With 2021 roughly in the mirror, now is a good time to reassess the idea that cryptocurrency is still a risky asset class. After all, crypto risk will help determine how to allocate assets in 2022.
For many traders, the March 2020 massive sale is still a memory, whether it is a big pain or a profit. Bitcoin and Ether as well as almost all cryptocurrencies plunged as if chained to the fall in stocks and bond yields at the time. It was around this time that we started hearing the refrain that crypto is a risky bet, which means it performs well when investors are feeling adventurous and bad when they get nervous.
And it is perhaps risky, since it is a bet on the future of finance; if the money is going to move to the blockchain, owning the blockchain money is a reasonable way to play it.
Of course, this is where we insert an obvious graph: the one showing a stack of correlations.
The black line shows the correlation between bitcoin and the S&P 500, the index that represents the US stock market. If stocks are generally a risky bet (compared to bonds), then one would assume that bitcoin would be highly correlated with the index or at least move in that direction.
Except, well… no, it doesn’t. At its peak two months ago, the 90-day correlation coefficient between bitcoin and the S&P 500 peaked at around 0.31. It is quite weak. At its 2021 nadir in June, the coefficient was -0.04, meaning there was statistically no relationship between U.S. stock prices and bitcoin.
Thus, we also throw a red line showing the correlation of bitcoin with gold. Given the limited supply of 21 million cryptocurrency coins, it should serve as a hedge against inflation in a world where the Federal Reserve and the U.S. government are considering new ways to flood the market.
No dice there either. The 90-day correlation between bitcoin and gold peaked in 2021 in early January, also at 0.30. He has since flopped around the 0 line to no avail like a fish seconds before getting his head kicked on the deck. Its lowest point was -0.18 in August and it sits at a measly 0.07. Gold and bitcoin do not trade together.
Exasperated, we launch a last line: the correlation of bitcoin with bonds, represented by the iShares 20+ Year Treasury Bond ETF (TLT, in yellow). If cryptocurrency doesn’t trade with stocks or gold, it’s surely close with bonds, right? Wrong. Compared to the others, this line sticks to 0 as Seth Rogen sticks to bad scripts. This also applies to commodities (represented in green by the iShares S&P GSCI Commodity-Indexed Trust).
There are several reasons why bitcoin does not correlate with these major macro assets. Some of them have to do with its value proposition. Another may be due to the fact that the crypto markets are still in their infancy and therefore being pushed around by a handful of major players, whether people like to recognize it or not.
The advantage for a portfolio manager is that the low correlations with other asset classes make crypto something that should at least be considered for a portfolio to stimulate diversification.
The downside is that unstable crypto – even the “most secure” bitcoin – is terribly volatile.
Still, the perception that bitcoin is correlated with other risky assets or gold persists, but what happens over the next two quarters will test that thesis, according to Chen LI, CEO of the venture capital firm Youbit Capital. He expects risky assets to decline as interest rates rise with the Fed’s reduction in its bond buying program (bond yields rise when bond prices fall, which is expected since the central bank will not be as much in the market to buy as it used to).
“We’ll see if bitcoin can withstand gravity,” Li said CoinDesk’s First Mover program Thursday.
Where Li sees the correlations breaking down is not between macro assets and, say, bitcoin, but between bitcoin and other cryptocurrencies.
Between bitcoin and ether, the 90-day correlation coefficient is at a very high level of 0.80, even though the ether has beaten bitcoin’s returns in 2021, like many others.
However, the correlation coefficients are somewhat lower for the native tokens of Ethereum’s competitors. Li argues that these correlations will drop and other smart contract platforms will be adopted more. And he sees another contributing factor, and one that may not be so intuitive: it’s how assets are traded.
“In centralized and dexes [decentralized exchanges] we’re seeing more volumes in stablecoin pairs instead of BTC or Ethereum pairs, ”Li said.“ Because… alternative tokens are traded for stablecoin, the correlation between Ethereum [or] bitcoin has just gone down.
If a cryptocurrency is primarily priced against another cryptocurrency such as bitcoin, they will simply move together, Li said. Exchanges for stablecoins, which are often pegged to the US dollar, break the link. of these currencies with bitcoin and ether, he added.
Perhaps, then, 2022 will be the year that altcoins become less correlated with bitcoin which, in turn, is not correlated with macro assets. In this case, we could see a world where traditional portfolio managers will have to give successors a minimum of control just to have a diversified portfolio.
It should be interesting.