Bybit x Block Scholes: How to Sail Through the Rate Cuts Cycle and U.S. Election With Your Crypto Investments

Key Takeaways:

• Since the launch of BTC Spot ETFs in Jan 2024, Bitcoin’s correlation with risk-on equities, such as the S&P 500, has grown. We’ve seen BTC lead major market moves in risk appetite following significant macroeconomic events, indicative of institutions leading the charge.
• As the Federal Reserve prepares to lower its benchmark interest rate for the first time since 2020, historical precedent tells us that risk-on assets have outperformed their historical average return in non-recessionary cutting cycles.
• While increased market liquidity in 2020 set a favorable stage for risky assets (including BTC and other cryptocurrencies) to rally, previous cutting cycles indicate that more aggressive cutting cycles that are followed by a recession result in a poor performance of risky assets in the following year.
• Current market expectations narrowly predict the Fed will embark on its cutting cycle with a 50 bps cut, with the Fed more concerned about risks to the employment side of its dual mandate.
• Attention in the derivatives market is focused primarily on the U.S. election, with a strong volatility premium assigned to BTC options expiring in late 2024 and early 2025. This is justified by BTC’s previous response to twists in the election campaign.

‍

If BTC is a new macro asset, what kind of macro asset is it?

Digital Gold or Risk-On?

Cryptocurrencies — in particular, Bitcoin — are increasingly being coined as digital gold, a modern alternative to the precious metal's role as a safe-haven asset. With both being viewed as stores of value, Bitcoin has been promoted by some as the new way for investors to hedge against inflation and global economic uncertainty. With this logic, it would follow that gold and BTC would be highly correlated, and recently we’ve seen this emerging trend.
‍

The COVID Crash of Mar 2020 dramatically changed BTC’s relationship to macroeconomic assets. Prior to the pandemic, there was minimal correlation between BTC and gold (see Figure 1). However, post-pandemic a transient correlation emerged. This relationship has surged over the past year, with both commodities displaying a higher sensitivity to macro movements and, hence, showing similar price movements after these global changes in market sentiment.
‍

The correlation between BTC and U.S. equities is stronger, notably with the S&P 500, a risk-on asset. Similar to Bitcoin’s relationship with gold, this relationship first became strongly correlated in 2020, oscillated in the interim and has since grown stronger post–BTC Spot ETF launch. As can be seen in Figure 2, S&P 500 has demonstrated a positive correlation with BTC for most of this year (2024), led by an overriding macro sentiment sensitivity across both assets. Understanding this dynamic provides us with an indication of how BTC may move under different market conditions, particularly with the upcoming U.S. election and the Federal Reserve rate cuts, expected in 2024.

‍

Macro Drives Bitcoin, Bitcoin Leads Other Macro Assets

Crypto markets trade 24/7, and BTC can be seen to follow macro sentiment, which has resulted in BTC often leading major market moves outside of TradFi market hours. One notable example of this early price action was during the unwinding of the Japanese yen carry trade, an event we’ve covered previously here. With traditional markets closed over the weekend, BTC plummeted first, with the S&P 500 following suit as markets opened.

‍

Following the U.S. Employment Situation report on Sep 6, 2024, a macro data point, we noted a synchronized movement between BTC and the S&P 500. Markets had expected the U.S. economy to add 160,000 new jobs in Aug 2024. This figure came in below expectation, at 142,000, and we subsequently witnessed a BTC sell-off. When traditional markets opened an hour after the release, the S&P 500 mirrored the downward movement that BTC had begun.

‍

We find BTC's correlation with macro has solidified post the ETF launch in Jan 2024, indicating that traders have increasingly begun to see BTC as a risk-on asset. This correlation has resulted in BTC setting the pace for market reactions outside of market trading hours, and moving alongside US equities during them. As crypto is increasingly driven by broader market sentiment, understanding this sentiment is crucial in understanding how the next leg of this cycle could play out.

‍

 If BTC moves closer in tandem to risk-on assets, what will it mean when the Fed cuts interest rates?

Recession or no recession?

The trajectory of BTC at the end of a global hiking cycle has limited historical data, as it was too young as an asset in the 2008 Great Financial Crisis, and the unique case of the two-month recession during the COVID-19 pandemic stands as an outlier.

