Before the arrival of the pandemic in March 2020, no one would have thought of bitcoin as something that would rise and fall together with the stock market. Between 2017 and 2019, the correlation coefficient between bitcoin and the S&P 500 (the index commonly used to gauge the stock market) was only 0.01. This is on a scale that sets 0.7 as a very strong correlation and 1 as a perfect correlation. Traders viewed bitcoin’s tendency to work by its own rules as a potentially useful tool to diversify and manage risk.
When the virus arrived, the S&P 500 took a hit of 110 points and a brief recession ensued. Central banks responded by loosening financial conditions, risk appetite was renewed, and cryptos took off alongside US stocks. By the time the recession ended, stocks had managed to double their value in the meantime. As to bitcoin, its value skyrocketed and multiplied by a factor of four through 2021.
The crypto-stocks correlation shot up to 0.36 between 2020 to 2021, but this doesn’t mean traders viewed the two assets as equivalent. On the contrary, a large number of traders who had lost faith in the stock market during its plunge had relocated their funds in crypto assets, which partially explains the bitcoin surge. Big institutions deduced from bitcoin’s stellar showing during the pandemic that it had the makings of a stand-alone asset class – one that had the power to send back robust returns when traditional markets were failing.
Lots of crypto brokerages appeared on the scene, together with crypto-linked financial products in familiar form, like ETFs. People grew accustomed to crypto as a new member of the trading instrument family and, by late 2021, cryptos started behaving like equities, which went on until mid-year 2022.
Coming out of the crypto bear market of last year, what is the prevailing view of Bitcoin? Is it a risk asset like stocks or not? And why is it important to know? Let’s address the second question first.
What a Correlation Implies
In January 2022, the connection of stocks with crypto was even stronger than their relationship with other assets like currencies, bonds, or gold. One thing this meant was that bitcoin would not be a good diversifier for someone involved in stock trading, contrary to pandemic-time hopes. Another thing it meant, and one which the IMF (International Monetary Fund) were more concerned about, was that problems in one market had the potential to spread to the other. Especially in countries that have embraced crypto strongly, the connectedness could threaten financial stability.
There is data that indicates that, when bitcoin prices drop, traders lose the will to buy, not just crypto, but stocks too. And the opposite is true: when stocks go out of favor, bitcoin goes along with them to some extent. In other words, a high correlation between the asset classes can translate into a free exchange of trader sentiment from one to the other.
2023
In June last year, a big stock selloff was accompanied by a bitcoin plunge and the correlation between them rose to a huge 0.9. Anyone who still believed bitcoin was an inflation hedge wouldn’t have had the courage to admit it, because it plummeted just when inflation really heated up. From January 1st this year to March 11th, however, bitcoin fought back and added as much 38%, even though inflation had not cooled. Some analysts wanted to revive the theory of bitcoin as an inflation hedge, but with a new twist: bitcoin was coming into its own when the effects of inflation were, at last, manifesting in the economy.
Other strategists put things differently: When inflation rises, interest rates are often hiked, which can tend to contribute to a financial crisis (characterized by, say, the shutting down of banks). Bitcoin has the potential to hedge against such a crisis, in our case by giving people an alternative address in which to hold their funds. There’s an argument to say that, when three major US banks went under in March, trust in the traditional financial system was shaken and bitcoin reaped the fruits because it works on blockchains, independently of banks. A proof for this might be that bitcoin prices saw their most pronounced upturn just after Silicon Valley Bank collapsed.
Wrapping Up
A more salient reason bitcoin prices reacted in this is simply that the bank blowup gave strong reason to believe the Fed would have to stop hiking rates, which was good news for all risk assets, including digital ones.
Still, there’s a difference between the reactions of the various asset classes to the events of Q1. Between New Year’s Day and April 11th, gold gained 10%; the Nasdaq 100 went up 19%; and bitcoin surged by 82%. The figures led people like ETC Group’s Bradley Duke to conclude that “investors are drawn to crypto because it’s an asset outside of traditional banking and finance”.
According to the iFOREX trading platform, investors can short the big cryptocurrencies using CFDs and benefit from price declines. When you open a CFD deal, it’s your choice whether to open a “buy” deal (when you expect prices to rise) or a “sell” deal (when you think they’re about to drop).
