it’s reasonable to think that those ambitious forecasts will be dialed back this time around, leaving more room for a potential downside surprise.

And with 75 bps at the FOMC meeting in November being now all but a foregone conclusion, it certainly sets us up nicely for a continuation of a green October.

Correlations Continue to Breakdown – Does Crypto Care About Earnings?

Regardless of where CPI lands next week, it is interesting that crypto continues to witness a breakdown in correlations with the dollar (rates) and risk assets.

Below we build on a rolling 30-day (measured in trading days for equities) correlation chart featured last week. It is evident that major cryptoassets, particularly Solana, continue to decouple from macro variables.

This breakaway from the dollar could still certainly be temporary, but the divergence is pronounced enough that we are starting to give this pattern more legitimacy.

At the very least, we think that this decoupling indicates a lack of residual sell pressure still embedded in the crypto market and gives us more confidence that the current asymmetry skews to the upside. However, going forward, it raises an important question over whether crypto cares much about macro outside of the amount of liquidity present in the global economy.

The dollar’s strength is simply a function of supply and demand. A stronger dollar reflects the current tightening economic conditions. In tightening monetary conditions, both liquidity and economic demand decrease. If economic demand decreases, not only will tech indices start to lose ground due to reduced available dollars for individuals and funds to invest, but companies will falter, and earnings might fall due to decreasing demand and a retreat to the USD.

Thus, we are tempted to consider the following logic:

• If crypto and equities were broadly correlated before due to their risk profile and moved in tandem based on the projected liquidity throughout the global economy,
• And as time progresses, some of the move in the dollar and equities will be due to earnings and not liquidity conditions,
• Then, perhaps in a world where reduced liquidity is priced in, a drawdown in equities that is driven by a decrease in earnings will not have the same negative effect on crypto prices.

The downside of this is, of course, that the crypto market would be relying on better liquidity conditions (i.e. Fed Pivot) before we could witness another parabolic rally, as we saw in 2020 and 2021. But it is a scenario that opens the door for more idiosyncratic performance within crypto and carries less downside risk.

Bitcoin Supply Showing Signs of a Cyclical Bottom

Bitcoin’s accounting model is brilliant. One of its perks is that it allows us to ascribe ages and behavior patterns to specific wallets. The longer it has been since a wallet acquired its bitcoin, the more likely that address is a HODLer, and consequently, the less concerned that investor will be with fluctuating asset prices.

In a bull market, a greater relative amount of speculative capital enters the fold and increases the risk of massive drawdowns. Conversely, at each market trough, we often see the overall “ages” of bitcoin holdings increase until a significant enough proportion of BTC is held by individuals that will not capitulate regardless of market conditions.

Below we see that the lion’s share (72%) of the Bitcoin network weighted by relative cost basis was acquired no earlier than six months ago. This skew in age distribution coincides with previous cyclical bottoms. The probability that this supply remains immune to capitulation is supported by the logic that those who acquired their BTC 6 months ago, when the price was still north of $40k, likely would have parted with their bitcoin by now. This is especially true when considering the massive deleveraging events that have unfolded in the crypto space since that time.

For a full breakdown on HODL waves, visit here.

Encouraging Miner Data

In Q3, we frequently discussed bitcoin’s underperformance due to the residual supply overhang from distressed miners. For a while, we were subject to a world “benefitting” from free debt. Thus, many miners entered the space, borrowing dollars at favorable rates to purchase hardware and scale operations. Concurrently, many were holding onto their mined assets on their balance sheet in hopes of becoming a quasi-leveraged play on BTC price. Unfortunately, many of the smaller miners and the miners that did not appropriately manage their capital expenditures found themselves underwater and were forced to sell their bitcoin and, in many cases, dispose of their ASICs.

The good news is that consistent with the past few weeks, we are starting to see signs that the period of severe miner capitulation may be ending. The chart below demonstrates how ASIC prices have normalized after undergoing a rapid ascent over the past two years.

