It finally looks like the Federal Reserve's rate-hiking cycle has come to an end, as policymakers signaled that next year could see more rate cuts than previously expected. The Fed maintained its key policy rate at 5.25%-5.50%, but still kept the door open for additional firming. Fed officials now see three rate cuts in 2024 and four in 2025, but Chair Jerome Powell cautioned that the Fed is "just at the beginning" of discussing policy easing. Despite the message of caution, the Fed has clearly taken a dovish tone here. Meanwhile, the European Central Bank and Bank of England also maintained rates, but they pushed back against rate cut talk. This creates more questions than answers as to why the Fed decided to show its hand now.

The shifting rate outlook sparked a price rally in the bond market, sending yields lower. The yield of the 10-year U.S. Treasury bond fell below 4.00% on Thursday for the first time since late July. The 30-year Treasury yield also dropped, remaining slightly about the 4.00% threshold on Friday.

U.S. stocks ended the week largely higher even as some Federal Reserve speakers pushed back on euphoria around interest rate cuts following the central bank's dovish pivot last Wednesday. Equities also fluctuated amid some volatility on a day that marked a quarterly "triple witching" event. The tech-heavy Nasdaq advanced 0.35% to settle at 14,813.92 points. The SP500 and the blue-chip Dow Jones Industrial both swung between gains and losses, with the former eventually finishing little changed at 4,719 points and the latter climbing 0.16% to conclude at 37,309 points. Overall, stocks registered their seventh straight week of gains, which was the best winning streak for the SP500 since 2017 and the best streak for the Dow since 2019. For the week, the Dow Jones Industrial gained 2.9%, the SP500 was up 2.5%, and the Nasdaq rose 2.9%.

Structurally, the rally is clearly built on sand. It was a very negative gamma-induced rally that took the market initially higher, followed by systematic flows, which led to vol compression and volatility selling, being capped off by Opex. After this historically massive Opex (options expiration) we will find out how much of the rally is actually real and how much is just mechanics and FOMO.

The economic calendar is heavy next week as releases covering housing, manufacturing, and consumer sentiment pour in just ahead of the three-day weekend for the Christmas holiday. The key release will be the monthly update on core PCE. The Federal Reserve's favored inflation gauge is forecast to show a soft 0.2% month-over-month rise in November to take the year-over-year rate down to +3.4%. Crucially, that mark would also imply a six-month annualized inflation rate of just above 2.0%, which is the Fed's stated inflation target.

At the time of publication, federal funds futures trading implied a 95% probability that the Fed's target rate would be lower than the current level after the May FOMC meeting. Globally, the Bank of Japan meeting next week also has the potential for some dramatic news on the end of the negative interest rate era for the nation.

Bitcoin, and the cryptocurrency market in general, could not continue the rally experienced in previous weeks this week, and Bitcoin experienced a 4.26% decline in the last seven days. Although there are exceptions such as Avalanche and Solana, the effects of the decline in Bitcoin were also felt in the altcoin market.

Macro y news

This Week's Major U.S. Economic Reports:

The Fed's bizarre “Mission Accomplished” moment

The Fed held interest rates at 5.25-5.50% at the December 2023 meeting, as widely expected. However, the Fed signaled a significant 0.75% easing in 2024, almost matching an exuberantly dovish market expectation before the meeting. This was a major dovish turnaround for the Fed.

Just two weeks ago, Fed Chair Powell stated: "It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease." Thus, even the doves were expecting at least some pushback from the Fed against the aggressive easing expectations. So, what happened? Why the major dovish turnaround?

First, Powell gives a recession warning in his prepared statement:

“..Our actions have moved our policy rate well into restrictive territory, meaning that tight policy is putting downward pressure on economic activity and inflation, and the full effects of our tightening likely have not yet been felt..”.

In other words, the Fed feels it went too far "well into restrictive territory" with the interest rates, and the full effects of the recent monetary policy tightening are likely to be felt in 2024. This is a recession warning, but more importantly, the Fed is possibly panicking now and trying to reverse at least some of the tightening to prevent a recession, just before the ELECTIONS.

Powell's abrupt policy shift will (if sustained) help Yellen out significantly, returning the favor from her "issuance twist" liquidity assist. The government’s interest-rate bill is expected to rocket to at least $1.4 trillion next year. Already the drop in yields since Wednesday’s Fed announcement, if sustained, will help lower the Treasury’s interest-rate bill.

Unrealized losses at US Banks now represent just over 30% of their equity capital. The BTFP expires in March. This is another political motive for Powell's coup de rudder?

The Fed has been using the Summary of Economic Projections as the communication tool, this is where the FOMC signals the future path of monetary policy. So, the December dot plot puts the 2024 Federal Funds rate at 4.6%,  which is about 75 bps lower than 5.33% right now, and it's below the 5.1% level predicted in September. This is the signal that the Fed will cut in 2024.

Powell also specifically mentions that the FOMC was discussing the timing of the cuts at the December meeting, despite saying that it was premature just two weeks ago.

“..But of course, the other question (the question of when will it become appropriate to begin dialing back the amount of policy restraint in place) that begins to come into view, and is clearly a topic of discussion out in the world and also a discussion for us at our meeting today..”.

But when asked about those discussions, Powell revealed a bizarre process:

“..Everybody wrote down an SEP forecast. So many people mentioned what their (what their rate forecast was and there was no) there was no back and forth, no attempt to sort of reach agreement, like this is what I wrote down, this is what I think, that kind of thing, and preliminary kind of a discussion like that. Not everybody did that, but many people did. And then this will be a topic for us looking ahead. That’s really what happened in today’s meeting. I can’t do the headcount for you in real time, but that’s generally what happened today..”.

