Introduction

The fluctuations in crypto prices to start the month of August have been somewhat unnerving. The market shock pulled at the threads that connect different markets, triggered by the unwind of massive JPY-funded carry trades. Many assets including crypto, US stocks and gold all moved in tandem during this event, creating the perception of correlated markets. However, the reality is that the sheer size of the leverage unwind likely meant that many investors had limited discretion over what they could sell to meet their margin calls, acting as a drag across nearly all markets.

Nevertheless, stocks and crypto continue to share a relatively weak linear relationship, which we believe is (1) a function of the current monetary regime and (2) becoming more stable and predictable over time. Our empirical evidence shows that the dispersion of recent correlation values has actually been clustered inside a relatively small space – between 0 to 0.40 for at least the last ten months. The observable trend where higher inflation expectations have been associated with higher correlations appears to be anomalous, in our view, to the traditional relationship between these variables, caused by the intensity of the tightening cycle at that time.

That said, we expect market players to remain cautious about their risk exposure in the weeks ahead. Both ETH and SOL are currently showing greater sensitivity to the overall crypto market with higher betas of around 0.85 and 0.83, respectively. Previously, SOL had been the primary crypto “beta play” (i.e. more volatile than the overall market) for most of 2022 and 2023, but its risk profile has converged with ETH’s since late July – around the same time that spot ETH ETFs launched.

Markets tumble … everything, everywhere, all at once

In early August, markets witnessed one of the sharpest sell-offs since the pandemic, ostensibly triggered by a myriad of factors including a hike by the Bank of Japan, soft earnings reports for US tech giants and a lackluster jobs report in the US. (See our report “Weekly: Shock and Awe” published August 9 for more details.) The unwind of JPY funded carry trades have led short JPY futures positions to drop from a high of US$14.3B in early July to only $968M as of August 6, based on CFTC data. (That said, this doesn’t capture the precise size of total JPY carry trade activity.) The association between JPY borrowing and the total open interest in CME bitcoin futures can be modeled using a second order polynomial equation, with the former able to explain around 50% of the variation in the latter. See Chart 1.

But while the BoJ decision and July’s nonfarm payrolls may have represented the tipping point that triggered the massive unwinds in the JPY carry trade against higher yielding currencies and assets like US tech stocks, global recession fears have been ramping up for weeks if not months – which we noted in early July.

These concerns have led market players to price in around 125bps of cuts (in Fed fund futures) across the next three Federal Reserve meetings. Indeed, that would put the policy rate not far from the 4.5% suggested by the Taylor Rule (vs today’s 5.5%) given current levels of inflation and unemployment [1]. Nevertheless, we believe that the recent sluggish growth in the US does not mean that America’s economy is plunging, which would be a prerequisite for a technical recession in 4Q24 (i.e. two quarters of negative GDP growth). As such, we consider the short-lived tumult to be somewhat of an overreaction to what’s actually happening in the real economy.

Gossamer threads

Notably, this deleveraging has not only affected traditional assets but crypto as well, for two big reasons in our view. First, market players have treated crypto as a proxy hedge for risk when other markets (e.g. stocks) have been closed. Second, we also saw things like gold fall almost 4% amid the rout, suggesting that even supposed traditional “safe haven” assets weren’t immune to the selling pressure as investors likely had limited discretion over what they could offload to meet their margin calls. All of this has created the perception of correlated markets, particularly given the summer’s low liquidity environment.

However, the reality is that with US inflation expectations (proxied by 2y breakeven rates) mostly contained inside the 1-3% range at the moment, correlations between the daily returns of bitcoin and the S&P 500 since the start of 4Q23 have actually been relatively low. In fact, the linear relationship between these two variables has been between 0 and 0.40 (or 40%) over the last nine to ten months, which we would consider weak or negligible. See Chart 2.

