Cryptocurrencies have been promoted as an uncorrelated asset class that should be owned to offset potential dips in traditional investment buckets. So far, the lack of correlation has been proven by showing Bitcoin versus equities and fixed income, as well as gold, real estate, and other commodities. Though the analysis is technically true, the analysis is faulty. Bitcoin has only existed since 2009, when global markets bottomed and began a new cycle; a bull market which has lasted for over nine years. Further, Bitcoin is the only asset in this asset class with enough data to begin to measure. And the data that is measurable is for an asset that today has a market cap of only $100B and around $3B of daily volume (best guess, since much of the volume is OTC). Just 18 months ago, the market cap was only $15B with $200mm of daily volume. This does not have enough statistical significance to measure against traditional investment pools. As for the entire cryptocurrency market, it only has a $250B market cap. Within this asset class is a very disparate group of digital assets, ranging from digital currencies, to network gas, to utility tokens (no different than reward points), to asset backed tokens, and even tokens representing VC ownership.
I have always argued that Bitcoin and other digital assets would eventually become more correlated to traditional markets. Just three things need to be present:
- Growth in market cap and liquidity
- Retail investor adoption
- Actual use cases for utility tokens
In the last year alone, all three have become apparent. Subsequently, correlations are starting to become apparent.
As can be seen in the chart below, most analysts are only comparing Bitcoin and other digital assets to US stocks, bonds, and gold.
Chart courtesy of Sifr Data
However, there are other markets that show much higher correlations to Bitcoin. South Korea and China were both early adopters of digital assets. A strong correlation between South Korea’s KOSPI and Bitcoin began to emerge in 2016, and shortly thereafter followed by a correlation between the Shanghai Composite Index (SSE). The correlation held with the KOSPI throughout 2017 as Korean markets outperformed most global equity markets. The risk on trade in South Korea, along with other other developed markets, contributed to the strength of the digital asset market. If you look at Bitcoin compared to the SSE, the growing correlation emerged in 2016 and grew stronger through June 30, 2018. The 2018 YTD relationship between SSE markets and Bitcoin was 72% correlated, as the poorly performing Chinese economy created a risk-off trade in both local equities and digital assets.
The overall relationship between BTC and Chinese markets are possibly linked due to the early adoption of cryptocurrencies in China, and the observed trend of diversification out of Yuan into BTC due to limited ability to purchase USD. Most importantly, a large portion of BTC is earned in China due to the dominance of mining operations in the country, contributing to an outsized volume of Bitcoin trading in China.
Chinese Markets and Effect on Bitcoin
The Shanghai Composite Index is the worst performing country index for the first half of 2018, mostly due to tensions around US/China trade policies. There is uncertainty around further escalation of tariffs between the two countries, which could push the index lower, or potentially hold markets at a bottom. Perceived dovish statements from the PBOC after their June 28th meeting has helped to quell markets, and pushed the Shanghai Index up 2% on June 29th. Crypto markets received support at the same time, with a 5–10% move higher that began on June 29th and continued through July 2nd.
A decade of low interest rates for most developed countries have had a negative impact on emerging markets, which have already seen inflation and currency swings, particularly in commodity-producing countries. China’s inflation rate has held steady and currently around 2%, despite other emerging markets volatility, such as Brazil, which experienced 9% inflation in both 2015 and 2016 before settling to an annualized rate of 3.5% for the last 18 months.
Given that China is already in bear market territory, along with the potential of rising interest rates in the US, further trade tensions, and risk of global inflation, it is possible for China to experience a further pullback in domestic equities. These conditions, if the correlation holds, could be an obstacle for Bitcoin and the digital currency market to overcome before re-entering bull territory.
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