Just look at the range of forecasts, one FOMC member expects a 5.4% Federal Funds rate by the end of 2024, so no cuts. Somebody else expects a 3.9% Federal Funds rate in 2024 or 5-6 cuts. We assume both of these FOMC members looked at the same data, both are educated, and yet the range is very extreme.

That tells that these SEP projections are not credible. However, the fact is that the FOMC on average is very dovish,  they really want to ease and avoid a recession in 2024. The question is whether the inflation data will allow them to ease. The other question is whether it is too late to attempt to cancel the recession, given the lagged effects of prior tightening.

Mission accomplished? Here is what Powell said when asked how sticky is core inflation right now:

“..Well, that’s what we’re finding out. And we’ve, you know, we’ve seen real progress in core inflation. It has been sticky. And famously, the service sector is thought to be stickier. But we’ve actually seen reasonable progress in non-housing services, which was the area where you would expect to see less progress. We are seeing some progress there, though. And in fact, all three of the categories of core are now contributing (goods, housing services, non-housing services, they’re all contributing in different ways) at different levels, you know, meeting by meeting, or, rather, report by report. So, yeah..”.

Just to add context to this, core CPI just increased by 0.3% month over month, and stayed at 4% year over year in November. Both of these measures are double the Fed's target. Yes, Powell said that he's not going to wait for inflation to fall to 2% before starting to ease, as that would risk a recession. But, his statement above is likely his premature "mission accomplished" moment. This Fed meeting will surely be remembered for years to come as a truly historic mistake.

It didn't take long for the Fed (Friday) to release a slew of speakers to start the damage control from the FOMC press conference disaster on December 13th. Whether the damage has been contained is yet to be seen because the Fed has already made its biggest mistake, which was to show its cards too soon. But the Fed's mistake may come back to being a blessing in disguise, making one wonder if the Fed was using its "Fedi" mind tricks to get the market to do exactly what it wanted: drain excess liquidity once and for all.

While the nominal rate appears to price in more than three rate cuts, 80 bps, in 2024, the change in the real rates is less than two rate cuts, 40 bps, in 2024. So, while rates are going down in 2024 in both cases, the restriction in policy is only subtle. But of course, the market, as in the collective, not just the stock market, took this to mean that the Fed pivoted and was caving in. This led to Fed fund futures, pricing in a 10% chance of an actual rate cut by the January 2024 meeting and a nearly 70% chance of a cut by the March 2024 meeting as of Friday.

It is clear, though, that the Fed mind tricks have hit the market where it may matter most because if the Fed is going to start cutting rates, then the days of getting a 5.3% rate for doing nothing may be coming to an end, for those using the Fed's reverse repo facility over the past couple of years to get easy money for handing over their excess liquidity to the Fed. If the Fed cuts rates in 2024, then that means that the rate that the Fed pays at the reverse repo facility, which is currently at 5.3%, will be going down, too. It means that days of getting rates at 5.3% are nearing an end, and this is happening as rates across the yield curve are falling.

That is probably why the reverse repo facility has plunged since the Wednesday meeting. On December 13, the repo facility was around $825 billion; as of Friday, it was down to $683 billion, a fairly big drop in just two days.

While this may mean that the reserve balance climbs in the short term, once the repo facility is at its floor or completely drained, quantitative tightening will begin to have a meaningful impact, tightening financial conditions. One of the reasons why reserve balances have been increasing this year is that the repo facility has been dropping. This has offset a lot of the effects of quantitative tightening.

But with the repo facility at the lower bound, daily changes will be minimal as the Fed continues to shrink its balance, causing reserves balance to drop. As the reserve balance begins to drain and is no longer offset by fluctuations in the repo facility, a deleveraging process such as what was witnessed in much of 2022 will likely manifest itself again in 2024 until the Fed ends its QT process.

We will never know whether the Fed knowingly or accidentally accelerated the drainage of the reverse repo to the facility. But if the projections of the dot plot stand and the market fear rate cuts, the facility will drain quickly. While that may provide a short-term boost in liquidity, it won't last for long because as the Fed balance sheet shrinks over time, so will all of that excess liquidity.

U.S. Macro data

Tuesday’s report on consumer price inflation was roughly in line with estimates, with core (excluding food and energy) inflation staying steady at a year-over-year rate of 4.0%.

US CPI shot up to 9% due to a spike in money supply. Inflation is always a monetary phenomenon; CPI follows M2 with a lag. Given contraction in M2, US CPI will hit Fed's target in 2024. Unfortunately, contractions in the money supply always hurt the economy.

Wednesday’s producer price inflation report surprised modestly on the downside, with core inflation running at 2.0% for the year, a tick below expectations and its lowest level since January 2021.

Retail sales unexpectedly rose 0.3% in November, while October’s decline was revised lower, indicating a strong start to the holiday shopping season. Online sales and sales at restaurants and bars were particularly strong, indicating resilience in discretionary spending.

Other data released during the week indicated some surprising weakness in the manufacturing sector. US Manufacturing PMI confirmed contraction, only services survey Improved in December.

Bankruptcies soar as high rates and end of Covid aid hit businesses hard.

Eurozone macro data

The European Central Bank left its key deposit rate unchanged at a record high of 4.0% but cut its inflation and growth forecasts for 2023 and 2024. The bank called for inflation to slow to just below its 2% target by 2026, a move widely seen as paving the way for a reduction of interest rates. It expects the economy to grow 0.6% this year, a tick below the previous projections, and 0.8% in 2024, down from 1.0%. It also said it would phase out the reinvestment of maturing securities in its emergency pandemic program over the back half of 2024.

