The Breakdown - What Bitcoin and the Stock Market’s Correlation Really Means

Episode Date: November 1, 2022

This episode is sponsored by Nexo.io, Circle and FTX US.   On this week’s “Long Reads Sunday,” NLW reads:   “Bitcoin Is Macro, but Not ‘Correlated’ in the Way You Think” – Noelle Acheson  “Why Bitcoin Has Been Highly Correlated With Fiat” – Steven Lubka  - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - Circle, the sole issuer of the trusted and reliable stablecoin USDC, is our sponsor for today’s show. USDC is a fast, cost-effective solution for global payments at internet speeds. Learn how businesses are taking advantage of these opportunities at Circle’s USDC Hub for Businesses. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “War” by Enoch Yang. Image credit: Violka08/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

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 nexo.io, Circle, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, October 30th, and that means it's time for Long Read Sunday. Before we get into that, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the the conversation. Come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. All right, folks. Well, this past week was trading week on CoinDesk.

And so I thought for LRS, it would be fun to do a few of the pieces that relate to that theme. Where we're going to start is with a piece from Noel Atchison, who is a former head of research at Coin desk as well as Galaxy Digital, and who wrote on October 14th a piece called Bitcoin is macro, but not quote unquote correlated in the way you think. Quote, Bitcoin is correlated. I often hear that thrown out in conversations as a dismissive way of saying that it isn't really an alternative asset at all, and that all this mumbo-jumbo about it being external to the broader economy is just hopium. But very few who say this have actually dug into the data or thought about the reasoning behind that claim, which is understandable, why messes?

with convenient narratives. I confess that even I used to think that the surge and the correlation between Bitcoin and the S&P 500 was because the institutional investors marched into the market in the second half of last year. Now I'm not so sure. The institutions did indeed march in, and Bitcoin has, to a large extent, become a macro asset. But I don't think that's driving the correlation data. Before we start looking at charts to tell a different story, let's have a think about what correlation actually means and why we care. In theory, correlation is simply the measure of the degree to which the movements of two series are related. It measures how much two measures vary together, divided by how much they usually vary individually. There are other types of

correlation with different formulas, but that's too nerdy to get into here. For those who care, I use Pearson on a rolling 60-day window. Imagine two assets that are clones of each other. How much they move independently will be exactly the same as how much they move together, so the ratio between the two factors will be one. A correlation of negative one means they move perfectly in the opposite direction. A correlation of zero means there is no obvious relationship between the two. In reality, these perfect situations never exist. Correlations are generally a messy amalgam of erratic behavior that indicates strong or weak relationships, used by investors to design relatively robust portfolio strategies, and by analysts and storytellers to spot

changes and trends. Yet one trap many fall into is to treat correlation as a binary condition. To say something is correlated is vague and inaccurate. Highly correlates, negatively correlated, those qualifications make sense. Yet even then only at a specific point in time. As we will see, when it comes to market relationships, especially concerning an asset as young as Bitcoin, things change fast. Another frequent trap is to assume that a high or low correlation can explain behavior. To some extent, this is true, but more often than not, the relationship is coincidental, even if related. Ice cream sales and causes of sunburn are highly correlated, but one does not cause or explain the other. Back to Bitcoin.

The asset used to be pretty much uncorrelated to the S&P 500, oscillating around zero, even as institutions marched in, pushing the Bitcoin price to an all-time high in November. But something changed in April 2022. What changed? The overall market moved. Correlation is more about the direction than the size of the price moves, although they both matter. Up until the time that the 60-day Bitcoin to S&P 500 correlation had crossed zero on the way

up, never to return, the two series had been sort of moving in sync, but not really. By April 4th, the S&P 500 was down 0.7% on the year, while Bitcoin was down 7.5%. And the 60 days prior showed different trends for each. What triggered the mood change? Interest rate expectations. Fed funds above 2.5% started to become a remote possibility in terms of market in early April 2022, when the actual range was 0.25% to 0.50%. This freaked the market out, and the macro investors who piled into the crypto market over the

previous nine to ten months exited in a hurry. They didn't just exit crypto, a high-risk asset relatively easy to sell. They also exited equities. Prices fell across the board and the 60-day correlation between Bitcoin and the leading stock index rocketed up to an all-time high of 0.72. Macro investors weren't the only ones de-risking. Crypto fund managers were also exiting expecting a general market slump. The spike in correlation was not because Bitcoin was now a quote-unquote macro asset. Bitcoin's entrance to general portfolios had been more or less consolidated the previous year. It was because Bitcoin, along with other risky assets, was being hit by expectations of monetary tightening. Semantics, perhaps, but it matters, for the same reason

that Sunblock manufacturers are in a very different business than ice cream makers, even though their sales can move together at certain times of the year. Then in mid-May came the implosion ecosystem. This was a crypto-specific crisis, and unsurprisingly, correlations fell as the damage to crypto values far exceeded that in equities. The de-leveraging triggered by the collapse of hedge fund 3-Hours capital led to a further decoupling. With that digested, correlations on their way up again, but this is not, contrary to common perception, necessarily because Bitcoin and stocks are joined at the hip. There's an old adage that says that in times of fear, all correlations go to one. We are in times of fear. But Bitcoin and stocks have very, very different value premises,

