After the 2022 spike, the correlation between the crypto market and risk assets has reverted to the historically typical low levels. More recently, risk assets and the crypto market have been moving in opposite directions, and idiosyncratic factors remain the dominant drivers for crypto assets, such as regulatory developments, token supply and catalysts for fresh sources of demand.
After the last FOMC meeting, the S&P500 and NASDAQ rallied to all-time highs while crypto sold off. This recent move underscores the persistent low correlation between the crypto market and risk assets.
Despite daily media narratives about the crypto market being driven by global macro developments such as US interest rate and inflation trends, the actual correlation between crypto and risk assets has been very low most of the time.
Is crypto correlated with risk assets?
Correlation between the S&P500 and Bitcoin
Source: CoinMarketCap, Stoog, Sygnum Bank
After historical highs during 2022, the low correlation regime has reasserted itself. Idiosyncratic developments such as the US spot ETF approvals or regulatory actions (both positive and negative) have been the primary drivers of the crypto market over the last year and a half.
A brief increase in correlations in May gave rise again to the “global macro drives crypto” narrative; however, the high correlation dissipated very quickly as crypto-specific developments such as the Ethereum spot ETF approval, the US political and regulatory pivot and concerns about supply with the impending Mt Gox distributions and miner selling dominated flows by the end of May.
Meanwhile, the price of Bitcoin has been near-perfectly correlated with the net in- or outflows of the Bitcoin ETFs. This suggests that market sentiment is heavily focused on the ETF flows currently. As some of the ETF flows are arbitrage trades that have a neutral effect on the price, it is not always the flows themselves that drive the price but rather the impact they have on sentiment.
Shifts in correlation regimes
Up until 2020, the crypto market was uncorrelated with risk assets. The occasional spikes in short-term (one-month) correlation were extremely short-lived and went in both directions (positive or negative correlation), and the three-month correlation stayed consistently close to zero percent.
With crypto entering the mainstream from 2020 onwards, there was a shift in the correlation regime, and the average correlation moved from around zero percent to 20-30 percent. This regime shift was clearly the result of institutions entering the crypto market, and therefore a return to zero correlation is not likely. However, correlations of 20–30 percent are still low and bring substantial diversification benefits to portfolios.
Other than the low correlation of gold and the equity/bond correlation, which is sometimes strongly positive and sometimes strongly negative, it is hard to find the kind of low correlation between asset classes that crypto offers.
After the highly uncorrelated moves in the last few weeks, the Bitcoin vs S&P500 correlation currently stands at 15 percent, which is roughly the same as the correlation between gold and the S&P500.
Another regime shift in correlations is possible in the future if traditional institutional investors allocate to the crypto asset class in size. However, certain idiosyncratic factors such as trends in the technology, the development of use cases and evolving crypto regulation will limit how high correlation with risk assets can get.
A further barrier to high correlations is Bitcoin’s use as a safe haven asset or “hedge against financial disaster”, as Bill Miller put it. We saw this during the US banking crisis last March when banking stocks sold off -20 percent and Bitcoin rallied +20 percent within a few days.
What drives correlations?
Correlations between assets are affected by the fundamental drivers of these assets and the types of market participants trading them.
If a factor such as rising interest rates or the oil price has a similar impact on the value of assets, for example, by impacting companies’ profitability, this will lead to high correlations. Similarly, assets that are valued on the basis of future cashflows will see their fundamental value decline with rising rates, and the price movements of these assets will correlate.
The fundamental drivers of crypto assets suggest that correlation with risk assets should remain limited.
While the discounted cashflow methodology can be used to value certain crypto assets, it is not an appropriate valuation method for others – most importantly for Bitcoin.
At the same time, the growth trends of decentralised projects are still primarily driven by the adoption of a new technology, and in some cases, taking market shares from centralised businesses. Therefore, revenue growth in many cases is not impacted by economic cycles, and it can even be negatively correlated, as these projects take market shares from traditional companies. When crypto industries mature, they will be more closely driven by economic cycles, but at this stage, we are far from that.
The changing mix of market participants has had a greater impact on crypto’s correlation with other asset classes. The shift from retail dominance to institutional participation caused a change in the correlation regime, and in terms of the types of institutions, a future shift from hedge funds towards traditional asset allocators may cause another shift. However, idiosyncratic factors specific to the crypto market will always limit correlations.
Another consideration is the geographic mix of market participants. Should China relax its crypto ban, we may see different investor behaviour than what is typical of Western hedge funds and institutional investors.
Liquidity cycles
Apart from the typically low observed correlation between crypto and other asset classes, there has been a relationship between long-term trends in liquidity cycles and the crypto market.
Periods of looser liquidity conditions have coincided with crypto bull markets and vice versa. This has been true for the entire history of crypto assets – although it may have been accidental for the early market cycles, as Bitcoin halvings were extremely influential in igniting crypto bull markets initially due to the very significant impact on changing supply/demand dynamics.
In the case of the more recent crypto market cycles, it is reasonable to assume that periods of looser liquidity played a major part in igniting crypto bull markets. It is, however, important to note that liquidity cycles do not correspond to interest rate cycles, as interest rates are only one component of liquidity. For example, during the 2016–17 crypto bull market, liquidity conditions were loosening while interest rates were increasing.
Liquidity conditions (as measured by the Federal Reserve’s National Financial Conditions Index) are currently historically loose and have been getting looser since early 2023, even as interest rates were still rising. The crypto bull cycle again appears to highly correlate with the liquidity cycle.
Summary
Although multi-year crypto market cycles appear to be impacted by liquidity cycles in a similar way to other risk assets, the correlation of price movements has been very low historically. Despite a shift from a zero-correlation regime to 20–30 percent correlations, this is still low and offers substantial portfolio diversification benefits.
While brief periods of higher correlations occur occasionally, so do periods of negative correlations, and ultimately, the low correlation regime prevails. A future shift in the correlation regime is possible, but there are numerous factors in place that keep correlations with other asset classes low over time.
Read more about crypto assets from Sygnum here.
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