ECB's Lagarde: “ We did not discuss rate cuts at all” … but markets price in 5.3 cuts for 2024.

Business activity in the eurozone shrank in December, according to S&P Global. An early estimate of the Purchasing Managers’ Index (PMI) based on the combined output of the manufacturing and services sectors fell to 47.0 from 47.6 in November, a two-month low and a seventh consecutive month below 50, the level that indicates contraction.

Germany December manufacturing pmi 43.1; forecast 43.2Germany December services pmi falls to 48.4; forecast 49.8Germany December composite pmi falls to 46.7; forecast 48.2France December manufacturing pmi 42; forecast 43.3France December services pmi falls to 44.3; forecast 46France December composite pmi falls to 43.7; forecast 45

Germany continues on the path it started in 2018.

UK macro data

The Bank of England kept its benchmark interest rate at 5.25% for a third month running in November, as expected. However, policymakers reiterated their willingness to increase borrowing costs again if evidence of more persistent inflation were to emerge.

Official data showed that the UK economy shrank in October by 0.3% sequentially, after rising 0.2% in September. Relative to the three months to July, UK gross domestic product was flat in the three months to October.

Norway and Switzerland macro data

Norway’s central bank raised its key rate by 25 basis points to 4.5%, its 13th hike this cycle. It said rates would remain unchanged until the fall of next year, but given uncertainty about future economic developments, it did not rule out either another increase or a reduction earlier than currently envisaged.

Meanwhile, the Swiss National Bank kept its policy rate unchanged at 1.75% for a second month running, as was widely expected. It also reduced its forecasts for inflation to 1.9% in 2024 and to 1.6% in 2025.

Japan macro data

The yield on the 10-year Japanese government bond fell to 0.70%, from 0.77% at the end of the previous week, as speculation about the Bank of Japan (BoJ) ending its negative interest rate policy sooner than anticipated waned amid the focus on the Fed’s policy pivot. In this context, the yen strengthened to the JPY 141 level against the U.S. dollar, from the high range of JPY 144 the prior week. Much of this strength was due to expectations about narrowing U.S.-Japan interest rate differentials.

The Au Jibun Bank’s purchasing managers index of activity in Japan’s manufacturing sector dipped to 47.7 in December, the lowest since February and matching the level back in September 2020, when the economy was starting to emerge from the pandemic. The gauge has languished below the 50 mark that separates a contraction from an expansion for seven consecutive months. The reading for the service sector advanced to 52, helping to boost the composite index to 50.4.

The weak result in the factory sector isn’t good news for Japan, which saw its deepest contraction since the pandemic in the three months through September. Optimism regarding the year ahead weakened, as expectations for business activity reached the lowest level since March 2022, according to the PMI report.

The mixed data cloud the outlook ahead of the BOJ’s policy meeting that concludes on Dec. 19, as authorities wait to see if companies boost wages enough to enable a virtuous wage-price cycle. People familiar with the BOJ say authorities probably won’t change policy at the next meeting. About two-thirds of economists surveyed by Bloomberg earlier this month expect the bank to scrap its negative rate by the end of April.

Prime Minister Fumio Kishida has seen his popularity plummet and credibility dented amid news of a political funds scandal that has embroiled the ruling Liberal Democratic Party (LDP). Factions of the party have been accused of underreporting income from fundraising events, and four LDP cabinet ministers tendered their resignations during the week. Tokyo prosecutors have launched a corruption probe.

Speculation grows about earlier-than-expected monetary policy shift

Comments by BoJ officials during the last weeks were taken by some investors as suggesting that the central bank could be preparing for an earlier-than-expected shift in its ultra-accommodative monetary policy and that the removal of its negative interest rate policy could come soon after any potential lifting of the BoJ’s yield curve control policy.

One of the BoJ’s two deputy governors, Ryozo Himino, speaking hypothetically, said that Japan’s economy could benefit from an exit from ultra-loose monetary policy, as rising wages and prices would be favorable for households and firms. He nevertheless stressed that the BoJ should tread carefully.

Separately, BoJ Governor Kazuo Ueda stressed that the handling of monetary policy would get tougher in the new year, anticipating an even more challenging situation. He reiterated the importance of closely watching if a virtuous cycle of rising wages and prices becomes stronger.

BONUS: JPY dilemma, carry or carried out

The government of Japan is engaged in one massive $20 trillion carry trade. And while today everyone is talking about the BOJ hiking rates as soon as December in its attempts to normalize, it is impossible to understand the consequences of Japanese monetary policy normalization without analyzing what it means for this carry trade.

Here is the toxic dilemma faced by the Japanese central bank now that it has reached the end of the road: on one hand, if the Bank of Japan decides to tighten policy meaningfully, this trade will need to unwind. On the other, if the Bank of Japan drags its feet to keep the carry trade going, it will require higher and higher levels of financial repression but ultimately pose serious financial stability risks, including potentially a collapse in the yen.

Either option will have huge welfare and distributional consequences for the Japanese population: if the carry trade unwinds, wealthier and older households will pay the price of higher inflation via rising real rates; if the BoJ delays, younger and poorer households will pay the price via a decline in future real incomes.

The starting point are two excellent papers from the St Louis Fed and IMF, which consolidate the Japanese government’s balance sheet to include the central bank (BoJ), state-owned banks (namely, PostBank) and pension funds (namely, GPIF, the world's biggest pension fund). A consolidation of debt is crucial to understanding why Japan has not faced a debt crisis in recent decades given a public debt/GDP ratio of above 200% that continues to rise. It is also crucial to understanding what the impact of Bank of Japan tightening on the economy will be.

