​Analysts point to a possible liquidity crisis of the crypto market

Crypto markets are bracing for a downturn as liquidity tightening resumes after the U.S. debt ceiling is lifted, observers said.

The replenishment of the U.S. Treasury general account and the Federal Reserve (Fed) winding down its balance sheet will remove hundreds of billions of dollars from the financial system, weighing on cryptocurrency prices in the coming months.

Thawing liquidity conditions earlier this year helped lift the prices of risk assets, including equities and digital assets. The market-wide crypto rally propelled bitcoin (BTC), the largest cryptocurrency by market capitalization, to as high as $31,000 before turning into a meme coin speculative frenzy reminiscent of the sugar rush near bull market tops.

The trend, however, is set to turn once U.S. lawmakers approve raising the government’s ability to issue new debt, putting pressure on risky investments.

First, the U.S. Treasury will have to refill its almost completely depleted Treasury General Account (TGA), which means replenishing some $500 billion of cash from the financial system.

“This is likely to especially hit risk assets as they tend to be more sensitive to liquidity conditions than safer plays such as bonds and many groups of equities,” macro analyst Noelle Acheson said.

“The Treasury drawing down its account at the Fed was one of the tailwinds for the market earlier this year, as money that would normally just sit there was put into the economy in the form of government expenditures,” Acheson explained.

“Now, the reverse is likely to happen: the government needs to replenish that account balance by issuing debt which will draw liquidity out of the market and back into the Treasury's account.”

Refilling the general account coincides with the Fed continuing its quantitative tightening campaign, briefly interrupted in March due to the regional banking crisis, to reduce its bloated balance sheet from propping up the economy during the pandemic.

Macro analyst Lyn Alden called this a “negative double-whammy for liquidity” in a market report.

“The attractiveness of many large liquidity-driven equities is lackluster for the next few months unless or until we get more clarity on forward liquidity conditions,” Alden said. “This is an environment where an investor should know what they own, be prepared for volatility and avoid excessive leverage.”

The debt ceiling resolution bill – if passed in its current form – will also contribute to the negative impact on liquidity, according to Tom Dunleavy, founder of Dunleavy Investment Research.

Some key points of the deal such as curbing non-defense funding, clawing back unspent pandemic relief funds and resuming student loan payments will constrain the available money left for consumers to invest, he explained in a tweet. "Liquidity is going to be very net negative,” Dunleavy added.

The U.S. House of Representatives is poised to vote on raising the debt ceiling Wednesday evening.

Tightening liquidity conditions, decreasing probability of the Fed cutting interest rates this year and the present trading environment with depressed volatility and volumes make crypto markets ripe for a shock, institutional trading platform FalconX wrote in a newsletter.