Rotation from Gold to Bitcoin

Posted on December 8th, 2017

Bitcoin has exploded higher in recent weeks as futures trading draws near, slated for next week on the CME, and other mainstream financial products, like ETFs, are widely expected.  If it does grow in stature as a store of value, its fair value is conservatively $50,000 in our view.  It may not be a coincidence that as financial stress in China creeps up, and Trump throws Middle East peace under a bus, demand for bitcoin picks up.  There may even be evidence that investors are starting to rotate out of gold towards Bitcoin; a shift from the old world haven to the haven for the digital world.  The grumpy old men of finance are dismissing Bitcoin as a bubble.  It probably is, but one that is blowing up, and may do so much further.  The bearish consensus view for the USD is getting harder to square with its improved yield advantage and strong economic outlook.  Tighter USD short funding costs, position squaring and seasonal strength may propel the USD higher into year-end.  EM markets are tiring into year-end.


Higher dollar funding costs

The USD has broadly strengthened this week, in the wake of the tax bill passage through the Senate, despite the increased political uncertainty generated by the Flynn plea deal.

Political uncertainty in the USA remains high (Continuing Resolution/ Debt ceiling, Alabama election, Mueller investigation).  On the other hand, there is increasing confidence that a final tax reform bill will be passed as soon as before year-end.  Perhaps there is a degree of fatigue in the market in dealing with US political uncertainty, and the currency market has decided it matters less for now.

A factor that some have identified that may be supporting the USD is higher dollar funding costs for currency hedging that often occurs over the turn of the year. Cross-currency basis swap spreads have widened (become more negative) for other major currencies against the USD.  These add to the standard interest rate differential in determining FX forward contract points.

It is perhaps not a coincidence that the USD does exhibit some seasonality, tending to rise into the end of the year and fall in the new year.


EUR fatigue

Given the ongoing evidence of sustained and strong economic recovery in Europe and the political risk in the USD, it would not have been a surprise to see the EUR strength into year end.  However, it appears to have lost upward momentum and finding resistance near 1.20.  This may be a case of the market seeking to take profit and reduce risk into the year-end.

The CFTC data on speculative positioning in FX futures suggests that the market still has an extended net long EUR position. And FX options risk reversals are skewed to EUR calls, further suggesting that traders are long and bullish EUR.  As such, if there is a desire to square positions into year-end, driven in part by higher funding costs for long EUR/USD positions, then we could see further declines in EUR into year end.


Bearish dollar views despite higher US rates

There appears to be a significant number of analysts with bearish views on the USD next year, betting that strengthening global growth will continue to perpetuate stronger currencies against the USD.  Many analysts view the USD as expensive, and see its fall in 2017, despite higher US interest rates, as a sign of a longer-term topping pattern.

This may occur; we are not expressing a strong view on the USD one way or the other in 2018.  There are a number of significant two-way risks; both political and economic that make it hard to predict the USD performance next year.

Nevertheless, at this time, we note that US 2yr interest rates have persistently trended higher since September. And even though long-term US yields have been stable, they have risen relative to most other major countries’ bond yields that have fallen.  As such, the USD looks to be on the weak side relative to its improved yield advantage, and this too may play a part in a period of USD recovery;  this includes the EUR/USD.


Emerging market growth leads not so much

Part of this increasingly consensus bearish view for the USD and bullish view for everything else, especially many emerging markets, is built around the view that growth everywhere is rising and taking the lead from the US economy.

However, some of the recent evidence suggests that EM growth leadership is not exactly taking over.  The PMIs shows that developed markets are displaying significantly more optimism.


Emerging markets lose momentum

As we head into the end of the year, emerging market equities have lost upward momentum, correcting more significantly than developed market equities since late-November.

A good deal of this correction relates to Asian equities, which were the main driver of gains in EM since September.