So what does the government’s consolidated balance sheet look like? Below we show the results from the St Louis Fed paper. On the liability side, the Japanese government is primarily funded in low yielding Japanese Government Bonds (JGBs) and even lower-cost bank reserves. Over the last ten years the BoJ has effectively swapped out half of the entire JGB stock with even cheaper cash which it created, now held by banks. On the asset side, the Japanese government mostly owns loans, for example via the Fiscal and Investment Loan Fund (FILF), and foreign assets, primarily via Japan’s largest pension fund (the GPIF). The Japanese government's net debt position of 120% of GDP when accounting for all of this is one reason why debt dynamics have not been as poor as what would seem at first sight.

A gross balance sheet value of around 500% GDP or $20 trillion, the Japanese government's balance sheet is, simply put, one giant carry trade. It goes at the crux of why it has been able to sustain ever-growing levels of nominal debt. The government is funding itself at very low real rates imposed by the BoJ on domestic depositors, while earning higher returns on foreign and domestic assets of much higher duration. As that return gap has been expanding, this has created extra fiscal space for the Japanese government. Crucially, one third of this funding is now effectively in overnight cash: if the central bank raises rates the government will have to start paying money to all the banks and the carry trade’s profitability will quickly start unwinding.

The first question that then arises is why hasn’t this carry trade blown up over the last few years given the huge sell-off in global fixed income? Everyone else has stopped out of carry trades, why hasn’t Japan?

The answer is simple: on the liability side the BoJ controls the government's cost of funding and this has been kept at zero (or indeed negative) despite rising inflation. On the asset side, the Japanese government has benefited from a massive depreciation in the yen which has raised the value of its foreign assets. Nowhere is this more evident than the GPIF, which has delivered cumulative returns in the last few years larger than the past two decades combined. The Japanese government has earned returns from both the FX and fixed income legs of the carry trade.

It is not only the Japanese government that has benefited, however. Falling real rates benefit every asset owner in Japan, predominantly older wealthy households. It is often claimed that an ageing population does well from low inflation. In fact, in Japan it is quite the opposite: older households have proven bigger beneficiaries of rising inflation via the de facto decrease in real rates and increase in value of the assets they own.

What will force this carry trade to unwind ?

The simple answer is sustained inflation. Consider what would happen if inflation required the Bank of Japan to hike rates: the liability side of the government balance sheet will take a huge hit via higher interest payments on bank reserves and a decline in the value of JGBs. The asset side will suffer via a rise in real rates and an appreciation of the yen that causes losses on net foreign assets and potentially domestic assets too. The wealthy, older households will take a similar hit too: their asset values will drop while the fiscal capacity of the government to fund pension entitlements will erode. On the flipside, the younger households will be better off. Not only would they earn more on their deposits, the real rate of return on their future stream of savings would rise too.

If Japan is indeed embarking on a new chapter of structurally higher inflation, however, the choices going forward are going to be far less easy. Adjusting to a higher inflation equilibrium will require rising real rates and greater fiscal consolidation, in turn more damaging to older and wealthier voters, unless the younger voters get taxed. While this adjustment can be delayed, it would be at the cost of even greater financial instability down the road, and a much weaker yen. The yen, in turn, can only embark on a sustained uptrend when the Japanese government, via BoJ rate hikes, is forced to unwind the world's last big surviving carry trade in the post-COVID world, one which has allowed Japan to enjoy a period of eerie social and political calm. Those days, however, are about to come to a thunderous end.

Japanese 10 year extending the move higher. The gap vs the US 10 year is getting very short term wide.

Summing up the widowmaker trade in a chart. Higher Japanese rates would change the global landscape, the BoJ has been providing liquidity to the global economy by buying bonds, which puts cash in the hands of Japanese investors who often invest it abroad. This flow of funds may eventually stop.

Borrowing in JPY and parking the money in the MXN has beaten the SPX big time over the past 2 years. There are a lot of implications on global risk from the latest developments in Japan. Making "easy money" just got harder.

Just a blip or something bigger in the making? Obviously the JPY action is spilling over to various currencies. Chart shows the DBCVIX (historical volatility index of the major G7 currencies) vs VIX.

China macro data

China’s consumer price index fell 0.5% in November from the prior-year period, accelerating from October’s 0.2% contraction and marking the steepest drop since November 2020 as lower pork prices weighed on food prices. Meanwhile, the producer price index dropped a bigger-than-expected 3% from a year ago, marking the 14th monthly decline. Deflation is concerning for China since economists worry it could unleash a downward spiral of economic activity.

Other November data continued to paint a mixed picture of China’s economy. Industrial production grew a better-than-expected 6.6% last month from a year earlier, while retail sales surged 10.1% but missed expectations. Fixed asset investment rose a weaker-than-forecast 2.9% in the first 11 months of the year as declines in infrastructure growth and real estate investment deepened. The urban unemployment rate remained steady from October at 5%.

China’s real estate market continues to languish, as newly started construction has crashed, now down 23.66% year-over-year.

Foreign direct investment in China also fell for the first time ever in 2023, a rather dramatic sign that confidence in the country’s markets and leadership has faded.

Chinese exports to the US are also down 20% from their peak, a side effect of the trade war that continues to stoke tensions between the countries.

In monetary policy news, the People’s Bank of China (PBOC) injected RMB 1,450 billion into the banking system via its medium-term lending facility compared with RMB 650 billion in maturing loans. The medium-term lending facility rate was left unchanged as expected. Liquidity injections are seen as a part of the central bank’s continuing efforts to counter economic headwinds. Analysts predict that the PBOC will step up policy support in 2024 as the government ramps up measures to boost China’s economy.

