Deflation eaters are underperforming Bitcoin, here are 3 reasons

Ether (ETH) turned deflationary two weeks ago, with net supply growth turning negative for the first time in over a month.

The second largest cryptocurrency’s net issuance or annual inflation rate fell below zero on January 15 and stood at -0.01% at press time, according to ultrasound.money. The data shows that the leading smart-contract blockchain now burns more ether than is minted in contrast to bitcoin.

Still, the native token of Ethereum’s blockchain lags behind bitcoin (BTC) as January draws to a close.

While bitcoin has gained nearly 43% this month, ether has risen 36%, CoinDesk data shows. The ether-bitcoin ratio, or ETH/BTC, is on track to post its second consecutive monthly decline.

Here are three factors responsible for ether’s underperformance:

“The most important [reason] is defensive positioning ahead of the Shanghai update. In a few months this will enable the withdrawal of ETH from the Beacon Chain. Some fear that a share of these unlocked ETH will be sold,” Ilan Solot, co-head of digital assets at financial firm Marex Solutions, said in an email.

Ethereum’s Shanghai upgrade, expected in March, will allow the withdrawal of 17.2 million ether staked or deposited in the Beacon Chain since December 2020.

The entire stake balance of 17.26 million cannot be withdrawn on the day of the upgrade, and only 43,200 ETH can be deferred per day. However, the total stake reward for the past two years, which is equivalent to around 1 million ETH, can be withdrawn immediately.

The market is concerned that the unlocked ether will immediately be liquidated in the market, pushing the price of the cryptocurrency lower.

“The 1 million instantly withdrawable ether is more of a problem. This is about 1% of free-flowing ether, in other words, not staked ether. Within minutes the entire stack can be withdrawn, potentially causing holders to rush to exchanges to liquidate ether as soon as the floodgates are open, pushing the price down,” Saxo Bank said in a blog post.

“This sentiment of upcoming selling pressure is likely to intensify as the Shanghai hard fork draws closer,” Saxo Bank noted, adding that some traders may hedge against an expected price drop by shorting the cryptocurrency in the futures market.

Favorable macroeconomic developments have partly driven the recent decline in the crypto market, helping bitcoin, a macro asset, outperform ether.

Recent US government reports and business cycle surveys have shown a slowdown in manufacturing activity and inflation expectations, bolstering hopes for an early end to the Federal Reserve’s liquidity tightening that sent risky assets into a tailspin last year. As of Friday, traders saw a 55% probability that the central bank would halt rate hikes in May, according to CME’s Fed Watch tool.

“I think it is [BTC’s bigger gains] because this move is predicated on changing the macro regime towards the end of the Fed hike cycle, so it is a pure monetary policy play (hence gold also performing) – which in itself to me reflects that this move is driven by institutions, not retail,” David Brickell, director of institutional sales at crypto-liquidity network Paradigm, told CoinDesk.

Singapore-based crypto options trading firm QCP Capital made a similar observation, saying: “All BTC gains this year have come during US (trading) hours, with a sharp increase in open interest in CME futures.”

Several institutions and companies such as software provider MicroStrategy have looked to bitcoin as a hedge against fiscal and monetary policy imprudence since the crash of 2020. Ether remains a play on a broader alternative cryptocurrency ecosystem.

According to Adam Farthing, Chief Risk Officer for Japan at crypto trading firm B2C2, bitcoin’s relatively larger gains stemmed from a short squeeze – a rally fueled by mass closing of bearish bets.

“In Q4 2022, the market held short BTC against perceived credit risk issues, which are now unwinding. The market was not as short in ETH, so there is no unwinding,” Farthing said.

Short interest in bitcoin increased after Sam Bankman Fried’s crypto exchange FTX went bust in early November, raising the risk of a market-wide contagion. CME futures traded at a record discount in mid-November, reflecting extreme bearish sentiment.

Previous crypto market rallies began with bitcoin leading the way to higher and alternative cryptocurrencies, including ether, which outperformed the market leader in the later stages of the bull run.

History seems to be repeating itself, with bitcoin and stablecoins still preferred as a gateway to the crypto market.

“For most macro investors, BTC is the obvious entry into the crypto market – the most liquid, the widest range of on-ramps. We see this in the strong increase in BTC spot volumes (while ETH spot volumes have not increased much), the open interest in CME and stronger positioning in the options market,” said Noelle Acheson, author of the popular “Crypto Is Macro Now” newsletter.

Finally, the rotation of money into riskier corners of the crypto market such as gaming and non-fungible tokens (NFTs) appears to have played a role in slowing ether’s rise relative to bitcoin.

“One of our theories at the moment is that speculative demand has rotated away from ETH (blue chip) to riskier and newer coins like APT and SOL. This has taken some of the buying pressure away from ETH despite it becoming deflationary,” Matthew Dibb, chief investment officer at Astronaut Capital, said.

Gaming tokens such as AXS and MANA have gained 80% and 110% this month, while APT and SOL are up 420% and 140%, respectively, according to CoinDesk data. Some ether holders may have rotated money into tokens linked to liquid staking services such as Lido Finance and Rocket Pool, which are expected to see an increase in activity after the Shanghai upgrade.