Can Interest Rate-driven Crypto Selloffs Be Hedged?

It has been a very tough stretch for cryptos. In the past week (as of 2:50pm ET on 7-Jan-22),

  • Bitcoin – 11.4%
  • Ethereum -14%
  • Solana -19.1%
  • Avalanche -16.4%
  • Polygon -17.6%

And on and on. But cryptos have only mirrored some of the high-valuation, high-growth, momentum-oriented stocks. Week-to-date, some returns include:

  • iShares S&P 500 Growth ETF (IVW) -4.1%
  • ARK Innovation ETF (ARKK) -10.4%
  • Global X Cloud Momentum ETF (CLOU) -8.4%

But the reason is pretty simple. All of those – cryptos, momentum stocks, profitless tech – are just very much levered to rates. The Fed signaled this week that it was going to tighten policy faster than many expected, Treasury yields have spiked, and a lot of the high-fliers have been seriously wounded.

So what is a crypto investor to do

Most people buy cryptos because they think they’re going to go higher, not necessarily as a hedge to a portfolio or another asset class. In fact, one of the big selling points is that crypto is an uncorrelated asset class. But as I argued in December, the opposite is true – cryptos are just super high-beta assets. They just swing (quite widely) along with the markets over time.

But let’s pretend that crypto investors were interested in limiting risk. Without jumping into complex derivatives to limit up- and downside exposure, something like a pair trade between long crypto + short Treasuries would somewhat lock in the crypto-only exposure.

Does that work in practice though?

To preface: This is just a sample of one hedge, and over an unusual period for Bitcoin at that…

I looked at the price of Bitcoin and the price of the iShares 20+ Year Treasury ETF (TLT). If Bitcoin’s price rises, you gain. If long-duration Treasury yields rise (that is, Treasuries sell off), TLT loses. But if you’re short TLT and yields go up, you gain (there are other ETFs that are short Treasuries, but we’ll pretend we’re borrowing for free for this example). A long Bitcoin/short Treasury strategy should work because they should be natural hedges to each other.

If we look at a snapshot over the past week, the decline in Bitcoin’s price would have been offset somewhat by the short TLT position, as yields have jumped. Of course, I’d never expect TLT to fully offset Bitcoin’s ups and downs since cryptos are inherently much more volatile than Treasuries. But maybe it would help create a more stable portfolio.

Unfortunately, this one example didn’t work

From 6-Jan-20 to 5-Jan-21, $100 in Bitcoin alone would have ended up at $560. A $100 investment in TLT would have led to $106.50 over the same period – so a short TLT position would have netted you a $6.50 loss (we’re ignoring borrowing costs for simplicity).

Let’s say you invested in a 130/30 long Bitcoin/short TLT portfolio. That is, you borrow 30% of your position in TLT to roll into Bitcoin. That would have give you $697 at the end of the period. You’d also have increased your Sharpe Ratio – that is, your risk adjusted return – from 1.81 with Bitcoin alone to 1.82 for the long/short portfolio. However, you can’t get very much more levered without eating into your returns. In fact, a 110/10 portfolio would have give you a Sharpe Ratio of 1.81 – better than the 130/30 and about the maximum risk-adjusted return possible. A 200/100 portfolio would give you Sharpe Ratio of 1.15 – not great.

The problem is, you can’t really get the volatility of the mixed portfolio down by combining with a short TLT position. The Bitcoin portfolio had an annualized volatility of 0.75 (yikes!). The TLT was 0.182. The 130/30 portfolio is 0.90. That is – adding a short position did nothing to reduce your portfolio’s volatility. You have to have a portfolio that is long both Bitcoin and TLT to reduce your portfolio’s volatility – but even then, you’re going to give up some of your risk-adjusted reward.

This is probably all a function of a very unique period in Bitcoin’s history – and it may just work yet

If Bitcoin settles down and somehow becomes less volatile, the long/short strategy might just work to earn a significantly better risk-adjusted return. But Bitcoin futures are up only 5% over the past year to $41,665, and in that time there has been a closing high of $67,985 on 9-Nov and a closing low of $29,815 on 20-Jul.

However, since mid-2021, we’ve seen a broad decline in the volatility of Bitcoin – meaning it might just become tame enough to play some long/short positions against it.

Here’s a link to the spreadsheet if you want to play around with the numbers – you can change the weights of the portfolio by adjusting O14 on the calc tab (highlighted in yellow)


Why is 2021 ending with much love for web3, hate for Bitcoin?

As 2021 comes to a close, here’s no shortage of crypto annual recaps out there. This was the year of a new Bitcoin all-time high. Of Dogecoin. Of NFTs. Of Ken Griffin scooping up a copy of the Constitution over a DAO. Where you could ask somebody (under the age of, say, 40… or Ken Griffin) if they know what a DAO is and there’s a decent chance they can tell you.

But the vibe around Bitcoin as the year comes to an end just isn’t the same as it was in 2017. Or 2020. It’s… different.

The descendent Bitcoin

Let’s go back one year to December 2020, when the general sentiment around Bitcoin was through the roof. A garden variety of reasons tipped a lot of previously indifferent observers into something more akin to bulls (but not maximalists – that’s an entirely different breed altogether). Bloomberg’s Tracy Alloway captured the zeitgeist at the time very succinctly:

The list of Bitcoin’s purported uses goes on and on, and every time an obituary for Bitcoin is written, a new use case or bull argument steps in to to take its place. I used to think this was a weakness since Bitcoin could never be all these things at once. But the more I think about it, the more I realize that it’s actually a strength.

