When it comes to innovation and change, humanity in general has a tendency to want to think of the new in terms of the old. While this is understandable as the old is familiar and serves as a useful analytical springboard, it is also harmful; as we automatically attempt to shoehorn the new into frameworks that are not suitable for it.
Is this the case with Crypto?
Having seen how BTC’s correlation to inflation has changed over time, how about Gold and inflation?
Interestingly, over the past 18 months or so, we see Gold’s 1 year rolling correlation with inflation trending towards -1.
That is, over the past 1 and a half years, Gold has been moving in a manner that is opposite to inflation, at least on a 1 year rolling correlation basis. This obviously runs counter to the mainstreams’ perception of Gold being a hedge against inflation.
However, over the past decade or so, Gold’s 1 year rolling correlation with inflation has also constantly shifted between being positive and negative.
Which brings us to the point of this exercise – that relationships between variables can change, and in a lot of cases, changes frequently.
It will not be surprising for BTC to find itself positively or negatively correlated with inflation over different periods of time in the future, just as it has been over the past 10 years (same for Gold).
Consequently, the answer to the question “Are Cryptocurrencies good hedges against inflation?” is, it depends!
Should investors be holding Bitcoin during a period where it has a high positive correlation with inflation, then they would be owning an effective hedge against inflation.
On the other hand, if they were holding onto BTC during a period where it was negatively correlated, or even uncorrelated (correlation = 0) with inflation, then they wouldn’t be.
Also, it is important to remember that price data for Cryptocurrencies only run as far back as Bitcoin does, which is about 10 years.
As such, we do not know how BTC will correlate with inflation over longer time frames. More importantly, we cannot draw any data driven conclusions on how effective an inflation hedge BTC can be, should an investor choose to hold it for the “long term”.
Ultimately, relationships between markets, asset prices, and economic variables are always in flux, and categorizing an asset as “this” or “that” blinds us to this fact. Even relationships that have lasted so long as to be taken for granted, like the decades-long negative correlation between stocks and bonds, are subject to change, considering how prior to the late 1990s, stocks and bonds were positively correlated.
In light of this, just as Crypto can be a safe haven while also being volatile, perhaps it would be more constructive to think of Cryptocurrencies in a different way.
Not as an asset that definitively protects one’s capital against inflation; but as an asset that can do so.
From this perspective, Cryptos can be seen on their own merit, and for the different characteristics that they offer to investors who might or might not be looking to own such a blend of different exposures.
What is an uncorrelated asset? Quite simply, assets are uncorrelated if changes in one’s returns don’t affect the other. Perfectly uncorrelated assets have a correlation coefficient of 0, and, from an asset management perspective, are important because they allow money managers to diversify their portfolios effectively. Which is where Cryptocurrencies supposedly come in.
4. Is it a non-correlated asset?
Given their decentralized nature, and their independence from governments (although government legislation still affects Crypto holders/hodlers), the asset class should theoretically be an uncorrelated asset.
Unfortunately, that just isn’t the case.
1 year rolling correlations between BTC, SPX, Gold, and US 10y yields were calculated using the YoY returns of each asset class (using monthly price data) in order to get a longer term (and smoother) view of Bitcoin’s relationship with each.
As the chart of BTC and the S&P 500’s 1 year rolling correlation clearly illustrates, Bitcoin and US equities are, more often than not, highly positively correlated.
As a matter of fact, other than for a period of about a year from 2015 – 2016 where the correlation dipped sharply negative, both asset classes have remained positively correlated.
The opposite is the case for Bitcoin and Gold. While the correlation between both has flipped sharply a few times over the last 8 years, the tendency for both assets is to be strongly negatively correlated.
Finally, the 1 year rolling correlation between BTC and US 10y yields is a near mirror image of BTC vs Gold.
What can we make of all this?
Firstly, and most importantly, that relationships in financial markets always change. Even versus US equities, which Bitcoin has the steadiest correlation with, the coefficient still flipped from highly positive to highly negative once.
Relationships between market variables should never be taken for granted, and are rarely set in stone.
