As we see the crypto market being so volatile we must understand that is has connections to what is happening in the real world and many factors can affect the market just like the stock market.
These two cryptocurrencies Bitcoin and Ethereum are currently ranked among the world’s top 20 most traded assets. Their market caps are greater than some of the largest companies in the world. Growing popularity and participation in the crypto ecosystem explains their growth during the pandemic. However, how are decentralized markets influencing traditional ones with all the crypto mania? A new IMF working paper says the key is in the correlations.
- A new IMF working paper explores the connection between crypto and equity markets following a twentyfold increase in the market cap of decentralized assets during the pandemic.
- They find fluctuations in the daily returns of Bitcoin and Tether can explain a sixth of the variation in daily S&P500 returns, up from just one-percent pre-pandemic.
- Combined, volatility in the two crypto assets can also explain a fifth of the daily price action in EM equity markets.
Until at least the first half of the pandemic, many thought Bitcoin’s scarcity would help it become an inflation-hedging asset. But opinions changed when inflation started rising in May 2021. Bitcoin was turning out to be another play on risk marketsit was most correlated with US and Chinese equities. It is this connection with equity markets that the IMF paper considers because that is where the $3 trillion crypto market will probably have the largest influence. The paper finds the following.
- The correlation between Bitcoin price volatility and volatility in the S&P500 rose over fourfold from pre- to post-pandemic.
- Bitcoin is now responsible for 17% of the daily volatility in US equity prices.
- Crypto assets are also increasingly connected with EM equities.
- Bitcoin and Tether can explain almost 20% of the fluctuations in daily MSCI emerging market (EM) prices. For comparison, the S&P500 explains 30%.
Since the start of the pandemic, the correlations between cryptos and equities have skyrocketed. The intra-day price volatility of two major crypto assetsBitcoin and Ethereum is now about four to eight times more correlated with the volatility of the main US equity market indices (the S&P 500, Nasdaq and Russell 2000) versus 2017-19 (chart one). A similar pattern holds for the correlation with equity markets in emerging market economies, captured by the MSCI EM index.
Intra-day returns have also become more correlatedthough the increase has been particularly pronounced for Bitcoin (chart two). While the correlation between Tether and equities also strengthened, it turned negative during the pandemic implying people used it as a risk diversification asset in that period.
The rise in correlations between crypto assets and equities has been much bigger than for other key asset classes, such as the 10-year US Treasury ETF, gold and selected currencies (the euro, renminbi and US dollar).
However, the correlation between Bitcoin returns and high-yield bonds (HY CDX) and investment-grade bonds (IG CDX) has strengthened notablyas tends to be the case for risky asset classes. Meanwhile, the reverse holds for Tether, again implying risk diversification (chart three).
More complex correlations
To formally measure crypto’s link to asset markets, the authors run a VAR model to capture bi-directional correlations. They call these correlations ‘spillovers.’ Again, they analyze daily returns and volatility to gauge the extent of portfolio connection and diversification strategies across asset classes over time.
Like the simple correlations, spillovers have also increased during the pandemicthat is, from crypto to equity prices and vice versa. For example, volatility in Bitcoin prices now explains 17% of the volatility in the S&P500 (chart four). But volatility in S&P500 prices also now explains 15% of the volatility in Bitcoin prices. This shows a strengthening bi-directional correlation so, increased spillovers.
Also, the connection between Bitcoin and Tether increased since the start of the pandemic. Volatility in Bitcoin prices explains over a quarter of Tether price volatility. In the other direction, Tether only has a limited impact on Bitcoin’s volatility (12%). It can also only explain six-percent of the volatility in the S&P500.
Return spillovers also increased during the pandemic. The patterns are broadly similar to the volatility spillovers but smaller. The most striking result is that daily returns in Bitcoin and Tether combined explain a sixth of the variation in daily S&P500 returns. They also explain 15% of the variation in Russell 2000 returns. This is remarkable given their contributions were almost non-existent before the pandemic, and it shows just how much crypto assets influence equity markets.
The growing connection between cryptos and equities extends beyond the US. Bitcoin explains 14% of the volatility in the MSCI EM index during 2020-21 and eight-percent of its returns variation. These are up 12pp and 7.5pp from pre-pandemic, respectively. Combined with Tether, the two crypto assets explain almost 20% of the daily price action in the MSCI EM index (chart six). Comparatively, the S&P500 explains 30% of the daily MSCI EM price volatility.
To finish, the authors examine these spillovers in periods of market stress. Generally, the spillovers are larger when market volatility is high. For example, the March 2020 market collapse led to a pronounced and relatively extended rise in bi-directional volatility spillovers between crypto and equity markets.
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The pandemic’s macroeconomic implications have been huge. They have altered decade-long trends in labor markets, goods and services, consumption habits, inflation and more.
As this paper shows, the pandemic also appears to have accelerated the integration of decentralized markets into centralized ones. As such, investors, regulators and policymakers can no longer trivialize the importance of crypto within the global macro landscape. Events in crypto are now also events in equity markets and vice versathe speed at which this has changed is astonishing.