In policy news, senior officials drafted the agenda for China’s economy in 2024 during the Central Economic Work Conference, an annual meeting that sets economic policy for the coming year. Officials reportedly set out guidelines aimed at boosting domestic consumption and investment to drive growth as weak consumer confidence and a property sector downturn remain key risks for the economy.

Crypto News

=> Another week, another Crypto spot ETF meeting. The SEC engaged in a third meeting with BlackRock, discussing the proposed rule change for a spot Bitcoin exchange-traded fund (ETF). The regulator is intensifying discussions with major asset managers, including Grayscale, Franklin Templeton, and Fidelity, aiming to address concerns about market manipulation and investor protection.

The SEC plans to make decisions in early January on several spot Bitcoin ETF applications, potentially paving the way for cryptocurrency trading on Wall Street's major exchanges.

Latest ETF 19b-4 deadlines:

=> The Digital Asset Anti-Money Laundering Act, as proposed by Senator Elizabeth Warren, has gained new supporters in the form of five new senators.

=> The chairman of the CFTC has claimed that most cryptocurrencies are commodities and has admitted that a ‘turf war’ is going on with the SEC over who gets to regulate crypto.

=> In a statement, SEC Chair Gary Gensler said the securities agency denied Coinbase’s petition for new digital asset regulation, claiming that the existing rules are sufficient.

=> The United States National Vulnerability Database (NVD) flagged Bitcoin’s inscriptions as a cybersecurity risk on the 9th of December, pointing out the security flaw that allowed the development of the Ordinals Protocol in 2022.

=> The Ethereum community has adopted ERC-3643 as a standard for compliant tokenization of real-world assets (RWAs). This Ethereum Improvement Proposal (EIP) has been formally reviewed, discussed, and agreed upon. ERC-3643 focuses on securities tokenization, payment systems, and loyalty programs, verifying users' eligibility for tokens via a self-sovereign identity framework. It incorporates two permission layers for enhanced security and compliance.

Asset tokenization is expected to grow to a market worth $10 trillion by 2030, offering benefits such as increased liquidity and faster settlements. Notable companies exploring this technology include JPMorgan, Goldman Sachs, and Societe Generale.

=> Blockchain firm SafeMoon has filed for Chapter 7 bankruptcy after its founder and two executives were indicted on fraud charges. The trio allegedly used $200 million of clients’ funds for personal gain, leading to a significant impact on the price of the SFM token. The bankruptcy filing has left former employees unpaid and caused frustration among investors, with allegations of being scammed. The token's price has experienced significant fluctuations, and the company had previously suffered a net loss of $8.9 million due to exploitation in March.

=> Several Ethereum-based applications, including Zapper and SushiSwap, faced compromise due to a Ledger security breach, affecting decentralized finance (DeFi) projects. Ledger, the crypto hardware wallet manufacturer, fixed the malicious code, urging users to employ "Clear Sign" transactions.

The breach, termed a "supply chain attack," resulted in a potential loss of over $500,000. Ledger's CEO assured users the incident was isolated, caused by a phishing scam affecting a former employee. While such crypto exploits stain the industry, they also prompt lessons and opportunities for improvement. Tether's swift response further highlighted the community's ability to track and freeze affected addresses.

=> Cryptocurrency exchange CoinList has agreed to a $1.2 million settlement with the U.S. Treasury’s Office of Foreign Assets Control (OFAC) for allegedly facilitating 989 transactions in apparent sanctions violations. OFAC stated that CoinList's screening procedures failed, allowing users to misrepresent themselves as residents of non-embargoed countries while providing Crimea addresses.

While the violations were deemed "non-egregious," CoinList cooperated with authorities. The settlement follows similar actions against crypto firms like Poloniex and Binance, emphasizing heightened scrutiny on sanctions compliance within the industry.

=> The OKX decentralized exchange (DEX) fell victim to a $2.7 million hack on December 13, triggered by a leaked private key of the proxy admin owner. The attack exploited vulnerabilities during contract upgrades, prompting the removal of the compromised DEX proxy from the trusted list.

Despite claims of an old abandoned contract being attacked, blockchain security firms confirmed losses, emphasizing that decentralized platforms aren't immune to risks. The incident contributes to a concerning trend, with the crypto industry facing $1.5 billion in losses from hacks, exploits, and scams in 2023.

=> Worldcoin’s upgraded World ID 2.0 version will now allow users to verify their humanity on a multitude of platforms like Microsoft, Reddit, Telegram, Shopify, and others.

=> Cryptocurrency wallet Conio announced a partnership with cryptocurrency exchange Coinbase to bring a wide range of digital assets to Italy’s banks and financial institutions.

Cryptos: spot, derivatives and “on chain” metrics

The cryptocurrency market has been in a downward trend this week, with only a few coins bucking the trend. The top 10 cryptocurrencies by market capitalization have all experienced losses, with only Avalanche (AVAX), Cardano, Solana and BNB posting gains. AVAX is up 28% this week, followed by ADA at 2.51%, BNB at 1.90%, and SOL at 2.25%. The biggest losers this week were XRP with 5.5% losses, followed by Dogecoin, Ethereum, and TRX with 4.5%, 4.72%, and 4.2% decreases respectively. Bitcoin and Polkadot  were also down, but slightly less so, losing 3.53% and 2% respectively.

The overall market capitalization decreased by almost $50 billion. The crypto market ends the week at a total market capitalization of $1,59 trillion.

Gainers / Losers last 7 days, block size volume.

