The Breakdown - Is Bitcoin More Correlated to Stocks or Gold?

Episode Date: October 11, 2020

Today on Long Reads Sunday, a reading of Lyn Alden’s piece for CoinDesk: “Bitcoin Correlations Depend on What Phase It Is In” In it, Lyn argues that bitcoin’s correlation patterns are, in part, reliant on where bitcoin finds itself in its own cycles of expansion or consolidation.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big-picture power shifts remaking our world. The breakdown is sponsored by crypto.com, nexo.io, an elliptic, and produced and distributed by CoinDess. What's going on, guys? It is Sunday, October 11th, and that means it's time for Long Reads Sunday. This week, I confronted an issue that kind of surprised me. In my head, I had anticipated that I wouldn't really have an instinct to run into trying to read the same author's piece too close together. However, what I hadn't counted on is the unbelievable, prolific output of Lynn Alden in 2020. A few weeks ago, maybe two, I'm saying a few to reassure

myself, but either way, a few weeks ago, I read one of her pieces about the inflation versus deflation conversation and the historical context for it. This week, however, she tackled one of the issues that has been at the absolute epicenter of debate around Bitcoin, which is how correlated is it to stock markets and to gold, and what does that say about what type of asset it is? Even though I'd recently read another piece by Lynn, I had to take this one on as well. So I'm pretty sure you guys won't mind. This one was published in CoinDesk earlier this week and is called Bitcoin Correlations Dependix. depend on what phase it is in. Bitcoin has multiple long-term and short-term variables that

affect its price, and many folks debate what its major correlations are, if any. It turns out the same factors that affect Bitcoin's price, real rates of inflation, monetary and fiscal policy, and market exuberance also partially determined to which assets Bitcoin is correlated. Over the long run since its launch, increasing user adoption, ever-strengthening security, and the widening network effect have propelled Bitcoin's market capitalization to greater and greater heights. Those are the long-term variables. The halving periods tend to act as fundamental catalysts for the next bull market within this long-term trend, as new supply gets cut in half, while incoming demand remains robust. As long as that demand indeed remains strong,

upward pressure builds on its price. And then when it eventually breaks out, momentum traders hop on board with a new influx of demand and drive it up further. All pre-programmed halving events occurred during periods where Bitcoin had been off from its all-time highs for at least a year, and usually more than one year. On the other hand, the year after a halving has always been great for its price, without exception so far, albeit with a very small sample size, and has eventually led to the next blow-off top and a period of consolidation. During those long consolidations, Bitcoin becomes more correlated to short-term variables related to global liquidity and other risk assets. This becomes especially true as it reaches wider adoption and is invested in by the financial community.

Basically, the ongoing debates about the degree to which Bitcoin is correlated to other assets would do well to break Bitcoin's price behavior into two phases, bull runs and consolidation periods. If we look at percent drawdowns in Bitcoin compared to drawdowns in the S&P 500, for example, we can see a lot of correlation over the past two years in this consolidation phase, particularly when sharp drawdowns occur and investors broadly de-risk their holdings. More interestingly, during Bitcoin's consolidation period, it acts a lot like digital gold. Gold investors have long since known that the single biggest variable for gold price movements has historically been real interest rates.

Real interest rates measure the difference between a quote, risk-free yield, like the 10-year treasury rate, and the prevailing inflation rate or expected forward inflation rate. Whenever real rates go lower, especially if they turn negative, gold tends to spike in price. On the other hand, when real rates rise, gold usually suffers. The period from 1980 to 2000 was particularly bad for gold because real rates were strongly positive for the entire duration. This relationship is due to the opportunity cost of holding gold. Gold is a scarce but yieldless asset and has fees for minting, verifying, purchasing, transportation, and secure storage. When bank accounts and treasury bonds pay a yield

much higher than the prevailing inflation rate, your purchasing power can grow within the Fiat system. On the other hand, when bank accounts and treasury bonds no longer keep up with inflation and are being debased with negative real yields, the opportunity costs for gold vanishes. Its inherently inflation-protected zero yield becomes a lot more attractive. Over the past two years, we can see that Bitcoin behaved in a similar way during its consolidation phase. Real treasury yields peaked in late 2018 and have been on a multi-year downtrend into negative territory. Meanwhile, Bitcoin's price has been in a volatile rebound from the depths that experienced in late 2018 and early 2019. In this period, whenever real yields stalled or reversed upward, Bitcoin's price