so we cannot assume that correlations will remain high. Bitcoin is a macro asset in that it is now part of the global market, but not all macro assets are highly correlated. As fear subsides, which it will, one day, given the distinct value propositions of equities in crypto, we are likely to see correlations head back to lower levels, supporting the narrative of an alternative macro asset. Even before then, as the dust settles on the recent crypto crashes, as the outlook for global equities continues to get worse, and as the risk of holding dollars shifts higher, we could see investors calibrate the relative downsides of asset groups. The resulting flows of funds are likely to change correlations in narratives, driving a new momentum that impacts correlations even further. So, it is correct

to say Bitcoin is macro now and going forward. To say Bitcoin is correlated, however, requires more nuance and explanation, especially to emphasize that the numerical relationship may be convenient for the moment, but it does not mean what many think it does, and it is almost certain to change. All right, back to NLW here. I relate to Noelle here. I often will see people rag on Bitcoin for being correlated now. We saw this in March and April of 2020 as well, when markets crashed in the wake of COVID shutdowns. Nuel does a good job of explaining why correlation might increase the more insecure people get. But what I'd like to start exploring as well is how this might shift on the other side. So let's say we get through this period of quantitative tightening and rates start to reach

their peak and held similar if not actually fall. Inflation starts to show that it's actually coming down, et cetera, et cetera, et cetera. I think in that type of market environment you will see equity start to recover. How fast and in what way and in what sectors I think is a a big question. One of the big key changes that seems to be happening right now is all equities are being repriced for value. In other words, even stocks that were previously only looked at in the context of growth, tech stocks in particular, are now having investors ask the question of profitability. You're seeing this come to Apple, you're seeing this come to Facebook, etc., etc., etc. That's a process that's going to play out for a longer period of time, I think, than even just

this short-of-short-term monetary policy volatility. I think how it relates to Bitcoin and crypto is that even once monetary tightening has eased off, I do believe there will still be questions of what specific either narratives or changes to the market will get people excited about Bitcoin and Crypto specifically again. One of the things that's been remarkable about the last couple years is that it really is the first time in Bitcoin's history and crypto's history that they've traded in lockstep largely driven by the global appetite for risk assets in general. Once some new equilibrium is met in terms of what the market expects, the interest rate and monetary policy environment to be going forward, the crypto industry will find

reasons to be comparatively bullish or bearish relative to the macro landscape, and I would expect to see correlation come down at that point. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on Nexo Pro. The new Spot and Futures trading platform uses aggregated liquidity of over 3,000 order books collected from multiple sources. Utilizing the complete nexo suite allows you to earn interest and borrow funds as you wait for the next trade setup. Visit pro.nexo.io. That's p.r.org.n.exo.com and sign up today. This episode is brought to you by Circle, the sole issuer of USDA, and a leader in crypto that's held to a higher standard. USDC is a fast, safe, and efficient way.

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Download the FTCX app today and use Referral Code Breakdown to support the show. Continuing on our explanation of Bitcoin and correlation, let's read a piece by Stephen Lubka, a managing director of Swan Private Client Services. On October 25th, he published a piece on CoinDesk called Why Bitcoin Has Been Highly Correlated with Fiat, and whether it means that it has failed as an inflation hedge for traders. Bitcoin is in a conversation with Fiat. It isn't independent, it's contextual, it's relational. Bitcoin is contextualized by the existence of Fiat, and hopefully Fiat becomes contextualized

by Bitcoin. It's like hot and cold, light and dark. Bitcoin is the absence of monetary intervention, while Fiat is money optimized for and defined by monetary intervention. Bitcoin without Fiat is just money. Fiat without Bitcoin is just money. Starting with this lens, we can discuss why Bitcoin has been correlated to the unique macroeconomic environment we are in, which has been decidedly negative for practically all assets. You can hear it when people talk about Bitcoin. Wasn't Bitcoin supposed to be independent of traditional markets? Was it? Isn't Bitcoin supposed to be an inflation hedge? For an asset which is supposed to provide an alternative to contemporary finance, why has Bitcoin been so correlated to traditional markets

and central bank policies? If Bitcoin is anything, it's an alternative to fiat. Call it a hedge, call it an escape hatch, call it whatever you want. It's something you can own in case the current iteration of the dominant money system fails or becomes dysfunctional, or already has. Thinking deeply about this, one should realize this implies a relationship between Bitcoin in the current system. When the current system is engaged in reckless expansionary policies, in the debasement of the numerare, Bitcoin should become more valuable relative to whatever abused fiat currency you are measuring it against and measuring it with. So what happens when the inverse occurs? What happens when the hegemon contracts the money supply, when they