Myles Udland echoed this in his Substack “Bitcoin is a thing that exists

“No one cares if the network is good or the price is volatile. The strongest case for owning Bitcoin is that pretty much everyone has heard of it and has an opinion on whether you should own it.”

Everyone at the time had an opinion – and this year we continued to see a lot of capitulation among the skeptics, a ton of FOMO, and some new (maybe) uses (theories) for the broader crypto-sphere over the past 12 months. Just look at Solana and Avalanche – if you put $1 in either of those at the beginning of 2021, well, lunch is on you.

But sentiment around Bitcoin has plummeted in the past few weeks. After hitting an all-time high in November, pushing toward $70K, it’s since fallen into the mid-$40K range for several weeks.

The amazing thing was that it wasn’t really skepticism over how well Bitcoin is as a payment mechanism. Or how many HODLers are out there on Reddit touting Bitcoin. Or how many parents and grandparents are finally signing up for a Coinbase account and buying up a couple of bucks of Bitcoin at a time.

Bitcoin is basically just a momentum asset, just like cloud computing or payments stocks. Want to get a sense of how bullish investors are? Just look at the price of Bitcoin. Or Shopify. Or ServiceNow. Or ARKK. Or any of the numerous high valuation, growthy stocks and funds out there.

Bitcoin correlates with Nasdaq 100 futures more than bond-market inflation gauge

Even worse, just take a quick look through Crypto Twitter and it won’t take too long to find a mention of M2 or Jay Powell. The money printer go brrrr meme has been the lynchpin of a huge swathe of the Crypto universe for a long time.

The problem with this argument is that this was never true. Bitcoin’s price has never been driven by inflation expectations or money supply or any nefarious government plot to debase the dollar. Inflation is the highest it has been in decades (and is going to continue holding at elevated levels into 2022), and Bitcoin is off by a third from its all-time high just a couple of weeks ago.

(Not to mention M2 growth is way below its peak earlier this year and has settled only slightly above the levels of the previous couple of years – not surprising given nominal GDP grew by 17% in Q2 and by 10% in Q3. That was always a weird horse to hitch your argument)

Bitcoin and cryptos are first and foremost momentum assets. Second, they’re narrative assets – they require a vision of some grand future to get people to buy into the system now, so they can be at the vanguard of our new tokenized world

(For the record – I think there are a lot of interesting crypto projects out there, and while my own crypto holdings are very minimal, I will be happy to admit that I think there’s something there).

Which brings us to…

The ascendant web3

Call it what it is – web3 is a rebrand of crypto.

But that’s ok – it’s part of the narrative.

We’ve already pretty much stricken ICOs and ETOs from the crypto conversational dictionary. So this is just the next iteration.

And it seems to be working. Jack Dorsey pivoted the web 2.0 Square to the web3-focused Block. Lyft executive Brian Roberts pivoted from the web 2.0 ride sharing firm to the web3 NFT platform OpenSea. David Marcus let the face of web 2.0 – Facebook – to start his own web3 crypto project. Even Facebook’s own rebrand as Meta is an attempt to transition from web 2.0 to web3.

It’s going to take a while for web3 to move into the mainstream – if it ever does (or at the very least, it will certainly exist alongside web 2.0, if not remain a small fraction of the size of the old tech stalwarts).

But it’s a thing. People are leaving real jobs to be part of the web3 movement.

One of the best parts of my week is getting Packy McCormick’s Not Boring Substack. If you’re at all interested in finance, banking, payments, art, technology, social media, or really any part of the modern economy – there will be some web3 element trying to disrupt it. At the end of the day, they may only scrape off a few pennies from each of these massive segments of the economy – but that doesn’t mean they aren’t important or aren’t A Thing.

But 2022 will be even more interesting for crypto and web3 because…

The Fed said it will hike rated three times in 2022

The past 21 months have been incredible for risk assets. Since the pandemic, pretty much everything is up and to the right – small-cap stocks, large-cap stocks, big tech stocks, unprofitable tech stocks, bonds, junk-rated debt, crypto… Everything was a winner. Some more than others, but it’s been a good run.

And crypto is already feeling the wrath of a tightening Fed.

Growth stocks have been hit particularly hard in recent weeks, with companies like Facebook, Tesla, the whole cloud/momentum software universe, Cathie Wood’s ARK Innovation ETF all taking it on the chin as the threat of higher rates takes some of the air out of these previously high fliers.

And that’s the problem – Bitcoin (and certainly Solana and Avalanche) haven’t lived through a true cycle of tightening monetary policy (recall the Fed started and quickly stopped tightening in 2018 and 2019 – nothing close to a full tightening cycle). What’s the appeal to Bitcoin when you can start actually getting paid to hold cash and government debt? What happens to cryptos in a disinflationary cycle?

The narrative has to shift in 2022.

We’ve already seen it start in 2021 with the comeuppance of the term web3. The Fed policy backdrop might mean next year has be a show-me year. The narrative might no longer be enough by itself. Now, it’s how can consumers start using cryptos for real-life purposes? I look forward to hearing about how it goes (like Joe Weisenthal, on web 2.0 Twitter).