Emerging market currencies lose momentum

Looking an EM currency performance we have set up some unweighted regional indices.  They show a mixed performance in EM currencies since September.  Europe, Mid East and Africa (EMEA) currencies have weakened significantly, recovering partially in November, but falling again so far in December.  Latin American currencies have also been weakening since September, now pressing lows since mid-year.

Asian currencies have been more consistently stronger, firming to new highs for the year in November, but stalling in recent weeks and down somewhat so far this week.  In light of the corrective action in EM equities, and stalling action in EM currencies, perhaps the USD can display a broad strengthening pattern into year end.

As discussed, US rates and yields have been rising since September,  US economic growth has retained a solid tone, and tax cuts raise the possibility that the US economy and asset markets remain strong, or even strengthen next year, notwithstanding political uncertainty.  Investors are likely to be more cautious heading into year-end, and may look to take some profit on long EM positions seeing recent stalling in EM currencies and corrective equity markets.


Uncertainty  in China as financial conditions tighten

The biggest EM market is China, and evidence suggests that China is posing a risk to the otherwise bullish sentiment for EM markets.

Chinese economic growth indicators have been mixed this year despite considerable fiscal and monetary support and strong global growth.  Arguably it points to vulnerability as  China faces up to dealing with excesses in its financial sector.

 Evidence of tightening credit conditions is apparent in higher corporate bond yields and higher NCD rates, used by small and medium-sized banks to fund investments in Wealth Management Products.

Financial markets in China tend to be highly managed by Chinese authorities. They are likely to step in with various measures to stabilize the recent selloff in equities and bonds.  Nevertheless, the recent weakness may reflect concerns that increasing efforts to control excesses in shadow-finance and excessive debt creation generate risks for the rosy outlook many investors have towards China and emerging market economies and financial markets.

A lot is going on in Bitcoin, but greater financial market uncertainty in China may account for some of the increased demand for Bitcoin.  Chinese investors have developed an affinity for bitcoin, using it in recent years as a vehicle to move capital offshore.



Rotation from gold to bitcoin

The bubble calls on bitcoin are coming thick and fast.  A lot of proud old men in neat suits are deriding the cryptocurrency and declaring its rise as irrational.  Bitcoin probably is a bubble; one that is blowing up and will continue to do so until the so-called experts get tired of calling it a bubble.

The talking heads are now either saying the CFTC should not go ahead with beginning its futures trading in the instrument (set for next week) or that when it does, bitcoin will fall abruptly because smart people are waiting to for the futures instrument to short bitcoin.

In the last month, the meteoric rise in bitcoin has probably been fueled by signs that it is moving into mainstream finance with futures trading imminent and ETF trading widely expected before long.  This interest has helped push up bitcoin as people are attracted by the prospect of quick gains, and want to get ahead of these new derivative instruments.

Perhaps bitcoin will fall when futures trading begins in a ‘buy the rumour sell the fact’ type reaction.  But this is likely only to be corrective and may be very short-lived, if it happens at all.

The main reason for the rapid rise is that stronger and broader interest is bumping up against limited supply.  Bitcoin has almost a fixed supply.  The reality is that if bitcoin becomes an accepted, liquid, highly effective store of wealth, its potential value is still significantly higher.  $50,000 per bitcoin is a conservative target for the cryptocurrency, in our view. (Bitcoin – bubble or growing pains?; 30 Nov –

As discussed above, another factor that may be spurring new heights in bitcoin is demand as a haven from Chinese financial assets.

Risks associated with Turkish and Venezuelan assets, and the backlash in the Middle East over the Trump administration’s declaration that it recognizes Jerusalem as the capital of Israel are reasons that investors might clammer for a safe haven.

It might seem to be drawing a long bow, linking bitcoin’s unconstrained rise to global geopolitical and macroeconomic events, but these events do underline why it has attracted interest.  You can’t trust governments to maintain stability in their currencies.

It doesn’t gel to see the rise in bitcoin as linked to haven demand when the price of gold is falling.  On the other hand, we may be witnessing the beginning of a rotation out of gold into bitcoin;  from the old world store of value to the new up and coming version.