In crypto’s early days, the fledgling asset class was almost entirely uncorrelated to traditional markets. This has changed recently as crypto has matured and prices have moved more in line with other assets.
In this month’s letter, we share three key factors we believe are driving crypto’s increasing correlation with traditional markets, and what this might mean for crypto’s investment case going forward.
May began with the Fed announcing the largest rate hike in two decades, but headlines in the crypto world were dominated by the Terra/LUNA saga. We’ve viewed algorithmic stablecoins with caution (the Nasdaq Crypto Index doesn’t include any stablecoins) and shared our views early in the month on what this means for stablecoins and the crypto ecosystem as a whole. More of our perspective on Terra/LUNA can be found here.
As always, our team is here to answer any questions you might have about these markets.
-Your Partners at Hashdex
In May, the crypto market fell for the second consecutive month. Performance was driven by the macroeconomic environment, as inflation and the expectation of monetary tightening in the U.S. set the tone in the first days of the month, impacting both crypto assets and traditional risk assets and indices. In the first week of the month, the Nasdaq Crypto Index (NCI) dropped nearly 10%, just before the collapse of Terra/LUNA. The stablecoin’s implosion caused a panic among some investors, and on May 9 the NCI dropped 10.5%. Despite having been one of the largest crypto assets by market cap, LUNA did not meet the NCI’s standards and was never held in the index.
In the wake of Terra/LUNA’s decline, crypto assets fell more sharply than traditional risk assets. The S&P 500 began a rally toward the end of the month, helped by positive inflation surprises, but crypto assets continued on a downward trajectory. On May 27, the NCI’s decline exceeded 30%, but in the last days of the month, there was a modest reversal. The index closed down 21.9% for the month, down 37.4% for the year. As is common during periods of market stress, bitcoin was the best performing NCI constituent, down 19.9%. Filecoin declined the most, losing more than half its value.
Crypto market faces unprecedented test as Fed announces largest rate hike in 20 years
The Federal Open Market Committee (FOMC) announced a 50 basis point rate hike on May 4, the largest increase of the federal funds rate in over two decades. The Fed’s increasingly hawkish posture is a response to surging inflation that had reached a 40-year high, with consumer price index (CPI) figures for March showing an 8.5% annual rate of inflation. The accelerated tightening is providing uncertainty for the crypto market.
Terra collapse draws policymaker attention
The fallout from UST’s depegging caught the attention of U.S. regulators. Treasury Secretary Janet Yellen cited the stablecoin’s meltdown to illustrate how they could potentially disrupt financial stability. She said a new regulatory framework for stablecoins should be ready by the end of 2022.
SEC Commissioner Hester Pierce revealed during a virtual forum that UST’s collapse has created a sense of urgency among authorities considering new regulations for stablecoins. While Commissioner Pierce agreed that there was a need for further regulation, she also highlighted the importance of the trial and error process that begets new technologies. A similarly balanced sentiment was echoed by U.S. Senator Pat Toomey, a senior member of the Senate Banking Committee. While Sen. Toomey agreed that the Terra situation is likely to intensify regulatory focus on stablecoins, he also defended the importance of regulation that does not stifle innovation.
Bitcoin mining makes a comeback in China
Miners in China now account for the second largest share of global bitcoin mining by hashrate, a measure of processing power used to mine bitcoin. This is after Chinese mining dropped to nearly zero in the wake of the government’s 2021 cryptocurrency ban. Data from the Cambridge Centre for Alternative Finance showed that since September 2021 China has accounted for more than 20% of Bitcoin energy usage. Experts speculate the abrupt hashrate recovery may have been caused by miners who utilized virtual private networks (VPNs) to conceal their location in the months following the ban.
“It will probably take some failures in this space in order for the market to figure out what works.”
U.S. Senator Pat Toomey commenting on Terra/LUNA on May 11, 2022
Revisiting crypto’s correlation to traditional markets
During crypto’s first decade (2009-2019), the asset class was viewed by many as uncorrelated to traditional markets. Bitcoin’s price rising or falling was not closely linked to price movements in stocks, bonds, and other traditional assets. As a result, decorrelation became a relevant and popular crypto investment thesis during this period.
