Zaps: December 19, 2021

7 min readDec 20, 2021

Welcome to Zaps, Friktion’s DAO Contributor driven Market Notes covering the latest market developments, implications, and opportunities.
Thanks to MordantBlack, JP, Vicinal, Marco, Pizza, Lawrencium, and Leonardo for contributing to this Week’s Zap.
Interested in contributing to Zaps? Drop us a message on Discord or Twitter!

We’re excited to also announce the launch of Friktion’s Mainnet for Lightning Thieves, our earliest users and community members. Visit app.friktion.fi to start earning yield!

What happened with the FOMC and why does it matter for crypto?

The United States Federal Open Market Committee (FOMC) schedules a meeting 8 times a year to determine the Fed’s monetary policy. The main tools used by the Fed to control inflation are setting the benchmark interest rate and bond buybacks.

Lower interest rates are considered “dovish” (and “hawkish” vice versa) and are used to stimulate economic growth (since businesses and people can borrow more cheaply to fund investments and purchases respectively). Similarly, larger amounts of bond buybacks are considered “dovish” since there is more money flowing in the financial system which spurs investments.

The FOMC on 12/15 indicated that the Fed would raise interest rates 3 times next year as well as cut back on its bond buyback programs. However, because the market was pricing in a possibly more hawkish scenario, this proved to be a relief for market participants. Crypto, being a risky asset, benefitted from this relief, which is why we saw crypto markets rallying ~5% after the announcement was made.

Markets were dominated by FOMC proceedings this week, with vol being bid up in the days prior. Right after, institutional players sold a significant amount of vol, especially around the 60k strike for year end, pushing 1m IV down 6% for BTC and 10% for ETH. Interestingly, skew remained unchanged, which indicates that other than the relief rally, people’s expectations have not significantly changed. Funding rates show a more mixed signal, improving slightly but nowhere significant enough to turn bullish.

In the alt space, MATIC moved towards a deflationary token emission schedule, pushing it back above $2. SOL and AVAX also saw strong interest, recovering strongly from last week’s dip as investors continue to recognize the scalability of these chains. In the next week, Polkadot (DOT) Parachains will finally be live, with projects like Moonbeam promising to offer cross-chain, EVM compatible infrastructure.

ATM implied volatility (IV) on the 7-day window tested lows for the month yesterday and continues to see a decline as investors sell volatility into expiry while remaining cautious about taking directional positions. With IVs testing lows, this may be an opportunity to purchase “cheap” volatility. However, so far the resistance at $50k has been strong, and with gamma flooding the market, there may be option-related price support down below as well. (Genesis Trading)

BTC Volatility Term Structure (Genesis Volatility)

ETH Volatility Term Structure (Genesis Volatility)

Macro — Inflation and Volatility

Volatility Remains Elevated; The Fed and Year-end are the Culprits

Equity factor, fixed income, and cryptocurrency volatility increased before, during, and after this week’s Fed meeting.
The Value factor has seen the largest increase in realized volatility over the past month with the short leg of the factor pair (short expensive companies) seeing a 15 percentage point jump in its annualized volatility.
When liquidity is set to tighten (i.e. via Fed tapering or rate hikes), more “expensive” companies tend to see their valuations fall as investors demand more premium embedded for the risk they are taking.
By contrast, the long leg of the factor pair (long cheap companies) has seen a six percentage point jump over the same time frame.
We expect a continuation of this volatility in the near-term as investors adjust portfolio positioning amidst a backdrop of lower market liquidity into year-end.

Morgan Stanley US Value, Growth, and Realized Volatility Index (Bloomberg)

As was widely expected, the FOMC shifted its policy view due to higher inflation and a tighter labor market in Wednesday’s meeting.

Fed members changed their summary of economic projections (SEP) for 2022 to include 3 interest rate hikes by end-2022; thirteen participants see at least three hikes as appropriate versus only one participant believing that was appropriate as of September.

**The 10-Year US Treasury yield (ST): a bullish bottoming formation?**

Additionally, the Fed indicated they will speed up tapering of asset purchases which will now conclude in March rather than June.
By the end of the week, Fed Funds futures priced in 67 basis points of cumulative rate hikes throughout 2022, roughly 12 basis points shy of the FOMC’s median three hike projection.
The first interest rate hike is priced as a split between the May and June meetings, according to market pricing.

Assuming modest Fed hiking next year, the overall policy environment is likely to remain highly accommodative by historical standards.

As inflation has increased over the course of 2021 and the Fed has held policy rates steady, the actual accommodation in the economy has increased, as the penalty for holding cash in “real” or inflation-adjusted terms has increased.
A more credible approach to recent inflation dynamics should shore up sentiment, in turn supporting the view that this growth cycle can continue.
The real concern with a Fed not acknowledging the increase in inflation was that they would fall so far behind the curve and then need to be reactionary and choke off activity levels to contain inflation levels at some future date.

Positioning of systematic and discretionary equity investors has declined significantly, leaving potential for a positive equity run-up into year-end

Long positioning of these two cohorts stands in the bottom third of the historical distribution (long positioning has been higher two-thirds of the time, historically), suggesting that there is room for these investors to add to long positions in coming weeks ahead of (seasonally strong) January.
The National Association of Active Investment Managers Weekly Exposure Index Survey supports this positioning anecdote (higher = more exposure to equity markets):

What happens after the Fed starts hiking interest rates, historically?

There tends to be solid growth in the first year of the hiking cycle, with an average return of +7.7% after one-year.
On average over the past 13 hiking cycles, the S&P 500 sees a period of over a year without a positive return from around 9-months after the start of the rate hiking cycle.
As mentioned above, the first rate hike is currently priced to happen between the May and June FOMC meetings.