As a result of the growing inflation that is being experienced in Europe and the United States, a debate has arisen about whether cryptocurrencies can be useful as a refuge asset and if they are still interesting to incorporate them into an investment portfolio, for reasons of diversification.
Traditionally, in periods of high inflation, investors sought to preserve the value of their savings by investing in assets such as fixed income, gold or real estate, among others. The recent addition of cryptocurrencies as an investment option has added a possible new alternative hedge to inflation.
Currently, in the United States we find ourselves with the highest rate of inflation in the last forty years (7.5%). To curb this non-transitory inflationary situation, the FED will raise interest rates and withdraw the monetary stimulus or tappering.
Rate hikes would anticipate a return to a certain financial normality, which could be causing investors to flee positions with a high level of risk.
In these times of high uncertainty, investors cover their positions seeking refuge in liquidity, which will translate into investments in liquid assets such as fiat money and other assets very close to this money, such as fixed income issued by solvent States. .
As with gold, the yen and the US dollar are considered safe-haven values. In situations of great economic instability, the dollar tends to appreciate against other currencies.
For example, the interests of the US public debt have skyrocketed in recent weeks. This rise in rates has increased investors’ returns, providing them with a greater hedge against inflation. This has caused capital outflows into risky positions, such as certain stocks and crypto assets.
Investors seek to buy assets in dollars or directly, they buy dollars, thinking that their money is safer. That is why when the American economy is in a weak situation, the dollar usually falls against the rest of the currencies, but when the American economy begins to strengthen, the relationship of the dollar against the rest of the economies changes.
This has also affected digital assets, whose behavior has lately followed a path very similar to the Growth values of the stock markets, due to their high volatility and their disruptive and risky value propositions, in the field of new digital business models in the so-called WEB3. As an example, between 2017-19 the correlation ratio between bitcoin and S&P500 was 𝟬.𝟬𝟭 and between 2020-21 this correlation ratio between bitcoin and S&P500 was 𝟬.𝟯𝟲. An increase of 3500%, regardless of whether or not this value is representative.
In recent months, it has been observed how crypto assets are suffering a severe correction in their value. After reaching record prices, the change in the economic outlook and the return to a certain financial normalization (with expectations of interest rate hikes in some jurisdictions) seem to have changed the market dynamics of these digital assets.
Given this situation, we have carried out a small economic study to quantitatively analyze whether there would be a relationship between the price of bitcoin and the US Dollar Index and whether the conclusions of this study can help us when managing our investment portfolio. To carry it out, we have considered a historical series that goes from January 1, 2021 to February 18, 2022. The data source is from investing.com and the treatment of the same is ours.
Continuing with our argument, for example, there are assets that have a certain correlation, as is the case with oil and the US dollar. Correlations between currencies and commodities can be used to trade one of two correlated assets.
The correlations established between assets can be divided into two: positive correlations or negative correlations.
Positive correlations is that if one asset goes up, the other will too. In contrast, negative correlations assume that if one asset goes up, the other should go down. Normally between currencies and raw materials, the correlation is usually negative, if one goes up, the other goes down.
In our case, the methodology that we have followed in our study is the use of statistical measures such as the Pearson correlation coefficient, the use of a dispersion map to visually see if there is a relationship or not, and finally, the calculation of the coefficient of determination.
Pearson’s correlation coefficient is a test that measures the statistical relationship between two continuous variables. The correlation coefficient can take a range of values from +1 to -1. A value of 0 indicates that there is no association between the two variables. A value greater than 0 indicates a positive association, telling us that as the value of one variable increases, so does the value of the other. A value less than 0 indicates a negative association; that is, as the value of one variable increases, the value of the other decreases.
On the other hand, scatter plots are used to find out the strength of the relationship between two numerical variables. The X axis represents the independent variable, while the Y axis represents the dependent variable. In our study, the independent variable is the US Dollar Index and the dependent variable we have considered to be the price of bitcoin.
Finally, the coefficient of determination serves to reflect the goodness of fit of a model to the variable that is intended to explain. It is important to know that the result of the coefficient of determination ranges between 0 and 1. The closer its value is to 1, the greater the fit of the model to the variable we are trying to explain. Conversely, the closer to zero, the less fit the model will be and, therefore, the less reliable it will be.
But What is the US Dollar Index? And why do we use such an index in our analysis?
We primarily use such an index as a clear indicator of the value of the US dollar, being a measure of the strength of the US dollar against a basket of currencies of the US’s major trading partners.
