Let’s talk about Bitcoin Inflation Hedge Theory (BTC-USD)

After publishing my article on Bitcoin (BTC-USD) two weeks ago, a few commenters mentioned how this latest Bitcoin crash was different. And this difference made all the difference, and therefore there would be no next time. The difference at stake was that Bitcoin crashed below an environment of high inflation. The idea that swirled around the crypto fan club was that Bitcoin was an inflation hedge and should perform well in periods of high inflation. However, this was a poorly constructed argument that was continued by banks that wanted to sell a trading product. Bitcoin does not have to be a hedge against inflation to keep working and reach the next step higher.

Back to basics

At its core, the idea of ​​inflation protection comes from, at least in part, the idea that Bitcoin is a deflationary asset.

What does this mean?

This means that access to the asset is limited and, in its basic function, decreases. It achieves this by having a fixed supply – 21 million coins. Theoretically, it becomes increasingly challenging to reach this number as time goes on, creating an asymptotic situation and forcing the frequency of new supply to shrink constantly. After extracting 210,000 blocks, the reward for miners is halved. The next 210,000 trigger the same designed response, and are halved each time the milestone is reached. Estimates estimate the final coin recovered sometime in the year 2140. This time frame varies depending on the miners’ abilities and network hash rate.

At the other end of the offer is the loss of Bitcoins; wallets (and passwords for wallets) disappear, holders forget the address of the wallet, or bits and bytes of addresses are corrupted with hard drives and other storage devices. In practice, the whole system means that coins come into circulation through mining, but are removed through the unfortunate methods I just mentioned. This creates a system where the supply is slightly increasing, flat or directly decreasing, depending on the variables at all times, but always on the same coded path. This inherent scarcity in theory creates an inflatable asset through a deflation system.

This is where things get interesting and where the misleading conclusion comes from.

The US dollar is known to be a fiat currency, and has since the loss of the gold link (XAUUSD: CUR) in the summer of 1971 created the opportunity to print it at no immediate cost (such as increasing gold stocks). This means that its basic operation has become an endless supply on demand, supported only by the full faith and credit of the United States.

Absolutely, the United States will pay you back – if it can not, who will?

This is the opposite idea to Bitcoin; The dollar may continue to rise in supply, but the value decreases if GDP does not keep up, leading to inflation.

The reason we even have this conversation is because of the 40-year-long inflation records we have set recently. That, and the stock market crashes on expectations of more inflation (and mine too) while Bitcoin and all other cryptocurrencies follow.

But since Bitcoin can be exchanged for dollars (and many other currencies), this should mean that deflationary assets increase while inflationary assets decrease.

That is at least the conclusion of the ongoing argument.

However, due to several other factors, the correlation has been lost when Bitcoin crashed with the S&P 500 (SP500) and Nasdaq (COMP.IND). In fact, cryptocurrencies have plummeted far more than indexes.

The markets seem to be moving together, so there must be nothing to see here.

So much for that theory of being an inflation hedge!

The problems with the argument

But there are two problems with the argument and one problem with the scale, which give each side of the debate a wrong conclusion.

A cherry picking problem

The problem with the measurement – to say that Bitcoin is not a hedge – is cherry picking of stocks over short periods of time versus Bitcoin’s performance in the same period. If you want to measure the benefit of being a hedge against inflation, you will measure it against the value of the dollar, not stocks, over many years.

The truth is that the purchasing power of the dollar over many decades is a down-and-right slope, even when it was at the gold standard – we have only accelerated the problem since then. On the other hand, Bitcoin is an up-and-right chart, much like stocks, mind you!

Measuring something like Bitcoin against a few months to a year of inflation data is not a logical argument; it’s cherry picking data in time. Of course, we can do this for any period and any graph we want and argue on each side of the issue. But unfortunately it leaves us with a poorly constructed argument in the end.

The problem stems mainly from the relatively short periods of “high” inflation throughout the history of the dollar. Finding a correlation becomes difficult as the volatility of Bitcoin and the short periods of high inflation provide too much room and noise to choose from. Things that have been shown to be hedged against inflation, such as gold, have been seen for decades.

The real problem, however, is deciding how to measure something as a hedge against inflation. Gold, for example, shows an inverse correlation to the value of the dollar. As the dollar becomes worthless, gold continues to rise in value. Sounds like a hedge to me. In fact, at any time in history, an ounce of gold can give you a very nice suit and a fancy shave, whether it was in 1890 or 2022. Keeping the same five dollars from 1890 today can not do it like the same ounce of gold .

The argument for Bitcoin as a hedge can be made here because, like stocks and gold, it moves up-to-the-right and is almost locked in at least the stock market (regardless of whether Bitcoin moves more volatile). So if stocks or gold are a hedge (which can be argued), then by Bitcoin moving with stocks over time, it is also a hedge. The problem, again, is how long it takes. Bitcoin’s lack of track record (relatively speaking) means that we can not prove a correlation with enough data. That’s why there’s a lively debate about Bitcoin’s endurance in the first place.

