Notes on the Recent Market Pullback

The crypto market sold off sharply over the past week, with the Bitwise 10 Index dropping over 20%. The move extends a general pullback that began in November, when both bitcoin and Ethereum hit all-time highs.

Given the uncertainty, we wanted to share our views on three important topics: 1) the macro drivers of the pullback; 2) the long-term fundamentals underpinning crypto; and 3) what we’re looking for in the coming weeks.

TL/DR: A common criticism of crypto historically is that sentiment, not fundamentals, has driven its success. Ironically, the reverse seems to be holding true today: Weak sentiment is driving the market lower, even as fundamentals remain strong. The market is likely to continue experiencing short-term volatility as it works through macro challenges, but our experience from past crypto pullbacks (along with the space’s strong fundamentals) leaves us optimistic about the long-term outlook.

The Macro Drivers of the Market Pullback

The largest driver of crypto’s pullback over the past three months has been a broad-based shift in capital-market sentiment from a risk-on orientation (favoring growth-oriented investments) to a risk-off orientation (favoring assets that prioritize capital protection, like bonds). This movement is being driven by an emerging consensus that the Federal Reserve will soon begin tightening monetary policy in an effort to battle inflation.

This sudden “risk-off” pivot has impacted many markets: The Nasdaq Composite Index is down more than 10% from its November 2021 peak, and many tech stocks are down 20% or more. In these types of market environments, it is normal to see crypto selling off; it typically functions as a “risk asset” during acute market pullbacks.

In fact, for those of us who have been in this market for a while, the recent sell-off is reminiscent of Q4 2018, the last time the market got uncomfortable with a more hawkish Fed. Then as now, the Fed’s stance sent risk assets tumbling across the board: The Nasdaq Composite fell 18% during the quarter, and the Dow and the S&P 500 had their worst December since the Great Depression. Bitcoin dropped 44% in that same quarter.

Q4 2018 is instructive because it reminds us of two things: 1) Crypto’s negative and high-beta reaction to a risk-off market shift is normal; and 2) as long as the fundamentals remain intact, this too shall pass. After all, crypto bottomed in Q4 2018 and proceeded to enter a multi-year bull market, running up more than 2,000%. (Of course, past performance is no guarantee of future results.)

It remains to be seen whether we are close to the end of this rotation or not. One important thing to keep in mind this time is that the Fed is working with a very short blanket, trying to rein in inflation while making sure that nothing dampens an economy still challenged by the pandemic.

Investors seem to be buying the Fed’s hawkish rhetoric for now—the market is pricing in four rate hikes this year, and some are calling for the central bank to be even more aggressive. But if that were to change, whether because of weak jobs data or lower-than-expected inflation, we could see a quick reversal. 

The Long-Term Fundamentals Are Strong

One reason long-term investors may be bullish on crypto is that, sentiment aside, the fundamentals of crypto are robust.

Consider, for instance, that in the last year we saw:

• Record Venture Capital Investment: Venture capital investors poured over $30 billion into crypto startups in 2021, more than all previous years combined.

• Record Developer Activity: The number of developers working in the crypto ecosystem rose 75% in 2021 above year-ago levels, to a new all-time high.

• Record User Activity: The number of people using actual crypto applications (rather than just speculating on crypto assets) soared last year. As one example, monthly active users of MetaMask—a wallet that lets you log into crypto applications to buy NFTs, participate in DeFi, and access other applications—rose more than 20x in 2021, from 1 million to 21 million.

• Record Institutional Adoption: Crypto crossed the mainstream divide in a major way in 2021: According to a new study, a majority of the world’s largest banks—55 of the top 100 by assets under management—are now invested in crypto and/or blockchain projects.

• Record Public Markets Activity: Public markets opened up to crypto in a major way in 2021, headlined by Coinbase’s debut at an $80+ billion valuation (the largest debut in the public markets last year in any industry).

• Record Addressable Markets: Before 2021, crypto was mostly about bitcoin and digital gold (at least for mainstream investors). In the past year, however, it has added massive new markets: decentralized finance, NFTs, DAOs, the Metaverse, Web3, and more.

What to Monitor Going Forward?

Looking ahead, we’ll be monitoring multiple factors as we consider the short-term outlook for crypto prices.

On a macro level, any changes in the market’s expectations around rate hikes will clearly impact sentiment. As the Fed meets in the coming days, the market will likely obsess over any small detail that could be interpreted as a window into the Fed’s latest thinking. We consider any sharp turns from here unlikely.

On a crypto-specific level, we’ll be monitoring overall flow data for signs that selling force is exhausted. One key indicator is funding rates for crypto derivatives, where negative funding rates are often a sign of peak negative sentiment.

The biggest thing to watch news-wise, however, may be the February release of the Biden administration’s executive order on crypto. The market currently expects a fairly bearish directive, with a large focus on systemic risks, investor challenges, and issues around criminal activity. Any sign that these concerns are balanced by the positive impacts that crypto can provide—whether technological innovation, economic competitiveness, or more efficient access to capital—would be welcomed by the market.

Fundamentals often don’t matter in the short term, but they usually dominate in the long run. While there is likely continued volatility ahead, the secular and fundamental tailwinds powering crypto are likely too strong to hold down the asset class over the long term. 

We believe that, as it has so many times in the past, the market will find its bottom and continue to build.