F. Scott Fitzgerald said “the test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”
Bitcoin is the embodiment of this idea in markets, and why I suspect many in finance and business journalism dismiss its connections to the economy and other major asset classes. They write it off as a bizarre offshoot of finance more akin to a casino than an asset class. While that is true for most of the tokens, it is not for bitcoin. Viewing the King Crypto as a completely random roulette wheel that’s detached from traditional financial markets and the economy is a mistake.
Right now bitcoin is signaling that volatility is on the way. To see why, one has to hold the ostensibly opposing ideas of bitcoin as a risk asset and also a store of value, at the same time.
Bitcoin is indeed much closer to a roulette wheel than just about anything else in traditional markets, but for enough of its investor base, it is a wager on a specific series of events happening. The likelihood of those events is very low, hence the sluggish adoption, risk of investment, and potential reward if bitcoin becomes widely accepted as a store of value. As evidenced by its unprecedented, astronomic volatility, bitcoin is extremely risky. Its trading history since becoming a household name reflects its nature as a risk asset: peaking in 2017 right before the stock market’s frothiest peak of the bull market yet, breaking down ahead of the S&P 500’s epic 4Q18 selloff, and gaining steam again this year just as the VIX dropped back to the bottom of its 2-year range.
But wait: bitcoin also trades like a safe haven.
It surged this year as the U.S-China trade war was looking like it might turn into a currency war, the Fed was reversing course, and the amount of negative yielding debt was mounting across the globe. As this backdrop fell into place, bitcoin, which many in the crypto space refer to as “digital gold,” traded closely in sync with actual gold, with the 30-day correlation between bitcoin and gold futures reaching a record high of 0.91 in mid-July.
Thinking about bitcoin as a very far out-of-the-money call option on its adoption event series is a helpful way to thinking about why bitcoin can trade both as a safe haven and a risk asset. It is a risky bet that certain economic events will happen – mostly negative ones that spur big changes to the structure of financial markets.
But here’s the kicker. There was sufficient overlap this year not just between the reasons for owning bitcoin and gold, but between the reasons for owning Treasury bonds and certain types of stocks, too. People bought bonds because they foresaw extensive central bank accommodation on the way and knew they’d have a buyer for government debt. Bond buyers were just as worried about the global economy as gold bugs, who themselves were touting a just slightly less manic narrative than the cryptoknights. In the stock market, investors funneled cash into bond-proxy plays like utilities, and expensive growth companies whose valuations are more easily justified in a world where rates are going seemingly infinitely lower.
Bitcoin’s crash is the most damning for gold, whose use-case as basically a more traditional bitcoin is looking less compelling by the day as economic data comes in ahead of bearish forecasts from this summer. Gold has already demonstrated that it is inclined to move in the same rough trends as bitcoin this year, peaking in September and now following bitcoin’s patterns of lower highs and lower lows. If inflation does not appear soon, the case for owning gold will take a big hit. And even if inflation does show up, it’s unclear how much gold will be able to respond, considering its big rise this year happened in the absence of inflation.
U.S. 10-year Treasury notes and gold have also traded in a tight correlation for almost all of the year. If Brexit is resolved amicably, European countries enact fiscal stimuli, China’s economy stabilizes, or the U.S. is able to demonstrate steady growth in the face of a tariff war, Treasuries are likely to continue moving with gold. The price of bitcoin is now almost where it was in May. Gold and bonds by no means have to do the exact same thing as bitcoin, but if the need to own bitcoin is dropping this quickly, the need to own gold and bonds is going to come under further scrutiny. A move in the 10-year Treasury yield that takes it back to May levels would mean a 2.4% yield. This would be a shock to investors if it happened too quickly.
Stocks are tricky. While bitcoin’s explosive action in 2017 was a good sign that concurrent euphoria in stocks would also be short-lived, the signaling relevance of bitcoin for stocks is probably waning. Stocks have indeed been kept afloat to some degree by the same force that pushed investors into bonds and gold – the expectation and delivery of interest-rate cuts by central banks. As such, the S&P 500 is getting expensive again and needs earnings expectations to turn upwards to justify its price. If that happens, equities will have a good buffer to volatility elsewhere. If it doesn’t happen soon, it’s unlikely stocks will be able to retain their elevation for long in an environment where bitcoin, the world’s riskiest asset, is now 50% off its high.