usually would either stall or reverse downward. The same phenomenon continued into the second half of 2019 and increased sharply in March 2020 during the deflationary shock. Most recently, it has occurred gradually since the beginning of September 2020. There are multiple reasons that real yields can change direction, and it particularly depends on what part of the yield curve we are looking at. Longer-term rates are mostly controlled by the market. For instance, inflation expectations were on the uptrend this year from their March lows due to stimulus, but stalled and rolled over at the beginning of September when second round stimulus talks weren't going well. Due to where we are in the long-term debt cycle, the current trend of currency debasement, most of the developed world and

particularly the U.S., is likely to experience negative real yields for its banksavers and sovereign bondholders for quite some time. This won't be a linear process. There will likely be occasional political gridlocks on stimulus, deflationary shocks, and other roadblocks, but the trend itself is almost inevitable. System-wide debt and wealth concentration, unfolding in the backdrop of civil unrest and slow growth, will keep pressuring policymakers to stimulate. Going forward, Bitcoin's price is likely to continue to be affected in the near term by stimulus. outcomes, and consequently shifts in inflation expectations and real yields. Thus, it could very well be correlated to some extent with other risk assets and inflation hedges, like stocks and precious metals. Over the past

month, fundamentals have served as a headwin for these various assets, including Bitcoin, because we've been in one of these gridlock, counter-trend, no-stimulus rising real yield periods. However, when fundamentals turn back to a tail win, likely due to another stimulus bill being passed and a renewed decline in real rates at some point, Bitcoin likely has a lot more upside potential than similar asset classes. The network effect for the protocol remains very strong. And whenever it breaks out to new highs, momentum investors, and institutional money have plenty of capacity to propel its market capitalization upwards. This episode is brought to you by crypto.com, the crypto super app that lets you buy, earn and spend crypto all in one place and earn up to 8.5% per year on your Bitcoin.

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So I'm not going to do a full recap of that article. I think Lynn writes with a lot of precision. The first is that I believe that we will look back on 2020 as the year that members of the Bitcoin community move beyond a simplistic narrative understanding of macro and macroeconomics, and instead tried to actually understand the interplay of the asset that they happen to be most interested in, which is Bitcoin, with the specifics of other assets in the macro context. Part of why FUD remains viable when it comes to people lobbying bombs at Bitcoiners about, well, it's correlated to stocks, so it doesn't make that useless, is that we don't know.

necessarily have the tools to bite back with data rather than narratives. But these tools are available, and I'm bolstered by the idea that many, many, many more people are working hard to understand how Bitcoin actually fits in with the rest of the market, how it interacts with that market in different ways in different cycles. With this piece by Lynn points out is that it's not as simplistic to say it's correlated to this and not that. It's related to, at least in part, the specific cycle of Bitcoin's own market that it finds itself in. Anyway, my guess is that if you're listening this long, you also feel this compulsion to understand Bitcoin in the macro context.

So welcome to the journey. I'm glad you're here. The second thing that I'll say is that I think we need to not be scared of how Bitcoin interacts with other assets. It is inevitable that the longer Bitcoin survives and thrives, the more different types of investors with different expectations are going to come into this market. To be clear, this doesn't mean we can't meme at them, but I think that we would do well to understand where they're coming from as they make especially short-term decisions about Bitcoin.

A great example of this is Keith McCullough this week, who got roundly dunked on for saying that he had sold all his Bitcoin. The reason for Keith's move has to do with the framework that he uses to judge, everything, which is his quad system. If you want to hear more about this, go check out my interview with Keith from a few weeks ago. But basically, everything to Keith comes down to two big macro factors, expectations of real economic growth and expectations of inflation. Quad 3 is an expectation of declining economic growth with inflation increasing at the same time. That's the type of environment where he sees things like Bitcoin thriving. Quad 4, however, is an

expectation of economic growth declining, with also having an expectation of inflation declining. For Keith, this stallout of the stimulus talks means that we moved from quad three to quad four, that kicked Bitcoin out of his scenario as an asset that made sense based on his framework. Now, I'm not saying at all that you have to agree, A, with Keith's framework, B, with his decision to sell his Bitcoin, or C, his decision to clearly tweet something that was intended to cause the reaction that it caused. So dunk away, fight away, engage away, I'm all for it. I do think, though, that it does us well when we understand where these different types of market participants are coming, because in the future there's going to be a whole lot more people

who aren't either on the sign of long-term holder forever or total skeptic. We're going to have a big, messy gray area of people like Keith who have some amount of long-term conviction around the asset, but who are going to dump on the way. Basically, I am invested in this asset and in this space, and I want us to be as savvy and sophisticated as anyone else who's paying attention to it. Anyways, guys, I hope you enjoyed Lynn's excellent piece. I know I did. I'll be back tomorrow with another episode of The Breakdown, so until then, be safe and take care of each other. Peace.