The Cryptoverse - Teenage bitcoin throws an interest rate tantrum

Bitcoin is growing up. The original cryptocurrency turns 13 this year and is showing signs of becoming a more mature financial asset - but watch out for the teenage tantrums.

This drift towards the mainstream, driven by the big bets of institutional investors, has seen bitcoin become sensitive to interest rates and fuelled a sell-off in the coin this month as investors braced for a hawkish Federal Reserve policy meeting.

The cryptocurrency, born in 2009, was still on the fringes of finance during the Fed's previous tightening cycle, from 2016 to 2019, and was barely correlated with the stock market.

Times have changed.

Bitcoin has been positively correlated with the S&P 500 index since early 2020, according to Refinitiv data, meaning they broadly move up and down together. Their correlation coefficient has risen to 0.41 now from 0.1 in September, where zero means no correlation and 1 implies perfectly synchronised movement.

By contrast, that coefficient was just 0.01 in 2017-2019, according to an International Monetary Fund analysis published this month.

"Now that bitcoin isn't completely out to early adopters, it's sitting in a 60/40 sort of portfolio," said Ben McMillan, chief investment officer at Arizona-based IDX Digital Assets. 40 percent to relatively risky equities and bonds, referring to the institutional strategy of allocating 60% of the portfolio.

"It's not surprising that it's starting to trade with a lot more sensitivity to interest rates."

Bitcoin on Friday closed below $40,000 (approximately Rs 30 lakh) for the first time since August 2021, somewhat lower than its November peak of $69,000 (approximately Rs 51 lakh).

Hedge Against Inflation?

The crypto market is increasingly characterized by large investors, not the smaller retail players, who drove its initial movements.

According to data provider CryptoCompare, total assets under management of institutional-focused crypto investment products increased from $36 billion (about Rs 2,69,245 crore) in January to $58 billion (about Rs 4,33,720 crore) in December.

On top of that, there were bumper buyouts from corporate likes like Tesla and MicroStrategy, as well as hedge funds adding crypto to their portfolios.

"The cryptocurrency ecosystem grew from a total market valuation of $767 billion (approximately Rs 57,35,050 crore) at the beginning of the year to $2.22 trillion (approximately Rs 1,65,99,500 crore) at the end of the year," said CryptoKitties.

The shift toward mainstream finance in 2022 and beyond raises broader questions about whether bitcoin can retain its role as a diversification play and hedge against inflation.

IMF researchers said bitcoin's growing correlation with equities has "limited its perceived risk diversification benefits and increased the risk of transition to financial markets".

Bitcoin is also often regarded as a hedge against inflation, primarily because of its limited supply. Like gold, a more established store of value in an inflationary environment. However, its correlation with stocks has seen it slide sharply along with broader markets from the largest annual increase in US inflation in nearly four decades.

"In the current case, bitcoin is not acting as an inflation hedge. Bitcoin is acting as a risk-proxy," said Nicolas Kavle, strategist at DailyFX based in London.

Jeff Dorman, CIO of Los Angeles-based digital asset management firm Arca, said: "It is also an irony that the bull case for many digital assets in spring 2020 was expected to be high inflation. Now that we really have inflation, here it is. Weighing in on prices."

'Waiting for higher prices'

Investors are increasingly holding onto bitcoin for the long term.

Kraken Intelligence, a research blog from cryptocurrency exchange Kraken, said that nearly 60% of all bitcoins in circulation had not changed hands in a year, the highest level since December 2020.

Meanwhile, funding rates for perpetual swaps across major exchanges – a sign of sentiment among investors betting on bitcoin's future price movements – were fairly flat, hovering around 0.01%, according to data platform Coinglass.

Positive rates mean traders are bullish because they have to pay to hold a long position, while negative rates mean traders have to pay to hold a short position or bet on a fall in prices.

According to blockchain data provider Glassnode, investors are displaying a remarkable reluctance to spend the coins.

"In the face of turbulent and uncorrelated price action, this signals that this group of holders is waiting for higher prices to spend their respective supplies," it said.