Key Takeaways

• In this first edition of our “Macro Thoughts” series, we examine concerns related to stagflation and its impact on growth assets like crypto.

• While there are indicators of slowing economic growth and sticky inflation, we believe that stagflation concerns may be overblown considering resilient domestic demand and moderating wage growth.

• Probabilities of rate hikes or the Federal Reserve (“Fed”) not cutting rates this year are not zero, but these scenarios do not seem likely.

• The recent correction in the crypto market may not be entirely negative as it positions the market for more sustainable growth. Moreover, despite the correction, the market is still up 38% year-to-date.

Concerns over potential stagflation risks in the U.S. have been brewing in the markets. Investors have cited persistent inflation, coupled with relatively disappointing economic growth as indicators that stagflation risk is real. Is this a cause for concern?

In the first edition of our “Macro Thoughts” series, we look under the hood to examine the drivers of economic growth and inflation, and detail our views on the impact on growth assets like crypto.

Stagflation 101: A Policy Maker’s Nightmare 

Stagflation is an economic condition that entails sluggish economic growth, high unemployment, and persistent inflation. This situation is tricky to navigate as traditional monetary policies do little to combat both inflation and unemployment simultaneously. For example, lower interest rates to spur consumer spending and investments generally boost the economy and create more jobs, but that could have the unintended consequence of causing inflation to rise further. 

Recent Economic Data Amplified Stagflation Worries

Latest data revealed that  U.S. gross domestic product (“GDP”) grew 1.6% in the first quarter, much lower than analysts’ expectations and at a level that’s near a two-year low. 

Figure 1: U.S. economy grew 1.6% in the first quarter

Moreover, the core personal consumption expenditures (“PCE”) price index, the Federal Reserve’s (“Fed”) preferred measure of inflation, rose 3.7% in the first quarter. This represented an acceleration from the preceding quarter’s 2% pace and higher than the Fed’s 2% target.

Figure 2: Inflation accelerated in the first quarter of the year

Stagflation Concerns May Be Overblown

While recent economic data reveal signs of slowing growth and persistent inflation, they do not paint the whole picture. 

1Q GDP came in below expectations largely as a result of fluctuating factors related to inventories build-up and a surge in imports. Trade and inventories tend to be volatile GDP components and may be subject to revisions. However, domestic demand has remained resilient - excluding inventories, trade, and government spending, the domestic private economy rose 3.1%.

Figure 3: Domestic demand remained resilient in the first quarter

There are also indications that the labor market is cooling. Specifically, the latest jobs report showcased that average hourly earnings increased 3.9% in the 12 months through April, representing the smallest wage gain in almost three years and the first reading below 4.0% since June 2021. While the unemployment rate rose marginally from 3.8% in March to 3.9% in April, it remained below 4% for the 27th consecutive month.  Overall, the cooler pace of hiring and moderate wage growth reduces inflationary pressures as well as concerns of potential wage price spirals. 

Figure 4: Wage growth has slowed to below 4% for the first time since June 2021

The potential signs of a slowing labor market have sparked hopes that the Fed might successfully orchestrate a "soft landing" for the economy and reduce the prospect of stagflation.

In a recent Federal Open Market Committee (“FOMC”) press conference, Fed Chair Jerome Powell pushed back on the idea of stagflation. Powell stated that he didn't “really understand where that [stagflation] is coming from” nor does he “see the stag or the flation actually”.

So What’s Next? 

Following recent economic growth and inflation data that were less ideal than initially expected by the market, some market participants are starting to wonder if the Fed may not cut rates at all this year or even be forced to consider a rate hike. 

Spoiler alert: While both scenarios have non-zero probabilities, we think they are off the cards for now. 

Let’s Address the Low Hanging Fruit - Are Rate Hikes on the Table? 

Unlikely. Most Fed members maintain that current rates are sufficiently high and expect the next move to be a cut. Jerome Powell further reiterated in the latest FOMC press conference in May that “it's unlikely that the next policy rate move will be a hike.” 

Figure 5: FOMC dot plot shows that most Fed members expect the federal funds rate to be lower this year

What If Rate Cuts Get Delayed Further or Do Not Happen This Year?

Indeed, traders have become increasingly pessimistic about the prospect of rate cuts. The market is now pricing in 2 interest rate cuts for this year (assuming 0.25% cut each time), with the first rate cut expected in September. This marks a significant shift from earlier in the year, when the market was expecting up to 6 rate cuts, starting in March.

Figure 6: Traders expect around 2 rate cuts in 2024

However, what this also means is that the bar has already been lowered, and the market has priced in the risk of delayed rate cuts to a certain extent. 

Importantly, if the Fed ends up delaying rate cuts even further, we would argue that understanding “why” they have done so matters more than the policy action itself. In our view, two broad scenarios may contribute to this, each with very different implications for growth assets like stocks and crypto:

• If the Fed is holding off on rate cuts because growth remains strong and inflation is just taking some time to trickle back down to 2%, the overall backdrop is still positive for growth assets like crypto.

• However, if growth continues slowing, inflation accelerates, and wage growth rises, the Fed may even need to consider hiking interest rates, which will likely be negative for growth assets like crypto.

How’s the Crypto Market Taking It?

Following a strong run in the first quarter of the year, with crypto market capitalization up around 60%, markets retraced in April as concerns over the trajectory of interest rates, and geopolitical tensions rose. The release of 1Q economic data on April 25 further weighed on performance - crypto market capitalization declined around 7% through the remaining days in April. 

Figure 7: Crypto market capitalization has declined from its peak in March

Investors’ sentiment have also reversed course and turned less optimistic in the past month. The fear and greed index is now in the “neutral” zone, a stark contrast to the peak in March, when animal spirits were high and the index was in the “extreme greed” zone. 

Figure 8: Fear and greed index is now in the “neutral” zone

Overall, This May Be a Healthy Reset

At first glance, growth seems to have stalled and sentiment on the ground seems to have turned significantly less bullish. However, a one-way “up only” market is not realistically possible and is unsustainable. 

The retracement and range-bound market provide an opportunity for investors to take a moment to consider fundamentals and valuations, rather than blindly chase sky-high prices. For project teams, the current environment may help take some pressure off fundraising or token launches and instead, allow them to focus on building tangible products. 

Amidst all the negativity, we would like to remind all that the industry has continued to see significant progress. In the past month alone, we have seen:

• The Bitcoin network process its one billionth transaction

• An expansion of liquidity in the ecosystem as stablecoin supply hit a near two-year high

• An unlock of new design paradigms as restaking on Eigenlayer went live in April

Considering the above, and despite everything, the market is still up 38% so far this year, suggesting that it may not be all doom and gloom.