Understanding the Correlation Between Crypto and Traditional Financial Markets

In recent years, cryptocurrencies and traditional financial markets have increasingly shown a curious relationship: their prices have started to move in tandem more often. But why do these volatile digital assets, designed to be independent, often mirror the behavior of traditional markets?

Find out more below about the correlation between crypto prices and traditional financial markets, with recent examples, to help unravel this evolving dynamic.

How Do Cryptos and Traditional Markets Correlate?

Institutional Involvement and Cross-Market Participation

Institutional investors, like hedge funds, investment banks, and asset management firms, have started including cryptocurrencies in their portfolios. With big players entering the space, crypto markets are now more influenced by the same macroeconomic factors as stocks, commodities, and even foreign exchange.

For example, Fidelity Investments, BlackRock, and even JPMorgan Chase have launched funds that include or focus on digital assets. This institutional adoption has increased the overlap between traditional and crypto markets, as these investors often treat cryptos as part of their broader portfolios. When risk appetite is high, both stocks and cryptos tend to see inflows. Conversely, during risk-off environments, capital flows out from both, leading to price correlation.

The "Risk-On, Risk-Off" Meter

The global financial markets are often driven by what’s known as the "risk-on" or "risk-off" meter. In a risk-on environment, investors are willing to invest in riskier assets for the potential of higher returns. In a risk-off setting, they pull back into safer investments, like bonds or gold.

Cryptocurrencies, with their high volatility, are often treated as high-risk assets. This makes them behave similarly to tech stocks, which are also generally seen as growth-driven and riskier than other sectors. The close alignment with tech stocks, like the NASDAQ index, has been particularly notable; during the market dip in early 2022, both the NASDAQ and Bitcoin saw sharp declines as investors moved away from high-risk assets.
 

Source: CoinShares

Macroeconomic Factors and Monetary Policy

Interest rate changes by central banks, inflation rates, and economic outlooks significantly impact both traditional and crypto markets. The U.S. Federal Reserve’s rate hikes in 2022-2023, aimed at controlling inflation, have dampened enthusiasm for riskier investments, which include both tech stocks and cryptocurrencies.

When rates rise, borrowing costs increase, which often leads to a reduction in spending and investing in risk assets. Bitcoin, for example, has reacted to Federal Reserve announcements almost as consistently as traditional financial assets, with price drops in response to interest rate hike announcements. This indicates that while crypto assets may be decentralized, they’re not immune to the effects of centralized economic policies.

Growing Regulatory Focus

Regulatory developments also shape the correlation between cryptocurrencies and traditional markets. Government scrutiny, tax regulations, and possible future legislation impact both sectors, particularly with the rise of discussions around stablecoins and central bank digital currencies (CBDCs).

For instance, when the U.S. Securities and Exchange Commission (SEC) initiated lawsuits against major crypto exchanges in 2023, market uncertainty surged. This regulatory scare caused both crypto and tech stocks to experience volatility, suggesting that regulatory developments in crypto can ripple into the broader financial ecosystem.

How Closely Are Crypto and Stock Markets Actually Correlated?

The Case of Bitcoin and the NASDAQ

Bitcoin, being the largest cryptocurrency by market cap, often serves as a proxy for the entire market’s performance. Studies have shown that Bitcoin's price has been moving in close alignment with tech-heavy indices like the NASDAQ. In fact, correlation coefficients between Bitcoin and the NASDAQ reached levels as high as 0.4-0.6 in recent years, especially in times of heightened market volatility.

For example, during the early 2022 market selloff:

• Both the NASDAQ and Bitcoin experienced nearly simultaneous drops.
• The correlation between the two assets surged as investors reduced exposure to speculative assets amidst inflation fears and potential interest rate hikes.

Ethereum and Broader Market Movements

Ethereum, the second-largest cryptocurrency, also shows a correlation with traditional market indices but to a slightly lesser extent than Bitcoin. Since it is closely tied to decentralized finance (DeFi) and smart contract platforms, its price movements often reflect developments within the crypto industry itself. However, in times of significant market turmoil or global macro shifts, Ethereum also tends to move with broader market trends.

