Why Is Ethereum Rallying?

Summary

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

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

Macro Signals

• We do not believe the SVB collapse is likely to be systemic.
• Nonfarm payrolls (+311,000 against +205,000 expected, hawkish) surprised to the upside, but employment data also revealed higher participation and lower wage growth (dovish).
• Headline CPI for February (+6% YoY) was in line with expectations, but core CPI (+5.5% YoY) rose +50bps MoM compared to expectations of +40bps.
• The probability of a recession remains over 90%.

On-Chain/Flow Signals

• We have four bullish signals, one bearish, and one neutral.

Overall View

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

Macro: Is Ethereum Still Correlated to the Stock Market?

Ethereum rallies on SVB news. Crypto markets have surged following the FDIC’s announcement to back all deposits at Silicon Valley Bank. This move follows the Silvergate Capital collapse and has calmed fears of a potential bank run across the US. As a result, ethereum and the wider crypto market saw double-digit gains yesterday.

Where have the extra flows into ethereum and bitcoin come from? USDC, a stablecoin, experienced a significant drop in value to nearly 86 cents over the weekend, after it transpired that more than $3.3bn of its cash reserves were held by SVB.

Although USDC has since regained its peg, the recent rally in ethereum and bitcoin may suggest that investors are seeking refuge from the volatile stablecoins by investing in these established cryptocurrencies. The dynamic nature of the cryptocurrency market underscores the importance of vigilance and adaptability to succeed in this space.

Ethereum’s correlation to the stock market drops. The overall risk-averse attitude in the market last week impacted both cryptocurrency and traditional stock market indices. Despite this, Ethereum has seen a significant decrease in its correlation with the S&P 500 and the tech-heavy NASDAQ (Chart 2).

At the start of January, Ethereum’s correlation with the S&P 500 and the NASDAQ stood at around 65% each. Currently, its correlation with the S&P 500 has flipped to negative (-12%), and it is essentially uncorrelated (-1%) with the NASDAQ.

Macro Backdrop: Core CPI

We do not believe the SVB collapse will be systemic – it represents less than 1% of total US banking assets.

The labour market is still strong. Employment data for February came out on Friday with something for the hawks (311,00 headline against 205,000 expected) and the doves (higher participation and slower wage growth).

February CPI data released today came in at 6% YoY (+40bps MoM) in line with expectations. Core CPI, which strips out food and energy prices, came in at 5.5% YoY (+50bps MoM) which was above expectations of +40bps MoM. Markets appear to be pricing in an over 80% chance of a 25bps hike at FOMC meeting next week. Right now, crypto markets have reacted positively to the release and ethereum is up 10% over the past 24 hours.

Will the Fed hike next week? Dominque believes that today’s CPI release supports an end-2023 federal funds rate (FFR) of around 6%. She expects the Fed to raise the terminal FFR in SEP next week and even if the Fed pauses, it can make up for it by hiking more later, based on markets recovering.

On-Chain/Flow Metrics: Exchange Outflows Dominate

We have four bullish signals this week:

• Liquidity demand: exchange outflows dominate.
• P&L: the profitability of the coin supply is rising and realised profits dominate on chain (SOPR > 1).
• HODLer behaviour: over 62% of the coin supply has not moved in at least a year.
• DeFi: total value locked in DeFi for Ethereum is up the most.

We have one bearish signal:

• Institutional demand: ETF outflows continue.

The remaining signal is neutral:

• Futures activity: futures open interest is down MoM and funding rates are negative on average, but both look to have turned a corner yesterday.

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: Bearish Ethereum

ETF outflows resumed in January, but the trend was short lived as outflows have returned since the start of February (Chart 3). This is in line with our last report. We use ETF flows as a measure of institutional demand, so this is a bearish signal for ethereum.

Demand for Liquidity and Exchange Activity: Bullish Ethereum

On exchange flows:

• Short term, a bias exists for exchange outflows. Net 334,536 coins exited exchanges over the past week (Chart 4).

• Longer term, the 30-day change in the exchange flipped to negative on 10 February and it has remained in negative territory ever since (Chart 5).

Together, the bias for exchange outflows is bullish for ethereum.

Futures Activity: Neutral Ethereum

On futures markets:

• Futures open interest, a good proxy for investor interest, is currently around $4.4bn – down 10% MoM (Chart 6). Though they have started to tick up with the recent rally.

• Perpetual funding rates turned positive on Monday after the Biden administration guaranteed that customers of collapsed bank SVB will have access to all their money. However, on average (across all exchanges we track) they are still negative (traders paying a premium to keep open short positions, Chart 7).

That futures open interest is down MoM and funding rates are still negative on average is a bearish sign. However, both metrics look like they have begun to turn a corner in the context of the SVB bail-out. For now, we view this as neutral for ethereum.

HODLers: Bullish Ethereum

On HODLer metrics:

• The 30-day moving average of the coin days destroyed (CDD) metric is down 18% MoM (Chart 8), suggesting reduced movement of older coins.
  
  
• Splitting the entire coin supply into those who have held for under one year and those for one year or more reveals the latter vintage shows no signs of abating yet with 62% of the coin supply having not moved in at least a year (Chart 9).

Generally, there has been little movement of older coins this year. A significant portion of the ethereum coin supply continues to hold despite the macroeconomic and regulatory headwinds thrown its way. This is bullish for ethereum.

Investor Profit and Loss: Bullish Ethereum

On profitability of the coin supply:

• The percentage of circulating supply in profit (PSIP) is 73% (+10bps MoM, Chart 10).

• Net unrealised profit/loss (NUPL) is now 0.17 (17% of market cap, Chart 11). This means that the overall ethereum supply remains in a state of unrealised profit (NUPL > 0) as market cap exceeds realised cap.

• Spent output profit ratio (SOPR, price sold/price paid) has maintained a bias for levels above one (realised profits) this year (Chart 12). Year to date, 74% of days have seen realised profits.

The profitability of the coin supply is rising again, the supply is in an overall state of unrealised profit (NUPL > 0) and realised profits on-chain (SOPR > 1) dominate. Overall, this is bullish ethereum.

DeFi: Bullish Ethereum

Of the top five DeFi protocols by total value locked (TVL), Ethereum is the only chain to have registered an increase in its TVL (+1% WoW, Charts 13 and 14). All other chains in the top 5 by TVL are down in terms of their TVL between 2% and 14% each.

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 Head of Research at 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.)