Kaiko Research: Bitcoin and Stock Correlation Soars, Market Volatility Will Persist

Recently, the forecast of the Fed's interest rate hike in 2022 has attracted close attention from the digital asset industry. Institutions such as Goldman Sachs and JPMorgan Chase have made predictions. JPMorgan Chase CEO Damon said that the Fed's four interest rate hikes of 25 basis points each will not have a huge impact on the economy. However, the Fed's December meeting triggered a sharp sell-off in the cryptocurrency and stock markets.

In addition to the volatility of price trends, the crypto market's DEX trading volume has achieved a fifth consecutive month of growth, mainly concentrated in Uniswap V3. Although the order book liquidity fluctuates greatly, the liquidity of the US dollar market remains stable. Derivatives open interest has also plummeted in the near term, but the funding rate remains neutral during the sell-off.

In addition, Bitcoin's correlation with the Nasdaq and S&P 500 indexes has reached its highest level since July 2020. From this point of view, the correlation between Bitcoin and stocks has begun to increase significantly. This article will conduct an in-depth analysis of the market reaction after the Federal Reserve's December meeting and the correlation between Bitcoin and stocks.

Source: Kaiko Research

Author: Kaiko

Compiled by: Chen Yiwanfeng

Price Changes

After the release of the Federal Reserve's December meeting minutes, the monetary policy outlook officially shifted to "tighter than expected", which led to a sharp sell-off in both crypto and stock markets. Bitcoin immediately fell 17%, and its correlation with the S&P 500 stock index reached its highest level since July 2020. Derivatives exchanges recorded hundreds of millions of long liquidations, exacerbating the price decline, and market sentiment now remains firmly bearish.

In other industry news, NFT marketplace OpenSea hit a $13.3 billion valuation after a year in which investors spent nearly as much on digital collective works as on traditional art. Additionally, a nationwide internet blackout in Kazakhstan caused a drop in hash power to the Bitcoin network.

Layer 1 tokens suffer after strong fourth quarter

Most Layer 1 tokens fell sharply following the Fed meeting, underperforming Ethereum along with the crypto market as a whole. This decline comes despite the fact that alternative networks have gained market share relative to Ethereum over the past year (measured by total value locked) and the network’s planned expansion is still months away.

Avalanche’s AVAX recorded its biggest drop since the start of 2022, falling 22%, far less than Ethereum’s 16% drop. Terra’s native token also fell 20%. Terra’s LUNA has enjoyed strong upward momentum in the past few months due to the launch of several projects such as the Columbus-5 upgrade and DEX Astroport.

Trading volume dynamics

Trading volume on major Ethereum-based exchanges has been rising steadily since July, reaching $57 billion in December, the highest level since May. This growth was almost entirely driven by strong trading activity on Uniswap V3, which now accounts for 77% of total trading volume. Curve, a DEX optimized for stablecoin trading, saw trading activity rise from $3 billion to $4 billion per month, while Sushiswap and Uniswap V2 saw volumes decline.

While Curve holds the largest share of DeFi Total Value Locked (TVL) on Ethereum (14%), more than double Uniswap’s TVL, trading volume remains relatively low compared to other dexes. This is due to Curve’s unique model of issuing liquidity rewards, which has caused TVL to surge as pools compete to attract liquidity, creating a phenomenon known as the “Curve Wars.” This liquidity war spans multiple protocols and is complex but relevant to understanding DeFi incentive models.

Order Book Liquidity

Although Bitcoin experienced double-digit losses in just a few hours, the recent sell-off was not as disruptive to liquidity as previous crashes. The bid-ask spread represents the transaction cost and is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. During the recent sell-off, the spread in the BTC-USD market was more volatile than average, but it did not widen to the extent during the Dec. 4 crash. The volume in the past month is only slightly higher than in previous days, which indicates that trader activity is limited and the “slow-burn” crash has not forced market makers to close their positions.