Bitcoin

Bitcoin started the week flying high and attempting to gain the $45,000 resistance level. However, the king of cryptocurrencies quickly reversed its trajectory, going on a weekly downtrend. In fact, at one point, it reached as low as $40.000. The drop stopped there and Bitcoin recovered to stabilize its trading value at around $42.200 at the end of the week.

Last weeks we warned the following:

“...The market after the great spike of late October has entered a dynamic of higher highs and higher lows, although tremendously overlapped and volatile, to finally reach the most relevant previous high volume node. We believe that at this point, the market is likely to take a break and consolidate gains during December while awaiting the next ETF decisions in January.

The key to this uptrend, in our opinion very overheated and overextended ahead of uncertain future events (BTC spot ETF approval) lies in the consolidation above the main VPOC shown in the chart. If we want to consider a bullish scenario where the market will test the upper part of the previous range (VAH), the price must consolidate in this zone. On the other hand, if selling takes over and pushes the price below this area marked in gray, it seems inevitable that we will look for the value area low (VAL). This scenario seems to us the healthiest and most logical and does not spoil more ambitious long-term long scenarios.

As can be seen in the price dynamics, the use of volume profile to establish the previous value area allows us to understand what the market is telling us. The accumulation from June 2022 to March 2023, had a first failed bullish imbalance when trying to enter the previous value area, however in a second attempt the market managed to enter and fly towards the VPOC. It is a first great battle won by the buyers, so thinking about retracements to the lower part of the range to consolidate is not at all unreasonable and as we have said, normal within a bullish dynamic that tries to recover and conquer previous trading zones.

Bitcoin 11/12/23 4h chart

Bitcoin 18/12/23 4h chart

On a low time frame chart, the verticality and lack of market structure and auction gave us clear clues that the bullish move was entering the final climactic phase. Two weeks ago the market entered a distribution phase leaving a very clear structure (marked in red in the charts below) and a very well defined seller control zone.

During the past week this distributive structure developed to the downside leaving a bearish continuation failure at the $41.900 area coinciding with the blue anchored Vwap. The market tried to defend itself giving rise to a minor cumulative structure (marked in blue) which has not been successful in developing to the upside, leaving 2 clear bullish failures below the upper major selling control.

At this point in time and based on the price dynamics written, it is quite evident to think that the bulls, despite their attempt to defend, have lost control of this intermediate volume node at $41.900 and that the target is to test the major lower trading zone of $38.000-$36.000. Long approaches in this short time frame chart necessarily pass through the recovery of the $41.900 level to then attack the main selling control zone located at $43.900. However, the climax and generalized overbought risk assets do not support this scenario in view of the imminent risk of at least a profit taking, not to say a risk off.

Bitcoin 11/12/23 5 min chart

Bitcoin 18/12/23 5 min chart

Bitcoin Core on Alert: Ordinals Vulnerability, an Officially Declared Threat

The controversy surrounding the Bitcoin network’s congestion caused by Ordinals has taken a new turn. The technical loophole exploited for their creation has just been assigned the identifier CVE-2023-50428.

The Bitcoin network has been experiencing an alarming congestion in recent days, caused by a massive influx of transactions related to BRC20 tokens. Tens of thousands of transactions have remained stuck, waiting for a confirmation that is slow to come, while miners’ memory is reaching its limits. This situation is mechanically causing the fees on the network to explode.

Per BitInfoCharts, it currently costs just over $37 to send BTC on-chain, the highest average figure since April 2021.

Additional figures from Mempool.space show that Bitcoin’s mempool, the size of the unconfirmed on-chain transaction backlog, is vast, resulting in transactions with an attached fee of even $2 having no on-chain priority. Almost 350,000 transactions are waiting to be confirmed at the time of writing.

Data from Blockchain.com shows miners’ revenue (the sum total of block subsidies and fees in USD) hitting levels last seen when Bitcoin hit its current $69,000 all-time high in November 2021.

Although the vulnerability is now cataloged, the implications of a future fix continue to be controversial. Its implementation planned for next year could spell the end of the BRC20 tokens and Ordinals, thus fueling tensions within the Bitcoin community. The debate is gaining significant traction, fracturing the crypto community. Proponents of the Ordinals thus emphasize the fact that developers do not have absolute power over a decentralized network.

Moreover, many users and miners have profited from the opportunities presented by the BRC20s, which have evolved into a thriving industry, especially in the sectors of NFTs. Notably, the OCEAN mining pool, supported by Jack Dorsey, has even decided to suspend the validation of transactions related to the Ordinals protocol. Whatever the outcome of this issue, the assignment of the CVE-2023-50428 identifier highlights the urgency of the situation. The critical question remains: will the flaw be fixed in version 27 of Bitcoin Core in 2024, potentially leading to the abandonment of Ordinals? Are Ordinals’ defenders willing to sacrifice their booming industry? The evolution of this situation is generating intense interest and promises to be captivating to follow.

While many are angry at the impact of Ordinals on fees, popular Bitcoin figures argue that double-digit transaction costs are merely a taste of things to come. Those wanting to shield themselves need to embrace so-called layer-2 solutions such as the Lightning Network, which is specifically designed to cater to mass adoption.

Ethereum

ETH started the week at around $2.222 and gradually declined throughout the week, reaching a low of $2.148 on Thursday, December 14th. It then saw a slight recovery on Friday and Saturday, but ultimately closed the week down at $2.167.

There is some uncertainty among investors about the upcoming Ethereum fork, which is scheduled to take place in March 2024. The fork will split the Ethereum blockchain into two separate chains, one that will continue to use proof-of-work (PoW) and another that will switch to proof-of-stake (PoS). Some investors are concerned that the fork could lead to instability in the Ethereum network.