However, the COVID-19 crisis in 2020 and its impact on financial markets changed this dynamic as bitcoin and other crypto assets began to move more in step with traditional markets. The graph below shows the five-year correlation between the returns of bitcoin and the S&P 500, calculated in 42-day rolling periods using 90% confidence intervals (90% CI):
Until February 2020, the average observed correlation between Bitcoin and the S&P 500 was less than 1%. However, since March 2020 the average correlation has been 34% (through May 2022). What explains this jump in correlation? There are a few possible explanations.
The first is the current macro environment. It is well known that correlations between risky assets tend to increase during periods of extreme stress as common factors lead to a risk-off sentiment and impact a wide range of assets. In March 2020, the spread of COVID-19, policies to address the pandemic’s economic impact, and then the emergence of new strains and development of vaccines have profoundly affected the prices of various assets. Even gold—which between January 2017 and February 2020 had a correlation of around -15% with the S&P 500—had a positive correlation of 10% in the period after March 2020.
Another possible cause is the maturation of crypto assets as an asset class. During the early years, there were many factors impacting prices specific to this market, such as technology, regulation, exchange hacks, and others. As a result, the correlation with traditional assets was low. After years of development of crypto as an asset class, the industry is far more mature. This maturation also impacts prices. One example of this impact is regulation. While there is still room for important improvement, crypto assets are currently regulated (and taxed) in the vast majority of major economies or—in the case of China—banned. With less regulatory surprises, these factors have lost some relevance. Ultimately, this has made crypto more similar to other asset classes, increasing its correlation to these markets.
A third explanation for increased correlations is the presence of institutional investors in the crypto assets market, a presence that has been increasing since the second half of 2020. The large traditional asset price movements that result from institutional changes in risk appetite or liquidity, have started to also impact crypto assets and are potentially driving up correlations with other traditional asset classes.
Regardless of these three factors, it is important to remember that the vast majority of crypto assets represent the possibility of decentralized services in the future. Therefore—just as with traditional assets—the present value of a crypto asset typically depends on the interest rate used to discount the value generated by these solutions in the future. Because the future value of crypto assets is not certain but a possibility, the value the market assigns to these assets today is susceptible to the market’s risk appetite. This is also true for traditional risky assets. These fundamental characteristics of crypto assets explain, at least in part, the existence of a positive correlation with traditional risk assets, especially as there is a substantial increase in interest rates and a reduction in portfolio risk.
It is also worth noting that bitcoin deserves special consideration when analyzing correlations. Because a key value proposition for the world’s first cryptocurrency is its use as a decentralized store of value, a safe assumption is that at higher risk, more investors would seek refuge in bitcoin, leading to an appreciation. However, such a value proposition has not yet materialized and, in the market's view, the speculative character of bitcoin prevails, leading to a positive correlation with other risk assets. If bitcoin manages to consolidate as a de facto store of value over time, we should expect a zero or even negative correlation with risk assets.
Also important to note is that cold analysis of the calculated value for the correlation coefficients ignores important aspects of crypto asset prices. There are impactful events with crypto assets that have no effect on traditional assets. In the last twelve months, we can cite the ban in China, the approval of bitcoin futures ETFs in the US, and most recently, the demise of the Terra blockchain. If it is unreasonable to say that crypto assets are uncorrelated from traditional assets, we can say that for most of the recent past, there was a moderate correlation. There is no reason to believe that the high levels of correlation recorded in 2022 are here to stay.
From a portfolio management point of view, the main consequence of increased correlation is that by adding crypto assets to portfolios, there will be a greater impact on the level of risk. However, this problem can be addressed with a position size recalibration in crypto or with the portfolio’s allocation to low-risk assets. It is also worth remembering that, gradually, most crypto assets have registered a reduction in their risk measures, which can mitigate the impact of increased correlation on portfolio risk.
Regardless of the level of correlation with other classes, crypto assets continue to be a unique portfolio component with a promising long-term outlook. The first large-scale use cases, such as DeFi and NFTs, are beginning to emerge and demonstrate the high potential of applications.
Crypto assets are moving into their adolescence, a stage where changes can be disorderly and, at times, painful. However, we believe patient investors with long-term investment horizons will benefit from exposure to these assets, which are setting the stage for a digitalized and decentralized future.
As always, we welcome your thoughts and feedback.
