Advocates of bitcoin suggest cryptocurrencies can serve as a hedge against volatility from such financial assets as stocks, reducing overall risk and allowing for diversification for investors.
The International Monetary Fund (IMF) explores the significance of cryptocurrencies in a blog earlier in the year.
In 2017 the market value of bitcoin was around $620 billion. Due to the growing popularity of this new asset class from both retail and institutional investors, the market value of bitcoin has soared to nearly $3 trillion on 11/10/21 when bitcoin traded to a record high of $68,978.64. Although bitcoin has recently fallen to $36,878 today, the capitalization is still around $2 trillion, or over a three-fold increase from 2017.
International Monetary Fund warned in the January 2022 post stocks and cryptos have become increasingly correlated amid greater acceptance and adoption of digital currencies in financial markets. The IMF blog raises the question of the risk of contagion across financial markets as stocks and crypto prices have become increasingly correlated with each other.
Before the Covid-19 pandemic, digital currencies showed extremely low correlations with equities. Bitcoin’s correlation to the S&P 500 (SPX) was only 0.01 from 2017 to 2019. As crypto prices and stocks soared with easy monetary policies, improving global financial conditions, and greater investor risk appetite, the correlation between the two assets has risen to 0.36 from 2020 to 2021.
Our technical studies also show the correlation between bitcoin and S&P 500 ETF (SPY) for the past two years is 0.64. Bitcoin and the Gold ETF (GLD) correlation is 0.58. Bitcoin and the Investment Grade Corporate Bond ETF (LQD) is 0.75. Another technical study between bitcoin and popular U.S. indexes confirms a sharp jump in the correlations since late-December 2021. For example, bitcoin correlation to SPX (0.87), INDU (0.84), NYA (0.89), COMPQ (0.89), NDX (0.89), MID (0.90), and SML (0.90).
IMF states the high correlation between the two assets today suggests bitcoin is now acting like a risky asset amid the expansion of digital currencies and its increased holdings among global investors. Since bitcoin’s correlation with stocks has become higher than that between stocks and other non-correlating assets such as currencies, hard assets such as gold, and fixed income investment-grade bonds, it has negated the risk diversification benefits of using cryptocurrencies to hedge against stock declines are no longer valid.
IMF cites the increase in crypto and stocks correlation can lead to systemic risks in the global financial markets primarily due to the closer sentiment relationship between those two asset classes. For instance, an abrupt and swift decline in bitcoin prices can trigger an increase in risk aversion among global investors, leading to a sharp collapse in stock prices.
Bitcoin has only been trading in the public markets since April 2014. Historically, bitcoin has not been correlated well to most asset classes, including stocks, bonds, and commodities. The non-correlation made this novel asset incredibly attractive for investors such as macro money managers and large institutional investors as a hedge against their global investment portfolio and an alternative asset class for portfolio diversification.
In the past, bitcoin has negative correlations or exceptionally low correlations to the VIX index and below-average correlations to most foreign and domestic stock market indexes. Today, bitcoin appears to be showing a high degree of negative correlation with the VIX volatility index. What has happened to account for this change?
In the past couple of years, Bitcoin is increasingly correlated with stock, as evidenced by the IMF blog and the above technical correlation studies. However, the question as to whether bitcoin has become a leading indicator of the stock market is less clear.
Yes, bitcoin, ether, and other cryptos have made considerable inroads in a short timeframe. They are popular with investors and widely covered by the press and media. Extensively studied and scrutinized by central banks and the investment community. Cryptos may no longer be a good investment hedge for investors from a diversification perspective and may pose a systemic risk to the global financial markets.
However, bitcoin and cryptocurrencies are still not in the same category as the older, well-established, liquid, and more significant financial assets such as Mutual Funds, ETFs, index funds, and other financial instruments.
Correlation studies have statistical values for investors as a reliable measure of the relationship between two stocks or two financial assets and the strength of that relationship over a specific point in time. However, cryptos have limited ability to predict returns in the stock market and even less predictable ability as a leading indicator of such important asset classes as stocks and bonds. Not yet, but possibly in the distant future.