‍
Given BTC’s correlation with U.S. equities noted in Figures 1 and 2 above, we can use the S&P 500’s index performance in historical rate-cutting cycles as an indication of what to expect from the Sep 18, 2024 FOMC meeting and its aftermath. Our analysis is focused on the past seven rate-cutting cycles since 1989. We can identify three soft landings and four hard landings (shown by red and blue lines, respectively) — that is, when the Fed cut interest rates mid-recession, or just before a recession was officially announced, as compared to when the Fed had the space to carry out cycle adjustments and normalize policy at its own pace.

‍
We find that in the immediate aftermath of a rate cut, the market tends to react bearishly in the short term once a cutting cycle is confirmed — this is despite an interest cut increasing liquidity, which is generally positive for risky assets over the long term In two of the three recessionary cycles (except the outlying 2020 COVID cycle), the S&P 500 performed significantly worse in the 200-day period after the first rate cut.

‍

‍

In the soft-landing scenarios however, once the market has bottomed out, typically 20-40 days after the first cut, we see the S&P 500 go on to post significantly positive returns. This rally takes off in particular 100 days (or roughly three months) after the first rate cut.

‍

‍

The average return over the 200-day period following the first cut, in the recessionary cutting cycles (excluding COVID), is −10% compared to +15% in a non-recessionary cycle. This is significantly greater than the 5% return over the entire data period, showing that cutting cycles, whether recessionary or not, do indeed have a marked impact on the S&P 500, which has an overall upward trend.

‍
The market responds differently to rate cuts, depending upon the factors responsible for causing them. In non-recessionary cycles, rates are cut for normalization, or when inflation has sufficiently declined. Markets are less worried about a downturn in the economy, and the boosted confidence results in greater spending and investment. In a hard landing, the reduction is against the backdrop of a lack of confidence in the economy, so it doesn’t have the same effect. The market is more concerned about downside risks to growth, which mutes the bullish impact that easing liquidity is expected to bring.

‍
A proactive and stable rate-cutting cycle is the ideal macro environment for risk-on assets (and therefore, cryptocurrency), and explains the positive returns in soft landing cases. As the risk-free returns from interest rates get smaller, investors shift to risk-on assets in search of greater yield. In this case, we can expect the S&P 500 to follow the trajectory of the blue lines in the chart, and BTC and other crypto assets to enjoy a rally along with it.

‍

The COVID Exception

‍

The Mar 2020 COVID recession is a clear outlier in our data set. It’s the only recession that we’ve analyzed in which 200-day returns were positive (and even greater than in the non-recession cycles). However, there are several reasons why this case may not be appropriately indicative of the current cycle, as the recession was a result of an exogenous shock from a global pandemic, which we do not expect to see repeated.

While the Fed had begun its rate-cutting cycle in 2019, it had held rates after three consecutive cuts. The market had begun to price in further interest rate cuts from late Feb 2020 and the resulting recession was brought on by the shutdown of the economy in response to the COVID pandemic.

BTC was unable to rally, however, as prevailing economic conditions created a dash for cash. We therefore saw a big sell-off ahead of rate cuts, starting on Mar 15, 2020.

‍

The Fed ultimately went on to deliver a total of 150 bps worth of cuts, and injected a significant amount of liquidity into the financial system. This response began a major BTC and crypto rally extending toward the end of 2021, as seen in the chart above. Similarly, the chart below shows S&P 500 performance before and after the 2020 cutting cycle; this was strikingly similar, as both BTC and the S&P 500 index enjoyed the liquidity-boosted rally. The dip initially following rate cuts is more easily observed here, as is the significant rally upward, which lasted around 500 days.

‍

‍

If we were to see a repeat of this case, in which the Fed is forced into ballooning its balance sheet once again, then we would expect a similarly positive response from risky assets. However, the unique factors governing the pandemic event mean that the positive returns of risk-on assets are less likely to be re-created in future recessionary cutting cycles.

The Current Cycle vs. the Great Financial Crisis

The alternative recession scenario is one in which the Fed is forced into a more aggressive rate-cutting cycle over concerns that the economy and labor market have cooled more than expected. This is what we witnessed during the 2007 rate-cutting cycle, when the Fed began with a 50 bps cut in its September meeting.

In such a case, we would expect equities to see a similar initial sell-off as the rate cut takes place, and an additional decline in prices across risk-on assets from panic around a potential recession. Should this scenario unfold, we’d also likely see the S&P 500 return negatively over the long-run period of 200 days, and if BTC maintained its correlation, we’d expect it to follow.

