When we look at the crypto market as volatile we must understand that is has connections to what’s happening in the real world . numerous factors can impact the market just like the stock market.
The two cryptocurrency Bitcoin as well as Ethereum can be currently among the world’s top 20 assets that are traded the most. Their market caps are greater than some of the largest companies around the globe. The growing popularity and involvement in the crypto industry is the cause of their rapid growth in the wake of the epidemic. But, how do market decentralization affecting traditional markets amid all the hype about crypto? An upcoming IMF working paper says that the most important factor is the correlations.
- A brand new IMF working paper examines the relationship between crypto and equity markets after an increase of twentyfold in the market value of assets decentralized in the course of the epidemic.
- They find fluctuations in the daily returns of Bitcoin and Tether could explain about a sixth of the variation in the daily returns for the S&P500 index, which is up from one percent pre-pandemic.
- Together, the volatility of both crypto assets could be a reason for a fifth of the daily price action of EM equity markets.
Up to at most the beginning part of the pandemic there was a belief that the scarcity of Bitcoin could help it become an asset used to hedge against inflation. However, their views changed when inflation began to increase in May 2021. Bitcoin proved to be another play on market risk – it was the most closely linked to US and Chinese equities. This linkage with stock markets in the IMF paper analyzes as that is the area where the $3 trillion crypto market will likely have the most impact. The paper reveals the following.
- The connection between Bitcoin price volatility and the volatility of the S&P500 increased by fourfold between prior to and post-pandemic.
- Bitcoin is currently responsible for 17 percent of the volatility of US equity prices.
- The crypto assets are increasingly associated with EM equities.
- Bitcoin and Tether can explain almost 20% of the changes in the daily MSCI Emerging market (EM) prices. To put this in perspective, the S&P500 accounts for 30%.
Simple connections
Since the outbreak of the pandemic, the interactions between equity and cryptos have risen dramatically. The volatility in prices of two of the most popular crypto assets – Bitcoin and Ethereum currently is 4-8 times more closely to the volatility in the three main US equity market indexes (the S&P 500, Nasdaq and Russell 2000) versus 2017-19 (chart one). Similar patterns are observed for the correlation with the equity markets of emerging market economies, as reflected with an index called the MSCI EM index.
In addition, the returns on intradays have become more interconnected – but the growth has been more pronounced with respect to Bitcoin (chart 2). Although the relationship between Tether and equity also grew but it weakened during the pandemic – implying people were using it to diversify risk asset during the time.
The rise in correlations between crypto assets and stocks has been more significant than other asset classes, such as The 10-year US Treasury ETF, gold and certain currencies (the Euro, Renminbi and US dollars).
But, the relationship between Bitcoin returns and high-yield bond (HY CDX) and investment-grade bonds (IG CDX) has strengthened in a significant way – as can be the case for risky asset classes. In contrast, the opposite holds for Tether and IG CDX, which implies the need for risk diversification (chart 3).
More complicated correlations
To formally measure crypto’s link to asset markets, authors use a VAR model to identify bi-directional correlations. They call these correlations ‘spillovers.’ They also analyze the returns and volatility of the day to determine the degree of diversification and connection strategies across different asset classes over time.
Similar to the basic correlations, spillovers have also increased during the pandemic – that is the transfer of crypto into equity prices and in reverse. For instance, volatility in Bitcoin prices has now been linked to 17% of the volatility in the S&P500 (chart four). However, volatility in S&P500 prices is also a reason for 15 percent of the volatility of Bitcoin prices. This indicates a growing bi-directional correlation , which means more spillovers.
Additionally, the link with Bitcoin and Tether was heightened since the beginning in the outbreak. Volatility in Bitcoin prices accounts for over one quarter of the Tether price volatility. On the other hand, Tether has only a small effect on the volatility of Bitcoin (12 percent). It can also only explain 6 percent of the volatility in the S&P500.
Return spillovers also increased during the pandemic. The patterns are broadly similar to volatility spillovers but smaller. The most striking result is that daily returns in Bitcoin and Tether together account for one-fifth of the variance in the daily S&P500 return. They also account for fifteen percent variance within Russell 2000 returns. This is quite impressive considering that their contribution was almost non-existent prior to the outbreak, and is a clear indication of how crypto assets impact equity markets.
The increasing connection between cryptos and equity markets extends over the US. Bitcoin explains 14 percent of the volatility in the MSCI EM index during 2020-21 and 8-percent of its return variation. The index is up twelve points and 7.5pp from pre-pandemicand. Combined with Tether, these two crypto assets account for around 20% of daily price movement within the MSCI EM index (chart six). Similar to the S&P500 is responsible for 30 percent of the monthly MSCI EM price volatility.
To conclude they examine the spillovers when markets are under stress. Generally, the spillovers are greater when volatility in the market is high. For instance the market crash caused an extensive and significant rise in bi-directional volatility spillovers between crypto and equity markets.
Final line
The implications of the pandemic’s impact on macroeconomics have been huge. It has altered the trends of the last decade in the labor market, consumption of goods and services, consumption habits as well as inflation, and many other areas.
As this study demonstrates, the pandemic appears to have led to the rapid integration of decentralized markets into centralized ones. Therefore, policymakers, regulators and investors are no longer able to dismiss the significance of crypto in the macroeconomic world. Events in crypto are now also events on equity markets and reversed – the speed at which this has changed is astonishing.
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