As the Federal Reserve ramps up efforts to tame inflation, sending the dollar surging and bonds and stocks into a tailspin, concern is rising that the central bank’s campaign will have unintended and potentially dire consequences.
Markets entered a perilous new phase in the past week, one in which statistically unusual moves across asset classes are becoming commonplace. The stock selloff gets most of the headlines, but it is in the gyrations and interplay of the far bigger global markets for currencies and bonds where trouble is brewing, according to Wall Street veterans.
After being criticized for being slow to recognize inflation, the Fed has embarked on its most aggressive series of rate hikes since the 1980s. From near-zero in March, the Fed has pushed its benchmark rate to a target of at least 3%. At the same time, the plan to unwind its $8.8 trillion balance sheet in a process called “quantitative tightening,” or QT — selling securities the Fed has on its books — has removed the largest buyer of Treasuries and mortgage securities from the marketplace.
“The Fed is breaking things,” said Benjamin Dunn, formerly a chief risk officer at a hedge fund who now runs consultancy Alpha Theory Advisors. “There’s really nothing historical you can point to for what’s going on in markets today; we are seeing multiple standard deviation moves in things like the Swedish krona, in Treasuries, in oil, in silver, like every other day. These aren’t healthy moves.”
Dollar’s warning
For now, it is the once-in-a-generation rise in the dollar that has captivated market observers. Global investors are flocking to higher-yielding U.S. assets thanks to the Fed’s actions, and the dollar has gained in strength while rival currencies wilt, pushing the ICE Dollar Index to the best year since its inception in 1985.
“Such U.S. dollar strength has historically led to some kind of financial or economic crisis,” Morgan Stanley chief equity strategist Michael Wilson said Monday in a note. Past peaks in the dollar have coincided with the the Mexican debt crisis of the early 1990s, the U.S. tech stock bubble of the late 90s, the housing mania that preceded the 2008 financial crisis and the 2012 sovereign debt crisis, according to the investment bank.
The dollar is helping to destabilize overseas economies because it increases inflationary pressures outside the U.S., Barclays global head of FX and emerging markets strategy Themistoklis Fiotakis said Thursday in a note.
The “Fed is now in overdrive and this is supercharging the dollar in a way which, to us at least, was hard to envisage” earlier, he wrote. “Markets may be underestimating the inflationary effect of a rising dollar on the rest of the world.”
It is against that strong dollar backdrop that the Bank of England was forced to prop up the market for its sovereign debt on Wednesday. Investors had been dumping U.K. assets in force starting last week after the government unveiled plans to stimulate its economy, moves that run counter to fighting inflation.
The U.K. episode, which made the Bank of England the buyer of last resort for its own debt, could be just the first intervention a central bank is forced to take in coming months.
Repo fears
There are two broad categories of concern right now: Surging volatility in what are supposed to be the safest fixed income instruments in the world could disrupt the financial system’s plumbing, according to Mark Connors, the former Credit Suisse global head of risk advisory who joined Canadian digital assets firm 3iQ in May.
Since Treasuries are backed by the full faith and credit of the U.S. government and are used as collateral in overnight funding markets, their decline in price and resulting higher yields could gum up the smooth functioning of those markets, he said.
“The Fed may have to stabilize the price of Treasuries here; we’re getting close,” said Connors, a market participant for more than 30 years. “What’s happening may require them to step in and provide emergency funding.”
Doing so will likely force the Fed to put a halt to its quantitative tightening program ahead of schedule, just as the Bank of England did, according to Connors. While that would confuse the Fed’s messaging that it’s acting tough on inflation, the central bank will have no choice, he said.
`Expect a tsunami’
The second worry is that whipsawing markets will expose weak hands among asset managers, hedge funds or other players who may have been overleveraged or took unwise risks. While a blow-up could be contained, it’s possible that margin calls and forced liquidations could further roil markets.
“When you have the dollar spike, expect a tsunami,” Connors said. “Money floods one area and leaves other assets; there’s a knock-on effect there.”
The rising correlation among assets in recent weeks reminds Dunn, the consultant, of the period right before the 2008 financial crisis, when currency bets imploded, he said. Carry trades, which involve borrowing at low rates and reinvesting in higher-yielding instruments, often with the help of leverage, have a history of blow ups.
“The Fed and all the central bank actions are creating the backdrop for a pretty sizable carry unwind right now,” Dunn said.
The stronger dollar also has other impacts: It makes wide swaths of dollar-denominated bonds issued by non-U.S. players harder to repay, which could pressure emerging markets already struggling with inflation. And other nations could offload U.S. securities in a bid to defend their currencies, exacerbating moves in Treasuries.
