Why do cryptocurrency prices crash after a bull run?

Cryptocurrency price correlation with fiat currencies is a topic that reflects the evolving relationship between digital assets like Bitcoin or Ethereum and traditional financial systems, such as the U.S. dollar (USD), Euro (EUR), or other government-backed currencies. Numerous factors, such as investor behavior, macroeconomic conditions, and the unique dynamics of cryptocurrency markets, can affect the correlation. Below, we explore how this correlation works and what drives changes in crypto prices relative to fiat currencies.

1. Definition of Price Correlation

Correlation refers to the relationship between two assets in terms of their price movements. If the price of a cryptocurrency moves in the same direction as a fiat currency, they are said to be positively correlated. Conversely, if they move in opposite directions, they are negatively correlated. Correlation is expressed as a coefficient ranging from -1 to +1:

• +1 indicates perfect positive correlation.
• -1 indicates perfect negative correlation.
• 0 means no correlation.

Cryptocurrencies like Bitcoin are often compared to major fiat currencies, particularly the U.S. dollar, due to its status as the world's reserve currency.

2. Key Factors Influencing Correlation

• Macroeconomic Trends: The correlation between cryptocurrencies and fiat currencies can vary depending on broader economic conditions. During times of economic uncertainty or rising inflation, investors may move towards alternative assets like Bitcoin, which is sometimes perceived as “digital gold.” This movement may cause cryptocurrencies to have a negative correlation with fiat currencies like the USD.
• Monetary Policy: Central banks, especially the Federal Reserve, have a significant influence on the value of fiat currencies and the broader risk sentiment. For instance, when the Federal Reserve increases interest rates, it often strengthens the U.S. dollar while making riskier assets, including cryptocurrencies, less attractive. This can lead to a negative correlation between crypto assets and the dollar.
• Investor Sentiment: Cryptocurrencies are heavily influenced by investor sentiment. When fiat currencies weaken due to political instability or economic concerns, investors may look towards cryptocurrencies as an alternative store of value, which creates a relationship where cryptocurrencies rise while fiat currencies fall.

3. Stablecoins and Correlation

One type of cryptocurrency, stablecoins, is specifically designed to be directly pegged to fiat currencies like the U.S. dollar. Popular stablecoins such as Tether (USDT) and USD Coin (USDC) maintain a 1:1 value with the dollar, which means their correlation with fiat currencies is essentially perfect. The existence of stablecoins helps reduce volatility within the crypto market and facilitates trading by providing a bridge between the fiat and digital worlds.

4. Crypto as a Hedge Against Fiat Devaluation

Some people consider bitcoin, also known as "digital gold," to be a hedge against the devaluation of fiat currencies. In times of high inflation or economic instability, the purchasing power of traditional currencies decreases, and investors may flock to assets like Bitcoin, resulting in a negative correlation between Bitcoin and fiat currencies.

During times of financial market instability, both gold and cryptocurrencies can attract investors who seek to protect their wealth. This can sometimes cause a temporary positive correlation between cryptocurrencies and weaker fiat currencies as investors move away from traditional stocks and bonds.

5. Historical Observations of Correlation

In recent years, the correlation between Bitcoin and the U.S. dollar has fluctuated depending on economic circumstances. During 2020, amid the COVID-19 pandemic, Bitcoin experienced a positive correlation with traditional markets, including the dollar, as investors treated it as a risky asset. However, at times of economic uncertainty and rising inflation, Bitcoin showed a negative correlation with the U.S. dollar as it attracted investors seeking an inflation hedge.

Final Thoughts

The correlation between cryptocurrencies and fiat currencies is complex and influenced by a combination of macroeconomic factors, central bank policies, and investor sentiment. Unlike traditional assets, the correlation of cryptocurrencies with fiat can be both positive and negative at different times, depending on the market context. Stablecoins play a unique role by maintaining a direct correlation to fiat currencies, serving as a stable bridge for investors in the highly volatile crypto market. Understanding these relationships can help investors make more informed decisions, especially during periods of economic uncertainty.