Is Ethereum an Inflation Hedge?

Summary

Trading View (next 2-4 weeks): We like to be bearish ethereum.

Investment View (next 1-3 years): We like to hold ethereum.

Macro Signals

• Crypto’s correlation with tech stocks has broken down.
• Ethereum might not be the inflation hedge everyone thinks.
• The macro backdrop is bearish for ethereum.

On-Chain/Flow Signals

• We have four bearish signals and three neutral signals this week.

Overall View

• With the macro backdrop bearish and on-chain/flow metrics bearish, our overall signal is bearish ethereum (Chart 1).

Macro: Relationships Are Changing

Historically, ethereum and bitcoin have been highly correlated with equities. They follow the tech sector most closely. And over the past year, the relationship has only strengthened. Just a month ago, the returns of both BTC and ETH had an 88% correlation to the NASDAQ (Chart 2). You could see similarly high correlations with single-name tech stocks. Moreover, even the broader S&P500 had a correlation above 70%.

But the relationship between tech stocks and cryptocurrencies is being tested. Correlations with equities have reduced significantly following the TerraUSD/Luna collapse (see our latest update on stablecoins).

In comparison, the relationship with FX on average was roughly half as strong as the correlation between crypto and tech over the past five years. And it was a quarter as strong with rates. The past year has been no better. But in the past month, correlations with rates and FX have risen.

In particular, the correlation between ETH and the US 10-year has gone from negative to positive. And ethereum’s relationship with the China 10-year has more than trebled. Meanwhile, in FX, US dollar strength has seen ETH correlations with the EUR and GBP rise towards 40%. A continued rise in correlation may leave ETH vulnerable to any return in USD strength.

Meanwhile, ethereum and bitcoin have historically been touted as a hedge for inflation. When inflation expectations rise, you would want the relationship between the cryptocurrency and inflation expectations to be at least positive. This, historically, has held (Chart 2). However, since February, the relationship has broken down. Inflation expectations remained anchored while ETH prices have fallen. A more hawkish Federal Reserve could weigh on ETH going forward.

With historic correlations breaking down, the macro picture looks mixed. We think an aggressive Fed hiking cycle and rising recession risks will continue to weigh on crypto.

On-Chain/Flow Metrics: Miner Revenues Down

We have three neutral signals this week:

• Net inflows to exchanges in the short term but with large outflow spikes.
• Futures open interest is declining but funding rates are positive on average.
• Longer-term HODLer proportion has not materially changed.

And there are three bearish signals:

• Reduced profitability of the coin supply and realised losses on chain.
• Ethereum’s TVL in DeFi decreasing.
• Hash rate and miner revenues decline.

On balance, on-chain/flow metrics are giving a bearish signal for ethereum. Here are the details of each metric (with explanations in the Appendix).

Institutional Demand: Neutral Ethereum

Our preferred metric to track institutional demand is flows into ethereum ETFs. As prices have declined, ETF inflows have picked up with valuations becoming more attractive (Chart 4). However, outflows have continued to meet inflows. We need to see a sustained period of inflows or outflows to reconfirm a bullish or bearish signal. In the short term, this is neutral ethereum.

Demand for Liquidity and Exchange Activity: Neutral Ethereum

There has been a consistent bias for inflows to exchanges over the past seven days – net 84,000 coins entered exchanges. However, extending to the last 14 days reveals net 394,000 coins have exited exchanges. This is due to a very large outflow spike of 479,000 coins on 16 May (Chart 5).

Longer term, the 30-day change in the exchange balance reveals fluctuations in the supply held on exchanges month on month. Relative to the last 30 days, this metric is still in negative territory (Chart 6). But it has been increasing over the past few weeks.

Overall, we view these metrics as neutral for ethereum.

Futures Activity: Neutral Ethereum

Futures open interest is currently $5.9bn, down 3% over the past seven and 14 days, respectively (Chart 7). Around $4.5bn (76%) of this comes from perpetual futures contracts.

Perpetual funding rates reveal the directional bias of investors. On average, they have been trending up recently (Chart 8).

Overall, futures open interest is falling but funding rates are rising: this is neutral ethereum.

HODLers: Neutral Ethereum

The 30-day moving average of the coin days destroyed (CDD) metric has jumped. This suggests an increased distribution of older coins (Chart 9). Splitting HODLers into those who have held for under one year and those for one year or more reveals some older hands have sold as the 1y+ vintage decreases slightly (Chart 10). However, 60% of the coin supply has still not moved in at least one year. On balance, we view these HODLer metrics as neutral ethereum.

Investor Profit and Loss: Bearish Ethereum

The percentage of circulating supply in profit (PSIP) is 52% (Chart 11) – down 8pp over the past 14 days. Net unrealised profit/loss (NUPL) is 0.11 (11% of market cap) (Chart 12) – down 13pp over the past 14 days.

Realised losses prevail on chain. SOPR (price sold divided by price paid) has remained below one (net losses) since 16 May (Chart 16). Looking at the past 30 days, 27 days have seen net losses.

Overall, these realised and unrealised profit and loss metrics are bearish for ethereum.

Mining Activity: Bearish Ethereum

The hash rate remains near all-time highs, but it is down 1% over the past 14 days (Chart 14). Miner revenues have seen a more extreme move downward – they are currently down 17% over the past 14 days. Current miner revenues are at levels last seen during the May-July 2021 selloff.

Decreasing hash rate and lower miner revenues are bearish for ethereum.

DeFi: Bearish Ethereum

Our latest Crypto Index Tracker revealed our DeFi Index is down 8%. The total value locked (TVL) in DeFi across all protocols is currently around $110bn – down 4% over the past 14 days.