‍

This scenario highlights the significance of the reasons for interest rate cuts on asset performance. When the market clearly loses faith in the likelihood of a soft landing, it doesn’t bode well for the price action of risk-on equities. This historical precedent means we’d expect that BTC and crypto wouldn’t be exempt from a similar reaction.

‍

As crypto (and BTC in particular) increasingly behaves as a risk-on asset, its response to how the Federal Reserve initiates its cutting cycle is expected to follow the S&P 500. Non-recessionary cycles have previously triggered an initial market decline before then the transmission of easier liquidity becomes a catalyst for spot prices. Conversely, recessionary cycles (excluding the COVID-19 case) which begin on the backdrop of broader vulnerabilities in the macroeconomy, experience prolonged downturns in risky-asset returns.

‍

The Data: Given the three possible scenarios, what are current market expectations?

What is the market currently pricing in for?

Positioning in interest rate markets holds a wealth of information for how traders expect the path of monetary policy to unfold — particularly in the shape of the yield curve. For two years, the yield curve has been inverted, which occurs when there’s been a tightening monetary policy as the Fed raises rates. Recently, we’ve witnessed a steepening of the yield curve, as measured by the spread between U.S. treasury yields at 2Y and 10Y tenors. Steepening occurs when the market expects an incoming easing cycle.

‍

The chart above shows that, in the past, the disinversion of the curve has preceded each of the last four recessions in the U.S. In multiple instances, we’ve seen the curve first disinvert before the Fed begins to cut rates, followed by a recession. If we examine the period between the time after the deepest level of inversion and the subsequent start date of the recession in the previous four recessions in the U.S., we see 460 days in the 1990 recession, 328 days in the dot-com bubble, 391 days in the GFC and 158 days in the case of COVID. This gives us an average recession start date of 334.25 days following the level of deepest inversion.

‍
This indicator recorded a disinversion in early Sep 2024 as the 10Y rate passed back above the 2Y rate. In this cycle, the deepest level of inversion recorded (so far) was on Jul 3, 2023 (443 days ago). If that was indeed the turning point, then positioning in bond markets shows increased pressure on the September FOMC meeting to help deliver a soft landing.

‍

Is the U.S. Presidential Election Driving Derivatives Markets?

Cryptocurrency has become a prominent issue in the 2024 electoral campaign, with the Republican party using it to tap into the Bitcoin user base for a wider reach of its party platform. With this increased institutional influence, the U.S. presidential election has become a focal point for cryptocurrency price movements. With the key event being Trump's appearance at the Nashville Bitcoin Conference, this election cycle marks a major turning point for the future of the crypto space to go mainstream by virtue of its entrance into politics.

‍

How does each party see the future of crypto?

‍

Although the Democratic party has previously attempted to tighten regulation in the crypto space, Harris herself has remained neutral on the topic and the 2024 Democratic party platform doesn’t contain any explicit mention of the topic. In contrast, the Republican party has a clear statement regarding its policy on crypto:

‍

“5. Champion Innovation
Republicans will pave the way for future Economic Greatness by leading the World in Emerging Industries.
‍

Crypto
Republicans will end Democrats’ unlawful and unAmerican Crypto crackdown and oppose the creation of a Central Bank Digital Currency. We will defend the right to mine Bitcoin, and ensure every American has the right to self-custody of their Digital Assets, and transact free from Government Surveillance and Control.”

‍

Trump has also delivered pro-cryptocurrency rhetoric throughout his campaign, vowing to hold all seized Bitcoin in the U.S. treasury reserve and fire Gary Gensler (the current SEC chair), alongside ensuring that America will play a crucial role in the future of crypto and Bitcoin mining if he is elected president. This embrace of crypto as a campaign issue was clearest when Trump spoke at the BTC Nashville conference.

‍
Although not directly written in the manifesto, the requirement for tighter rulings in the digital space is a rhetoric that has been repeated by the Republican party across its 2024 campaign. A clearer regulatory landscape isn't necessarily a bad thing, since it would follow that, with well-defined rulings, businesses and individuals alike would feel safer and more comfortable investing money and time into the digital asset space. Of course, the big deciding factor of whether the regulations will be a win for crypto investors, particularly in the U.S., is the scope of the regulations themselves.

‍

Has crypto responded to the election campaign so far?

‍

BTC’s increased sensitivity to macroeconomic events means that it has responded to developments in the run up to one of the most important events of the year — the U.S. presidential election. In addition, the fact that institutional investors are likely driving more of BTC’s price action, along with BTC’s emergence as a named issue in multiple candidates’ manifestos, has meant that twists and turns in the chances of either candidate have had an impact on crypto asset spot price action.
‍

This relationship wasn’t as clear in previous election cycles. Price movements near to significant twists in the 2020 campaign didn’t stand out from BTC’s own volatility.

