The Weekly Fix: Rising Rates Are an Unexpected Crypto Sugar Rush

Welcome to the Weekly Fix, where expectations are anchored and coins are stable. I’m cross-asset reporter Katie Greifeld.

A Silver Lining

The Federal Reserve’s uber-aggressive rate-hiking cycle — which thoroughly extinguished the cryptocurrency market’s animal spirits last year — has created a windfall for one corner of the digital asset universe.

Crypto exchange COINBASE reported larger-than-expected losses, sinking trading volumes and tumbling revenue this week, with one notable bright spot: interest income. That measure soared 79% quarter on quarter, thanks to its revenue-sharing agreement with Circle Internet Financial Ltd., the issuer of dollar-pegged stablecoin USDC.

For the purposes of this fixed-income newsletter, what you need to know is that USDC maintains its peg to the dollar by holding its reserves in cash and short-duration Treasuries. With $42 billion of USDC in circulation, that’s boosted returns for Circle in a big way — and by extension, Coinbase. 

To be specific: interest income clocked in at $182 million in the fourth quarter, of which $146 million was derived from USDC alone. That compares to just $8 million overall in the final quarter of 2021.

Of course, higher rates are a fickle friend — Mizuho’s Dan Dolev likened the surge in interest income to “empty calories.” Coinbase’s 10-K filing shows that the company is keenly aware of that as well:

Further, because interest income, particularly from USDC, has become an increased portion of our subscription and services revenue, if interest rates were to significantly decline from levels reached in 2022, our net revenue could decline. Conversely, when interest rates increase, investors may choose to shift their asset allocations, which could negatively impact our stock price or the cryptoeconomy more generally. 

The last point is interesting, since that’s been the rallying cry of bond bulls — higher yields mean that fixed-income makes sense again, and as we’ve discussed, cash is super hot right now. Circle’s Chief Executive Officer Jeremy Allaire warned in November that funds were from stablecoins — the crypto market’s haven asset — into Treasuries, and there’s not much that the issuer can do to stop it. 

“This is just a macro phenomenon,” Allaire told Bloomberg News at the time. “That’s not in our control really.” 

Great Expectations

Two months into 2023 and 10-year Treasury yields are profoundly unchanged. After dropping 37 basis points in January, as of Thursday evening in New York benchmark yields have risen nearly 37 basis points so far in February. 

Deconstructing that stillness reveals a bond market that’s suddenly aflutter over inflation once again. So-called real rates, which strip out inflation and account for one half of nominal Treasury yields, have largely moved sideways over the past couple months. The other half — breakevens — are a different story.

Rates on 10-year breakevens, which reflect the market’s outlook for inflation over the next decade, have risen 15 basis points so far in February, on track for the biggest monthly climb since October. The near-term move is much more dramatic: two-year breakevens have soared about 69 basis points so far this month to above 3%, the highest since August. That implies bond traders are bracing for the possibility that inflation is still well above the Fed’s 2% target in two years time. 

It’s interesting that this episode of breakeven widening hasn’t been accompanied by rising oil prices, given that inflation expectations and energy prices tend to move together. As noted by Bespoke Investment Group, this is the 14th time in data going back to 1998 that 10-year breakevens have climbed 30 basis points from five-week lows while crude oil has dropped at least 4%.

Yes, those are incredibly specific parameters. But the takeaway is that breakevens have further to rise:

In all but two instances (October 1998, October 2012) the divergence led to both further breakeven widening and higher crude prices. In other words it’s reasonable to expect this move to wind up with even higher breakeven inflation pricing and further crude price gains.

The Fed’s downshift back to quarter-point rate hikes earlier this month heightens that possibility. Because the central bank faces “a very high bar” to reaccelerate pace of hikes, signs of inflation pressure “should be felt incrementally further out the curve,” Goldman Sachs strategists wrote last week.

Friday morning brings a big checkpoint in the form of January’s PCE deflator, the Fed’s preferred inflation gauge. The headline figure is expected to jump to 0.5% on a monthly basis from a prior reading of 0.1%, while the year on year reading is expected to stay flat at 5%. 

Cashing In

Treasury bills aren’t typically thought of as a route to riches, but lofty yields on cash are forcing a rethink.

Six-month Treasury bills currently yield about 5.05%, the highest since 2007. That’s just a few ticks below the S&P 500’s earnings yield of 5.2%. While not quite an apples-to-apples comparison, that’s the slimmest advantage for stocks since 2001.

If I can get reliable 5% payouts with virtually zero credit or duration risk, and without the overhang of a gloomy earnings backdrop, why bother with equities? It’s an admittedly oversimplified question, but one that money managers are increasingly asking. 

“We think we’re headed into economic deterioration and the current volatility in the market is enough for us to be very cautious in equities, and you’re getting paid in the meantime to wait with cash,” said Jerry Braakman, chief investment officer of First American Trust. “So we do think it’s an attractive space to be in fixed income versus equities at this point.”

Of course, there’s more nuance than that. Cash comes with a connotation of indecision, is often seen as a waystation between allocation decisions and carries an opportunity cost. The possibility of missing out on a double-digit surge in the S&P 500 is a painful thought. 

“Stock managers manage stocks, bond managers manage bonds,” said Zhiwei Ren, portfolio manager at Penn Mutual Asset Management. “For stock managers, the motivation is not to miss the rally, or underperform. That’s one big driver behind the strong rally we saw.”

Not to mention, cash comes with a unique risk at the moment as Congress hesitates on raising the debt ceiling. The Congressional Budget Office last week that the government could run out of cash as soon as July unless the limit is lifted.

Investors are seemingly sanguine about the situation — Thursday’s $36 billion auction of four-month bills was the first sale in nearly a month where bidders didn’t demand a concession.

Not Quite America First

Europe’s outperformance against US equities this year extends to the junk bond markets as well. 

European high-yield debt has gained about 3.6% this year, outpacing 2.2% returns for their US counterparts, Bloomberg index data show. While Fed officials have made clear that they intend to stay aggressive to combat sticky inflation, Europe’s economic outlook is improving as the region emerges from a less-severe-than-feared winter, averting an energy crisis.

“We recommend Europe over US high-yield,” Steve Caprio, head of European and US credit strategy at Deutsche Bank AG, told Bloomberg’s Lisa Lee. “European credit still trades cheap and eurozone confidence is improving as gas prices recede.”

Fund flows suggest that appetite for US junk bonds is quickly souring. As reported by Bloomberg’s Sam Potter, the $7.6 billion SPDR Bloomberg High Yield Bond ETF (ticker JNK) lost $1 billion this week in its biggest one-day withdrawal since 2020. Meanwhile, Refinitiv Lipper data show that US junk bond funds recorded a $6.12 billion outflow in the week ended Feb. 22, the third largest on record.

Bonus Points

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