Further, stronger companies are starting to capitalize on the fallout from the mining massacre.

• Grayscale launched a fund to purchase mining equipment at distressed prices.
• Well-capitalized companies are considering scooping up hash rate as the anticipated industry consolidation starts to take place.
• Larger players like Marathon are turning on a significant amount of hash rate.

Mining difficulty levels corroborate the mining industry recovery (as a reminder, mining difficulty means more people compete for block rewards). The chart below clearly shows where the miner shakeout occurred, with the steep decline in mining competition in Q3.

As exemplified by a reversal in difficulty trend, the market has shaken out most of its unprofitable miners as larger, well-capitalized miners with better equipment start to turn on more ASICs.

Difficulty is expected to take a giant leap this weekend, with current estimates pointing toward a potential uptick of 10-15%, the most significant percentage increase this year.

Let’s Get Modular

With Ethereum’s scaling initiatives, most notably EIP-4844, around the corner, we will start paying more attention to layer 2 activity in anticipation of more network participants migrating there over the next 12 months.

Below we examine recent activity metrics for Ethereum and leading layer 2 networks Optimism (OP), Arbitrum, and Polygon (MATIC) (we acknowledge that Polygon is less of a layer 2 and more of its own quasi-layer 1, but from the perspective of developers and users, it is essentially an L2).

Below, we see that transactions on Ethereum and Polygon have been relatively flat since the beginning of September, with an apparent uptick in transaction activity on Ethereum Mainnet around the Merge.

Interestingly, the two emerging L2 networks (Arbitrum and Optimism) witnessed a sizeable and concurrent increase in transaction count post-Merge. We speculate that the Merge completion brought forward the expected timeline for scaling initiatives and therefore encouraged more economic activity to migrate to these L2 networks.

The transaction activity dynamics noted above are corroborated by the chart below, which maps unique addresses on each respective network. The number of users on Optimism, Polygon, and to a certain extent, Arbitrum launched higher post-Merge.

Interestingly, the number of unique addresses on Ethereum Mainnet decreased following the Merge completion, a likely sign that many were on Mainnet to be caught in the snapshot for any potential post-Merge airdrop.

The increase in users on Optimism and Arbitrum could also certainly be attributed to various ongoing incentive programs to bootstrap liquidity. However, the fact that users are also migrating to Polygon gives us some confidence that a portion of this user migration is due to organic demand.

The chart below further suggests an increase in organic demand on L2. Crypto commerce often accelerates in the presence of stablecoins as they are the preferred trading pair and unit of account across most ecosystems. Below we see that the market cap of stablecoins on Optimism and Arbitrum has increased substantially over the previous month, while stablecoins on Ethereum Mainnet have remained relatively flat over the same period.

We note that the stablecoin balance on Polygon has seen a sizeable decrease since last month. While this would appear disconcerting, after further investigation, it seems that the lion’s share of this stablecoin migration can be traced to a single application on Polygon, which has taken a nosedive. The reason for this is uncertain, but likely, it was merely a weak project whose flame had burned out.

In concert with the stablecoin chart above, we can see that aggregate TVL across all observed chains has taken a similar path as their respective stablecoin market caps. Notably, L2 networks in Arbitrum and Optimism have recovered their TVL post-Merge much more rapidly than Ethereum.

The key takeaway from these charts is that when contemplating commerce and activity on Ethereum, we must now consider all network layers. A clear trend is forming in which these layer 2 networks are siphoning a significant share of user activity previously confined to Mainnet, while also allowing for new users to perform new functions that would have otherwise been impossible or too expensive on the base layer. The liquidity flows from Ethereum to L2’s will be an exciting trend to watch and is a major reason we are constructive on OP and MATIC, in addition to ETH.

Strategy

Recent strength against the dollar and equities is encouraging for near-term price action. We are still constructive on select assets (core: BTC, ETH, SOL, merge-adjacent: LDO, RPL, OP, MATIC) through the balance of the year.