That being said, BTC and US stocks have a remarkably steady positive correlation, that is, they tend to rise and fall together. Of course, for those inclined toward categorization, this places Cryptocurrencies in the “risk asset” box. Although it must be said that categorizations tend to be subjective and nuanced, differing to each individual’s perspective.
More importantly, for the purposes of this discussion, it also means that Cryptocurrencies are not uncorrelated assets.
Their return profiles have changed together with the broader US equity market, at least for the past 8 years, and on the basis of rolling 1 year correlations. As long as these relationships hold, Cryptos cannot really be seen as an asset that diversifies portfolios away from broad market risk (beta).
Consequently, if traders or investors want to hold Cryptocurrencies in their portfolios, they should make certain that they are deriving some sort of utility from the asset class based on its other characteristics.
To be continued…
When markets crash, they tend to crash together, with all assets moving in tandem. In this sense, a “true” test of just how uncorrelated an asset can be is whether its price moves in lockstep with other markets during times of panic.
How does BTC fare in this regard?
In order to answer this question, we need to look at how correlations between Bitcoin and other assets change during times of crisis. However, we can only make this comparison over a single crisis period – 2020’s COVID related financial panic.
Considering that relationships between market variables change quite frequently, it would be preferable to observe Bitcoin’s correlations over multiple crises. But, since Bitcoin only made its trading debut in 2010, we have to make do with just what happened in 2020.
Versus the S&P 500, we can see from the chart above that BTC’s 1 year rolling correlation (on YoY returns) actually decreased over the course of the crisis period, before rebounding sharply after.
This is interesting, because it illustrates that as global markets crashed, Bitcoin actually grew less correlated with US equities, even as the price of BTC plummeted.
Does this make Bitcoin an asset that is uncorrelated to broader market risk?
If one looks purely at correlation coefficients, then yes, the fall in BTC’s 1 year rolling correlation with the S&P during 2020 would suggest that it is.
However, BTC’s price fell by about 60% on a high to low basis during 2020’s global panic, while the S&P fell by about 35% – which is quite a contradiction.
In order to resolve it, 1 year rolling correlations were calculated based on month-on-month returns to see how the correlation coefficient changed over the short term:
The results, shown in the chart above, clearly show that over the crisis period BTC became more strongly positively correlated with the S&P.
BTC really isn’t an uncorrelated asset.
While this seems opposite to what is implied in the first chart, it is actually in line with its general conclusion. Which is that, over time, both asset classes tend to be positively correlated.
The first chart was calculated using YoY returns, and provides a smoother, longer term perspective of BTC’s relationship with the S&P, sacrificing the ability to observe shorter term changes in order to do so. (This is also a good example of how statistics, and their interpretation, can vary widely)
Furthermore, the sharp and swift changes in Bitcoin’s correlations with Gold and US 10y yields during the 2020 panic also illustrate how BTC’s price is closely tied to what happens in other global markets.
At this point, it is important to note that assets which do not move together with everything else in a global financial panic are extremely rare.
This is due to the relative nature of markets and the human need to categorize. In times of crisis, folks sell assets deemed to be risky, and flock to those perceived to be safe havens, like gold and highly rated sovereign debt.
This either-or dynamic in turn makes most assets correlated. Risk assets, for e.g the S&P 500 and NASDAQ Composite, will see their correlations with each other tend towards 1 as they are sold off together.
Perceived safe havens, on the other hand, will have their correlations with risk assets tend towards -1, as money flows out of the latter and into the former.
Consequently, Bitcoin, and by extension, Cryptocurrencies, not performing like uncorrelated assets is neither a positive nor negative aspect of the asset class. It is simply a function of market participants’ current perception of digital assets, which, like everything else in markets, will no doubt change in the future.
Arguably the biggest criticism Cryptocurrencies get is that they aren’t actually, well, “currencies”. At least, they aren’t “currencies” in the mainstream’s perception; which, of course, begs the question, what is a currency, and where do Cryptos fit?
5. Is it a currency?
Standard (that is, mainstream) definitions of “currency” will include some reference to it being a store of value, medium of exchange, and a unit of account.