Recent Events Illustrating Crypto-Market Correlation

The 2023 Banking Crisis

In early 2023, when several US regional banks faced liquidity crises, crypto markets and traditional markets both experienced sudden movements. Fears of a bank run led to increased interest in stablecoins and Bitcoin as alternative stores of value.

Source: Reuters

However, when traditional stocks, especially in the financial sector, rebounded upon government assurances, crypto markets also stabilized. This demonstrated how investor sentiment in traditional assets can bleed into crypto markets.

The Inflation-Driven Market Swings

Crypto assets have experienced both bull and bear cycles that don’t directly correlate with broader macroeconomic inflationary shocks. This characteristic helps explain why adding crypto to a traditional investment portfolio can enhance returns, though it also introduces more volatility. Additionally, many retail investors in emerging markets suffering from currency devaluation or hyperinflation have adopted crypto assets to preserve their wealth.

Inflation is typically linked to an overheated economy, often following expansionary monetary and fiscal policies that elevate aggregate demand. Sometimes inflation also arises from adverse supply shocks, which can drive up consumption, resulting in demand-driven inflation. This in turn leads to fiscal policies that can also stimulate investment in high-yield assets, such as crypto, as investors seek greater returns.

Rising inflation in 2022-2023 prompted central banks around the world to raise interest rates. This led to a simultaneous pullback in tech stocks and cryptocurrency prices, as higher interest rates made safer assets more attractive relative to riskier investments like tech stocks and cryptocurrencies.

Inflation data releases became key indicators for both markets. If inflation came in lower than expected, Bitcoin and traditional assets would rally, reflecting relief from potentially slower interest rate hikes. A higher inflation figure, on the other hand, would lead to a selloff across both markets, showing how inflation affects investor risk appetite on both fronts.

Why Do Cryptos and Traditional Assets Still Diverge Sometimes?

While the correlation between crypto and traditional markets has increased, there are instances where the two diverge. Here are some of the key reasons for this divergence:

Unique market events in crypto

Crypto markets often have their own, unique events that don’t impact traditional markets. For example, the collapse of Terra (LUNA) in 2022 led to a market-wide crypto crash but had little to no effect on traditional stock markets.

Similarly, when major exchanges like FTX face crises or hacks, they primarily impact crypto assets, leading to short-term price divergences.

Crypto-specific sentiment and speculation

Crypto markets are heavily influenced by sentiment and speculation. Trends like NFTs or the rise of meme coins (such as Dogecoin and Shiba Inu) can drive crypto prices independently of traditional market performance.

During the 2021 NFT boom, Ethereum surged as it was the backbone of many NFT platforms. This happened despite traditional markets experiencing volatility from COVID-19 concerns, demonstrating how unique crypto trends can impact market movement independently.

Liquidity differences

Cryptocurrencies are still relatively smaller in market cap compared to global stock markets. As a result, their prices can be more volatile and may not always mirror broader market trends.
This was evident in the early days of the pandemic in 2020 when Bitcoin’s price initially plummeted more dramatically than traditional assets due to a liquidity crisis in the market.

However, it quickly rebounded, showcasing both its volatility and potential as a high-reward asset for investors.

What Does Correlation Mean for Investors?

Investors should keep in mind that while the correlation between crypto and traditional markets exists, it’s not absolute.

A few key takeaways to keep in mind:

• Crypto is a valid portfolio diversifier: despite its growing correlation, crypto still offers portfolio diversification due to its unique trends and market cycles.
• Understand macro trends: investors in crypto should pay attention to broader economic trends, including interest rates and inflation, as these factors now influence both crypto and traditional assets.
• Risk management is essential: given the volatility and occasional divergence, it's important to approach crypto investments with strong risk management principles in place.

Final Thoughts

The correlation between crypto prices and traditional financial markets has grown in recent years due to institutional investment, macroeconomic influences, and regulatory developments. However, unique crypto events and the inherently speculative nature of digital assets make the relationship between the two complex and fluid. Understanding this connection can help you make informed decisions, especially since the lines between traditional and digital assets are blurring.

Whether you're a pro trader or just getting started, recognizing the factors behind this correlation can help you navigate both markets and better manage your portfolio amid an ever-evolving financial landscape.