‍

‍

In contrast, the 2024 campaign has already seen notable events move prices. For example, we observed a rally in BTC’s spot price soon after the attempted assassination of Trump proved positive for his election probability. The increase in Trump’s chances of winning the White House was confirmed by trading data on Polymarket, a decentralized prediction market. Similar to crypto markets, Polymarket trades 24/7 and, in particular, its Presidential Election Winner 2024 market has become a popular indicator of real-time sentiment changes, which is particularly relevant during periods of political uncertainty.

‍

­­

­­

‍

‍

This relationship is visible in the chart above, with BTC’s spot price rallying soon after Donald Trump’s implied probability rallied from 60% to above 70% on Jul 13. Also plotted is the date that Joe Biden dropped out of the race and endorsed the eventual Democratic candidate, Kamala Harris, on Jul 21. Notably, this didn’t result in any immediate reaction in BTC spot prices or Trump’s winning probability, as Harris’s chance of taking the nomination grew steadily over the following months.

‍

‍

These events indicate that, while responsive to the election cycle, there are many other factors (both macro- and crypto-specific) that affect BTC’s price action and must be considered. For example, BTC’s spot evolution in 2024 (shown in the chart above) shows that the unwinding of the yen carry trade caused a much steeper crash in spot. Clearly, political events aren’t the sole determinant of price action in crypto assets, but the impact of previous events indicates that the election will continue to drive the narrative in the future.

‍

How are markets positioned ahead of the November election?

Given BTC’s emergence as a policy issue and the previous response in spot price, option markets have begun to show signs of positioning around the Nov 5 election date. That can be seen in the term structure of at-the-money implied volatility, which shows market expectations for spot price volatility as a function of expiration.
‍

We’ve seen a clear kink develop in the term structure in the run up to the 2024 election, as markets price optionality at expirations after the election at a premium to those before it. The red dots in the chart below correspond to the at-the-money implied volatility level for the election date, and track the movement of the date across the term structure.

‍

The kink appears just after the actual election date, as the closest listed expiration is on November 8, an early introduction to the listing schedule by several exchanges to allow traders to take exposure covering the election. The current cycle’s positioning is a marked difference to the term structure curves observed in the run-up to the 2020 election, where no such behavior can be observed.

‍

‍

‍

While levels of implied volatility at longer-dated tenors have been lifted significantly above the front end of the term structure for several months, the dislocation grows clearest in the aftermath of the yen carry trade unwind crash in early Aug 2024, as short-tenor volatility falls significantly and the 90d and 180d constant tenors compress to the same level.

‍

‍

We also see a similar (if less drastic) dislocation between the skew of volatility smiles at tenors on either side of the election date. Options markets reflect a stronger focus on bullish upside exposure for expirations after the election, while short-term smiles indicate that a premium is assigned to the volatility of OTM puts.

‍

‍

We don’t see the same bullish positioning in the S&P 500 in reaction to the election, as shown by the term structures of the 25-delta put-call skew implied by the volatility surfaces of both assets below. Negative values indicate a higher relative pricing for downside protection in puts, while positive values indicate the same for upside exposure in calls.

‍

‍

‍

‍

Despite the correlation between their spot prices, options markets are pricing markedly different fortunes for U.S. equities and BTC over the next year. Where the SPX volatility surface is bearishly skewed toward puts at all tenors, BTC options markets assign a strong skew toward calls at expirations following the U.S. presidential election. Therefore, the market is pricing in the case where the wider equities market sells off, but crypto rallies following the conclusion of the election in early November.

‍
In previous election cycles we have observed a minimal relationship between the political landscape and BTC price. As a result, historical price action can not be used as an accurate indicator of future price performance. However, as the asset class has moved further mainstream, we see this politicization of the asset reflected in the 2024 derivative data.

‍
In particular, the kinks in the implied volatility term structure (reflecting the price premium associated with buying those specific options) indicate the market's expectation of major price movements immediately after the election. We find it particularly interesting that, although we have seen a clear price correlation between BTC and US equities (notably the S&P 500), the skew term structure (which shows how the market is positioning themselves post election) shows a conflicting picture - bullish on BTC and bearish on US equities. This is particularly odd given the strong (and increasing) correlation between the two asset classes.