Bonds, bears, and bubbles

This time we take a closer look at the bond market, which doesn’t normally get much airtime in the crypto space but is critical to understand. We’ll outline what it is, why it’s doing what it’s doing, and how the debt market’s dynamics could have a large impact on the direction of crypto as we venture deeper into the bear market.

What's in the news?

The bond market has rarely been out of the news in the past few months. In many ways, this is understandable since central bank interest hikes have been a driving force behind the current macro madness that has hammered global markets.

Of course, the hawkish policies, a rampaging dollar, and a falling stock market have all continued to pressure crypto markets, and understanding where the bond market fits into this picture can also help us get a better understanding of where we are right now.

But before at looking at how bonds interact with crypto, it’s worth recapping what this little-understood market is and why we need to pay attention to its signals in this time of economic chaos.

What bonds are and what they tell us about markets

Bonds are a type of security that represent a borrower’s promise to pay back the lender’s principal plus interest. They are issued by governments and businesses when they want to raise money.

Also known as fixed-income, bonds offer a regular interest payment to holders, known as the coupon. These characteristics along with their relatively low volatility are why they’re seen as safer investments and have historically been used to manage risk in TradFi 60/40 stock-bond portfolios.

It is a little-known fact that the global bond market is over twice the size of the global stock market and over one hundred times the size of the total crypto market cap. It is also commonly known as the “smartest” capital market due to its predictive power for output growth, inflation, and interest rates – all of which are critical variables to evaluate the performance of the economy and assets.

Understanding the relationship between prices bond prices, rates, and yields

The relationship between prices and yield is one of the more perplexing aspects of bond investing but very important to understand.

A bond’s yield is the return you will receive if you hold it to maturity. So, a bond with a 5% yield, will pay a 5% return each year until the bond matures. But bonds are a market and many investors instead trade them for a profit instead of holding them to maturity. Here it helps to look at an example.

If a government issues a $100 bond with a 5% yield, there will be investors buying those bonds to benefit from what looks like an attractive yield. But if that same government plans to borrow more but interest rates have risen over the past month, they will issue $100 bonds now with a 6% yield.

To try and benefit from the new yield, the investor may decide to sell the old bond to buy the new one, but the problem is that nobody wants to pay $100 for 5% when you can now get 6% for the same price, so you’d have to discount it to a lower price that will yield about 6%, just to make it worthwhile to other buyers. This is the principal reason why bond prices decline as yields rise and vice versa.

How the current macro picture is impacting bonds

In addition to interest rates, factors such as inflation and the financial health of the issuer also impact bond prices, and the current global macro and geopolitical instability continues to have a big impact on bond market dynamics.

For example, generationally high inflation means that purchasing power of the coupon rapidly diminishes over time as the prices of necessities rise. As a result, bond prices decline when inflation is high (due to the erosion of the yield) and rise when inflation is low. And with global central banks trying to stem inflation by cranking up interest rates at a time when liquidly is coming out of the system post-covid, it has been a perfect storm for bonds which have failed to provide cover from a tanking stock market amid a surging US dollar.

A great indicator of the bond market’s ability to predict economic health is the yield curve – a chart showing yields of short-term vs. long-term treasuries. An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. It often signals a lead-up to a recession or economic slowdown. A positive slope indicates that the bond market anticipates strong economic growth. A negative slope indicates that the bond market anticipates weaker economic performance.

In the chart above we can see that the US treasury yield curve is currently at its most inverted level in 40 years. This is sounding the recession alarm which is what Jerome Powell and other central bankers are trying to fight through increasingly hawkish monetary policy.

How the bond market is impacting crypto

In the case of bitcoin, it is currently showing an almost perfect negative correlation to the 10-year treasury bond real yield, something that has not been the case historically and this suggests further downside if rates continue to trend up. At the same time bitcoin’s correlation with the S&P 500 running as high as 0.7 means that further downside in equities coupled with a strong dollar will likely result in bitcoin could add to pressure from the bond market to send bitcoin down below 17K for the first time since November 2020.

The bottom line: for stocks, crypto and other risk-on assets, the path of least resistance may remain to the downside particularly as it becomes evident that rate hikes executed so far have not had the desired effect on inflation central bankers had hoped for, and the bond market will be the one to watch for a break of this trend.