This US Dollar Index (USDX) allows us to measure the performance or value of the US dollar against a basket of foreign currencies, letting us know how strong the US dollar is against the rest of the world’s economy.
When analysts talk about the dollar rising or falling, they are referring to the US dollar index.
The US Dollar Index helps investors monitor the value and strength of the dollar against other currencies through a single transaction or reading. This allows investors to protect themselves against any risk related to their investments in US dollars.
The USDX was established in March 1973, shortly after the dismantling of the Bretton Woods Agreements, being published by the Intercontinental Exchange (ICE) and was first developed in 1973 by the Federal Reserve (Fed). This date is not arbitrary, it is when the world powers had already abandoned the gold standard, and let their currencies fluctuate freely against each other, the foreign exchange market was born.
The US Dollar Index was designed to help analyze how the US dollar performed relative to the currencies of the United States’ major trading partners.
We can say that the US Dollar Index (USDX) is a weighted geometric average of the value of the dollar compared to: the Euro (57.6%), the Japanese Yen (13.6%), the British Pound (11.9% ), the Canadian dollar (9.1%), the Swedish krona (4.2%) and the Swiss franc (3.6%).
The USDX formula would be as follows:
USDX = 50.14348112 × EUR / USD ^ (- 0.576) × USD / JPY ^ (0.136) × GBP / USD ^ (- 0.119) × USD / CAD ^ (0.091) × USD / SEK ^ (0.042) × USD / CHF ^ (0.036)
Initially, the value of the Dollar Index was 100. Since then, the highest value at which the US Dollar Index traded was 164.72 in February 1985 and the lowest was 70.698 in March 2008.
The interpretation of the evolution of the index is simple. If the price is above 100, the US dollar is appreciating against the rest of the currencies in the basket, and if it is below, it is depreciating.
As an example and to understand how it works, if the value of the indicator were 120, it would mean that the dollar has risen 20% against other currencies during a certain period of time. Similarly, if the index value is 80, it would mean that the US dollar has fallen by 20% against all other currencies.
The composition of the basket of currencies from which the USDX was created was altered in 1999 as many European countries joined the Euro and therefore had to be restructured.
USDX is updated whenever the markets are open, that is, from Sunday afternoon New York time (Monday morning in Asia) to Friday afternoon New York time.
As with everything that has to do with currencies, the appreciation or depreciation of the US Dollar Index is highly influenced by the evolution of the American economy and the decisions made by the FED to influence interest rates. .
Those same interest rates, what they seek is to create money supply or reduce it, increasing consumption and accelerating the economy, or cooling the economy when inflation shoots up.
If we focus, again, on the results of our study, we can graphically see the evolution of the price of bitcoin and USDX between 11/1/2021 and 02/18/2022. While one goes up (US Dollar Index) the other goes down (the price of bitcoin).
(Source: investing.com and own treatment)
(Source: investing.com and own treatment)
Given this, could we say that there is some kind of correlation between the two?
To answer this question we have applied the Pearson correlation coefficient, we have represented it graphically using a scatter plot and finally we have calculated the coefficient of determination.
(Source: investing.com and own treatment)
The results obtained show that the correlation coefficient is 0.183, which means a very weak positive correlation between both. And, as regards the coefficient of determination, with a value of 0.034, the model is very poorly adjusted and is not very reliable.
The conclusion we draw is that bitcoin is an investment that remains quite independent if we relate it to other investments, such as our case of USDX, so it maintains its magnificent properties for portfolio diversification and its positive effects for risk management of portfolios.
An investment between 1% and 5% in bitcoin, depending on the risk profile of the investor, in an investment portfolio is a good proportion of diversification and is a decision that is increasingly supported by the gradual increase in institutional investment of large financial institutions and corporations.
Disclaimer: The information and/or opinions expressed in this article are the sole responsibility of Ismael Santiago and do not necessarily represent the points of view or the editorial line of Cointelegraph. The information set forth herein should not be taken as financial advice or investment recommendation. All investment and commercial movement involve risks and it is the responsibility of each person to do their due research before making an investment decision.
Ishmael Santiago He is a PhD professor in Finance and a researcher at the University of Seville. He international consultant on DeFi, ICOs, STOs and IDOs. He is the author of the books: “Introduction to Blockchain and Cryptocurrencies” and “The New Blockchain Economy”. Also, he is CEO of OLIVACHAIN R&D.