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Are cryptocurrency returns affected by monetary policy spillovers? 

Man stood at a maze

By Dr Ahmed Elsayed, August 2022

As international monetary policy spillovers become more commonplace, is cryptocurrency a safer investment? Dr Ahmed Elsayed, Associate Professor in Economics and Finance, investigates. 

In the aftermath of the global financial crisis, central banks in both developed countries and emerging market economies have deployed a series of unconventional monetary policies, whereby the expansion of the monetary authority's own balance sheet is used to support economic activity and promote higher inflation. 

These large-scale national policies were quickly transmitted across jurisdictions and a global surge in liquidity was witnessed. Not surprisingly, international monetary policy spillovers became particularly relevant, posing challenges for policymakers. Thus, understanding their nature and size is crucial. 

Spillovers are when an economic event in one country has a ripple effect on the economy of another, usually more dependent country, for example a stock market downturn. 

Though monetary policy spillovers are incredibly common in today’s economy, and the majority of investments are easily impacted by changes in central banks’ monetary policies. The emergence of cryptocurrencies in recent years could provide an investment opportunity that may be unaffected by these spillovers — at least that’s what we’ve been researching.  

Cryptocurrencies are unique, as they don’t generate cash flows. These virtual currencies rely on decentralised control and require no third-party involvement, being independent of central banks and governments, despite counting on regulated financial institutions to operate. Thus, in contrast with traditional assets (e.g. bonds, commodities and equities), the standard transmission channels of monetary policy don’t apply in the absence of intrinsic cash flows for investors to discount for or to form expectations about. 

Despite this, the empirical evidence on the link between monetary policy and cryptocurrency returns is rather limited and inconclusive. This is why I, along with my colleague, Professor Ricardo Sousa of the University of Minho, decided to comprehensively research the impact of monetary spillovers on cryptocurrencies. 

In order to understand the dynamic and spillover effects of leading countries’ international monetary policies on the cryptocurrency market — and whether or not they were affected in the same way as other financial traditional assets — we used daily data on shadow policy rates (indicators of monetary policy actions) for four major economies: the Eurozone, Japan, the UK and the US. We then used daily closing price data on three key cryptocurrencies, Bitcoin, Litecoin and Ripple, to determine whether these monetary policy changes had an impact on cryptocurrency returns. 

From conducting the research, we found that cryptocurrency returns are immune to spillovers caused by changing international monetary policies, meaning cryptocurrencies may offer diversification benefits as a digital asset. 

We also found that interconnectedness between cryptocurrency returns and monetary policy spillovers were particularly large when shadow policy rates became negative, moderated during the Fed's ‘tapering process’, and sharpened again more recently as cryptocurrency buoyancy returned. However, we did find strong interconnectedness between cryptocurrencies, with returns correlating as both high and positive for all cryptocurrencies reviewed. 

Shadow short-rates and cryptocurrency returns also typically had a low correlation, which tends to be negative, suggesting that monetary policy tightening has a negative effect on cryptocurrency returns. In a low interest rate environment, investors tend to ‘search for yield’, which again reinforces the view of some diversification gains provided by cryptocurrencies in addition to portfolios consisting of alternative and conventional assets. 

As previously mentioned, central banks around the world deployed unconventional monetary policies after the global financial crisis, with international monetary policy spillovers posing challenges for policymakers. Our research suggests cryptocurrencies are a less volatile asset when it comes to these spillovers. 

This research supports the view of a somewhat low monetary policy synchronisation in recent years, as economic growth geared at different speeds across jurisdictions. Thus, the US is generally a net transmitter of shocks, while the Eurozone and the UK are both net transmitters and receivers. As for cryptocurrencies, Bitcoin and Litecoin are net transmitters of shocks, while Ripple is a net receiver. 

These findings of strong international monetary spillovers pose challenges for national authorities, reinforcing the importance of policy coordination. The research suggests setting up a global level playing field to avoid regulatory arbitrage and deter any potential financial instability that might be attributed to sharp shifts in capital flows associated with portfolio reallocations into and away from the cryptocurrency space.

More information about Dr Elsayed's research interests.