On-Chain Metrics Turn Bullish Ethereum

Summary

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

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

Macro Signals

• Markets are pricing in a 25bp rate hike at the 1 February FOMC meeting, but Dominique expects a 50bp hike as she believes Q4 GDP (to be released on 26 January) will be well above the Federal Reserve (Fed) estimate.
• The probability of a recession stays close to 90%.

On-Chain/Flow Signals

• We have four bullish signals and two neutral signals.

Overall View

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

Macro: Inflation Slows, ETH Rallies

Ethereum, and the broader crypto market, have enjoyed an impressive rally throughout the first half of January. Ethereum is trading at multi-week highs of around $1,550 – recouping most of the losses it experienced because of the FTX fallout. Stocks have enjoyed the uptrend, too. So, if you are wondering, ‘should I invest in ethereum?’, read on.

Several key macro data releases this year have bolstered crypto sentiment (and risk sentiment in general).

• Earlier this month, US Jobs data revealed wages grew slower than expected, despite non-farm payrolls coming in stronger than expected.
  
  
• The ISM Services PMI plummeted to 49.6%, indicating a contraction of the services industry for December 2022. This supported risk assets as the Fed’s inflation-fighting tactics seem to be affecting the economy.
  
  
• US CPI rose 6.5% YoY in December, in line with expectations but marking the smallest rise since October 2021.
  
  
• A weaker outlook for the US dollar as markets price in a less-hawkish Federal Reserve (Fed). Crypto is typically negatively correlated to the US Dollar Index (DXY), which has taken a beating recently.

A combination of the above appear to be driving a rally in crypto markets as hopes for a slower Federal Reserve rate hike at the 1 February FOMC meeting intensify. Indeed, markets are now pricing in a 25bp hike. Options data from Deribit confirms a concentrated amount of call option open interest at the $3,500 and $4,000 strikes (Chart 2), indicating some bullish sentiment among options traders.

Despite the less bearish macro backdrop forming around risk assets. One wildcard is risks to upside growth. The December FOMC meeting minutes recognised the risks to growth for the first time. Dominique believes the market is underestimating upside growth, inflation risk, and Fed tightening. She maintains that the Federal Reserve (Fed) will hike 50bps as she believes Q4 GDP (to be released on 26 January) will be well above the FOMC estimate of trend at 1.8%, raising concerns over risks of wages recovery. We wrote about a disconnect between the markets view on inflation/rate hikes and the Fed’s in our latest Crypto Index Tracker.

On-Chain/Flow Metrics: Long-Term HODLers Dominate

We have four bullish signals this week:

• Futures activity: open interest is rising and funding rates are positive.
• HODLer behaviour: the long-term HODLer vintage (1y+, 61%) shows no signs of abating yet.
• DeFi: total value locked in DeFi is up for ethereum.
• P&L: profitability of the coin supply jumps to 67%, the supply is in a state of unrealised profit again (NUPL > 0), and realised profits return on chain (SOPR > 1) dominate.

The remaining two signals are neutral:

• Institutional demand: ETF flows are relatively muted.
• Liquidity demand: inflows to exchanges have returned – normally bearish, but given the FTX implosion, inflows may suggest the damage done to investor confidence in centralised cryptocurrency exchanges could be starting to abate.

On balance, on-chain/flow metrics are giving a bullish 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. Outflows have dominated since November 2022. However, inflows returned recently, though small in magnitude (Chart 3). We will look for a more prolonged period of inflows to reconfirm a bullish signal from this metric. For now, this is neutral ethereum.

Demand for Liquidity and Exchange Activity: Neutral Ethereum

On exchange flows:

• Short term, a bias exists for inflows to exchanges. Net 151,000 coins entered exchanges over the past seven days (Chart 4).

• Longer term, the 30-day change in the exchange balance reveals fluctuations in the supply held on exchanges month on month. This metric remains in negative territory though it has increased significantly from its at multi-year lows set in December (Chart 5).

Usually, we would interpret exchange inflows as bearish for ethereum. But, in the context of the FTX fallout, which saw investors flee centralised exchanges, exchange inflows may signal some level of renewed confidence in centralised exchanges. For now, we view these metrics as neutral for ethereum.

Futures Activity: Bullish Ethereum

Futures open interest is currently around $4.8bn – up 19% month on month (Chart 6). Around $4.3bn (90%) of this comes from perpetual futures contracts.

Perpetual funding rates reveal the directional bias of investors. They have been positive on average (across all exchanges we track) since December 2022 (Chart 7). This means traders are paying a premium to keep open long positions. This is bullish ethereum.

Together, this is bullish ethereum.

HODLers: Bullish Ethereum

On HODLer metrics:

• The 30-day moving average of the coin days destroyed (CDD) metric is down 51% MoM (Chart 8), suggesting a substantial DROP in the movement of older coins recently.
  
  
• Splitting the entire coin supply into those who have held for under one year and those for one year or more reveals 61% of the coin supply has not moved in at least a year (Chart 9).

We view these HODLer metrics as bullish for ethereum because a significant portion of the supply continues to hold despite the hectic year crypto markets have navigated throughout 2022. However, should prices continue to rally, we could see some older hands step in to take profit.

Investor Profit and Loss: Bullish Ethereum

On profitability of the coin supply:

• The percentage of circulating supply in profit (PSIP) has shot up to 67% (+25pp MoM, Chart 10).

• Net unrealised profit/loss (NUPL) is now 0.11 (11% of market cap) (Chart 11). This means that the overall ethereum supply is in a state of unrealised profit  (NUPL > 0) once again as market cap exceeds realised cap.

• Spent output profit ratio (SOPR, price sold/price paid) has returned to levels above one (realised profits, Chart 12). Year to date, 54% of days have seen realised profits.

The profitability of the coin supply is rising, it is in an overall state of unrealised profit (NUPL > 0), and realised profits (SOPR > 1) return. This is bullish ethereum.

DeFi: Bullish Ethereum

The total value locked (TVL) in DeFi across all protocols has been in an uptrend as crypto markets rally. Arbitrum recently replaced Avalanche in the top five protocols by TVL. Of the top five, Ethereum and Tron are up the most (+14% each WoW, Charts 13 and 14). This is bullish 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.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)