One of the biggest attractions of Bitcoin and other cryptocurrencies lies in its ability to act as an inflation hedge as opposed to traditional assets like bonds and stocks. This has even prompted Bitcoin’s classification as digital gold, even as the new asset continues to eat into the precious metal’s market share.
However, the International Monetary Fund (IMF) has now warned that this could gradually become a phenomenon of the past as the correlation between cryptocurrencies and the stock market increases.
‘Concern is growing’
In a blog post on Tuesday, analysts from the IMF noted that Bitcoin and other crypto-assets “have matured from an underutilized asset class to an integral part of the revolution.” digital asset network”, added,
“Crypto assets are no longer on the fringes of the financial system.”
However, the IMF believes that this adoption has entailed risks of financial instability due to the spillover between digital assets and volatile securities.
“In a more adopted context, the correlation of crypto assets with traditional holdings such as stocks has increased significantly, which limits the perceived risk diversification benefits of them and increase the risk of contagion in financial markets”.
New IMF research has shown that although 2017-19 saw Bitcoin move independently of the S&P 500, with their daily moves showing a small correlation coefficient of 0.01, this did change during the pandemic. The index has gained 3,600% to 0.36 between 2020-21, indicating that both asset classes have begun to move more in tandem than before.
A factor of 1 means the contents are moving in a lock step, while subtracting -1 will show they are moving in opposite directions.
Source: IMF
This is because the coronavirus has brought economic uncertainty and an “irregular central bank response”, causing an increase in inflation but also “investors’ risk appetite”. This has resulted in crypto-assets losing their status as a tool to “diversify risk and act as a hedge against the volatility of other asset classes.” Blog post added,
“Stronger correlations suggest that Bitcoin is already performing as a risk asset. Its correlation with equities has outperformed the correlation between stocks and other assets such as gold, investment-grade bonds, and major currencies, pointing to the benefit of limited risk diversification. contrary to what was initially perceived.”
This synchronicity between both markets also increases the likelihood of investor sentiment replicating, as spillovers from Bitcoin return and volatility to equities and vice versa has increased since May. April 2020, according to IMF analysis.
Additionally, the organization found that Bitcoin volatility causes about one-sixth of all S&P volatility along with about one-tenth of the volatility in S&P 500 returns during the pandemic, highlighting the growing connection increase between the two. It concludes,
“Therefore, a sharp drop in the price of Bitcoin could increase investor risk aversion and lead to a decrease in investment in the stock market.”
Last month’s stock sell-off is a prime example of this growing correlation. As investors withdrew from the stock market amid growing concerns about novel coronavirus variants, Bitcoin also saw a significant $1.3 billion devaluation.