The Crypto Cycle and US Monetary Policy 

By | October 23, 2023

Crypto assets exhibit considerable design and value proposition differences, ranging from inflation protection to facilitating more streamlined payments, ensuring censorship-resistant computing, and safeguarding property rights. Nevertheless, their prices often exhibit similar cyclical patterns. Surge periods with substantial returns have lured both retail and institutional investors. Meanwhile, the subsequent market downturns have garnered growing scrutiny from political figures and regulatory bodies. Additionally, the movements in crypto markets seem to be increasingly synchronized with other asset classes. For instance, Bitcoin once served as a semi-hedge against market risks before 2020. However, its correlation with the S&P500 has increased since then. 

Our recent paper delves into the factors affecting crypto asset prices by addressing several questions. We investigate whether a common cycle exists among crypto assets and examine the increasing alignment between crypto and global equity markets, seeking to uncover the driving forces behind this convergence. Furthermore, we analyze the extent to which US monetary policy, known to drive the global financial cycle, also significantly impacts the crypto cycle and explore the specific channels through which this influence is transmitted. 

First, we employ a dynamic factor model to pinpoint a single dominant factor in crypto-asset prices. Analyzing daily prices from some of the most longstanding tokens, which comprise about 75% of the total crypto market cap, we break down their fluctuations into individual idiosyncratic movements and a shared component. We label the latter “crypto factor” as it accounts for roughly 80% of the variance in the crypto pricing data. 

Next, we explore the co-movements between this crypto factor and a set of global equity factors formed using the stock indices of the biggest GDP countries (following the approach of Rey, 2013; Miranda-Agrippino and Rey, 2020). We observe a consistent positive correlation throughout the sample period, which intensified post-2020. This increasing synchronization is not restricted to Bitcoin’s relation with the S&P500 but extends more widely to the entire crypto and global equity factors. Upon closer examination across equity markets, we show that the crypto factor has a stronger correlation with the global tech and small-cap factors post-2020 while less correlated with the global financial factor. 

The synchronicity between crypto and stocks began rising, with more institutional investors entering the crypto scene after 2020. Even though the institutional involvement in crypto is proportionally small compared to their overall financial holdings, their sheer trading volume overshadows retail traders. Institutional trading on crypto exchanges ballooned by over 1700% (from about $25 billion to over $450 billion) between Q2 2020 and Q2 2021. Given that such institutional investors trade in both stocks and crypto, there has been a growing parallelism between the risk profiles of marginal equity and crypto investors (following the approach of Bekaert, Hoerova, and Lo Duca, 2013). This similarity explains a considerable portion (about 65%) of the correlation between the global equity and crypto factors.  

With US monetary policy pacing the global financial cycle, the rising crypto-equity correlation indicates that FED policy may have similar effects on crypto markets. We test this hypothesis using a daily VAR with the shadow federal funds rate to account for the critical role of balance sheet policy over our sample period. We find that FED policy affects the crypto cycle, as it does with the global equity cycle, in stark contrast with claims that crypto assets provide a hedge against market risk. Specifically, a 1% surge in the shadow rate results in a sustained decline in the crypto factor of 0.15 standard deviation. 

Our findings mirror those of Miranda-Agrippino and Rey (2020) for global stocks, indicating that the risk-taking channel of monetary policy holds significant importance in the crypto market as well. A monetary tightening reduces the crypto factor, which co-occurs with a spike in the aggregate effective risk aversion in crypto markets. In addition, we find that the significance of this channel increases with a higher proportion of institutional investors participating in crypto asset trading. 

In conclusion, our study shows that, notwithstanding the rationales for the various crypto value proposals, crypto markets are highly synched with equity markets and significantly affected by US monetary policy. Furthermore, we argue that the rising participation of institutional investors in crypto markets has corroborated these results and warns against potential contagion risk from crypto to global equity markets. 

Natasha Che is an Economist at the International Monetary Fund.  

Alexander Copestake is an Economist in the Research Department at the International Monetary Fund. 

Davide Furceri is the Deputy Division Chief of the Development Macroeconomic Division in the IMF Research Department. 

Tammaro Terracciano is an Assistant Professor of Finance at IESE Business School in Barcelona, Spain.  

This post is adapted from their paper, “The Crypto Cycle and US Monetary Policy,” available on SSRN 

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