Is Bitcoin Correlated to the Stock Market?

Is Bitcoin Correlated to the Stock Market?

Bitcoin is often called a hedge against inflation and compared to gold. Historically, gold has been inversely correlated with the stock market. Whenever stocks crash, investors pull out of the stock market and invest into gold. And when stocks are in a bull market, investors move money from gold into the stock market. But how is bitcoin correlated to the stock market? In this article I explore the relationship between bitcoin and stocks, why they sometimes move in tandem and what we should expect moving forward.

Table of Contents

Cypherpunks and Libertarians Invent a New Technology

In order to explore whether bitcoin is correlated to the stock market, we first have to gain an eagles perspective of where bitcoin is in its adoption cycle.

When bitcoin was first invented in 2008, few people, including Satoshi Nakamoto himself, expected it would get as big as it is today. He, she or they famously said:

It might make sense just to get some in case it catches on

Satoshi Nakamoto about Bitcoin

For the next few years bitcoin mainly attracted cypherpunks, programmers, gamers and nerds who fell in love with the engineering side of bitcoin. It also attracted libertarians who saw the potential for bitcoin to disrupt the current financial system.

Satoshi’s early forum posts reveal that bitcoin started as an uncertain experiment and almost everyone underestimated how fast it would grow. Those who held on to their bitcoin since these early days became bitcoin millionaires or billionaires.

Bitcoin’s Viral Loop Explained

As the price increased and bitcoin experienced its first two major bull runs in 2013 and 2017, more and more people became aware of bitcoin. This is the result of what Dan Held call’s bitcoin’s “viral loop”.

Due to the fixed supply of bitcoin, whenever the demand increases, the price of bitcoin goes up. This leads to a “viral loop” that brings in more people, which continues driving up the price of bitcoin with growing adoption.

Is bitcoin correlated to the stock market or not?

(Bitcoin stored in a Ledger hardware wallet by wuestenigel)

Bitcoin doesn’t need any marketing. Its qualities as scarce asset and consistent appreciation in dollar terms do most of the heavy lifting and bring in new people. During bull runs, bitcoin tends to become the center of conversation at Thanksgiving and Christmas dinners. People hear stories of how others made a lot of money with bitcoin.

But the talk of a revolutionary new money that has the potential to disrupt and even replace the current monetary system is often present as well.

While many people bought bitcoin to speculate on its price, more and more people began educating themselves about the history of money, how the banking system works and how bitcoin might replace fiat currencies one day.

These people can still be considered early adopters by most standards.

The Covid-19 Pandemic: Zero Percent Interest Rates, Quantitative Easing and Inflation

In 2020, the coronavirus started spreading and markets crashed. The S&P 500 and other indices lost 50% of their value beginning of the year as investors panic sold. The Federal Reserve quickly stepped in by lowering interest rates to zero percent and starting with Quantitative Easing.

The Federal Reserve bought $120 billion worth of sovereign bonds per month. The government then spent this money, and as the freshly printed money made its way through the economy, inflation began ramping up.

The rising cost of living put the government and Federal Reserve under pressure. In reality, the true inflation numbers are likely much higher. Inflation is measured using the Consumer Price Index (CPI), which is a basket of preselected goods and services.

Some of the most important goods are excluded from this basket, which could be seen as a direct or indirect way of manipulating true inflation numbers. If the inflation numbers are reported at 7%, true inflation might already be well in the double digits.

While inflation and hyperinflation certainly worry the government and Federal Reserve, debt deflation is their biggest nightmare. Deflation is bad for anyone who borrows money. And the United States government is the number one borrower in the world.

This is why at the slightest hint of debt deflation, the Federal Reserve steps in to reflate the “Everything Bubble” that we’re currently experiencing.

The Confusion About Risk Assets And Inflation

Gold and bitcoin are sometimes called “inflation hedges”. But the truth is that all assets are inflation hedges to some extent. The main reason why people invest money is to outpace inflation.

Some investors prefer doing this more conservatively while others are willing to take on more risk for a potential higher return. At the end of the day, investors want to increase their purchasing power and wealth. Some do this tremendously well and outpace inflation by a large margin while others outpace inflation by a few percentages or merely preserve their purchasing power.

This means, something can be a risk asset and an inflation hedge at the same time. For example, in Weimar Germany speculation on the stock market was one of the preferred ways people protected themselves from the German hyperinflation.

Stocks serve as an inflation hedge during hyperinflation

(The Weimar Republic stock market during the hyperinflation by Jashuah)

Some investors became millionaires and billionaires within weeks on the stock market. Often they were still not able to outpace the rate at which the German mark lost its purchasing power, but there were definitely those that preserved their purchasing power or made money speculating on the stock market during the hyperinflation.

