Why Ethereum Underperforms despite Lower Supply?
Ethereum has significantly underperformed Bitcoin both this year and following the Merge, despite transitioning to a deflationary asset. Why is this the case, and what might the future hold?
Less Ethereum, More Bitcoin
So far this year, Ethereum's growth has been nearly half that of Bitcoin, increasing by approximately 80% compared to Bitcoin's nearly 150%. The Ethereum to Bitcoin price ratio (ETH/BTC) has dropped to its lowest level since April 2021.
ETH/BTC
Since the Ethereum network's transition to a deflationary model post-Merge (where the Ethereum supply starts to decline), Ethereum has notably underperformed Bitcoin, which continues to see a supply increase due to mining. The difference in supply growth rates between Ethereum and Bitcoin is marginal (about 1.6% annualized), yet the underperformance of Ethereum, now a deflating asset, is intriguing.
Seeking Gold in Crypto
This year's Bitcoin outperformance seems largely influenced by broader market movements, especially the surprising divergence between gold prices and real interest rates. Typically, gold prices rise when real rates are low. For example, gold peaked in August 2020 due to real rates nearing -1% for the 10-year tenor, a trend consistent with past observations such as in 2011-2013. However, in 2023, gold has rallied by 11% year-to-date and reached new highs, despite an increase in real rates. This anomaly in the gold market, with its rising value despite higher real rates, suggests a shift in investment strategies, possibly indicating a move away from traditional finance towards assets like gold.
In this context, Bitcoin's outperformance can be seen as logical. It's increasingly perceived as a digital alternative to gold, appealing to those diversifying away from traditional financial assets. This trend may explain why Bitcoin, more than other cryptocurrencies, has attracted investment flows seeking diversification.
In the short term, Bitcoin's rally since mid-October reflects macroeconomic shifts, particularly expectations of a more lenient monetary policy from the Federal Reserve. Lowered expectations for the Fed's interest rate hikes have led to a general uptick in asset prices, benefiting Bitcoin more than Ethereum due to its closer ties with traditional financial markets. Following recent soft inflation data and dovish commentary from the Fed, market expectations are tilting towards lower interest rates by the end of 2024, with the implied policy rate projected below 4%.
While Ethereum's transition to a deflationary asset post-Merge was significant, its performance relative to Bitcoin reflects broader market dynamics and investor preferences in a changing economic landscape.
Implied Fed Funds Rate Path and Number of Hikes/Cuts Priced in as of December 14, 2023
Two months ago, the Federal Reserve was expected to maintain interest rates until mid-2024, with a possibility of further hikes. The implied policy rate stood at approximately 4.6% for the end of 2024. However, there has been a significant shift in expectations, now anticipating a more dovish policy. This reevaluation has been the primary driver behind the rally of Bitcoin and other assets since mid-October.
Implied Fed Funds Rate Path and Number of Hikes/Cuts Priced in as of October 13, 2023
In 2022, Bitcoin's high correlation with stock indexes, combined with its inherent volatility, likened it to a high-beta stock. However, in 2023, this correlation has substantially decreased, distinguishing Bitcoin from traditional stock market dynamics. Its correlation with gold, typically negligible, saw an uptick from the fourth quarter of 2022 to mid-2023. This shift, especially during the banking crisis in March 2023, has led to Bitcoin being increasingly viewed as a form of digital gold, highlighting its potential as a diversification asset.
Bitcoin Daily Correlation With Ethereum, S&P 500, Nasdaq 100 and Gold in 3-Month Intervals
Is Ethereum Different to Bitcoin?
Despite a drop in the correlation between Bitcoin and Ethereum this year, their relationship remains strong. Many traditional finance investors may view Ethereum's technical differences (proof-of-stake mechanism, deflationary nature, adaptability for advanced protocols) as less significant due to its continued strong quantitative correlation with Bitcoin. The Bloomberg beta calculator indicates that while the R squared value (indicating the strength of the relationship between Ethereum and Bitcoin) has decreased from 0.777 over the last two years to 0.623 in the past six months, it remains high. Additionally, Ethereum's negative Alpha suggests it has underperformed in these periods.
In conclusion, while Ethereum offers distinct technical features, its market behavior and perceived investment value remain closely aligned with Bitcoin. This strong correlation, coupled with a lack of clear fundamentals in the crypto space, may limit Ethereum's appeal to traditional finance investors seeking diversification benefits.
2-Year Ethereum Beta to Bitcoin (Daily)
6-Months Ethereum Beta to Bitcoin (Daily)
Conclusion
In my analysis, Bitcoin's outperformance this year is largely attributed to broader market movements, particularly the surprising divergence between gold prices and real interest rates. Traditionally, gold thrives in low real rate environments, but this year, it has rallied despite rising real rates. This trend suggests a shift in investment preferences, with gold being favored as a diversification tool away from traditional financial assets. In this context, Bitcoin's rise makes sense as it increasingly assumes a role similar to gold among cryptocurrencies.
However, Ethereum's journey is different. Its high correlation with Bitcoin limits its attractiveness as a diversification option for investors. While Ethereum shares some foundational aspects with Bitcoin, it still moves in tandem with it, reducing its appeal to those seeking portfolio diversification.
Looking ahead, the current gap between Bitcoin and Ethereum might not be sustainable, especially if Bitcoin continues its upward trajectory. If more capital flows into cryptocurrencies, it's plausible that Ethereum will benefit significantly from these investments due to its prominent status and unique features like supply deflation and technological adaptability.
The concept of Ethereum's supply deflation is somewhat analogous to stock buybacks. While buybacks alone aren't usually the primary driver for a stock's performance, they can amplify a stock's upward movement in a favorable market, especially if the underlying business is strong and growing. Similarly, Ethereum's decreasing supply might play a significant role in enhancing its value, particularly when the market starts to recognize its potential and unique attributes.
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