Coinbase: An Analysis of the Intrinsic Reasons Behind the Current "Bull to Bear" Transition in the Crypto Market

Original Title: 《The crypto market downturn explained》

Compiled by: Hu Tao, Chain Catcher

The financial market is essentially a massive information processing machine, as it influences the decisions of millions of individual buyers and sellers. Or as Benjamin Graham put it—"In the short run, the market is a voting machine." As of June 2022, the U.S. stock market had fallen about 20%, with roughly $10 trillion evaporated; however, for American stockholders, the sell-off still seemed far from historical lows, suggesting that the severity could further escalate.

Meanwhile, cryptocurrencies have dropped nearly 60%, with $1.7 trillion evaporated. However, this decline is still minor compared to the 2017 bear market, which saw an 87% drop in total market value after the peak of the 2017 bull market.

BTC, ETH, and the Nasdaq all peaked in November, while the S&P 500 index peaked at the end of December. So, what changes occurred in the economy over the past two months? To understand this market downturn, it is best to start analyzing from the historic bull market that stocks and cryptocurrencies experienced in 2020.

Entering 2020, Bitcoin rebounded sharply from the 2018/19 crypto lows, rising from $7,500 to nearly $10,000. At the same time, the S&P and Nasdaq indices also reached historic highs.

Then, the COVID-19 pandemic hit.

March 2020: The COVID Shock

On March 12, 2020, the World Health Organization declared the coronavirus a pandemic, and governments around the world had to enter lockdowns. With the outbreak of COVID-19, it became clear that the global economy was not adequately prepared to handle the shock, leading to panic across nearly all markets.

The S&P and Nasdaq indices both fell about 30%, with the crypto market experiencing an even greater impact (in absolute terms), as BTC briefly dropped below the $4,000 mark, with a market cap shrinkage of over 60%.

In short, the COVID-19 pandemic caused panicked investors to choose to sell off, leading to a sharp decline in all liquid markets.

Then, the Federal Reserve intervened.

The Federal Reserve's Response

As the central bank behind the world's largest economy, the Federal Reserve plays a unique role in financial markets, and their primary task is to control the supply of the world's reserve currency, the U.S. dollar.

Printing money and interest rates are the main tools the Federal Reserve uses to support the economy during extreme turmoil—

• By printing money and purchasing financial assets such as bonds from financial institutions, the Federal Reserve can inject newly issued currency into the economy.
• By lowering interest rates, the Federal Reserve allows other banks to borrow money from it at a cheaper rate, which also introduces newly issued currency (in the form of credit) into the economy.

After COVID-19, the Federal Reserve lowered the cost for banks to borrow from the central bank (i.e., the federal funds rate) to essentially zero, which in turn allowed banks to lower the cost of borrowing for customers. This way, cheap loans became available to fund households, businesses, spending, and other investments.

By increasing the money supply and purchasing Treasury bonds and other securities (what we know as quantitative easing), an unprecedented amount of dollars was injected into the economy. Over the next two years, the Federal Reserve printed nearly $6 trillion in new currency, increasing the broad supply of dollars by nearly 40%. Financial institutions, now flush with cash, competed to lend out this new money, which forced them to lower interest rates to remain competitive. Similarly, the availability of cheap credit encouraged borrowing, ultimately supporting the functioning of the economy.

Not only the Federal Reserve did this; the European Central Bank, the Bank of Japan, and the Bank of England all lowered interest rates to near (or even below) zero and printed money at historic levels. In total, the world's four major central banks increased the money supply by $11.3 trillion, a 73% increase since the beginning of 2020.

Most importantly, the U.S. government injected over $5 trillion in "stimulus" into the economy by taking on public, private, and foreign entity debts. Similarly, China injected another $5 trillion into its economy using the same methods.

Essentially, the world is now flooded with cash.

Don't Fight the Fed

"Don't fight the Fed" is an old investor adage, meaning that given the Federal Reserve's immense influence, people should invest in sync with any direction the Fed pushes financial markets. After the COVID-19 outbreak in 2020, this adage became a reality.

As the dollar was printed at record levels and dollar interest rates approached zero, this money and credit needed a place to go. Most importantly, when interest rates are low, the profits from conservative instruments like bonds also decrease, pushing funds toward higher-yielding assets. As a result, after COVID-19, these forces led to a massive influx of funds into stocks, cryptocurrencies, and even NFTs, helping to push asset prices to new heights.

From the bottom triggered by the COVID-19 panic, the S&P 500 index, Nasdaq index, BTC, and ETH surged by 107%, 133%, 1,600%, and 4,200%, respectively.

The Result of Massive Money Printing: Inflation

When the system is flooded with money and asset prices are rising, everyone feels wealthier. People can spend more, and companies can pay employees higher wages. When the growth rate of spending and income outpaces the growth rate of goods production, "too much money chasing too few goods" occurs, leading to rising or inflated prices.

Due to COVID-19's impact on supply chains, there were fewer goods in the economy. More money chasing fewer goods leads to one result: more inflation, which began to become increasingly evident in May 2021.
Take the Consumer Price Index (CPI) as an example, which measures the price changes consumers pay for goods such as gas, utilities, and food— from March to May 2021, the CPI soared from a healthy 2.6% to 5%. By March 2022, the inflation rate reached 8%, the highest in over 40 years.

Inflation makes everyone poorer, as people's money no longer buys as much as it used to, prompting the Federal Reserve to intervene again. To combat rising inflation, they first used tools that support financial assets.

The Fed Prepares to Reverse Course

As we explained, low interest rates and newly printed money supported economic growth and asset prices. However, when this tool is overused, it can also lead to inflation. Once this happens, the Federal Reserve flips the switch, raising interest rates and withdrawing funds from the market, reversing the process.