Those who didn’t like stocks bought gold, real estate, commodities — or put their money into anything as long as it wasn’t paper money. More sophisticated investors profiteered from the hyperinflation by taking on debt, which then could be repaid at a later date with debased currency.

Thinking that gold is the only inflation hedge is wrong, especially if we look at recent history. Speculation on the stock market is incredibly common during hyperinflation.

How Does Bitcoin Behave In This Macro Environment?

Bitcoin is both a risk asset and an inflation hedge. It’s a risk asset since it’s still a relatively new technology. While it has proven itself during the last decade, bitcoin can be compared to the internet in the mid 90s.

Back then nobody knew how big of a deal the internet would be and how it would impact the economy. And in the same way, investors are still trying to figure out how big of a deal bitcoin is, whether it is just digital gold or could completely disrupt the financial system and become the new world-reserve currency.

During this early adoption period (think of bitcoin like the internet in the mid 90s), it will be traded like a risk asset by certain types of investors.

The convinced long-term holders that have done their research and understand bitcoin’s value proposition as hard money aren’t treating it as a risk asset but a safe haven. But to individuals and institutional investors that are just discovering bitcoin and are still trying to figure out its value proposition, bitcoin appears no less risky than internet stocks in the mid 90s.

In other words: Bitcoin is a safe haven for long-term investors that are holding their bitcoin in cold storage and aren’t selling. And it’s a risk asset for new investors that are still figuring out bitcoin’s value.

Both long-term holders and new investors that trade bitcoin like a risk asset are investing to outpace inflation and hoping to do so by a large margin.

In the case of heightened inflation or hyperinflation, investors have to take on bigger risks to preserve their wealth and purchasing power. Hyperinflation and speculation go hand-in-hand.

Rsk assets are a preferred hedge against hyperinflation. Treating the terms “risk asset” and “inflation hedge” as if they were complete opposites is misleading. It ignores historic data of what actually takes place during hyperinflation such as in Weimar Germany.

Why Is Bitcoin Correlated to the Stock Market?

Now that we have established why bitcoin and stocks can be risk assets and inflation hedges at the same time, let’s take a closer look at why bitcoin and stocks might be correlated.

When the Federal Reserve lowers the Federal Funds Rate, like it did during the Covid-19 pandemic, it is essentially flooding the market with free money.

With low interest rates, individuals and institutions can borrow money and invest it in almost anything that is expected to outpace inflation. All this “free” money that is lent into existence has to go somewhere. Some of it will find its way into real estate and bonds and some of it will be invested in risk assets like technology stocks or bitcoin.

Jerome Powell, chair of the Federal Reserve influencing stock markets

(Chair of the Federal Reserve Jerome Powell by Federalreserve)

When there is more money chasing the same number of assets, this leads to asset price inflation. This is why stocks and bitcoin both rally when the Federal Reserve keeps interest rates artificially low and engages in Quantitative Easing.

The “free money” enters these assets and bids up their prices. This is why after the initial crash in 2020, both stocks and bitcoin rallied when the Federal Reserve lowered the Federal Funds Rate and started buying government bonds.

This correlation between stocks and bitcoin simply has to do with the “free money” that is entering the economy and bidding up asset prices.

The Reason Bitcoin Crashes During a Taper Tantrum

When the Federal Reserve announces that it will start tapering its bond purchases and threatens to increase the Federal Funds Rate, technology stocks, bitcoin and other risk assets start selling off.

This is because when the Federal Reserve stops inflating the economy with low interest rates and tapers its Quantitative Easing program, it can lead to deflation in asset prices. Investors then sell their stocks and bitcoin in fear of a crash. This is known as a “taper tantrum”.

Another reason why stocks and bitcoin might stop their bull run and go sideways for a while is because when the Federal Funds Rate increases, money gets more expensive. When money is more expensive, fewer institutions and individuals borrow money.

This means there is less money entering the economy and prices of stocks and bitcoin aren’t bid up at the same rate as they were.

Why is bitcoin correlated to the stock market? Because markets are extremely sensitive to what the Federal Reserve does. This is why we are currently seeing 7% inflation and stocks and bitcoin selling off at the same time. It doesn’t invalidate the fact that stocks and bitcoin are both hedges against inflation. All that is happening is this: Inflation is high and the Federal Reserve is threatening to increase interest rates.

How Markets are Reacting to the Federal Reserve’s Hawkish Policy

Inflation is at 7%, which is the highest it has been in 40 years, and because of this the Federal Reserve is under pressure to get inflation under control.

Jerome Powell announced that the Federal Reserve was going to taper its Quantitative Easing program and increase the Federal Funds Rate in order to fight inflation — This caused a “taper tantrum” in markets. Both stocks and bitcoin sold off for a variety of reasons.

