Crypto Correlation Breakdown

• Mar 28, 2024
Crypto Correlation Breakdown

by Ryan Shea

Last month’s update was entitled “Wen All-time High?” and luckily for us we publish on the first day of the month because just three days later Bitcoin squeezed above its November 2021 peak. It went on to hit a series of higher highs over subsequent days, hitting almost $74,000.

While Satoshi’s invention dominated the mainstream media headlines, it was not the only cryptocurrency that witnessed a surge in March. As confirmed by the Trakx Top10 Crypto CTI gaining a further 35% last month, the bull move was pretty much across-the-board. AI and Meme coins were particular hotspots, up 80% and 200% respectively, providing stellar launches for our newly introduced CTIs.

Helping drive prices higher was the FOMO-effect kicking in ahead of the all-important Bitcoin halving event slated for next month1. As I have outlined in previous commentary, halvings typically provide a bullish signal for the seminal cryptocurrency.

Positive vibes were also encouraged by the continued sizeable inflows into various US spot BTC ETFs. Since their launch just over two months ago, investors have put $12bn in these products – a figure that takes into account the $14bn outflows from Grayscale’s GBTC ETF created via the conversion of its hard-to-exit Bitcoin Trust Fund - see chart.

Spot Bitcoin ETF Flows By Fund (BTC)

Crypto Correlation Breakdown

Source: Bitmex

As a result of these inflows, Bitcoin ETFs have combined assets of over $57bn. One can hardly overstate the impressive nature of this product launch. Having pushed silver ETFs into second place almost immediately, Bitcoin ETFs have their sights set on dethroning Gold as the largest commodity ETF. First launched in the US back in 2004 over the following two decades gold ETFs have accumulated a combined AUM of $100bn. In just two short months Bitcoin is already more than half-way to matching that. Not too shabby for an asset with only a 15 year track record of serving as a store-of-value compared with gold’s thousand years plus track record (testimony to the power of logic!)2

During these first two months, ETF purchases of Bitcoin on behalf of their clients has swamped issuance coming from the 6.25 BTC block reward (soon to be 3.125 BTC) awarded to miners for compiling blocks of transactions3. And, as any student of economics knows, when demand exceeds supply the result is upward pressure on prices until a new equilibrium is achieved. Indeed, this is what one finds when comparing cumulative ETF inflows with the price of Bitcoin – see chart. (NB. The ETF holdings are denominated in BTC and hence do not grow in line with the BTC/USD price due to revaluation effects).

Cumulative ETF flows vs. Price

Crypto Correlation Breakdown

Source: Bitmex and author calculations

Amid such strong upwards price momentum, macro was largely relegated to the backseat. However, ignoring economic gravity is never a good plan and, as I warned about in the two preceding Monthly Updates, the market was again forced to downwardly adjust its expectations as to the pace of Fed easing in 2024. The catalyst for the latest revision to rate expectations was the hotter than expected CPI and PPI reports. They fueled a nascent sense that the continued disinflationary trend seen a necessary for the Fed to initiate its easing cycle may not be a strong as previously assumed, although this was subsequently tempered by a dovish Powell press conference following this month’s FOMC policy meeting. As a consequence, three 25bp cuts from the Fed are priced for the remainder of the year, which is less half of what was expected back at the start of January.

This negative macro shock triggered a liquidation cascade in crypto that saw prices decline sharply mid-month, and it was not just the crypto degens that were selling. As the chart above confirms, ETF holders also tempered their BTC enthusiasm – albeit only temporarily.

That crypto-asset prices stumbled on the back of the higher than expected US inflation prints and upwardly revised interest rate expectations is not that surprising. It is widely understood that Bitcoin is an asset that does not generate cash flows. This makes it relatively less attractive to hold in high versus low interest rate environments relative to cash flow generating assets such as bonds because of the greater opportunity cost of holding them.

Obviously, the naysayers take this aspect of cryptocurrencies to the extreme. To their way of thinking, the absence of cash flows, which (correctly) implies investors can only profit if the price goes up in the future, is a price dynamic that has similarities with a Ponzi scheme. Ergo, all cryptocurrencies are bubbles. A great illustration of such thinking is shown below – see image.

Crypto Correlation Breakdown

Source: Twitter

Correlation Causation

However, one of the truisms of scientific analysis is that correlation does not imply causation. Just because two things occur in quick succession does not imply one directly leads to a change in the other (in the above example, low rates = rising Bitcoin, high rates = falling Bitcoin). In fact, Bitcoin bulls should be thankful for this because otherwise the recent release of Dune 2 (btw - a fabulous film that I highly recommend) would be cause for great concern as highlighted in this recent humorous4 tweet – see image.

Crypto Correlation Breakdown

Source: Twitter

What the simplistic analysis (rates up, Bitcoin down) fails to take into consideration is that there are remarkably few readily tradeable (read: liquid) assets that are divisible, fungible and able to provide resistance to both inflation and/or censorship – meaning they have the ability to hedge against something going wrong with the fiat money system because they cannot be easily manipulated or accessed by governments.

Real assets, whose worth derives from their usefulness to society, may be able to provide inflation protection but in almost all instances they are not censorship resistant, liquid or fungible. Similarly, financial assets, which are typically more liquid and fungible than real assets, are definitely not censorship resistance because they have an associated financial liability that resides in private companies, most often commercial banks5.

In fact, only two match all of these criteria - gold and crypto6. Two non-cash generating assets whose value is almost exclusively based upon the willingness of others to purchase them at a specific price. For anyone of the view that psychologically derived valuations imply worthless assets please feel free to contact me to dispose of your gold or Bitcoin holdings.

No takers?

Thought not!