Historically, the incidence of correlations above the 0.40 coefficient threshold have mainly occurred under extraneous conditions like the pandemic in 2020 or massive monetary policy tightening in 2022. Since 2017, we’ve seen roughly four major monetary policy regimes:

• The 1Q17 to 3Q19 period saw a gradual pace of rate hikes from the Federal Reserve as a response to economic strength.
• The 4Q19 to 4Q21 period then included dramatic cuts and quantitative easing in response to the COVID-19 pandemic, alongside a strong expansionary fiscal stance from the US government.
• The 1Q22 to 3Q23 period was characterized by the fastest tightening cycle in four decades, mainly in response to high inflation. US CPI peaked at a headline figure of 9.1% YoY during this time, while breakeven inflation (2y expectations) climbed to 5%.
• The Fed has maintained its tight monetary policy stance through the current 4Q23 to 3Q24 period, but we now appear to be in a disinflationary environment where rate cuts seem imminent.

While the correlation between bitcoin and stocks has breached coefficients as high as 0.60-0.70 in the past, we think that the clustering of those results within the 1Q22 to 3Q23 period suggests this can be explained by the high interest rate environment at the time. Looking ahead, we believe the empirical evidence suggests that in a lower inflation and interest rate environment – the most likely scenario, in our view – the relatively weak relationship between stocks and crypto (that we’ve observed in recent quarters) should continue. This would support crypto’s role as a diversifier for traditional equity and bond portfolios.

Crypto risk exposure

Although the crypto market has clawed back its losses since the market sell off on August 5, we expect many institutional players to remain cautious about their risk exposure in the weeks ahead. Interestingly, while SOL has been the primary crypto “beta play” for most of this year, we’ve recently seen a convergence in how sensitive ETH and SOL’s respective returns are to the overall market, particularly coinciding with the launch of spot ETH ETFs in the US on July 23.

At the start of 4Q23, SOL had a beta of around 1.25 to the overall crypto market, suggesting SOL exposure would net an increase or decrease of roughly 25% more than the market on average. That moderated to an average of 0.71 in the first half of 2024, albeit still higher than ETH’s 0.61 average over the same six-month period. We believe that these figures reflect the fact that the asset class started to incorporate an increase in smaller cap altcoins that tend to be higher risk and more volatile than the aforementioned “blue chip” tokens.

But both ETH and SOL currently have a higher beta of around 0.85 and 0.83 (compared to just a month ago) measured over a 90-day window of daily price changes relative to the Coinbase Broad Index. The Coinbase Broad Index (COINB) is a market cap weighted crypto index that captures 79 tokens worth $1.7T (almost 80% of the total crypto market.) In Chart 4, we update the beta continuously over time to see how the relationship between these tokens and the crypto market has progressed. It shows that bitcoin’s beta has been stable over the last eight months near the YTD average of 0.62, suggesting (unsurprisingly) that it is much less volatile than the overall crypto market, especially when compared to its peers. Indeed, both ETH and SOL's beta relative to bitcoin is above 1. Higher beta assets tend to offer higher returns in exchange for higher risk.

Conclusions: market outlook

Overall, our market views haven’t changed despite how the recent sell-off has unnerved investors. We anticipate a choppy market in 3Q24 but also expect a more constructive environment for crypto markets to materialize in 4Q24. That presupposes that the US economy will avoid a recession, even if it slows down. See table 1 below for a history of our views:

Table 1. Coinbase Research market views since inception

The sell off to start the month has been consistent with our defensive approach for this quarter, even if the magnitude of the move caught us by surprise. We expect the price action to remain range bound at least through the FOMC meeting on September 17-18, as we foresee a lack of new idiosyncratic catalysts for the crypto space over the next few months. That suggests that the influence of macro factors on performance may be more dominant in the short-term. For example, the Jackson Hole Economic Symposium on August 22-24 will likely be the next major macro event that could test the pulse of markets.

Nevertheless, the high degree of deleveraging in the crypto perpetual futures market following over $1.6B in liquidations in the first full week of August suggests positioning in the crypto market is far cleaner now, which is a positive technical factor in crypto’s favor. Moreover, we may see a pickup in net demand for spot ETH ETFs following a relatively subdued launch, as many of the front loaded withdrawals from Grayscale Ethereum Trust (ETHE) have started to subside. While the US elections in November will still be a key variable to watch, all of this supports our longer term constructive view for the asset class.