Bitcoin, Ethereum and Tether didn’t pass the Covid crash test. Why do they drop in lockstep with equities? The key reason is risk appetite and the Fed becoming a central player devoted to equities.
Are cryptocurrencies a safe haven, a hedge, a diversifier of any sort to equity markets? The short answer is no. Safe haven assets are typically uncorrelated or negatively correlated with traditional assets in periods of market turmoil. The Covid-19 pandemic gave us the first live test for how cryptocurrencies hold their ground in times of a global meltdown.
What happened left little room for doubt. The price of Bitcoin (–53%) corrected even more than the MSCI World (–34%) between the February highs and the March lows. On September 2, both Bitcoin and the S&P 500 again dropped simultaneously, reviving the correlation talk.
Now a fair amount of academic research is confirming the correlation. The most recent paper examines the safe haven properties of cryptocurrencies from April 2019 to April 2020. Researchers from universities in Ireland and New Zealand tested how Bitcoin, Ethereum and Tether behaved when included in six international indices (MSCI World, S&P 500, FTSE 100, FTSE MIB, IBEX and CSI 300). Their conclusion: «Bitcoin and Ethereum were not a safe haven during the Covid-19 market turmoil for the majority of equity markets examined. Their inclusion increases portfolio downside risk».
There was one exception, however: «Only investors in the Chinese CSI 300 index realized modest downside risk benefits, but only assuming small allocations to Bitcoin (16%) or Ethereum (14%). For larger allocations we again observe increasing relative portfolio downside risk for CSI 300 investors». As to Tether, it did act as a safe haven for all of the international indices examined, but that was because it maintained its peg to the US dollar during the Covid-19 turmoil.
The authors warn that Tether's dollar peg has not always been maintained, in which case it only gets you «impaired downside risk hedging properties». Besides, if you compare Tether to cash holdings in US-dollars, the former is exposed to added counter-party, technological, security and liquidity risk.
This research report confirms a previous one focused on the US market, released in March by the same Dublin scholars. It says: «Bitcoin does not act as a safe haven, instead declining in lockstep with the S&P 500 as the crisis develops. When held alongside the S&P 500, even a small allocation to Bitcoin substantially increases portfolio downside risk. Our empirical findings cast doubt on the ability of Bitcoin to provide shelter from turbulence in traditional markets».
These analyses provide a result, but they hardly ever explain the cause. The one decisive factor is Fed action and liquidity. On the upside, cryptocurrency prices are highly correlated to risk appetite. And risk appetite is now dictated by the Fed. With its asset buying, the central bank leads the pack and is now the heart of the financial system. Cryptocurrency behavior now mainly depends on how much central bank liquidity is provided.
When the Fed withdraws from the game, everything has a life of their own. When liquidity was being drawn from the markets, cryptos became less correlated to equities, as investors were getting more selective and discrete in their choices. A case in point was during the short episode when federal fund rates went up from 1% to 2,5% between the end of 2017 and August 2019.
At that time of scarcer liquidity, Bitcoin was more independent from the S&P 500: during most of 2018 and 2019, the two asset classes had an inverse relationship and were only (positively) correlated for brief periods. In 2018, an analysis found that there was little to no correlation between Bitcoin and the Nasdaq.
Research conducted in 2017 to 2019 often found that Bitcoin could be a safe haven, though acknowledging that this function was time-varying. A few papers asserted that cryptocurrencies reacted positively to uncertainty (making higher returns), and could be a hedge against uncertain monetary policies, or in times of high geopolitical risk. But all this talk came to an end in August 2019, when the Fed ended its tightening course, and became more accommodating than ever. Bitcoin immediately became more correlated to equities.
On July 9, Bitcoin reached an all-time correlation record with US equities. That came after a major, if not historic, liquidity build-up. In March, the Fed brought the federal funds rate down to zero. Equities and Bitcoin both sharply rebounded. A few weeks later, the Fed announced that it would underwrite and buy investment grade bonds, directly and through ETFs. In April, it announced it would buy junk bonds and junk-bond ETFs.
In June, it extended its buying to bonds of giants like Apple or Microsoft, that are not remotely in need of help. In mid-June, the Fed confirmed that rates would stay at 0% as long as needed, increased its holdings of Treasuries and MBS securities, and continued to offer large-scale Repo operations (short term spec funding). With all that, Bitcoin rebounded 115% from the March 23 low – disproportionately benefitting from the regained risk appetite – , and the S&P 500 gained 50%.
The fundamental case is the following: the major player and market maker is the central bank, and this is becoming a permanent feature of today’s market structure. The Fed is now the second largest owner of US government debt, and the BIS calculates that the drop in interest rates alone accounted for half of this year’s S&P 500 rebound. The BIS didn’t even include the effect of the dramatic QE boost.
We can see how the correlation between Bitcoin and equities is now a factor of access to Fed benefits: cheap borrowing, leverage, and arbitrage. In other words, the Bitcoin price is in good part driven by the same Fed signals that drives indices. But the Fed is exclusively devoted to traditional markets and doesn’t buy crypto assets. This means that, when it comes to arbitrage, investors having access at little cost to liquid and plain-vanilla assets like the S&P 500 and Nasdaq with guaranteed central bank liquidity, give these assets a risk premium.
Cryptocurrencies come second: during downdrafts they are sold first and disproportionately. That is because the central bank is no buyer and lender of last resort in crypto markets, only in traditional markets. That is why Bitcoin corrects along with the S&P 500, but more sharply. BTC now displays its highest correlation to the VIX (the volatility index) since January 2017.
Either way, the whole point is that cryptocurrencies were put into the orbit around the Fed, becoming a satellite competing for its liquidity. Once upon a time, investors called the shots, and their variety resulted in distinct markets and asset classes. Now we moved into a Fed-centric universe, with the central bank as the number one buyer. Investors better do their Copernican revolution and get this.