 Confidence intervals provide the degree of precision associated with an estimated parameter, which in this case is the correlation coefficient. If a certain value is contained within the confidence interval means that, from a statistical point of view, the hypothesis that this is the true value of the estimated parameter cannot be rejected.
The information contained herein (“Information”) may not be reproduced or redistributed in whole or in part, in any format, without the express written approval of Hashdex Asset Management Ltd. (“Hashdex”) and its affiliates and subsidiaries (“Hashdex Group”). By accepting this document, you acknowledge and agree that all of the Information contained in this document is proprietary to Hashdex Group. While not explicitly referenced within this piece, Hashdex Group manages the Hashdex Nasdaq Crypto Index ETF, Hashdex Nasdaq Ethereum ETF, Hashdex Nasdaq Bitcoin ETF, Hashdex DeFi Index Fund, Hashdex Smart Contract Platforms Index ETF and other investment vehicles focused on digital assets (collectively the “Fund” and each a “Fund”) which invests in digital tokens. The Information is not an offer to buy or sell, nor is it a solicitation of an offer to buy or sell, interests in the Funds or any advisory services or any other security or to participate in any advisory services or trading strategy. If any offer and sale of securities is made, it will be pursuant to the confidential offering memorandum of the Fund (the Offering Memorandum). Any decision to make an investment in the Fund should be made after reviewing such Offering Memorandum, conducting such investigations as the investor deems necessary and consulting the investor’s own investment, legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of an investment.
Each Fund seeks to track a relevant index. The performance of each Fund will vary from the performance of the relevant index that it seeks to track. The Information is being provided to you solely for discussion purposes and may not be used or relied on for any purpose (including, without limitation, as legal, tax or investment advice) without the express written approval of Hashdex Group. Certain statements reflect Hashdex Group’s views, estimates, opinions or predictions (which may be based on proprietary models and assumptions, including, in particular, Hashdex Group’s views on the current and future market for digital assets), and there is no guarantee that these views, estimates, opinions or predictions are currently accurate or that they will be ultimately realized. To the extent these assumptions or models are not correct or circumstances change, the actual performance of Hashdex Group and the Funds may vary substantially from, and be less than, the estimated performance. None of Hashdex Group, the Funds nor any of their respective affiliates, shareholders, partners, members, directors, officers, management, employees or representatives makes any representation or warranty, express or implied, as to the accuracy or completeness of any of the Information or any other information (whether communicated in written or oral form) transmitted or made available to you.
Each of the aforementioned parties expressly disclaims any and all liability relating to or resulting from the use of the Information or such other information. Except where otherwise indicated, the Information is based on matters as they exist as of the date of preparation and not as of any future date and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after the date hereof. Investing in financial markets, the Funds and digital assets, including Bitcoin, DeFi tokens, and Ethereum, involves a substantial degree of risk. There can be no assurance that the investment objectives described herein will be achieved. Any investment in the Funds may result in a loss of the entire amount invested. Investment losses may occur, and investors could lose some or all of their investment. No guarantee or representation is made that Hashdex’s investment strategy, including, without limitation, its business and investment objectives, diversification strategies or risk monitoring goals, will be successful, and investment results may vary substantially over time. Nothing herein is intended to imply that the Hashdex Group’s investment methodology or that investing any of the protocols or tokens listed in the Information or the Funds may be considered “conservative,” “safe,” “risk free,” or “risk averse.” Neither historical returns nor economic, market or other performance is an indication of future results. Certain information contained herein (including financial information) has been obtained from published and non-published sources. Such information has not been independently verified by Hashdex Group, and Hashdex Group does not assume responsibility for the accuracy of such information. Hashdex Group does not provide tax, accounting or legal advice. Certain information contained herein constitutes forward-looking statements, which can be identified by the use of terms such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe” (or the negatives thereof) or other variations thereof. Due to various risks and uncertainties, including those discussed above, actual events or results, the ultimate business or activities of Hashdex Group or the Funds or the actual performance of Hashdex Group, the Funds, or digital tokens may differ materially from those reflected or contemplated in such forward-looking statements. As a result, investors should not rely on such forward- looking statements in making their investment decisions. None of the Information has been filed with the U.S. Securities and Exchange Commission, any securities administrator under any state securities laws or any other governmental or self-regulatory authority. No governmental authority has opined on the merits of the offering of any securities by the Funds or Hashdex, or the adequacy of the information contained herein.