To any reader that simply has a modicum of economic understanding will realize the assertion made in this article is anathema to all that is logical and established. Yet the data (and your eyes) confirm the painfully obvious: bitcoin valuations and interest rates on U.S. Treasuries are directly correlated to each other. So highly correlated, in fact, that it would withstand multiple statistical tests and evaluations, further cementing incredulity into our discussion. What has created this unusual circumstance? More importantly, are there any implications towards domestic and international economic dynamics?
Bitcoin Interest Rates
Applying Pearson’s correlation coefficient towards a monthly one-year chart of bitcoin and interest rates on 10-year Treasuries reveals a correlation strength of 0.73, with a maximum ceiling of 1.0, a perfect positive correlation rating. Visually, the relationship is remarkably lucid, with major downward swings in the digital currency soon accompanied by similar negative sentiment towards interest rates. In fact, an argument could be made that in the current circumstance, bitcoin may be a leading indicator of interest rates, with stronger positive correlation noted in the second half of 2014 as opposed to the first half.
Interesting as the odd relationship may be, correlations are typically used as forecasting tools by measuring analytics from an independent variable to a dependent variable. This should not be confused with causality as clearly, interest rates have been driven by other factors before the very existence of digital currencies. But the strong correlation between two seemingly unrelated indices suggests that one or more variables are applying identical levers to these two markets.
Under normal circumstances, the relationship should be inverse. Lower interest rates incentivize “risk-on” investments as the rate on return on parked cash becomes unattractively low. Further, the lower rates creates a self-fulfilling prophecy of higher inflation as capital expenditures are encouraged to avoid devaluation of savings. The fact that bitcoin and interest rates are positively correlated suggests that one or more of the fundamentals within normal supply demand dynamics is not true. In other words, despite lower rates, the economy is actually deflating, and that the conditions are not conducive for capital expenditures and other business activities. Assuming the accuracy of this scenario, not only would bitcoin fall with interest rates, but other commodities as well.
However, this still does not quite explain the overall correlation between interest rates and bitcoin as both have fallen in roughly the same time and manner. As a contrasting example, while crude oil was certainly hit hard this year, this was a fairly recent experience and a one-year correlation analysis between the oil market and bitcoin would reveal a weak relationship.
So what explains the strange phenomenon?
An exact answer is difficult to quantify but the relationship is likely to be a mixture of coincidence and the absorption of fundamentals creating similar trading sentiment between the respective markets. Demonstrably, participants of both bitcoins and the U.S. bond market have interpreted outside data in a manner consistent with each other, at least for this past year. Unfortunately, the trend cannot reliably be depended on creating future predictability models as the mathematical derivative of bitcoin valuations and interest rates have no useful correlation.
In other words, if two quarterbacks threw for an equal number of touchdowns over the same season, one may be tempted to view them as being equivalent in skill level. However, if it was revealed that one of the quarterbacks played with an injury throughout the season, or one team in the comparison had a much more difficult schedule, the validity of any forward assumptions based on touchdown productivity alone would be suspect.
The same can be said of the bitcoin to bonds relationship. While it is peculiar that traders in both markets are reacting in a similar fashion to macro-fundamentals, this correlation reflects the overwhelming weight of the fundamentals themselves rather than that of any inherent connection between the individual markets.