Obviously, how valuable these assets with scarce characteristics are fluctuates depending upon the collective view people have on the overall health of the fiat money system.

As alluded to above, but explicitly stated in prior research notes, fiat money is a debt-backed system. The majority is backed by private debt because most money, certainly all electronic money, held by the general public is privately-issued by commercial banks. However, as we witnessed during the Great Recession, if financial institutions get into difficulties they get bailed out by the central bank so, in the end, the backstop is the government. Given this, a crucial determinant of the health of a fiat money system is the level of government debt and specifically, its sustainability.

In low government debt environments, the prospect of the government having to print fiat money to finance themselves is minimal. Hence, the value people will ascribe to “psychologically-valued” assets is typically rather modest, albeit relatively more attractive when interest rates are low as opposed to high due to opportunity cost effect. In fact, in a high interest rate low government debt world, the best thing to own would be bonds (high return, low risk of default).

In high debt environments, which is an accurate description of where we find ourselves today, the relative attractiveness arising from opportunity costs is still present, but it finds itself in competition with changes in the perceived default risk (either in the form of failure to repay, or more likely because central banks can always issue fiat money to cover fiscal shortfalls, inflation).

In a high debt environment, low interest rates help because it keeps the government debt servicing costs low. So even though it is higher than in the low debt scenario, the default risk remains moderate. By contrast, in a high interest rates environment, sustainability becomes a much greater problem because, absent any change in the government’s fiscal stance, the perceived default risk (a barometer of the health of the fiat money system) increases.

Depending upon how these various effects shake out, it is perfectly plausible to envisage a scenario where demand for gold and Bitcoin rise in tandem with high interest rates. Indeed, when we update the chart shown in the above tweet, that is exactly what we have witnessed over the past year or so. The negative relationship that supposedly signaled the end of crypto has flipped.

Crypto Correlation Breakdown

(FYI: For readers who may think that this analysis is just a post-hoc justification for the recent crypto rally I would direct you to a research note published back in February 2022, outlining this exact thinking).

A Narrative Reborn

Confusing correlation and causation may be dangerous to one’s financial health, but that does not mean that correlation is bad, quite the reverse. Correlation, it is extremely valuable, particularly for people who construct portfolios (or cryptocurrencies indices!).

Why? Because low correlation is the source of diversification in any portfolio.

Crypto as an uncorrelated financial asset was one of the predominant narratives during the last bull market. However, when the Fed and other central banks belated recognized that the post pandemic surge in inflation was not “transitory”, and they slammed on the monetary brakes, the “everything bubble” burst. Bond prices slumped, equity prices slumped and crypto prices slumped. As always happens during periods of market stress or economic crisis, correlations go to 1 and the uncorrelated financial asset narrative died.

Perhaps though it is time to revive this narrative because the flip in the relationship between crypto – proxied by Bitcoin’s USD price and short-term US interest rates- means that correlations have shifted. In fact, as can be seen in the chart below, the 3-month rolling correlations of Bitcoin to gold, equities (proxied by the S&P500) and 2 year Treasury yields (a market determined US short-term interest rate that displays more movement than the Fed’s Funds target rates) has dropped to almost zero.

30-day Rolling Correlations vs. BTC

Crypto Correlation Breakdown

Source: Author calculations

To illustrate how valuable uncorrelated Bitcoin returns could be to tradfi portfolio managers consider the following chart. It plots the returns of a standard 60-40 equity-bond portfolio versus one which had a modest allocation to crypto (Bitcoin is the proxy due to its long price history). Not only are cumulative returns higher, but the increase also improves the Sharpe and Sortino ratios of the portfolio (two measures of risk-adjusted returns) without increasing drawdowns. This is holy grail for any portfolio builder!

Historic Cumulative Returns

Crypto Correlation Breakdown

Source: VanEck7

Maybe, that is why Black Rock – the world’s largest asset manager - last month amended their SEC filings to incorporate Bitcoin into its Strategic Income Opportunities Fund. This change, if mirrored by other tradfi institutions, could imply quite a considerable amount of Bitcoin ETF buying on the behalf of their clients because the total market cap of equities globally stands around the $100tr mark while the global market cap of bonds is around $133tr. Compared with these numbers, Bitcoin’s $1.3tr market cap or crypto’s total market cap of $2.4tr seem to be a tad on the slim side.

1 Halvings occur every 210,000 blocks mined and as Bitcoin blocks do not have a pre-determined block time the exact timing of the halving is not known precisely. However, due to the fortnightly difficulty adjustment that targets an 10 minute block time on average, crypto players have a fairly good idea when the next halving block will be mined on or around April 15.

2 For those interested in who might be buying Bitcoin ETFs, especially larger institutional investors, circle May 15 in your diary. This is when the SEC publish the 13-F Filings from Q1, which contain details on the publicly traded holdings by investors with over $100mn in AUM.

3 Daily net issuance due to the block reward equates to approximately 900 BTC per day.

4 At least I assume it was supposed to be humorous.

5 Assets with an associated liability are called inside assets because they sit inside the private financial system. At the aggregate level these assets “net out” to zero. Outside assets, by contrast, have no associated liability do not and as such they constitute the net wealth of the system. As per Willem Buiter, founding member of the Bank of England Monetary Policy Committee, “[O]utside assets are the stocks of natural resources (including land) and physical capital (residential housing, other structures, equipment, infrastructure), the human capital (the current and future labour endowments of the economy, that is, the resources embodied in current and future natural persons) and the productive resources (goodwill, synergy, monopoly power) embodied in legal persons such as incorporated firms.“ - see:

6 Moreover, as I recently pointed out only one supports digital transactions (Bitcoin in case you were wondering) – see:


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