Why is Bitcoin so correlated with the stock market? A deep dive

It has been a turbulent year in the markets, to say the least.

But one thing that is both bearish and bullish, in my view, is the correlation between Bitcoin and the stock market. It sounds funny, but let me explain.

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The bull case for Bitcoin is a disconnect from the stock market

Many Bitcoiners believe that it is only a matter of time before Bitcoin disconnects from the stock market, spreads its wings and claims the “hedge” title that has so far been so elusive.

Arguably, this is the upside – Bitcoin’s hard supply cap, circumvention of government control and its unique ability to separate money and state means the bull’s vision is tempting.

But looking at the data, the correlation between Bitcoin and the stock market is as high as it has ever been; this utopian (or dystopian, depending on your mindset!) future has never seemed further away. In fact, I plotted the correlation from the beginning of the year to now, and the results are telling (for the geeks, my metric of choice was the Pearson 6-month rolling coefficient).

For those less familiar with correlation, a coefficient of 0 means no relationship. For example, the correlation between the number of apples you eat in a given day and the number of times UK Prime Minister Lizz Truss changes her mind is (presumably) close to zero.

A correlation between 1, on the other hand, is perfect. So the correlation between the number of pints you drink and how drunk you are will be close to +1. And it also follows that -1 is a perfect negative relationship, so the correlation between the number of pints you drink and how sober you are is probably close to -1.

The closer the number is to 1, the stronger the relationship. The closer to -1, the stronger the relationship is in the opposite direction. And zero, or somewhere close to it, means there is no meaningful relationship. So it’s a sliding scale from between -1 and 1.

Let’s look at the graph of the correlation between Bitcoin and the stock market, zooming in on the time period of 2022.

The correlation between Bitcoin and the stock market has never been higher

It is immediately clear that the correlation increased sharply at the end of January/February, before it increased further in April. In fact, it has been close to a perfect 1 for much of the year, with markets moving in lockstep.

And what is unique about this year? Well, it’s the interest rate environment. The Federal Reserve has taken the markets for a ride with its aggressive stance on interest rates. The higher interest rates are raised, the more liquidity is sucked from the economy and the more bearish it becomes. Too much hiking and we get the r-word: recession.

The Fed has set in motion a new paradigm, as inflation has spiraled off the back of a decade of money printing, quantitative easing and near-zero interest rates. With COVID kicking all of this up to a new level, inflation has gone wild. Watch for the rate hikes as the Fed tries to tame inflation back down.

So let me add a variable to the previous graph that shows the bullish correlation between Bitcoin and the stock market. Take a look at the rolling correlation with the Fed rate sprinkled in:

Hmm. And remember – Bitcoin first launched in 2009, the year after the world economy collapsed as bankers lost their act, with a US subprime mortgage crisis triggering one of the worst financial crises of all time. Since those dark days, the market has been on an absolute tear, with one of the longest bull markets in history. This has been the era of meager interest rates (negative?) and quantitative easing, with outrageous asset gains layered in.

COVID was the same, only on steroids. One of the most revealing graphs is below – from my analysis of money printing and inequality published yesterday).

And then the graph below as well, showing the magnitude of the stimulus compared to 2008. It’s like comparing apples to genetically modified, enlarged oranges.

Given this context, it makes perfect sense that the correlation is so high. COVID flushed the entire system with cash, and then came inflation. Now the Fed is set to suck it all out again – the worst possible news for the markets.

All that really matters right now is the word of Jerome Powell (I talked about the market’s reliance on this recently here). The markets react based on expectations of future interest rate increases, which come straight from Powell’s mouth, as well as the monthly CPI report.

And what is the old saying? Well, correlations go to 1 in a crisis. Investors flee for the safest assets possible, dumping anything and everything for liquidity. This is actually a major reason behind the dollar’s tremendous strength this year, which I analyzed earlier this year. It’s all connected.

Looking back at the analysis of the strength of the dollar earlier this year, one of my favorite charts is below, which shows the strength of the dollar historically and highlights times of crisis. Do you notice anything?

Bitcoin’s first crisis

Again, nothing surprising here:

Step 1: Unique money printing. Assets moon, with those further out on the risk spectrum (tech stocks, Bitcoin, Dogecoin, etc.) seeing more gains.

Step 2: Inflation jumps as a result

Step 3: The Federal Reserve pursues an aggressive interest rate policy to curb inflation

Step 4: Assets are selling off, with those further out on the risk spectrum (tech stocks, Bitcoin, Dogecoin, etc.) experiencing more losses.

And – crucially – sellers do not discriminate. The selling is widespread, so the correlations increase, and that’s what we’re seeing with Bitcoin. It is not necessarily the stock market that leads Bitcoin; it’s that there’s one variable lurking—the Federal Reserve—leading them both. Again, look at the chart above that shows the Fed rate versus the correlation between the S&P 500 and Bitcoin.

And this is why I’ve been banging my head on the table (is that an expression?) all year about a fallacy: the claim that crypto and Bitcoin have been here before. Supporters argue that this is just the latest of many falls for crypto.

It is not true. Bitcoin was launched in January 2009, meaning this is the first time it has existed during a macro bear market. Past crypto winters came in the midst of a low-interest, welcoming environment where all was well with the world.

Today, it is expected that there will be blackouts on cold nights in London this winter. Big tech companies have shaved 70%+ off their share price. People struggle to afford milk and bread. So no, crypto hasn’t been here before. Economically, these are dark times. And crypto has never before seen dark times.

What happens afterwards?

This is not me saying that crypto will not do what it has always done – bounce back. I’m just saying this isn’t your friendly neighborhood crypto winter, this is a completely different beast – fueled by the macro carnage, with correlations increasing accordingly.

Let me circle back to the opening paragraph of this piece when I said Bitcoin’s growing correlation was both bullish and bearish.

In the long term, Bitcoin needs to be decoupled to achieve its “goals” of becoming a store of value; an exit from the government-controlled world of fiat money. It’s hard to argue with. And in that respect, it is disappointing to see the sky-high correlation, which has risen so much this year. Absolutely, Bitcoin will have zero hope in the long run if it does not end this dirty habit of volatility, as well as refuses to do anything without holding the stock market in hand.

The reason I say it’s also a bit bullish is that it shows that Bitcoin is now a mainstream financial asset. Previous years showed a Bitcoin that was not overly correlated with the market. It was a geeky magic money thing on the Internet, something your friend’s older sibling told you about at a barbecue.

Liquidity was scarce and it did not affect the wider financial market.

But now it has arrived. Adoption has skyrocketed. It is presented together with the Dow Jones and gold when the media shows the daily market movements. The correlation backs this up – it moves with the stock market more than ever before.

The next step is to dump that correlation. And looking at Bitcoin’s fundamentals, which are more like a commodity than a stock (the opposite of Ethereum, by the way), it has the makeup to do so. The real question is whether people will realize this and begin to value it as such.

And that’s what makes it so compelling as an asset class. We’ve never seen anything like it before – a kind of commodity that lives in the digital world. That is why the range of outcomes is arguably wider than any other asset.

Whatever happens, it’s going to be a fun ride. But the numbers show that right now Bitcoin is nothing more than the stock market’s toy, tossed around at will.