So, if anything, Bitcoin’s argument for hedging is proven through correlation with the stock and gold markets – up-and-right. However, just like the argument against it, the view of it does not have enough data to prove it in relation to the data it stands next to. And to advance the point of the difficulty of finding something to secure at the moment of roaring inflation, gold, which is the inflation hedge for hedges, has not risen, but 3% this year, while inflation consistently continues at 8%.

A confused case

Moving away from the data in the time argument, the argument that Bitcoin is a hedge against inflation assumes that it will go up or at least remain stable as inflation increases. But why should that be the case?

Simply because it is a deflationary currency system? Or because it is separate from the economy?

The first reason why this hedging theory is difficult to argue for is that the money in one market comes from those with money in the other. This creates both a positive feedback loop and a negative one. For example, when things start to break down and the stock market shows signs of heavy losses, profits in crypto can dampen margin calls on the stock side. The opposite is also true; If the crypto creates a margin call situation, the sale of shares to cover the call can lead to balanced accounts. But this means that both markets are beaten as money goes out of both of them at almost simultaneous prices.

Because of this, any inverse correlation to inflation is lost as the traded price of one of the assets is a net loss.

The Fiat system and Bitcoin’s infrastructure can be complete economic contradictions, but that does not mean that it can be used as a working security. There are many reasons to claim that Bitcoin is built on a better system, able to give it an inflationary response due to a deflationary supply system. Nevertheless, market movements trump this in the short to medium term. Although an expansion of the charts shows the inverse correlation, it will take years to even out the gains from an inflation hedge standpoint.

Still for marketing

There is another level to this inflation hedging theory where the loose argument about hedging was continued as a marketing tactic. While Jamie Dimon called for the leaders of his crypto-trading employees, his bank and other banks set up their own trading tables. And before you think I’m just saying this in hindsight, I said it in early October:

It is clear that companies are trying to find a position with the latest explanation as a hedge against inflation. Let it be clear, these companies are selling you something. People like JPMorgan (JPM) have gone from saying that everyone who trades in Bitcoin will be “fired in a second” to setting up their own cryptocurrency for internal transfers among clients to give in and follow the money by allowing trades. So it’s no wonder we see headlines from the same company now that say, “Bitcoin is a hedge against inflation.”

Naturally, when a new commercial product is brought to market, it needs marketing. It was not that difficult with cryptocurrency, but reinforcing ideas about Bitcoin does not hurt. Using known assets such as gold against known problems such as inflation makes it easy to connect the dots to an asset that is designated as the answer. So when JPMorgan’s analysts pour gasoline on the fire, it helps them.

Not easy to move from conversations, analysts continued to push the narrative even as Bitcoin fell this year. Why do it when many are now turned away from the belief in hedging through price action? Simple. The trading desk and the crypto product needed a shot in the arm as trading revenues more than likely dried up during this declining market.

But now Bank of America (BAC) is the first bank to switch gears and say so not an inflation hedge. But, like most analysts, they are a bit behind the curve when it comes to telling their clients – or at least the public. As most would say, they are one day late and a dollar short – no different than their stock calls. Always be suspicious of someone who sells you something for a weak reason.

Bitcoin and inflation, the arguments on both sides are weak

You work uphill if you are a Bitcoin supporter and agree that it is a hedge against inflation. Bitcoin does not have enough time on the book to make a good case for whether it does or does not hedge against inflation. Gold is easier to argue for since there is almost as much data over the same period to show correlation through price action. This does not mean that Bitcoin is not, but the short time window and the short-term noise from the markets through volatility make it difficult to point out where it is. And just because one or more banks highlight this as a reason for Bitcoin’s rise, does not mean it is true.

If you are either an opponent of Bitcoin or do not see the inflation link, you are driving the fallacy “argument from ignorance” – just because it has not happened (or there is not enough data to prove it) does not mean it will not. For the same reasons as volatility and noise, one can not prove that it is not an inflation hedge.

In the future, Bitcoin may show signs of being an inflation hedger, but it will take many years of continuing trends to theorize it. Just because it is a deflationary system and it works in conjunction with an inflation-based fiat system does not automatically make it a hedge against the US dollar’s inflation problem. Having a bank further push the story changes nothing and can lead to cementing it is an unfounded idea.

No matter where the answer lies, investing in Bitcoin should not be based on the idea that it is an inflation hedge. Only time will tell through continued use; even then, the debate must reshape and argue for the benefits. Nevertheless, Bitcoin’s design has advantages over fiat currency. A valid argument is still found as it is observable in the code and the daily operation of mining and halving events.