Does Bitcoin’s Rally Justify the ‘Inflation Hedge’ Thesis – or Is Risk Back on the Menu?

Bitcoin (BTC) has risen astonishingly this week, up 38% since March 11. It has outperformed pretty much every altcoin, including Ethereum. All this has happened as various banks were self-immolating in protest of Jason Calacanis’ hairline.

Some have argued that this is a vindication of bitcoin’s “inflation hedge” thesis, which looked very much dead, if not dead, just nine months ago. Bitcoin went down when inflation was at its peak. But the argument is that we are only now seeing the real effects of that inflation on the financial system, and Bitcoin is finally responding. This will largely accompany crypto’s thinner market, making it less likely to respond, so to speak, in advance to various leading indicators.

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The systemic chaos, not the erosion of consumer purchasing power, is what bitcoin is a “hedge” against. The idea that bitcoin would move nicely in response to dollar inflation was always at best a simplification of the actual argument. First, as I have argued elsewhere, bitcoin will need wider adoption before these mechanisms can possibly work. There’s just too much speculation baked into the price right now for it to respond linearly to inflation, a problem we’ll dig into more here.

But beyond that, a more nuanced version of the inflation-hedging thesis would say that the real risk bitcoin can hedge is the structural chaos of a financial crisis—say, the closing of a bank holding your savings. As we are seeing right now, financial crises are increasingly linked to interest rate and other central bank maneuvers – about half of which come in response to inflation.

Joe Wiesenthal at Bloomberg noted bitcoin’s performance and very tentatively suggested that it was performs as advertised. Galaxy Digital’s Alex Thorn pointed to this version of the thesis in a brief appearance on Castle Island’s “On the Brink” podcast last week. Thorn will speak in more depth about bitcoin and the inflation issue at Consensus 2023 next month. I will definitely check it out.

But there is also a case that this was a misinterpretation of the bitcoin price signal. Rather than rising because of the long-tail effects of inflation, it may be rising because markets see the opposite: an end or a pause in central bank interest rate hikes, which signal a glorious return for risk assets of all kinds.

After all, the sharpest part of bitcoin’s rally has come since Monday, March 13, when it was announced that the floundering Silicon Valley Bank would get a bailout. In another newsletter this morning, Joe Wiesenthal has changed his mind – “MAYBE YOU SHOULD NOT TURN IT TO BITCOIN,” he tweeted.

Wiesenthal points to this piece by Bob Elliot of Unlimited Funds, about recent hedge fund losses, as helping to change his thinking. Elliot roughly describes hedge funds being beaten up because they have had a double reverse. First, they ate the 2022 risk that crushed tech stocks during rate hikes. This is actually what caused the crisis at Silicon Valley Bank, which foolishly bet on interest rates staying low well into the future.

During the last week, newer trading positions based on higher rates over a longer period of time were also blown up. Basically, it’s because the bank failures are seen as a red light for Fed rate hikes, a signal that the economy has slowed down enough.

“Many of these funds were positioned for a continuation of the inflationary, late-cycle tightening of monetary policy,” Elliot writes. “The deflationary risk from a banking crisis quickly drove a change in fundamentals and market action, which took many of these funds offside.”

That momentum could also help bitcoin rally. After three banks imploded in a week, markets may believe the Fed is likely to halt rate hikes or even reverse, leading to a renewed risk-on fest. It may simply have contributed to the deepening shift to bitcoin by those anxious about banking.

We will find out more about the question this week. The Fed’s Federal Open Market Committee meets on Tuesday, and is expected to announce any rate hikes on Wednesday. If the FOMC decides that the threat of further financial disaster is high enough, it could stop raising interest rates. On the other hand, we’re still staring down 6% inflation, so I personally think another increase is still likely – maybe 0.25% to split the difference, but definitely not nothing.

If we don’t get an increase, markets could interpret it as a renewal of the cheap money bonanza, and bitcoin could really go astray as a risk asset even as the Fed renews its commitment to fight inflation at all costs.

The real test for a more nuanced version of the “inflation hedge” thesis will be whether further banking problems lead to further bitcoin price increases, without interest rates directly in the mix. Until then, everything is (in several senses) speculation.