Because paper money has been so ubiquitous throughout the memory of humans alive today, the majority of people immediately associate the term “currency” with paper money and everything to do with it.
This means a wallet to store paper money in, bank vaults to hold large piles of cash in, and ATMs from which we can retrieve them from bank accounts. Also, the banking system through which we write and deposit checks (also paper based), and of course other mundane objects like cash registers to symbolize transactions.
However, in lumping all of these things together as “money”, or “currency”, people fail to realize that each of these different parts run on different types of currencies.
For example, while consumers may use cash to transact for groceries, banks process payments between themselves (like if a customer deposits a check) with bank reserves, which is the currency banks use to settle interbank transfers.
As the world became more digitized and debit and credit cards proliferated, “currency” has become even more digital, with more people transacting with each other, and merchants, via direct transfers of some kind.
Whatever form this may take, or what app it may use to facilitate it, the point is that cash is increasingly obsolete, and currency has increasingly changed hands digitally.
In this sense, we are already living in an era of digital currencies and assets, with payment systems set up internationally to facilitate it.
So why can’t Cryptocurrencies be considered as currencies?
Instead of the credit/debit card network linked with banks who then settle transfers between accounts using bank reserves, we have blockchains and tokens.
Which means that the payment system exists. All that is left is for people to use it – which is the biggest problem Cryptos face, the current lack of mass adoption.
But, does the lack of mass adoption make a “currency” less of a currency?
Here is where a little change in perspective will help. A currency exists to serve the needs of those who choose to use it. By extension, this means that as long as people are using it to transact, then the “currency” can be considered a currency since it is a valid medium of exchange.
Humans have used various kinds of objects as currencies throughout history, including, but not limited to, goats, gold, cigarettes, and paper.
As a matter of fact, in some parts of the world, some of these objects are still used as mediums of exchange.
So why not Crypto?
To be continued…
While adoption isn’t widespread enough for them to be used in daily transactions like purchasing groceries, Cryptocurrencies are used by community members (not all of whom need to be diehard believers/evangelists) for transactions between themselves.
A good example of this is the recent massive interest in NFTs, where blockchain based collectibles are purchased and traded in Cryptocurrencies. Which, incidentally, also tells us all we need to know about whether Cryptos are currencies or not.
Firstly, Cryptocurrencies are obviously being used as a medium of exchange to buy and sell NFTs, which also demonstrates Crypto’s use as a unit of account, as the NFTs are priced in Crypto.
Secondly, and not so obviously, NFTs also demonstrate growing acceptance of Crypto as a store of value, since people are holding Crypto denominated assets as investments. Just like people hold USD denominated stocks/bonds as investments.
As such, while Crypto adoption still isn’t anywhere near what can be considered to be “widespread”, there are communities which do utilize them in ways that meet their specific needs.
However, this does not mean that adoption and use of Cryptocurrencies will one day become widespread enough to be thought of as mainstream.
But it also does not mean that they won’t.
No one knows what will happen in the future, and the same applies to digital assets, which is, at the end of the day, what the biggest draw of Crypto is.
Cryptocurrencies provide an avenue to participate in a future of exchange, wealth, and economy where the possibilities are up to communities to define.
Furthermore, individuals who care enough about it and join in the discussions today have the unique opportunity to be part of that process of creation and discovery, with all its attendant successes and failures.
How would this perspective fit into mainstream asset management categorizations? More importantly, can such a perspective fit into mainstream asset management categorizations?
Which begs the question, can Cryptocurrencies be viewed in a non-mainstream way? More specifically, can Crypto be viewed from a perspective that does not stem from mainstream asset management categorizations?
The simple answer is, of course! Anything can be viewed from a different perspective, we just have to be open to it. In the case of Cryptocurrencies, this entails that folks stop thinking about them using frameworks that they are already familiar with.
This would prevent them from falling into the cognitive trap of forcing everything into mental boxes of “something is either this or that”.
It is important to remember that change occurs on the margins and then works its way inwards, to the core. That’s how ideas, beliefs, and paradigms change.
It’s also how systems change. Like it or not, believe it or not, we just have to be open to the possibility of change brought about by something new.
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