The market has been experiencing rejection in the $1700 to $2150 zone. It has clearly been a sell initiative zone since August 2022. At the same time it is coincident with the VWAP anchored at all time highs.

The market has managed to break out of this sell zone, but now has to consolidate above it. It is time for the bulls to prevent the price from returning to the inside of the sell zone. Bulls must avoid a false breakout, as a return to the zone marked on the chart could throw away the buying strength shown since the end of October.

Ethereum 11/12/23 4h chart

Ethereum 18/12/23 4h chart

On Chain Metrics

While some on-chain metrics like hash rate decline and DeFi TVL drop hint at bearishness, others like deflationary supply and active addresses offer a more neutral or even bullish outlook.

Hash rate decline: Ethereum's hash rate, a measure of mining activity, fell by 3% over the past week. This could suggest a decrease in miner confidence or profitability, potentially indicating bearish sentiment.

Total value locked (TVL) in DeFi protocols on Ethereum dropped by 21% last week. This decline in locked value could imply reduced investor appetite for DeFi on the platform.

The premium on ETH futures contracts was negative last week, meaning traders were betting on the price of ETH to fall.

Classic markets

The Federal Reserve got Wall Street bulls charging this week with its planned pivot toward lower rates, but major U.S. indexes turned mixed in premarket trading Friday after bearish comments from a Fed official. They're on pace for their seventh straight weekly gain, the longest stretch since 2017.

New York Fed President John Williams splashed cold water on things just before the open, telling CNBC that the Fed "isn't really talking about rate cuts right now" and that the Fed should be ready to hike again if needed. He feels the Fed is at or near the right place with its current policy. One policy maker's comments may not represent the entire Fed, but stock index futures pared gains after he spoke.

Over the last week alone, the SPX is up 3%, and info tech isn't even in the top five sectors during that time frame, evidence of how the rally has broadened to include a wider slice of the market. Interest-rate-sensitive sectors like real estate and financials helped propel Wall Street's surge, with materials and industrials also in the lead pack as hopes for an economic "soft landing" drove shares of companies that deliver the goods, so to speak. Gains in financials could reflect the idea that lower interest rates will boost profit margins for banks.

Also, the small-cap Russell 2000 continued to outgain large-cap counterparts, rising 2.7% Thursday to a 5 month high. Small-cap stocks are often sensitive to interest rates because these companies tend to rely more on borrowing to finance operations. The rotation out of mega-cap tech and toward interest-rate-sensitive sectors, including financials, real estate, and utilities, has been apparent.

Sentiment and exposure metrics: extreme readings, all in!!

November’s extreme easing of financial conditions had a rather profound impact. When looking at Bloomberg’s measure of financial conditions, it’s as if the Fed never actually tightened at all. We’re now at levels of easiness that exceed that of where we were before the tightening cycle started.

US equities continue to defy gravity. Equities vs. bonds valuation model from Longview Economics is on strong sell (and has been since August). That is its first strong sell signal since pre GFC.

The latest Investment Manager Index showed investment managers reporting increased risk appetite through November. Respondents basically reported the reasons as “mission accomplished” on Fed rate hikes (peak in rates and prospective pivot), less of a drag from politics and fiscal, and declaration of soft-landing (with recession risk now off the table as far as most people are concerned)

Speculators have been stampeding into tech stocks. The combination of AI hype, passive flows favoring the big end of town, and the prospect of peak rates has powered up speculative fervor.

Retail investors have registered the highest level of bullishness since mid-July, during the summer stock rally when bullishness was pervasive.

Dumb Money Confidence, as it’s called, surged to significant highs recently.

The proportion of stocks showing up as “overbought” (in this case an RSI reading greater than 70) has reached one of the highest levels in recent decades.

Equities saw very large inflows this week.

Futures positioning in US equity index futures is also quite elevated, suggesting that there is a rather large net long position in place by money managers and traders.

Hedge funds have significant gross leverage, but their net leverage remains rather low compared to 2021, making them an exception to the stretched positioning. However, they are stretched elsewhere. Single stock short exposure is rather elevated, and many of those same hedge fund favorite shorts have been rallying significantly over the last few weeks.

Retail traders and investors are also buying stocks again, according to Vanda Research. Flows that are somewhat unusual based on prior seasonality from 2014-2022.

The UBXXSHRT basket is up 36% since the October low compared to an average of 34% with a range of 21%-42% during past short squeezes. Seems that the short squeeze is almost over.

CTAs have been increasingly adding to longs at a rather rapid pace, also helping to push up equities over the last several weeks, as these momentum trading funds had started rather short going into November.  Global CTAs are now the most long equities in 8 years after buying more than $225 billion worth over the past month. The largest such inflows since 2014.

GS CTA Update

Over the next 1 week:

Flat tape: $18 billion to buy (-$436 million SPX to sell)Up tape: $20 billion to buy (-$1.3 billion SPX to sell)Down tape: -$5 billion to sell (-$1.9 billion SPX to sell)Over the next 1 month:

Flat tape: $30 billion to buy (+$1 billion SPX to buy)Up tape: $44 billion to buy (-$636 million SPX to sell)Down tape: -$213 billion to sell (-$67 billion SPX to sell)Key pivot levels for SPX:

Short term: 4,471Med term: 4,407Long term: 4,377

SP 500 10% risk control exposure at 91% or 84%-tile versus 3y with daily break even at 70 bps. Therefore, if SPX moves roughly 50 bps a day, risk control exposure could reach the vulnerable level of 100% by the second week of January. In English, this means that a 2% decline on one day could trigger up to $100 bn of selling.