tighten the monetary policy? What happens when liquidity disappears? What happens when growth inverts? If Bitcoin appreciates in value relative to fiatts when monetary expansion takes place, It follows that it could decline in value when the fiat system tightens and contracts. That's precisely what has happened. When the COVID-19 stimulus plans and massive quantitative easing were announced, you could have bought Bitcoin between $6,000 and $9,500 for over a month, even if you didn't catch the bottom. Over the next year, Bitcoin outperformed every major asset class,

and even today, after the precipitous drop from all-time highs, Bitcoin has still outperformed the S&P 500 and NASDAQ 100 by a huge margin if you bought both at the beginning of the pandemic, before the expansionary monetary policies began. Since June 2020, Bitcoin went from 9,500 to today's price of 19,500, over a 100% return. In comparison, the S&P 500 went from 3,000 to 3,700, slightly over 23%. Bitcoin bought prior to the monetary expansion, has outperformed other major asset classes, even today after a more than 70% decline from the highs. Bitcoin's price rally was consistent with the direction of monetary expansion, and its collapse, along with every other asset,

was consistent with the reversal of this direction of monetary expansion, a huge contraction. The contraction wasn't limited to central bank stopping QE. It also included artificially raising interest rates along with the collapse and other financial assets, which also serve as part of the money supply, in practice, if not in theory, at least. Financial assets, equities, and real estate represent most of the dollar-based liquidity that Americans own. Actually, dollars are a far smaller slice of the pie. When the total value of U.S. financial assets declines by over $20 trillion, dollars, there is significantly less total dollar-denominated financial values sloshing around the world. What is this, if not a contraction in the money supply? Paul Krugman might disagree with me on a

semantics basis, but I don't care about semantics. I care about how reality functions. Low interest rates, rampant money creation, and rising financial asset values and premiums led to Bitcoin outperforming all other asset classes. Rapidly increasing interest rates, a cessation of money creation and crashing financial asset values and premiums led to a steep drop in Bitcoin's dollar-denominated price. Can I back up this point of view? Yes, let's look at gold. Gold is down 19% from its all-time high. This is meaningfully less than Bitcoin, but it is still an example of the market's most commonly accepted inflation hedge declining in a macro environment with inflation at multi-decade highs and geopolitical tensions. The common threat is any discussion

of inflation hedges is only relevant insofar as we use the actual and original definition of inflation, monetary expansion. The modern semantic switch to inflation representing consumer goods prices doesn't help us here. Golden Bitcoin are both inflation hedges in this sense. They appreciate when the fiat money supply is expanded and they decline when that money supply contracts. Consumer goods price increases due to decades of malinvestment, underinvestment in commodities, supply chain disruptions, and de-globalization do not constitute a boon for fixed monetary assets that should appreciate in value as economic growth increases. Bitcoin's price performance in 2022 is not evidence of a failure for Bitcoin or even a failure of narratives around Bitcoin when properly contextualized.

It is solely evidence of rapid destruction of liquidity and profound geopolitical disruptions. The good news for Bitcoin investors is that a prolonged contraction of economic growth and of credit will eventually render the system totally insolvent. While this would be devastating, our esteemed central planners will eventually stop short of this and engage in a jubilee of monetary and fiscal support. While anything is possible, the skillfully leveraging and austerities that would be involved in avoiding the inevitable monetary debasement appear far beyond the means or appetite of the current political apparatus. Therefore, the base case is more monetary expansion and more debasement

of fiat. And when this comes, Bitcoin will likely continue to be the best performing asset relative to all other major asset classes. I love that Stephen here is digging into this definition of Bitcoin as an inflation hedge. This was used in a very narrative sort of way, obviously, at the beginning of the last bull market. Paul Tudor Jones, great monetary inflation, was in many ways the intellectual wellspring from which that bull market started. However, I think it's important to point out not only what Stephen does here in terms of what definition of inflation are we using, but also of the idea that when people talk about Bitcoin as a store of value and an inflation hedge, there's the financial portfolio construction version of this argument and the I

Live My Life in an Unstable Monetary Regime version of this argument. What people are excited about why Bitcoin has attracted so many, is the idea that it's an opt-out to the local monetary regimes that people are born into as accidents of birth. Argentina is currently on the verge of 100% inflation for this year. Bitcoin is theoretically a way to get money out of that system that you just so happen to have been born into, away from exposure of failed policies. In other words, I don't think that the point of Bitcoin's inflation hedging has ever been to deal with the fact that milk costs more than it ever has. It's about much bigger questions of how much my money will be worth when I wake up and look in my account tomorrow, which unfortunately for big parts of the

world are questions that have never been that far away. Now, I will say I don't think that we can completely dismiss the other version of the Bitcoin inflation hedge narrative. We took advantage of it on the way up. We have to own it on the way down, if only because we're trying to help people understand it the way that we do. In either case, I think both of these pieces do a great job of helping better explain some of these concepts of correlation that get thrown around a lot. So thanks again to Stephen and Noel for their pieces. Thanks to my sponsors, nexo.io, circle nftx for supporting the show. And thanks to you guys for listening.

Until tomorrow, be safe and take care of each other. Peace.