Interest rate hikes ripple through the economy. Since this raises the cost for banks to borrow from the central bank, they in turn charge customers more for borrowing. Besides making it more expensive for everyone to borrow money, the cost of servicing existing debt also rises (think about if your credit card rate goes from 5% to 10%).

Quantitative easing involves injecting funds into the economy by purchasing securities from financial institutions, while quantitative tightening is the opposite. First, the Federal Reserve stops purchasing securities while allowing existing securities to mature, and eventually begins selling them on the open market. This ultimately leads to a reduction in funds in the economy. Due to simple supply and demand, a decrease in borrowed funds leads to rising interest rates.

As borrowing costs and the costs of servicing existing debt rise, everyone slows down the spending that initially led to inflation. With less money injected into the economy through asset purchases, the funds chasing inflated goods decrease, and theoretically, prices should normalize. The funds chasing investments also decrease, leading to a continuous decline in asset prices— in fact, the "old hands" in the investment market are very aware of this.

In the summer of 2021, U.S. inflation hovered around 5%, and at that time, the Federal Reserve claimed that this inflation was "transitory" or non-permanent.

On November 3, 2021, the Federal Reserve announced it would begin to slow the pace of asset purchases while remaining patient regarding any interest rate hikes as it continued to monitor inflation.

On November 10, 2021, the U.S. reported that the CPI for October reached 6.2%, making it clear that inflation was not under control, and the Federal Reserve would have to intervene. Although the first interest rate hike would not come until March 2022, the market, as a powerful information processing machine, seemed to react immediately, indicating that a change in the market was imminent.

Do not fight the Fed again, as BTC and ETH peaked on November 8, the Nasdaq peaked on November 19, and the S&P peaked at the end of December, with even some NFT floor prices and DeFi lock-up volumes hitting new highs—so what happens next, we should be quite clear.

In Summary

Essentially, in response to the COVID pandemic, interventions by central banks and governments helped maintain record low interest rates and printed vast amounts of money, along with numerous stimulus measures. These loose monetary policies ultimately helped push stocks and cryptocurrencies to historic highs, which then led to inflation.

As inflation persisted and it became evident that central banks would have to change direction and end the policies that pushed many assets to new heights, a macroeconomic recession began.

While it may seem that everything started in early 2020, the era of central bank loose monetary policy began after the 2008 financial crisis. Of course, 2008 was also a time that witnessed the birth of cryptocurrencies and the historic run of stocks.

Faced with inflation not seen in 40 years, central banks have signaled that the era of loose monetary policy is undoubtedly over. Previous frameworks for valuing companies and assets no longer apply to this shift, and all values have been "reassessed," which is the downturn we have experienced over the past six months.

As interest rates rise, bonds become a more attractive investment. Meanwhile, "growth" stocks, or companies expected to pay dividends many years into the future, are hit the hardest. As funds tighten, investors' preferences shift toward investments that can generate immediate cash flow, rather than focusing on the distant future.

Then, the technical sell-off came.

Cryptocurrency Sell-off

Some may think that cryptocurrencies should be an inflation hedge, right? Not necessarily.

If you bought Bitcoin in May 2020, your gains are still over 200%, far outpacing inflation. However, if you purchased Bitcoin after inflation began to rise, the situation may be entirely different.

Nevertheless, even with significant price drops, Bitcoin and ETH are still up 500% and 1,000% respectively compared to when the pandemic broke out. In contrast, long-tail assets have not performed well, and it is hard to deny that cryptocurrencies are becoming increasingly correlated with stocks—especially tech stocks.

Historically, tech stocks have been viewed as risk assets. Given the correlation, it is fair to say that most people still treat cryptocurrencies in a similar manner. Risk assets carry higher upside and downside risks, and when monetary tightening occurs, this is what happens when central banks tighten money; risk assets are usually the first to be sold off.

In summary, these are the main reasons for the recent downturn in the crypto market.

While cryptocurrency prices are also influenced by Federal Reserve policies, in the last market cycle, cryptocurrencies remained one of the best-performing asset classes. Loose monetary policies encourage speculation, and speculation has always accompanied paradigm-shifting technologies, such as personal computers, the internet, smartphones, and even railroads in the 1800s.

Bitcoin and its fixed supply of 21 million stand in stark contrast to the Federal Reserve's money printing machine. History tells us that massive inflation caused by poor economic management ultimately leads to failure for the Federal Reserve's money printing. In contrast, cryptocurrencies further validate that decentralized systems do not have unilateral control risks. While cryptocurrency prices will still be influenced by Federal Reserve policies in the short term, in the long run, cryptocurrencies and Web3 remain more attractive than ever.

Looking Ahead

If this is your first encounter with a cryptocurrency downturn, the current plummeting market may seem frightening.

In fact, cryptocurrencies have been declared "dead" in 2018, 2015, and 2013, but ultimately, after each setback, cryptocurrencies emerged stronger.

Just like the previous internet, regardless of market cycles, crypto innovation will continue to move forward.

From our perspective, cryptocurrencies are more important than ever.

• Bitcoin has been globally adopted, held by institutions, companies, nations, and millions of individuals.
• DeFi has laid the foundation for an internet-based financial system that no single party can control.
• The groundwork for Web3 and a user-owned internet has been established.
• NFTs have spawned a multi-billion dollar industry in art and gaming, with a variety of use cases emerging in the process.
• The assets managed by DAOs are nearing $10 billion, and this is just the beginning.
• Nine of the world's ten largest central banks are exploring digital currencies.
• Analysts at JPMorgan have referred to cryptocurrencies as "the preferred alternative asset class."
• Facebook has rebranded to Meta, while Twitter, Spotify, TikTok, and Instagram are integrating NFTs, and both Google and Microsoft are venturing into Web3.

Time will tell the answer.