During the recent market sell-off, Bitcoin and other cryptocurrencies fell in lockstep with equities, disproving any claims of uncorrelation with traditional asset classes. The one and only culprit is excess liquidity, prompting increasingly interconnected movements.
The recent stock market sell-off that sent US indices down almost 10% at the end of February due to fears triggered by the coronavirus, provides an opportunity to test whether cryptocurrencies prove resilient during phases of increased nervousness. The question is whether digital assets such as Bitcoin, Ethereum, Tether, XRP and others, which have become a full part of the investing universe, provide a hedge during stock market downturns and prove uncorrelated with global equities and bonds. Fundamentally, do cryptocurrencies offer a real diversification benefit to traditional asset classes? Based on the latest market movements, the answer is no.
If we compare what happened during the sell-off in the last week of February, we observe that the S&P 500 index lost 11,5% during February 21-28, the Dow Jones slumped 12,4%, while the MSCI World was down 12%.
What happened to cryptocurrencies? Their curves followed a similar pattern over this time period, except that they corrected even more. If we take the biggest cryptos by market capitalization, Bitcoin was down 14,5% in dollar terms, Ethereum lost 20%, Ripple slid 18%, and Bitcoin cash, a cryptocurrency born from a hard fork from Bitcoin, plunged 24%, which is double the loss suffered by the MSCI World.
Their price curves show a similar trajectory, with varying magnitudes. Even gold, the ultimate uncorrelated asset, lost 5,3%. Though subdued, the decline drew the same-shape curve over those trading sessions.
The synchronized correction invites a few remarks. In times of market stress, or market panic, cryptocurrencies become highly correlated with equities and other assets. Cryptos even overcorrect, like all riskier assets. The same happens to emerging markets equities, a category with similarities to cryptos in terms of risk classification.
A positive correlation between the S&P 500 and Bitcoin, though, hasn’t been the rule recently. It was rather the exception: during most of 2018 and 2019, Bitcoin and the S&P 500 had an inverse relationship and were only (positively) correlated for brief periods. Do these random correlation patterns follow investors’ whims? By no means. The hidden variable is liquidity.
The common denominator, explaining how correlations change over time, is liquidity, or how much cheap borrowing the market has at hand. One has to compare charts with an eye on what the US central bank, the Fed, was doing at the same time. Starting in August 2019, the Fed reversed its tightening course, bringing interest rates from 2,25%-2,50%, all the way down to 1%-1,25%.
More importantly, since September 17 the Fed started injecting huge amounts of liquidity, exceeding 400 billion dollars by now, through intensive «repo» market operations. The liquidity shot has doped investors and their speculative appetite. That led to a compression of spreads and a blurring of perceived differences between assets. Risks get flattened out, watered down and investors become less discriminate.
In an excess liquidity regime, correlations tend to increase because people are ready to buy stocks and then take on some additional risk with alternative assets like cryptos. The bull run propelled stocks and bonds from the second half of last year. Bitcoin and gold did not decline because of the Fed's action, but they were less in demand, and hence not boosted by the same magnitude.
Why? Because liquidity favored maximal performance for best liquidity and lowest risk, and therefore equities and high-yield bonds. Bitcoin and gold had both been rising fast during the first half, at constant/decreasing liquidity, until the new liquidity bomb altered investors’ preferences in the second half of the year. Bitcoin and gold then became second choice.
Similarly, the apparent increase in correlation described above, when the coronavirus bear market hit in February, owes it all to liquidity. While liquidity enters the riskiest market segments last, it leaves them first. Crypto markets bear a resemblance to emerging markets because both are subject to the decisive impact of big speculative liquidity, raiding in and out at lightning speed. On March 8, nervous investors anticipating the need for cash sold Bitcoin (down 8% in one session), illustrating this thankless pattern that is the burden of more volatile and less liquid assets.
Excessive liquidity jams correlation signals. Distinct asset-specific properties dissolve, as everything goes up and down in sync, in order of preference and in varying magnitudes. To get less correlation between asset classes, interest rates would need to be normalized, re-establishing discriminate choices, differentiated risk/return profiles, making bonds an alternative to equities again, and giving investors a choice among a range of unadulterated risks.