Will crypto decouple from other markets in the future?

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by Zain Jaffer

When one variable increases while another also increases or vice versa, the two are said to be correlated. If the opposite is happening and the movement is opposite, then these are negatively correlated. If the movement of one has nothing to do with the other, then these are uncorrelated.

Currently, the crypto sector is correlated with the technology sector, especially the NASDAQ. This is likely because most tech and crypto stock buyers are people who are not risk averse and have extra cash. Those who buy tech stocks also buy crypto, although some simply buy crypto or tech stocks. But the models are similar.

When there is excess liquidity in the system, such as when governments around the world gave money to citizens during the pandemic, many of them end up in risky assets such as tech stocks and cryptography.

However, when the Fed started raising rates in 2022, by nearly 500 basis points from April 2023, liquidity suddenly disappeared. The banks did not want to lend, and so the cheap debt disappeared. The money for speculation suddenly disappeared.

Many now believe that the Fed or any other central bank should not have the power to arbitrarily change their lives. They are now looking for ways to decouple from the system that puts the world on a path of inflation or recession just because the Fed said so.

These folks are hoping crypto will decouple and do its own thing, regardless of what central banks want. In other words, they want crypto to decouple from traditional finance.

A manifestation of this is how crypto, in April 2023, was still doing well despite talk of a recession and low liquidity. What was needed was a loyal base that was not so interested in other financial instruments.

For Bitcoin and Ethereum in particular, the fact that supply is either fixed (in the case of Bitcoin) or reduced (in the case of Ethereum) means that both are deflationary and go against typical fiat currencies. which can simply be printed. US money supply M2, which tracks the amount of money in circulation in the US [see https://fred.stlouisfed.org/series/M2SL]shows that M2 suddenly spiked in 2020, reflecting the sudden influx of new money printing during the pandemic. This is the cause of high inflation in the United States and other countries that have also done the same.

Proponents of Modern Monetary Theory (MMT) believe that printing fiat money can be done as long as it leads to the creation of new jobs, and therefore to increased GDP and eventually productivity. However, this excess money in 2020 was simply released to prevent people who could not go out and work from starving.

Yet this event, and the current US$32 billion deficit, is at odds with what advocates for the Vienna School and the Milton Friedman Chicago School believe, that overprinting money should not be done. Many in this camp believe that Bitcoin, and some also believe that Ethereum, is a solution to the possible future failure of fiat currencies around the world.

These days, many people also have doubts about banks. Although just to point out, we need the banks, since our economy relies on lending to businesses, home and car buyers, etc. A new trend in crypto called Decentralized Finance (DeFi) gives the user the power to obtain collateralized loans, lend funds, deposit interest and other functions that would normally require a bank, and use instead a smart contract on a blockchain to do these functions.

Will crypto decouple from everything else? If nothing changes in the traditional financial system, it probably will. More importantly, it should. Crypto is a possible solution to the excesses of our current financial system, and should not try to recreate it but rather reinvent it.

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