Getting Back to Normal: Crisis Financing and Correlations

“Getting back to normal” is a phrase that politicians and business leaders increasingly use as they look past the current pandemic, but how closely future “normal” will reflect the pre-COVID-19 world remains to be seen. What is certain is that we are in an unprecedented situation, at least in our lifetimes. The ways that we conduct business, travel, and interact with our fellow human beings will almost certainly be different going forward than they have been up to now. We can and should expect significant changes to how we do business and operate our economies, from the global to the personal and everything in between. What happens in the next 2–5 years may very well shape the future.

In recent weeks, the markets have been rallying back from their March 23rd lows at a rapid pace. The below chart of the S&P 500 shows the significant recovery that has taken place since March’s market selloff.

Although the pandemic is clearly unwelcome, for many in the crypto community who believe that BTC, as a borderless currency with a finite supply, can be a store of value and a hedge against inflation, the massive printing of fiat currencies by the central banks of the world presents a true test. As I wrote in an earlier article, COVID-19 was simply a catalyst for present central bank responses. As influential traders like Ray Dalio, Jeff Gundlach, David Tepper, and others have said for a long time, the U.S. economy has been over-leveraged to an unhealthy level in just about every sector, from government debt to corporate bonds and beyond. The market was already primed for a large scale correction, even though, absent the virus, the fall may not have been as sharp or pronounced, and it may not have occurred for another several years.

But what does this mean in terms of markets “getting back to normal”? Currently, there is disagreement on this point. One side argues that general business activity will not come back in the short term. Instead, there will be a long cycle of deleveraging. The other side believes that present stimulus measures will bring markets right back to where they were once the virus is contained. While both sides have their own entrenched beliefs, the argument itself overlooks a crucial detail: the fact that, once the intended effects of the stimulus start to take place, winding down those central bank measures is hugely difficult. Even without the virus, attempting to return to pre-crisis finances after serious market stimulus has its own consequences. For some perspective, let’s take a look back at our most recent financial crisis.

The below chart shows the Federal Reserve balance sheet over the last eight years. After the mortgage induced financial crisis a decade ago, the Fed balance sheet grew to about $4.5 Trillion, where it steadily remained until 2018. At that point, with markets seeming stable, the Fed began to gradually sell off the assets it had originally purchased to steady the economy during the worst of the crisis.

As soon as the downsizing began, the market began to respond “negatively.” In other words, the market stopped going up and setting daily record highs as linearly as investors would have liked. Why? Because many companies had grown to depend on crisis financing — to treat a temporary, emergency stimulus program as a part of normal operations. As soon as the central bank began to wind down these measures, the markets shuddered. In the second half of 2019, under mounting public pressure over slumping markets, the central bank reversed course and the markets sprang back up.

This dynamic — where markets reacted negatively to even a gradual “return to normal” — happened during the longest bull cycle in history. Even against a backdrop of consistently positive economic indicators, the markets still saw a marked decline when stimulus measures were removed.

Market behavior during this period suggests that any thought of reducing this balance sheet in the next five years is likely out of the question. Why? Because present stimulus efforts dwarf those of 2008 by several orders of magnitude. Even if we assume that today’s business models survive in their current state (which is not necessarily a safe assumption), businesses will take a long time to get back to pre-COVID-19 revenues and profit margins. And even if they do, if current stimulus efforts become part of daily business operations as the 2008 stimulus program did, market reactions will likely be even more severe when central banks attempt to revert to anything approximating past normal.

Over the last month, the main criticism from within and outside of the crypto industry has been that Bitcoin failed its test of being a safe haven uncorrelated with risk assets. Grading on a strictly pass/fail basis, Bitcoin does fail the test of being uncorrelated. Taking the full test into account, though, it gets more than partial credit. A close examination of the events of Thursday, March 12th paints a much fuller and more nuanced picture of BTC correlation.

Although Bitcoin is largely owned by Hodlers, as of today, it is still considered a risk-on asset by a large majority of market participants, particularly those new to the space. On March 12, as the traditional markets were crashing, traders in those markets were hit with margin calls, triggering the need to deposit cash. Being one of the most liquid risk assets out there, Bitcoin was most likely sold off to raise cash to cover those calls. These sales were significant enough to start hitting Bitcoin futures market liquidations. But they likely weren’t enough to drive prices down as far as they fell.

The largest driver of Bitcoin price (although its influence has been shrinking over time) is still idiosyncratic events specific to crypto. On Black Thursday, the particular idiosyncrasy in play was the fact that there is 100x leverage in Bitcoin — something that is not freely available in traditional markets. The higher a trader levers themselves, the higher the probability of a liquidation event. On this particular Thursday, as soon as the BTC price drop (driven by traders selling BTC to raise cash for margin calls) started triggering the first wave of liquidations, the following sales by the exchanges into the market sparked a second wave — one that cleared most of the leverage spectrum, leaving only the most collateralized positions to survive. (Kyle Samani does a great job explaining what happened in detail in this article.)

On top of these liquidations, during the price drop, a patient but malicious actor plugged up some of the Bitcoin operational pipes coming from BitMex — the exchange where most of the liquidations occurred — through a DDoS attack. BitMex wrote a post-mortem here. These factors together, largely a consequence of idiosyncratic microstructure, exacerbated the fall.

The popular saying goes that, in a market crash, all correlations go to one. And there may be some truth to it. During the month of March, the correlation between Bitcoin and the S&P 500 was 0.496 — a value far outside the range expected from any “uncorrelated asset.” Still, with any market case study, it is important to take a step back — to look at the events anew after some of the wake turbulence has dissipated. Even now, if we zoom out just a little bit, with a time series going back to the beginning of the year, the correlation between BTC and the S&P 500 looks quite different.

The next test for Bitcoin is to see what its correlation to the S&P will be over the next month, next 6 months, next year, and so on. The global money printer will not be stopping any time soon. If we truly are at the beginning of a paradigm shift, the economy in a decade may bear little resemblance to the system we recognize today.

Historically, market crashes happen over time. There are many after-shocks, and the down moves are typically sharper than the bullish rebounds. Assuming another sharp drop or two later this year, it will be crucial to monitor how the Bitcoin and S&P 500 correlation holds-up. For the “Bitcoin as a Safe Haven” thesis to gain credibility, the correlation must decouple and return to an acceptable range. When we look back at the crash from the vantage of some future normal, we will very likely see the high correlation of March 2020 as more of an outlier than anything else.