Two Indicators That the Bull Market Might Be Back
What Caused the Market Rally?
We believe there are two main reasons for the small bull market that began in early 2023.
- Externally: an easing of liquidity in global financial markets; the slowdown of U.S. inflation makes the market believe the Fed will soon pause its rate hikes cycle.
- Inside the crypto market: the market has more or less deleveraged after the bloody bear market in 2022. With no new black swan events, capitals that remain in the market have gradually started to build positions of high-quality assets.
Easing of Global Liquidity
Although the performance of crypto assets may be decoupled from the performance of traditional investment products in the future, crypto markets, for now, are still closely correlated with the performance of traditional financial markets. The past year has been the worst year in decades for traditional financial markets as stocks and bonds have fallen in tandem. The reason for this is mainly due to the Federal Reserve's drastic and rapid interest rate hikes to curb inflation in the US, which led to a rapid tightening of global financial liquidity.
U.S. inflation has slowed down since the second half of 2022, with U.S. inflation recorded at 6.5% year-over-year in December, representing the lowest number since December 2021. Markets generally expect a slowdown in Fed rate hikes. Financial market stress has eased, and liquidity has returned. The chart below shows an index measuring overall financial market stress, covering credit markets, equity markets, financial institution financing markets, safe-haven assets, and volatility, it shows the overall financial market stress is now at its most moderate level since early 2022.
The Crypto Market Has Deleveraged
The crypto market has seen a significant reduction in leverage after the bloodbath in 2022.
The two main sources of leverage in the crypto market are leveraged trading on exchanges and collateralized lending in the on-chain DeFi. Both leverage trading on exchanges and collateralized lending in DeFi are currently at their lowest levels in several years. The overall level of leverage in the market has declined significantly.
Open Interest is the total number of open derivative contracts held by investors and represents active positions. Open interest can help us understand the leverage level in exchanges. The current amount of open interest on exchanges is still down 30% compared to last November before the FTX bankruptcy and down over 60% compared to the 2021 bull market.
For on-chain collateralized lending, $ETH is the most important collateral in DeFi, and we can observe the on-chain leverage through the potential liquidation amount of $ETH as collateral in lending protocols. DeFillama's data shows that if the price of $ETH falls to $1,000, only $220 million worth of $ETH will be liquidated. This suggests that the leverage of on-chain lending is very low and that borrowers are keeping their borrowing amounts at very safe levels. With such low leverage, the probability of a large liquidation is almost negligible.
With liquidity easing and deleveraging within the crypto market, we believe that the market has indeed bottomed out in the end of 2022. However, during this strong rally, capitals were still in a wait-and-see mode for non-mainstream coins, fearing whether there would be new bursts of blackswan events, resulting in bitcoin becoming the first choice for funds to return to the market.
This led to a distinctive feature of this market rally, $BTC leading the way. Bitcoin's market share rose to a nearly 6-month high (the rapid jump in $BTC's market share between May and June 2022 was due to risk aversion and capital outflows from small and mid-cap).
On-Chain Activity Is Picking up, but There Are Concerns
The price rebound is just one aspect. The industry's goal is to create a blockchain-based economy where active economic activity happening on chain, this is the fundamental of crypto asset prices. In the real world, we measure economic development in terms of GDP, while the on-chain world does not yet have a measure of overall economic activity. Ethereum's gas cost can be used as a reference indicator in the short term, with active on-chain economic activity leading to higher gas costs. (We would like to emphasize that gas cost is only suitable for short-term observation, with the technical development of Ethereum and the popularity of Layer 2, the gas cost will be getting increasingly lower, making it not an ideal indicator for on-chain economic activity in the long run)
Excluding the spike in gas costs in last November due to the panic over the FTX event, the gas cost is currently at 26 gwei, at a six-month high. On-chain activity is clearly picking up, and $ETH is back to deflation.
Both prices and on-chain activity are up, but we still don't think the market has fully recovered. The biggest concern in the market right now is that stablecoin is still flowing out.
Net inflows of stablecoin are the source of liquidity in the crypto market, and funds entering the crypto market from outside the crypto market will first convert their funds into USD stablecoin. The net inflow of USD stablecoins represents external funds entering the crypto market, while the net outflow represents funds leaving.
There have been two significant waves of outflows of stablecoins over the past year. The first wave of outflows occurred between May and July 2022, caused by the bankruptcy of Terra and 3AC, and the second wave began in October, before the collapse of FTX and continues to today. During the quiet period between the two severe market panics in August and September, stablecoin outflows were significantly mitigated and even saw some inflows.
We expect that with this round of market recovery, stablecoin outflows will gradually ease and change from net outflows to net inflows.
The Most Important Question is, Will the Market Continue to Go up?
Will the bull market return, investors are only concerned about this single question.
What does a real bull market look like? To use a phrase from the traditional investment world: large-cap stocks set the stage while small-cap stocks sing.
In a bull market, tokens of all kinds of small and medium-sized projects are driven by capital and will rise several times, tens of times, while bitcoin has very limited room to rise due to its huge market cap. While the small and medium-sized tokens go up several times or tens of times, bitcoin maybe double its price or less than double, so the ratio of bitcoin's market cap to the overall crypto asset market cap drops. At the same time, the hot market full of money-making opportunities attracted a steady flow of new capital into the market, further pushing the market forward.
Therefore, we need to observe two indicators:
- a gradual change from net outflows to net inflows of stablecoins.
- the market share of bitcoin starts to slowly decline.
The ideal scenario would be for the market to stabilize after the strong rally, and gradually attract new capital to enter, with the new capital further driving small to medium size tokens to go higher, creating a new bull market. We are still in the first stage.
While I think the market is playing according to the most desirable scenario, I cannot predict that a bull market will definitely come. We have not yet reached the stage where we can just follow the wave, everyone can make easy money. What is needed at this stage is to observe the indicators, stay flexible and leave the market decisively if it does not play as expected.