Crypto Collapse: Irrelevant Or ‘Foreshock’ To A Coming Earthquake?

I’ve said it so many times over the past few days the joke is probably old already: Inflation was all that mattered to the financial media until cryptocurrencies crashed.

When Bitcoin lost a third of its “value” in matter of hours last Wednesday (figure below), editors and journalists took one hand off the steering wheel, leaned over, unfastened inflation’s seatbelt, pushed open the passenger door and shoved the story out into the middle of the highway to make room for crypto, which has been riding shotgun ever since.

Bloomberg readers woke up Sunday to learn that Bitcoin was again down double-digits. By the time you read these lines, it may well have recouped those losses, doubled them or, less likely, traded sideways.

While the inflation story has an obvious, legitimate claim on the wall-to-wall media coverage it’s received, crypto arguably doesn’t, or at least not from a macro perspective.

It’s true that dramatic losses in the space have the potential to catalyze broader risk-off events, in part due to the notion that Bitcoin and its progeny are the quintessential example of “froth,” other manifestations of which are in the process of de-rating as inflation fears mount. A more concerning aspect of the Bitcoin story is the extent to which everyday investors who own S&P 500 index funds are exposed through Tesla’s balance sheet, but unless holding crypto as a cash substitute becomes a trend among corporate treasurers, contagion risk through that channel is probably low.

Panning out to a 30,000-foot perspective, JPMorgan argued that crypto doesn’t appear to be particularly “contagious.”

“Deflating a large and very expensive market creates a substantial wealth loss, which can impact the real economy by impairing the balance sheets of households, corporates and the banking sector and reducing their spending, investment and lending,” the bank said, in a note dated late last week. “The more leveraged the private and financial sectors before the event and the more widespread the ownership of a frothy market, the higher the likelihood that a bubble burst proves contagious to the economy and to other markets,” the bank added.

In the private sector, leverage was up just 7% over the half-decade to last year, a figure JPMorgan called “remarkably low considering how recessions amplify balance sheet weakness.” As the figure on the right (below, from JPMorgan) shows, private sector debt in Japan ballooned more than 40% as the Nikkei bubble inflated and private sector debt in the US climbed by 15% and 25% of GDP, respectively, prior to the dot-com bust and housing collapse.

Clearly, corporates borrowed quite a bit in 2020 as management teams took advantage of the Fed’s backstop for the credit market and capitalized on insatiable demand amid a reinvigorated hunt for yield. But households were bolstered by stimulus checks and generous federal assistance, while the shock of the crisis compelled some to reduce borrowing and build cash buffers. (Also note that the figure shows the five-year change in leverage.)

Additionally, the ownership structure of crypto is obviously unique. Indeed, quite a few bull cases depend heavily on the assumption of more widespread adoption, which is just another way of saying that currently, adoption isn’t any semblance of widespread.

“It’s true that flows into crypto have become more balanced between retail and institutional over the past few quarters, but institutional holdings are probably limited to an array of hedge funds rather than the fuller spectrum of asset managers, insurance companies, pension funds, central banks, sovereign wealth funds and commercial/investment banks,” JPMorgan went on to say, juxtaposing that with US mortgages and stocks, which were (and are) “almost universally owned” making burst-bubbles “more infectious financially and economically.”

Consider, as another example, that although crypto currencies shed a seemingly gargantuan $600 billion in market cap during this month’s rout (figure below), the market cap loss for Chinese equities during the 2015 collapse was more than three times as large, and most regular people outside of China scarcely remember that episode even though it’s only six years old.

So, does crypto even matter? Maybe not or, if it does, perhaps more so as a canary than as a risk in itself.

As BofA’s Michael Hartnett put it last week, those of a bearish persuasion in the current environment “can point to 2007/8, as a sinister series of deleveraging ‘events’ ended with a Minsky Moment.” Nomura’s Charlie McElligott said US equities are currently “withstanding waves of macro- and idiosyncratic- shocks.”

Similarly, JPMorgan’s John Normand wrote that “even if crypto represents a relatively contained wealth loss by the standards of previous financial crises, it’s still possible that other expensive and systemically-important markets could succumb to negative catalysts like higher inflation and Fed tightening [making] crypto the foreshock ahead of the [coming] earthquake.”