How a US Recession Can Boost Crypto

Key Points

• Data this week showed that the US economy was in recession in the first half of 2022.
• Meanwhile, other recent data has shown a further worsening of economic conditions in early Q3, but crypto has been resilient.
• A worsening economy could result in easier financial conditions as Fed tightening bets are pared, which is crypto bullish.

Crypto Resilient Despite Growing US Economic Pessimism

US GDP growth data released this Thursday revealed that the US economy shrunk at an annualized pace of 0.9% in the second quarter, a big miss on median economist forecasts for a modest expansion. That marked a second successive quarter of negative GDP growth in the US after the economy shrunk at an annualized pace of 1.6% in the first quarter.

Two consecutive quarters of negative GDP growth is often cited as the main definition of an economy in recession. US Treasury Secretary Janet Yellen on Thursday argued that the US economy wasn’t actually in recession in the first half of 2022, given that the labor market remained strong. Typically, the labor market worsens in a recession.

But the labor market has shown some signs of moderating in recent weeks, with weekly initial jobless claims rising. Moreover, while consumer confidence has been in the dumps and inflation-adjusted consumer spending stagnant for a while amid the bite of high inflation, other indicators are also blinking of weakness elsewhere in the economy.

PMI data released last Friday showed that the dominant US service sector likely contracted in July. So while, Yellen can argue that the US actually wasn’t in a recession in the first half of the year, things are not looking good for the second half of the year.

Despite growing pessimism about the US economy in the last few weeks, cryptocurrency prices have risen. At current levels around $23,800, Bitcoin is trading over 35% higher versus its June lows in the $17,500 area. Meanwhile, at current levels above $1,700, Ethereum is nearly up 100% from its June lows around $880 per token.

If things in the economy are so bad, then why have cryptocurrency prices been able to recover?

Easing Financial Conditions Boost Speculative Risk Assets

The reason why crypto, as well as other highly speculative risk assets like certain US tech/growth stocks, has been able to perform so well in the last few weeks is because US financial conditions have loosened significantly.

Amid growing evidence that the US is entering/already in a recession, optimism is growing that sky-high inflation may have peaked. As optimism about a more benign inflation outlook grows, so do bets that the US Federal Reserve won’t have to be so aggressive with its rate hikes in the coming quarters, which the bank is implementing in order to attempt to get inflation back to its 2.0% long-run target.

Indeed, at this week’s Fed meeting, where the bank lifted interest rates by 75 bps for a second successive meeting and back to roughly in line with the so-called neutral rate of 2.25-2.50% that neither stimulates nor slows the economy, Fed Chair Jerome Powell sounded a little more dovish. He noted the recent slowdown in the economy and evidence that US prices pressures might have already peaked and refused to back further outsized rate hikes at the Fed’s upcoming meetings.

Money markets, which can be viewed as the market’s view on where the Fed will take interest rates, have subsequently moderated bets on tightening for the rest of 2022 and in 2023. The market’s base case now seems to be for a 50 bps rate hike in September, followed by a series of 25 bps rate hikes in the rest of 2022/early 2023 that will take interest rates to close to 3.5%.

Money markets then see the Fed cutting rates back to around 3.0% for the remainder of 2023. In response to the recent moderation of Fed tightening bets, US inflation-expectation adjust bond yields have fallen sharply. The 5-year TIP yield ended the week around -0.09%, down nearly 70 bps versus earlier monthly highs. 10-year TIPS yields were last around 0.11%, down around 60 bps from earlier monthly highs.

Analysts interpret real yields in positive territory, as they were earlier this month, as being restrictive to the economy, while real yields close to zero have a neutral impact. In other words, financial conditions have arguably moved back from being slightly restrictive to around neutral.

Easier financial conditions have historically boosted speculative risk assets like US tech stocks and cryptocurrencies. This is because easier financial conditions reduce the appeal of holding now lower-yielding bonds, which forces investors into riskier asset classes.

Given the above, a further worsening of economic conditions in the US, if it helps bring inflation under control and results in a further reduction of Fed tightening bets, has the potential to boost crypto prices. As inflation starts to fall, traders may continue to boost Fed rate cut bets for the second half of 2023 and beyond.

If the Fed starts to give credence to such bets by coming across as more dovish at its last few meetings in 2022, that could result in a further easing of financial conditions, which could act as a major tailwind for crypto.