Derivatives

Bitcoin perpetual futures open interest fell 38% to $7 billion between January 5 and 7, 2022, as the spot price plunged from $46,000 to $41,000, triggering deleveraging and forcing liquidations on derivatives exchanges. The drop in open interest last week was steeper than Omicron’s sell-off in early December, where open interest plunged 33% in 2 days. Retail-facing exchanges Binance and Bybit saw the biggest drops, suggesting traders are using a lot of leverage. Derivatives volumes fluctuate with Bitcoin’s price movements, surging 74% to $59 billion between January 5 and 6, before retreating to $29 billion on January 7 and surging again to $51 billion.

Despite the sharp drop in open interest, funding rates for Bitcoin perpetual futures have barely budged, in stark contrast to the sell-off in early December, when funding rates briefly turned negative across all exchanges.

The funding rate is the cost of holding a long position and is seen as a measure of market sentiment and leverage. When the funding rate is positive, long traders dominate and pay short traders. Negative funding rates indicate that the market is generally bearish and short traders dominate. The fact that funding rates have not plummeted as they did in early December suggests that leverage is not as extreme and the balance between longs and shorts is more stable.

Options volume is different from futures

Bitcoin options volume has increased dramatically since the summer, while futures and perpetual futures volume has declined slightly. The above chart shows BTC futures volume on leading derivatives exchanges and options volume on Deribit, which now accounts for more than 90% of the entire options market. Average weekly futures volume fell by more than half from November to December 2021. Perpetual futures account for more than 80% of total Bitcoin derivatives volume, which has also declined compared to the previous period, although at a slower rate. However, BTC options volume is still significantly higher than during the summer bear market, with call volume (bullish bets) accounting for 60% of total volume in December.

Macro Trends

The Federal Reserve's December meeting had a strong impact on global financial markets, with traders reacting quickly to the prospect of monetary tightening. During the volatility, Bitcoin behaved very much like a risk asset, with its correlation with the Nasdaq and S&P 500 stock indexes jumping to their highest levels in more than a year, at 0.61 and 0.58, respectively. On the other hand, Bitcoin's correlation with safe-haven gold has been negative since September.

Despite the sell-off in risk assets, U.S. Treasury yields hit multi-month highs last week. The following chart shows the yields of 2-year, 10-year and 30-year U.S. Treasury bonds, which are considered safe havens.

From the chart above, we can observe that despite concerns about the potential impact of the growing COVID-19 outbreak, yields, which move inversely to bond prices, have mostly risen throughout December. But this trend is actually related to high inflation, which has caused real (inflation-adjusted) bond yields to remain negative. Overall, tightening financial conditions are expected to have a negative impact on risky assets such as stocks and cryptocurrencies, as they are less attractive than safe-haven bonds.

Volatility takes a toll on annual cryptocurrency returns

Despite the market downturn, annual cryptocurrency returns were strong, with BTC and ETH up 64% and 404%, respectively. The U.S. stock market also performed well, with strong profit margins, despite soaring inflation. While crypto assets had the highest absolute returns, stocks performed better after risk adjustment. The above chart shows the annual total returns and Sharpe ratios (risk-adjusted returns) of major assets. Taking volatility into account, the S&P 500 and ETH performed the best, while gold and bonds performed the worst.

As the withdrawal of pandemic-era monetary stimulus roils markets, especially for riskier assets, volatility is expected to persist throughout 2022. Below we plot the Fed's balance sheet alongside S&P 500 implied volatility, as measured by the VIX index, to see how monetary policy is affecting stocks.

We observe that volatility and the Fed’s balance sheet have been moving in opposite directions, with the VIX falling significantly since the March 2020 market crash (and the shortest recession on record) while the Fed’s balance sheet has more than doubled to over 8.3t. Bitcoin has been closely correlated with the stock market sell-off over the past few months, from which we can predict that global financial trends will increasingly influence crypto market sentiment in the future.