Not a safe haven in 2022

Chart 1: This chart plots the rolling monthly performance of Bitcoin and the S&P 500 from January 2018 to July 2022. It also shows the rolling correlation over this period, which has been increasing since mid-2021.

Cryptocurrency has been touted as a hedge against macroeconomic risks and inflation. Proponents of cryptocurrencies have argued that fiat currency is vulnerable to devaluation due to inflation, especially when central banks “print money” to support the economy. It is common for cryptocurrencies to be designed to remain scarce as their demand increases, which in theory bolsters their value.

Throughout much of 2018 and 2019, the major cryptocurrencies were able to deliver significant positive returns to their investors and appeared to be uncorrelated with the broader equity markets, meaning it seemed possible that cryptocurrencies could deliver on their promise.

This independence has not been maintained throughout 2022 (Graph 1). From the beginning of the year to its low point in June, the S&P 500 fell more than 20%. Despite bouncing over the summer, it is still down more than 13% at time of writing. Cryptocurrencies have been corrected along with stocks. Since January, the major cryptocurrencies have fallen by more than 50%.

The higher move in the correlation between stocks and cryptocurrencies appears to be related to the changing economic backdrop. Cryptocurrencies have shown lower correlations with stock markets in times of stable, high economic growth and low interest rates. But in more precarious and uncertain economic times, like the current one, they have moved in the same direction as the stock market.

The cryptocurrency market is highly concentrated and highly correlated

The cryptocurrency market remains highly concentrated despite the proliferation of more than 15,000 coins since the popularization of Bitcoin. Together, Bitcoin and Ethereum made up about 60% of the market capitalization of the cryptocurrency universe as of August 2022.

Chart 2 – This chart shows the market share of Bitcoin, Ethereum and other selected top cryptocurrencies.  Bitcoin and Ethereum account for around 60% of the market, with no other coin exceeding 5%.
Chart 3 – This chart shows the correlation of the selected cryptocurrencies with the largest coins, Bitcoin and Ethereum.  They all generally have a positive correlation with both, ranging from 0.4 to 0.6 for most.  Dogecoin's correlation with Bitcoin and Ethereum is lower.

Chart 2 illustrates how much bigger Bitcoin and Ethereum are compared to a selection of seven other cryptocurrencies that have been among the next largest coins for much of 2022. These are Binance Coin, Cardano, Ripple, Solana, Dogecoin, Polkadot and Tron. The smallest of these as of August 2022 is TRON, which has a market cap of around US$500 million, compared to Bitcoin’s roughly US$450 billion market cap. The exact rankings fluctuate with cryptocurrency prices, which are of course volatile. For example, TRON nearly doubled its 1% share of the total cryptocurrency market capitalization a few months ago.

Bitcoin and Ethereum are not only the largest assets in the class, but also appear to be strongly correlated with the other cryptocurrencies. Chart 3 shows how the smaller players in the market generally exhibit a high correlation with the dominant players, Bitcoin and Ethereum, using the daily returns in these markets. In other words, an investor in this market would find it difficult to diversify risk from it.

Cryptocurrency movements with stocks (sort of)

The most important thing for investors looking to hedge against market risk is whether cryptocurrency returns are correlated with those of traditional risk assets. The basket of cryptocurrencies reviewed above has generally been positively correlated with the stock markets. Chart 4 shows that there has been a strong correlation with the S&P 500, the stock market index most closely related to the US business cycle. In general, general developed market indices show positive correlations with cryptocurrency returns, while the correlation is very low for emerging market stock indices.

Cryptocurrencies have also been commonly promoted as a kind of “digital gold”, as gold is the original safe haven asset for investors. But Chart 4 also shows that gold prices have little correlation with cryptocurrencies, and certainly far less than stocks. In 2022, so far, daily gold returns have had close to zero correlation with the returns of major cryptocurrencies.

Chart 4 – This chart shows the average correlation of selected daily returns of major cryptocurrencies against major stock indices as well as gold.  Cryptocurrencies have a high correlation with most major stock indices and a low correlation with gold.
Chart 5: This chart shows the average correlation of our selection of top cryptocurrencies against the S&P 500, calculated using a 28-day rolling window.  While the correlation has fluctuated over time, it has been on the rise since 2020.

Of course, these correlations are not constant over time. Chart 5 shows the 4-week moving average correlation of these cryptocurrencies against the S&P 500, the index with which it has generally shared the highest correlation. Here, we see that the correlation has been increasing during the recent market correction and has had periods of apparent independence, particularly during the relative boom years before the pandemic and during the recovery from the pandemic.

Inflation and growth surprises increase correlation with equities

It seems that there was a turning point in the correlation of cryptocurrency with stock returns in 2021, when the economic environment began to change to one of higher inflation and weaker growth.

The increase in correlation also aligns with higher errors by forecasters. To see the extent of economic surprises, we use the Atlanta Federal Reserve Board’s Survey of Professional Forecasters, which aggregates professional forecasters’ views on the short-term economy. We compare the forecasts for the next quarter with the data made during the last years.

The results are illustrated in Chart 6: The uptick in cryptocurrency correlation, which began in the second quarter of 2021, was a turning point for the US economy. After this point, growth surprises turned negative more steadily, inflation surprises became much larger, inflation itself rose much higher, and expectations for future interest rates rose sharply.

Graph 6: This graph compares a series of macroeconomic factors in two time periods: 2020Q1-2021Q2 and 2021Q3-2022Q2.  It shows that GDP growth surprises are more negative in the second period, inflation surprises are larger, GDP growth has been weaker, inflation has been higher, and interest rate expectations are higher.
Chart 7: This chart shows the results of the selection of variables used to model the average correlation of cryptocurrencies with fundamental macroeconomic factors.  We find that GDP growth, interest rates, and growth surprises help explain the history of this correlation.  The average correlation predicted by the model is close to the actual average correlation.

To understand the drivers of the correlation between cryptocurrencies and stock markets, we built a model using a variable selection algorithm to determine the specification. The results are shown in Table 7.

  • The fitted model to produce Figure 7 tells us that the following relationships tend to hold:
  • Real GDP growth is negatively related to the correlation between cryptocurrencies and stock markets. Higher economic growth increases the independence of cryptocurrencies with stocks.
  • Interest rates have a negative relationship with the crypto-equity correlation. Cryptocurrencies and stocks move more independently when interest rates are low.
  • There is a very strong correlation between the crypto-equity link and economic growth surprises. If growth is weaker than expected, cryptocurrencies and stocks will move more in the same direction.

Bottom line

Cryptocurrencies have shown the highest returns and greatest independence from other asset classes when economic growth has been strong, interest rates have been low, and the economic environment has had limited surprises. As a corollary, the asset class has shown extraordinary weakness this year, in an environment where the opposite has been true.

As a warning, our story is short: the largest coins have been around for about a decade and the cryptocurrency market has evolved considerably each year. The current form of the market, where Bitcoin and Ethereum are dominant players but new entrants can repeatedly emerge, attract investors and gain significant market share, has taken hold in the last five years or so. We only have the end of the last expansion and the pandemic period to base our analysis on. In that time, cryptocurrencies have not had stable relationships with fundamental factors, and new forms and flavors of cryptocurrencies continue to develop. The experience of the past year suggests that cryptocurrencies, like stocks, are a growth-linked asset and investing in them is an investment in future economic growth, albeit more volatile than investments in other growth-linked assets.

It is possible that future innovations in this area will lead to a crypto asset that can function as a secure store of value and protect against economic risk for its investors, but such a world is hard to see today. Right now, they look like an asset class that relies on the same factors as other risky assets.

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