Crypto markets brace for liquidity tightening after U.S. debt ceiling lift

Analysts predict that the recent improvement in liquidity conditions, which has benefited crypto markets and other risk assets, will soon reverse as the United States raises its debt ceiling and the Treasury, along with the Federal Reserve, resumes tightening measures.

Impact on crypto markets and risk assets

Observers anticipate a forthcoming downturn in the crypto markets as liquidity tightening recommences following the lifting of the U.S. debt ceiling. The replenishment of the U.S. Treasury general account and the Fed’s reduction of its balance sheet will withdraw hundreds of billions of dollars from the financial system, exerting downward pressure on cryptocurrency prices in the upcoming months.

Earlier this year, the thawing of liquidity conditions contributed to the rise in prices of risk assets, including equities and digital assets. The widespread rally in the crypto market propelled bitcoin (BTC), the largest cryptocurrency by market capitalization, to reach as high as $31,000 before succumbing to a speculative frenzy reminiscent of the euphoria seen near the peaks of bull markets.

However, this trend is expected to reverse once U.S. lawmakers approve an increase in the government’s borrowing capacity, placing strain on high-risk investments. Initially, the U.S. Treasury will need to replenish its nearly depleted Treasury General Account (TGA), requiring approximately $500 billion of cash injection into the financial system.

Noelle Acheson, a macro analyst, highlighted that risk assets are likely to be particularly affected as they are more sensitive to liquidity conditions compared to safer investments such as bonds and certain equity groups.

Acheson explained that earlier this year, the Treasury drawing down its account at the Fed provided a tailwind for the market, as funds that would typically remain idle were injected into the economy through government expenditures. However, the situation is now expected to reverse, with the government needing to replenish the Treasury’s account by issuing debt, thereby draining liquidity from the market and redirecting it back into the Treasury’s account.

Liquidity risks from U.S. treasury refill and fed tightening

As the U.S. Treasury refills its general account, the Federal Reserve (Fed) continues its quantitative tightening campaign, which was briefly interrupted in March due to the regional banking crisis. The purpose is to reduce the Fed’s bloated balance sheet that supported the economy during the pandemic. This combination of events has been described as a “negative double-whammy for liquidity” by macro analyst Lyn Alden in a market report.

Alden emphasised that many large equities driven by liquidity will have limited appeal in the coming months unless there is more clarity on future liquidity conditions. In this environment, investors should be aware of their holdings, be prepared for volatility, and avoid excessive leverage.

According to Tom Dunleavy, the founder of Dunleavy Investment Research, the debt ceiling resolution bill, if passed as it currently stands, will further contribute to the negative impact on liquidity. He explained that certain aspects of the deal, such as reducing non-defence funding, reclaiming unspent pandemic relief funds, and resuming student loan payments, will limit the available money for consumers to invest. Dunleavy added in a tweet, “Liquidity is going to be very net negative.”

The U.S. House of Representatives is set to vote on raising the debt ceiling on Wednesday evening. FalconX, an institutional trading platform, highlighted in a newsletter that tightening liquidity conditions, a decreasing likelihood of the Fed cutting interest rates this year, and the current trading environment characterised by low volatility and volumes create a vulnerable situation for crypto markets, making them susceptible to shocks.

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