All chains in the top 5 by TVL are down in terms of their TVL on the week except for Tron (Charts 16 and 17). Ethereum TVL is down 3%.   On balance, we view this as bearish for ethereum.

Bottom Line

We have introduced a framework for understanding the flow and microstructure dynamics of ethereum markets. The seven key metrics are:

1. Institutional demand: returned ETF inflows with occasional outflow spikes. Neutral ethereum.
2. Liquidity demand: a large bias for inflows to exchanges. Bearish ethereum.
3. Futures activity: futures open interest and perpetual funding rates both in downtrends. Bearish ethereum.
4. HODLer behaviour: some older coin spending, but the overall proportion of the coin supply holding for a year or more continues to rise. Neutral ethereum.
5. P&L of investors: decreased profitability of the coin supply and large losses on-chain. Bearish ethereum.
6. Mining activity: the hash rate continues to rise, but miner revenues plummet. Neutral ethereum.
7. DeFi activity: TVL of ethereum is down 29% on the week. Bearish ethereum.

Appendix

Institutional Demand

Perhaps the largest institutional vehicle for ethereum is the Grayscale ETHE Trust, with over $27bn in assets. It invests solely in ETH, and so many investors, notably institutional, who cannot hold ETH directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to ETH prices, it may imply ‘excess’ demand from institutions, but ‘excess’ supply if it trades at a discount. Alternatively, the discount may suggest investors have found other ways to get exposure to ETH, whether through ETFs or directly holding ETH. We therefore focus on how the discount has changed in recent months to gauge investor interest. Alternatively, investors may be using other vehicles to get exposure such as ETFs or holding ETH directly. We put more weight on ETF flows than the Grayscale premium.

Liquidity Demand

Another measure of cryptocurrency bullishness is whether investors are willing to hold it in illiquid form (e.g., a private wallet) or prefer a liquid form (e.g., on an exchange). The former would suggest investors are bullish, as they are comfortable with being unable to sell easily. Conversely, holding it in liquid form would suggest investors are bearish, as they prefer being able to sell easily.

Therefore, large flows onto crypto exchanges would suggest investors want to convert their holdings to a more liquid form, implying more bearishness.

Futures Activity

We track the growing market of ethereum futures. Open interest – the sum of long and short contracts – is a good measure of investor interest.

Perpetual funding rates reveal the directional bias of investors. Exchanges set funding rates to prevent a lasting divergence in the price of the futures contract and the underlying since perpetual contracts have no expiry date so never settle in the traditional sense. Consequently, we can interpret funding rates as the cost of holding ethereum via perpetual futures. Positive funding rates imply longs pay shorts and vice versa. We use it as a proxy for trader sentiment since a positive funding rate implies traders are paying a premium to keep open long positions.

HODLers

In our introductory bitcoin flow framework, we explained ‘HODLers’ and ‘HODLing’. HODLing refers to buy-and-hold strategies in the context of bitcoin and other cryptocurrencies. Those who HODL for extended periods are die-hard adherents.

We can categorise HODLers by the length of time they have held ETH. We define long-term or staunch HODLers as those who bought ETH five or more years ago and have held it ever since, medium-term HODLers as those who bought 6-12 months ago, and short-term HODLers as those who bought 3-6 months ago.

The coin days destroyed (CDD) metric is defined as the number of coins in a transaction multiplied by the number of days since the coins were last spent. So, increasing CDD suggests older coins are being spent (more coin days are destroyed) and vice-versa.

Profit and Loss

• The percent supply in profit (PSIP). This tracks the share of circulating ETH supply in profit. That is the percentage of circulating ETH whose current price is higher than when it was last transacted (movement).

• Net unrealized profit and loss (NUPL). This is the ratio of unrealised profits over total market capitalisation. While PSIP just focuses on whether ETH coins are in profit or not, the NUPL focuses on the size of profits. So, we could have a situation where the PSIP is low – that is, a low share of supply is in profit – but the NUPL could be high if the size of those profits is large.

• Spent output profit ratio (SOPR). While PSIP and NUPL focus on unrealised profits or mark-to-market, this measure focuses on realised profits. SOPR is the realised value of a transaction divided by the value at initiation (or creation) – more simply, price sold divided by price paid. If SOPR is above one, investors in aggregate have realised profits, while below one means they have realised losses. In broad uptrends, SOPR spends a significant amount of time above one, whereas the opposite is true for broad downtrends.

When SOPR is rising, sellers are increasingly realising profits. The opposite is true when it is falling. A price rally with a flatter SOPR trend indicates investors are not yet realising their profits with the rally. The reluctance of investors to sell and realise a profit may be because they believe the price will increase further, which would be bullish. At the same time, more profit taking could precede a correction. Typically, buying as SOPR moves around one during bullish periods has proven to be a profitable strategy.

Mining Activity

Computing power is central to the crypto market. Miners use advanced computing hardware to solve complex problems that confirm ETH (and other coins) transactions on the public ledger or blockchain. The miners are rewarded with new coins for their efforts. A measure of the complexity of the problems and so the computing performance required to solve them is the hash rate. The higher this rate, the more computing performance is needed to maintain the blockchain. The rate can fluctuate depending on demand for crypto.

DeFi

We track the total value locked (TVL) in decentralized finance (DeFi) – the sum of all assets deposited in DeFi protocols, many of which use ethereum as the underlying protocol. The more DeFi products are created, the more ethereum gets locked into the DeFi system and removed from the broader market. This reduction in supply should lead to higher ethereum prices.

Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.