So-called zombie companies that have managed to stay afloat because of the low interest rate environment of the past 15 years will likely face a “reckoning” of defaults as they struggle to tap more expensive debt, according to Deutsche Bank strategist Tim Wessel.
Wessel, a former New York Fed employee, said that he also believes it’s likely that the Fed will need to halt its QT program. That could happen if funding rates spike, but also if the banking industry’s reserves decline too much for the regulator’s comfort, he said.
Fear of the unknown
Still, just as no one anticipated that an obscure pension fund trade would ignite a cascade of selling that cratered British bonds, it is the unknowns that are most concerning, says Wessel. The Fed is “learning in real time” how markets will react as it attempts to rein in the support its given since the 2008 crisis, he said.
“The real worry is that you don’t know where to look for these risks,” only that they will come, Wessel said. “That’s one of the points of tightening financial conditions; it’s that people that got over-extended ultimately pay the price.”
Ironically, it is the reforms that came out of the last global crisis that have made markets more fragile. Trading across asset classes is thinner and easier to disrupt after U.S. regulators forced banks to pull back from proprietary trading activities, a dynamic that JPMorgan Chase CEO Jamie Dimon has repeatedly warned about.
Regulators did that because banks took on excessive risk before the 2008 crisis, assuming that ultimately they’d be bailed out. While the reforms pushed risk out of banks, which are far safer today, it has made central banks take on much more of the burden of keeping markets afloat.
With the possible exception of troubled European firms like Credit Suisse, investors and analysts said there is confidence that most banks will be able to withstand market turmoil ahead.
“The problem with all this is that it’s their own policies that created the fragility, their own policies that created the dislocations and now we’re relying on their policies to address the dislocations,” Peter Boockvar of Bleakley Financial Group said. “It’s all quite a messed-up world.”
The market is currently in a news-driven environment where the prices of cryptocurrencies have been determined by news agenda rather than fundamentals.
Bitfinex analysts have warned crypto investors to be cautious as bitcoin’s (BTC) recovery over the weekend is not a sign that its correction is over; the asset could witness more bloodshed in the near term.
In the latest Bitfinex Alpha report, experts deemed the market’s reaction this week critical, especially as supply alleviated over the weekend could return when traditional markets open.
“No Man’s Land”
Since Saturday, bitcoin has risen almost 10% from $57,600 to $63,000, closing last week in the green. The asset has surged above the 125-day range low of $60,200, which it broke through earlier this month after news of the German government’s massive BTC selling hit the market.
Market sentiment began to improve after reports that wallets linked to the German government were almost empty. However, the positive sentiment may not be sustained for long as the BTC the German authorities moved to trading desks and exchanges are yet to be sold.
While the supply from Germany appears to have been factored into bitcoin’s market price, Bitfinex analysts believe the end of selling pressure depends on how the involved trading desks execute their trades in the coming days.
Although the shift in sentiment underscores the market’s capacity to integrate new information and adjust expectations quickly, analysts think the market’s reaction over the first two trading days of the week cannot be overlooked for two reasons.
First, the low support level in the $60,200 range has now become a potential resistance line. Second, trading patterns over the past three months suggest that weekends are usually favorable for markets, especially on Saturdays when supply pressure seems to subside.
“We are now in no man’s land until we get clear resolution above or below this level,” the analysts said.
A News-Driven Environment
Besides the potential resistance level and three-month weekend trading pattern, the market is currently in a news-driven environment, where the prices of cryptocurrencies have been determined by news agendas rather than fundamentals.
Since selling pressure concerns are not yet completely obsolete due to upcoming Mt Gox creditor distributions, Bitfinex analysts expect such headlines to continue to have some impact on price movements. As such, the analysts urged investors to exercise caution in their trading strategies.
BlackRock’s IBIT led with $117.25 million in inflows on July 15, also being the most traded Bitcoin ETF.
The US spot Bitcoin ETFs recorded a daily net inflow of $301 million on July 15th. This extended their winning streak to seven consecutive days amidst a broader market recovery.
None of the ETFs recorded outflows for the day.
Bitcoin ETFs Rake in $16.11B in Net Inflows Since Jan
According to the data compiled by SoSoValue, BlackRock’s IBIT, the top spot Bitcoin ETF by net asset value, recorded the largest net inflows of the day at $117.25 million. IBIT was also the most actively traded Bitcoin ETF on Monday, with a volume of $1.24 billion. Ark Invest and 21Shares’ ARKB came in close behind with net inflows of $117.19 million.
Fidelity’s FBTC experienced net inflows of $36.15 million on Monday, while Bitwise’s BITB saw $15.24 million in inflows. VanEck’s HODL, Invesco and Galaxy Digital’s BTCO, and Franklin Templeton’s EZBC funds also recorded net inflows. Meanwhile, Grayscale’s GBTC and other ETFs, such as Valkyrie’s BRRR, WisdomTree’s BTCW, and Hashdex’s DEFI, registered no flows for the day.
