IMF Paper Explains Daily Price Action
When we look at the cryptocurrency market becoming so unstable, we need to understand that it is linked to the events in the real world , and numerous factors can impact the market , just as the stock market.
The two cryptocurrency Bitcoin as well as Ethereum have been currently among the world’s top 20 assets that are traded the most. Their market capitalizations are higher than the majority of corporations in the world. The growing popularity and involvement in the crypto community is the reason for their rise during the epidemic. But, how do the decentralized markets impacting traditional markets in the midst of all the crypto-mania? The latest IMF working paper suggests 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 capitalization of decentralized assets in the course of the epidemic.
- The researchers have found that fluctuations in the return on the market daily of Bitcoin and Tether could explain about six percent of the variance in the daily returns of the S&P 500, which is up from just one percent pre-pandemic.
- Together, the volatility of both crypto assets could be a reason for a fifth of the price movement that occurs daily within EM market for equity.
At least for the first part of the pandemic people believed that Bitcoin’s lack of supply could make it an asset that could be used to hedge against inflation. However, the consensus changed when inflation began to rise in May 2021. Bitcoin turned into a investment in risk markets, and it was the most closely linked to US and Chinese equity markets. This connection to market equity that this IMF paper examines since this is the place the area where the $3 trillion crypto market is likely to have the most impact. The paper reveals the following.
- The relationship between Bitcoin price volatility and the volatility of the S&P500 increased by fourfold between the time of the pandemic to the post-pandemic.
- Bitcoin is currently responsible for 17 percent of the fluctuations in US equity prices.
- The crypto assets are increasingly linked to EM equity.
- Bitcoin and Tether can explain around 20% of the variations in every day MSCI Emerging market (EM) price. In comparison the S&P500 is responsible for 30% of the.
Since the beginning of the pandemic, relationships between equities and cryptos have risen dramatically. The volatility of prices in the intraday period of two key cryptocurrency assets such as Bitcoin and Ethereum has increased to be about 4-8 times more closely to the volatility in the major US equity market indexes (the S&P 500, Nasdaq and Russell 2000) versus 2017-19 (chart one). Similar patterns are observed for the relationship between the equity markets of emerging markets, as documented in MSCI EM index. MSCI EM index.
The intra-day returns are also more closely linked – although the rise has been especially significant in the case of Bitcoin (chart 2.). The correlation between Tether and equity also grew but it weakened during the outbreak, suggesting that the use of Tether as a risk-reflecting asset during that time.
The increase in correlations between crypto assets and stocks is much greater than other asset classes, like 10 years of the US Treasury ETF gold, gold and a few other currency pairs (the euros, the renminbi, and US dollars).
But, the relationship among Bitcoin returns and high yield bond (HY CDX) and investment-grade bonds (IG CDX) has strengthened significantly – which is what tends to be the case with high-risk asset classes. However, the opposite is true for Tether which, in turn, implies the need for risk and diversification (chart 3).
More complicated correlations
To quantify crypto’s connection to the asset market, the authors use a VAR model to identify bi-directional correlations. They refer to these correlations as’spillovers. They examine the daily returns and volatility to determine the degree of the connection between portfolios and diversification strategies across different asset classes over the course of.
Similar to the basic connections, spillovers have been increasing during the pandemic, which means the transfer of crypto into equity prices, and reverse. For instance, the volatility of Bitcoin prices is now responsible for 17 percent 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 in Bitcoin prices. This indicates a growing bi-directional correlation , which means more spillovers.
Additionally, the link with Bitcoin and Tether has increased since the beginning in the outbreak. The volatility in Bitcoin prices is the reason for more than one quarter of the Tether price volatility. On the other hand, Tether has only a small influence on the volatility of Bitcoin (12 percent). It is also able to explain only 6 percent of the volatility in the S&P500.
Return spillovers increased as well during the pandemic. The patterns are roughly similar to spillovers of volatility, but are less. The most striking finding is that the daily returns of Bitcoin and Tether together account for six percent of the variance in the daily returns of the S&P 500. They also account for 15percent of variance of Russell 2000’s returns. This is quite remarkable considering their contribution was almost absent prior to the outbreak, and also shows the extent to which crypto-assets impact the equity market.
The increasing connection between cryptos and equity markets extends far over the US. Bitcoin is responsible for 14 percent of the volatility in the MSCI EM index during 2020-21 and 8 percent of its return fluctuation. The index is up twelve points and 7.5pp from pre-pandemiclevels, respectively. Together with Tether, these two crypto assets account for about 20% of the daily price movement within the MSCI EM index (chart six). In contrast, the S&P500 accounts for 30 percent of day-to-day MSCI EM prices’ volatility.
In the final analysis the study, the authors look at these spillovers during times of market stress. In general, spillovers are more severe when market volatility is high. For instance the March 2020 market crash caused an extensive and significant increase in the bi-directional spillovers of volatility between equity and crypto markets.
The bottom line
The macroeconomic consequences of the pandemic are huge. The trends have changed over the past decade in the labor market, consumption of goods and services, consumer habits as well as inflation, and many other areas.
This paper demonstrates that the pandemic may have helped accelerate the transition of decentralized markets with centralized ones. This means that the regulators, investors and policymakers cannot afford to ignore the significance of crypto in the macro-economic landscape of the world. Crypto-related events are also happening in the equity market and vice versa. The rate of change is awe-inspiring.