Why bitcoin's decline may be signaling a warning for markets

Key Concepts

• Bitcoin-Equity Correlation: The historical positive correlation between Bitcoin and NASDAQ, and how divergence can signal market weakness.
• Moving Averages: Technical indicators used by traders, particularly trend followers, to identify potential shifts in asset prices.
• Liquidity: The availability of money in the financial system, measured here by bank reserves on the Fed's balance sheet.
• Treasury General Account (TGA): The U.S. Treasury's account at the Federal Reserve, which influences bank reserves.
• AI Narrative: The strong investor sentiment and investment driven by advancements and potential in Artificial Intelligence.
• Fed Cuts: Interest rate cuts by the Federal Reserve, which can influence market sentiment and liquidity.
• AI Bubble: The concern that the rapid growth and investment in AI may be unsustainable and resemble a speculative bubble.
• Credit as a Hedge: The idea that credit markets can act as a protective investment against equity market downturns, especially in the context of an AI bubble.

Bitcoin Weakness as a Warning Sign for Equities

The discussion begins by highlighting a recent note from City pointing to the weakness in Bitcoin as a potential warning sign for the broader equity market. Dirk Viller, Head of Macro Strategy and Asset Allocation at City, explains that this observation is based on a historical pattern of divergence between Bitcoin and the NASDAQ.

• Divergence: While the equity market was performing well, Bitcoin showed weakness, which is considered unusual given their typically positive correlation.
• Historical Reliability: Backtesting revealed that when Bitcoin trades below its 55-day moving average, the information ratio of the NASDAQ is significantly lower (0.5) compared to when Bitcoin is above it (1.5). This suggests that NASDAQ's performance is meaningfully better when Bitcoin is part of the bullish sentiment rather than diverging downwards.

Explanations for Bitcoin's Weakness

Several factors are identified as contributing to Bitcoin's recent decline:

• Flash Crash and Retail Shock: A 14% drop in Bitcoin over two days in early October, which disproportionately affected altcoins, led to a significant change in flows into Bitcoin ETFs. Retail investors appeared "shell-shocked," resulting in outflows.
• Institutional Trend Following: Many institutional investors use Bitcoin with a trend-following approach. Breaking key moving averages likely reduced demand from this segment.
• Tightening Liquidity: A decrease in bank reserves on the Fed's balance sheet, by over $500 billion, is a significant factor. This was driven by the Treasury increasing its Treasury General Account (TGA) at the Fed through the sale of T-bills.
  • TGA Increase Drivers:
    • Government Shutdown: Reduced government spending led to a mechanical increase in the TGA.
    • Increased T-bill Sales: The Treasury sold more T-bills than usual.

Improving Liquidity Outlook

Despite the recent tightening, the outlook for liquidity is expected to improve by year-end.

• TGA Stabilization/Decline: The TGA is anticipated to at least flatten out and likely decline.
• Increased Bank Reserves: This will lead to an improvement in bank reserves and overall liquidity between now and year-end, partly due to government spending reopening and the Treasury having already sold a substantial amount of T-bills.

Equity Market Resilience and the AI Narrative

The equity market has shown resilience despite tightening liquidity, largely attributed to the "AI story."

• AI Narrative as a Driver: The strong performance of the equity market has been fueled by the robust AI narrative.
• Sustainability of the Disconnect: The question arises whether this disconnect between Bitcoin's weakness and equity strength is sustainable. The hope is that Bitcoin will catch up with equities.

Structural Negative Stories for Equities

Two structural negative factors for the equity market are identified:

• Doubt on December Fed Cut: The possibility of the Fed not cutting interest rates in December, which was a key bullish expectation, could lead to a pullback in equities.
  • Fed's Usual Stance: Typically, the Fed leans against strong equity market moves, and a lack of a cut would remove a significant bullish catalyst.
  • City's Expectation: City's economists still expect a December cut, contingent on weak employment data for October and November.
• Weakening AI Narrative: While the AI narrative has been a strong driver, it has also faced questions, particularly concerning companies like OpenAI, leading to some pullback.
  • Nvidia Earnings: Nvidia's upcoming earnings report is seen as a potential catalyst to reset the AI narrative.

AI-Driven Debt Financing and Bubble Concerns

The trend of big tech companies issuing billions in bonds to finance AI initiatives is discussed.

• Historical Parallel: This is compared to the debt issuance during the dot-com bubble for internet build-out, which was not necessarily a sign of the bubble ending.
• Hyperscalers' Balance Sheets: Hyperscale companies generally have strong balance sheets and significant debt capacity.
• Concerns for Smaller Companies: More concern is raised for "neo clouds" and smaller companies outside the hyperscalers.
  • CDS Market Movements: Credit Default Swap (CDS) markets for some of these smaller companies have shown movement, which is considered a negative sign.
• Debt Capacity: Despite concerns, hyperscalers still have substantial debt capacity, and the question is which companies will need to finance it.

Investment Opportunities and Hedging Strategies

Looking ahead to year-end and 2026, the advice for clients is:

• Don't Give Up on Equities: It's considered too early to abandon equities entirely.
• Advise Hedges: Clients are advised to implement hedges due to the belief that the market is in an "AI bubble."
  • Explosive End of Bubbles: While a bubble, the final stages can be explosive, so remaining involved is recommended.
  • Increased Hedging: The necessity of increasing hedges in a bubble environment is emphasized.
• Credit as a Better Hedge: Credit is seen as a better hedge for the equity market than typically the case.
  • Financing Needs: The significant build-out in AI will require substantial financing on the debt side, suggesting that credit should underperform equities.

Conclusion

The core takeaway is that while Bitcoin's weakness has served as a warning sign for equities, an improving liquidity environment is anticipated by year-end. The equity market's strength is heavily reliant on the AI narrative, which, despite some recent headwinds, could be reignited by key earnings reports. However, concerns about an "AI bubble" persist, leading to a recommendation for increased hedging, with credit markets identified as a potentially effective hedge against equity market downturns.