According to Goldman, the corporate blackout window began last Monday, with the $5 billion daily VWAP machine going into hibernation until mid-January. Without these supportive flows it will be interesting to see if the derivatives market alone can support these overbought indexes.

Options, Gamma, IV, SKEW

On Friday we saw a historic $4.9 trillion of notional options exposure expiration.

IWM call open interest surged again, closing in on all-time highs. This also pushed IWM call skew to very, very high levels as the lopsided exposure has shifted the distribution of volatility premiums.

Speaking of volatility, Nasdaq volatility has hit lows that we have not seen in years. As a result, downside hedges are quite attractive at the index level, particularly in QQQ where call skew is also quite elevated. Making 3M out ATM puts even more attractive in comparison as a portfolio risk hedging vehicle.

As for how cheap volatility is: the VIX cross-asset rank is at 9%, SPX implied volatility and skew are both low and SPX 2m put premium is 0-5 percentile versus five years; while SPX 2m put spread premium is 5-15 percentile versus five years. We warn that systematic risk about to flip to the downside

Call skew in SP500 stocks has surged as put skew has fallen quite significantly, demonstrating stretched positioning in the options market. Particularly among some of the very popular Magnificent 7 stocks, as well as many of the index ETFs.

Gamma

Once we pass this last Friday Opex, where 40% of the SP500 gamma (mainly Call gamma) has been shed, we expect the absence of supportive flows to lead to increased volatility in the market. The loss of gamma and the absence of the buybacks set the market up for more volatility. The big central bank meeting will also be the BOJ, which will be this week. If the BOJ decides to move and come out of its negative interest rate policy, it will start strengthening the yen and moving it lower, which does put at risk stability because it would likely start the unwind of the carry of trade, and it is hard to measure just how much impact that would have.

Once Opex is overcome, not only Gamma disappears but Vanna as well. With net positive Vanna (which was remarkable in this expiration), there is a virtuous bullish cycle that causes drops in implied volatility to be met with market makers buying to hedge which provides bullish flows which can in turn continue pushing price up. This does not mean that the market must necessarily fall, but it does mean that it is facing a period of repositioning of the participants where the absence of these flows that have been supportive is a reality and a risk against possible bearish attacks.

Opex unpinned the 4700 level. Events leading up to Opex helped flows, that continued to build big call gamma now at 4800, but also strong support above. Call resistance moved up from 4700 to 4800. The market continues to insist but these supportive flows are much smaller in scale and weaker during the window of weakness after Opex.

The market remains in a positive gamma regime, so the 4705-4800 call wall is established as a resistance zone, difficult to overcome and roll without the intervention of a relevant macroeconomic catalyst as it was last week. On the short side, a loss of the Gamma Flip at 4670 points would trigger a change in the market's gamma regime, triggering volatility and selling. According to the Gamma profile of the market, the last support is at 4700, from there things could get complicated.

Market Comment

Bear market rallies are notoriously violent and abrupt. And this last one was among the most violent and abrupt of them all. The year-to-end rally in the stock market wasn't just some random event or a simple anomaly, it was a 3-part move primarily due to a market in an extreme net short gamma position (which caused the initial short covering), systematic flows, and volatility selling. These are primarily a function of flows and positioning and have nothing to do with improvement in the fundamental outlook for the economy or earnings growth. This is important because mechanical flows are subject to swift and sudden shifts.

In terms of auction and market structure, November is the best example of an aberration. We are firm in our opinion that all this upside movement initiated at the end of October does not respond to a healthy and well auctioned market. The following chart shows how the volume profile for the month of November presents a disastrous auction, full of gaps and inefficiencies. We believe that sooner or later all of this will be fully repaired.

By flipping, Powell and the Fed are taking a big risk. The risk is of animal spirits going wild in the stock market and history tells us how these situations usually end when the whole market is on the same side, chasing the price in total anxiety. In our opinion, the degree of complacency and FOMO that equity markets have reached far exceeds previous climaxes. The market and its new dynamics led by the vol crunch seem to be trying to create their own reality where flows defeat macro. I am sorry to tell the reader that although this has been successful in the short term, the final outcome is going to be very abrupt and painful. Macro takes its time, does not lie and always arrives.

Deep negative gamma regime sparked a short-squeeze in the options market in late October, which lead to systematic short-covering, and then repositioning to go long in these funds, which then lead to vol compression, and then the pinning of gamma heading into last week's OPEX. So now that OPEX is over, and Vixperation ends on Wednesday, if this market was built on sand, then this is likely to be this week that things should start to melt and that JPMorgan collar trade, which lives down around 4,500 could offer an excellent magnet for the market over the final two weeks of the year.

The verticality of the movement since the end of October is certainly historic and at the same time worrying. If we anchor a Vwap (light blue) at the lows of the impulse we observe that we are touching its third standard deviation without any rest and without consolidating previous trading zones. For us and according to the explanations above, the market is at high risk of corrections. Regardless of the upper level that sweeps, the first key will be in the 4625 zone (of the SP500 adjusted future). If the retracements manage to hold that level the market will consolidate the rise, on the contrary if we lose it the rally will dissolve like a sugar cube in a cup of coffee.

ES_F 4h chart 11/12/23

ES_F 1h chart 18/12/23

Remember the market is "all in" celebrating the capitulation of Powell and the FED but with the fixed income markets showing that this is not just about a perfect disinflation process and softlanding achieved. The long end of the yield curve reflects growth and expectations and the message released last week is wild and historic. Many equity focused participants think that this time it will be different, we as well as the fixed income market do not think so.