Risk assets can be seen as a more aggressive inflation hedge, so if the Federal Reserve increases the Federal Funds Rate and tapers its Quantitative Easing program and is successful at lowering inflation, investors don’t need to rely on these riskier inflation hedges anymore — In anticipation of the Federal Reserve’s success, investors are scaling out of aggressive inflation hedges like technology stocks and bitcoin and into less aggressive ones.

Investors are fearing deflation in asset prices as a result of less “free money” coming into the market and they sell their stocks and bitcoin in an attempt to time the top. They might plan to buy these assets back after a deflationary event and benefit from the price increase once asset price inflation continues.

Due to the Federal Reserve tapering its bond purchases and once the Federal Funds Rate is effectively increased, less money is available in the economy to chase assets like stocks and bitcoin. This would slow down the bull run in stocks and bitcoin and lead to sideways price movement until the Federal Reserve reverses its policy.

This is in a nutshell why bitcoin has been correlated to the stock market in recent months.

What Will Happen Next: The Federal Reserve Is Stuck Between Debt Deflation and Inflation

As soon as there is asset price deflation and credit markets and stocks start crashing, the Federal Reserve will have to step in and reverse its hawkish policy. The reason for this is because deflation in asset prices can lead to debt deflation.

Debt deflation is the Federal Reserve’s worst nightmare and is a bigger evil than heightened inflation.

The sovereign bond market is in a bubble, and since it’s the most senior asset class, everything went into a bubble — This is why it’s called the “Everything Bubble”.

The Federal Reserve will have to do everything it has in its power to keep the “Everything Bubble” inflated and prevent debt deflation. At the slightest hint of a crash that could negatively effect the credit market, the Federal Reserve will have to lower the Federal Funds Rate and start the next round of Quantitative Easing.

In addition to that, the Federal Reserve’s monetary policy will have to become more and more extreme with each intervention because the potential for a financial crisis becomes more systemic and severe every time the Federal Reserve prevents a recession.

It’s likely that the Federal Reserve will continue tapering its Quantitative Easing program and hike interest rates until the market crash becomes too severe. We don’t know when that will happen, but as soon as it does, the Federal Reserve will have to reverse its hawkish policy.

Once course is reversed, the economy will be flushed with “free money” again. Institutions and individuals will borrow more money, which will find its way into markets where it will bid up prices of stocks and bitcoin.

Quantitative Easing is inflationary as well. Freshly printed money by the Federal Reserve will enter the economy and financial markets, leading to asset price and consumer price inflation.

Once again, we are likely to see stocks and bitcoin rise in tandem.

Is Bitcoin Correlated to the Stock Market Forever?

The reason why bitcoin is treated like a risk asset is because many new investors don’t fully understand its value proposition. Long-term holders that have conviction in bitcoin aren’t reacting to this cat-and-mouse game by the Federal Reserve.

This can be seen by looking at the on-chain data of bitcoin.

Bitcoin's on-chain data for long-term holders

(Bitcoin supply held by long-term holders)

Long-term holders have mostly not been selling their bitcoin even during the recent 50% bitcoin crash. They don’t care if the Federal Reserve is hawkish or dovish in the short term, since they understand that fiat currencies are all going to zero given a long enough time horizon.

They view bitcoin as a superior form of money and a long-term inflation hedge. For them, bitcoin is a safe haven and not a risk asset.

As bitcoin grows and more people start to view it as a safe haven rather than a risk asset, bitcoin won’t be correlated with stocks anymore the way it is now. It won’t be as sensitive to what the Federal Reserve does or says any given moment.

That being said, in the event of hyperinflation both stocks and bitcoin should appreciate significantly. Due to bitcoin’s fixed supply, when more money is chasing the finite number of bitcoins, the bitcoin price should increase faster than stocks.

Bitcoin As the Preferred Inflation Hedge

While stocks have historically been a common vehicle for people to try and preserve wealth during hyperinflation, we can expect bitcoin to become the preferred inflation hedge if —or rather when— the United States experiences hyperinflation.

In that sense, bitcoin is a risk asset, a safe haven and an inflation hedge all at the same time. It simply depends who you ask and how much research they’ve done on bitcoin.

Is bitcoin correlated to the stock market? As we have seen that is the case. But bitcoin’s correlation with stocks, and bitcoin selling off despite inflation being at historical highs, says nothing about its narrative as inflation hedge. It simply means those in the mainstream media who are confused about bitcoin selling off while inflation is peaking, or those who think risk assets can’t be inflation hedges, know little about macroeconomics and history.

Don’t let them confuse you or get you off track.

January 24, 2022