What Bitcoin’s inflation-proof narrative needs: More time
For nearly a decade, crypto investors and advocates have promoted bitcoin as a hedge against inflation and a store of value against fiat currency. Because of the tokenomics behind bitcoin, many savvy investors believe that bitcoin is a hedge against the loss of purchasing power experienced in many fiat currencies.
Bitcoin has a fixed supply of 21 million bitcoins. The issuance rate of bitcoin is known by all market participants, and the bitcoin blockchain will eventually reach a state of 0% inflation when all bitcoins are mined. Many investors and bitcoin advocates believe that this economic design makes the cryptocurrency far superior to other permanently inflationary cryptocurrencies and fiat currencies.
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The impact of value manipulation
The value of fiat currencies is determined by governments and central banks. For over a decade, the US Federal Reserve has had an inflation target of 2% for the US dollar. Another way of thinking about inflation is that the purchasing power of the dollar decreases. When a currency is inflated, the purchasing power of that currency declines over time.
On the one hand, many economists believe that by creating an inflationary currency they can stimulate economic growth and encourage spending in the market – which they believe strengthens the economy and business cycles.
On the other hand, many other schools of economics do not believe that a loss of purchasing power in an economy’s main currency is beneficial to the long-term health of an economy. This disagreement and conflicting beliefs have led many to adopt and hold bitcoin – among other cryptocurrencies – as an alternative to fiat currency.
Read more: Why Bitcoin Has Been Highly Correlated With Fiat
Proof of bitcoin as an inflation hedge
Bitcoin has certainly outperformed fiat currencies over the past decade. But while many fiat currencies were stable over the past decade, bitcoin’s price was not.
Bitcoin has become incredibly popular all over the world, has been adopted and used in large parts of the global economy and has had a very impressive growth rate. Bitcoin traded below $100/coin in 2012 and reached an all-time high of nearly $70,000 in 2021, less than a decade later.
The performance of bitcoin over the past decade served as further evidence that the asset was a hedge against fiat currency devaluation and reinforced the theory of value investing.
Inflation hedge narrative shifts
In 2022, however, it has been a different story. Starting in 2022, the US central bank began raising interest rates and withdrawing liquidity from the market. Spurred on by record high inflation, the US Federal Reserve took these extreme measures to combat inflation in the economy.
By raising interest rates and reducing market liquidity, the Fed caused assets such as stocks, bonds, real estate and even cryptocurrencies to see massive headwinds. US stocks are down over 20% year to date, bonds are down over 30%, real estate is down over 15% and cryptocurrencies are down over 60% so far this year (as of November 2022).
Many traders describe the market we see in 2022 as a “risk-off” environment.
Bonds reinstate inflation protection priority
US government bonds are considered the safest investment in the world. Often described as “risk-free interest,” these bonds provide investors with a guaranteed return and protection of principal.
Because the Federal Reserve has raised interest rates significantly this year, risk-free yields on US Treasury bonds are higher than they have been in over a decade. Many investors see this as an opportunity to invest in government bonds – and as a result, they have been buying and investing in government bonds over other assets such as stocks and crypto.
In fact, individuals were so eager to invest in these bonds that the web traffic of people visiting the Treasury Direct website was so high that the website could not handle the traffic and crashed.
Bitcoin is losing ground as an inflation hedge
As the market shifted from a “risk-on” environment, where bond yields were low enough for individuals to prefer a more speculative asset allocation, to a “risk-off” environment, cryptocurrencies have underperformed many other assets.
This underperformance has led many crypto critics to state that the inflation hedge and store of value behind bitcoin is invalid. These individuals believe that cryptocurrencies are “risk-on” assets.
In other words, when the risk-free rate in the economy is low—and U.S. Treasury yields are trivial, as they have been for most of the past decade—investors will flock to assets like stocks and cryptocurrency where the potential return is much higher than it is in bonds.
When the market is “risk-off”, market participants believe that investors will flock to bonds over speculative assets such as crypto.
See: Bitcoin is not a pure CPI hedge: strategist
Bitcoin’s future as a risk asset
While cryptocurrency is still very young compared to other asset classes, these markets help individuals understand the driving investment thesis behind cryptocurrencies. It is important to understand all the nuances that go into global markets and investment allocations, and know how to pivot when the market changes.
There has never been a time in bitcoin’s existence when the risk-free rate has been so high, and the final result will be very useful for investment managers in the future. Whether Bitcoin and other cryptocurrencies are long-term inflation hedges and a store of value or just a “risk-on” speculative asset preferred in times when bond yields are unattractive is not yet fully understood.
This year has been significantly different than most of the past decade, and the market we’re currently seeing will be very beneficial to advisors looking to better understand this new emerging asset class.