A total of $2.26 billion was traded on Monday. The trading volume for these ETFs was less than in March when it exceeded $8 billion on some days. Meanwhile, these funds have collectively attracted $16.11 billion in net inflow since their January launch.
What’s Next For Bitcoin?
Earlier this month, bitcoin’s price decline was mainly due to fears of massive selling pressure from Mt. Gox and the German government’s BTC sales.
But the assassination attempt on pro-crypto former US President and presumptive Republican candidate Donald Trump at Saturday’s rally seemed to spark a recovery in the world’s largest digital asset, and experts are bullish on the asset’s price trajectory going forward. Bitcoin surged more than 9% over the past week and was currently trading slightly below $64,000.
Veteran trader Peter Brandt discussed bitcoin’s price outlook, suggesting a potential major rally. He referred to a pattern he terms “Hump->Slump->Bump->Dump->Pump” and highlighted that the July 5 double top attempt was a bear trap, confirmed by the July 13 close. He sees a likely continued upward trend but warned that a close below $56,000 would negate this bullish view.
“Bitcoin $BTC could be unfolding its often-repeated Hump…Slump…Bump…Dump…Pump chart construction. Jul 5 attempt at the double top was a bear trap, confirmed by Jul 13 close. Most likely scenario now is that bears are trapped. Close below $56k negates this interpretation”
PeckShield alert reveals LI.FI’s protocol vulnerability is similar to a March 2022 attack, with the same bug recurring.
The decentralized finance (DeFi) platform LI.FI protocol has suffered an exploit amounting to over $8 million.
Cyvers Alerts reported detecting suspicious transactions within the LI.FI cross-chain transaction aggregator.
LI.FI Issues Warning After $8 Million Exploit
LI.FI confirmed the breach in a statement on July 16 via X: “Please do not interact with any http://LI.FI powered applications for now! We’re investigating a potential exploit.” The team clarified that users who did not set infinite approval are not at risk, emphasizing that only those who manually set infinite approvals seem to be affected.
According to Cyvers Alerts, more than $8 million in user funds have been stolen, with the majority being stablecoins. According to on-chain data, the hacker’s wallet holds 1,715 Ether (ETH) valued at $5.8 million and USDC, USDT, and DAI stablecoins.
Cyvers Alerts advised users to revoke relevant authorizations immediately, noting that the attacker is actively converting USDC and USDT into ETH.
Crypto security firm Decurity provided insights into the exploit, stating that it involves the LI.FI bridge. “The root cause is a possibility of an arbitrary call with user-controlled data via depositToGasZipERC20() in GasZipFacet, which was deployed 5 days ago,” Decurity explained on X.
“In general, the risks behind routers, cross-chain swaps, etc. are about token approvals. Raw native assets like (unwrapped) ETH are safe from these kinds of hacks b/c they don’t have approvals as an option. Most users & wallets also no longer do “infinite approvals” which gives a smart contract total control on removing any amount of their tokens. It’s important to understand which tokens you’re approving to which contracts.
This dashboard looks for all transactions of a user that intersects Lifi. Not all of these transactions indicate risk- but you can see how, broadly, integrations & layers of tech (like how Metamask bridge uses Lifi on BSC) can complicate how users do or don’t put their assets at risk. Revoke Cash is the most well known approval manager app.
But it’s also good security practice to simply rotate your address. New addresses start with 0 approvals, so starting fresh by moving your tokens to a fresh address is another good security practice.” – commented Carlos Mercado, Data Scientist at Flipside Crypto.
Recent Exploit Mirrors March 2022 Attack
Further analysis by PeckShield alert revealed that the vulnerability is similar to a previous attack on LI.FI’s protocol that occurred on March 20, 2022. That incident saw a bad actor exploit LI.FI’s smart contract, specifically the swapping feature, before bridging.
The attacker manipulated the system to call token contracts directly within their contract’s context, making users who had given infinite approval vulnerable. This exploit resulted in the theft of approximately 205 ETH from 29 wallets, affecting tokens such as USDC, MATIC, RPL, GNO, USDT, MVI, AUDIO, AAVE, JRT, and DAI.
“The bug is basically the same. Are we learning anything from the past lesson(s)?” PeckShield Alert said in a July 16 X post.
Following the 2022 incident, LI.FI disabled all swap methods in its smart contract and worked on developing a fix to prevent future vulnerabilities. However, the recurrence of a similar exploit raises concerns about the platform’s security measures and whether adequate steps were taken to address the vulnerabilities identified in the previous breach.
LI.FI is a liquidity aggregation protocol that allows users to trade across various blockchains, venues, and bridges.
