Bitcoin is not an inflation hedge
Crypto investors have had a lot to worry about lately. Bitcoin is down over 25% in less than two weeks thanks to Tesla’s about-turn on bitcoin acceptance and a warning from China. I have been content to respectfully watch the crypto action from the sidelines, but couldn’t help notice the recent chatter on bitcoin’s value as an inflation hedge and comparisons with gold. E.g. Bank of America published a report unfavorable to bitcoin’s inflation prowess while JP Morgan who earlier saw bitcoin as an alternative to gold now sees investors doing the opposite - ditching bitcoin for gold. There have been bloomberg articles on both sides of the issue (see here and here). Clearly it is hard to find good information on this topic!
The inflation-hedge viewpoint is an article of faith in the crypto community. The logic goes that bitcoin will become the asset of last resort when inflation finally makes fiat currencies worthless and gold obsolete. Gold-bugs are no less. There’s a fairly well-funded movement that would like to re-establish the gold standard. To say the least, both visions gloss over a lot of important details(!)
Causes of inflation are multi-dimensional. It comes in many flavors and to hedge against it you have to first figure out why it is happening. It follows that the hedging conversation should not revolve around gold or any one asset. In fact, typically the best hedge against inflation is just the stock market. This is because the majority of the time inflation is caused by strong consumer demand which also benefits stocks. What about “bad inflation” or stagflation that can hurt stocks? There is nuance here too. Inflation can hurt growth if caused by constraints on the supply of labor or raw materials, like right now in the US (see my earlier post). Another cause of stagflation can be excess deficit spending by the government - often referred to as “money printing”.
In supply-constrained stagflation, stocks are not helpful because growth is under pressure. The best strategy may just be to buy the raw materials in short supply. One could do that with the commodity futures market or through commodity-linked ETFs. In this kind of inflation, gold may or may not help because it is not a factor of production. And that argument should apply to bitcoin as well. If gold or bitcoin do happen to help it would be more because of US Dollar depreciation, and that may or may not happen in this type of inflationary environment.
Inflation caused by excess deficits or “currency debasement” is more complex. Since stocks, bitcoins, commodities and gold are all denominated in US Dollars, currency depreciation causes upward pressure on their prices across the board. So, if you have financial assets of this sort, they should all act as inflation hedges. Again, nothing special about bitcoin or gold! But things can change if currency devaluation gets more extreme. In moderate to severe currency falls, the highest quality stocks may still act as inflation hedges but speculative ones could suffer a lot. Commodities may begin to segregate out with the more essential ones such as agricultural or oil doing better than industrial metals or even gold. What if it’s a really bad situation where hyperinflation destroys the currency and markets cease to function? In that case I can only argue for three minimum assets: a bag of gold, a fuel efficient vehicle with a full tank of gas and several guns - with a bias towards the latter.
Where does bitcoin fit in? As expected, it has not been helpful in the recent supply-based inflation episode. As per the chart below, inflation expectations are up 0.32% since a low on April 23rd, but bitcoin is down 14%. Meanwhile a broad-based commodity ETF is up about 5% while cyclical stocks are down 2.5%.
Obviously there are far more important drivers of bitcoin prices than inflation!
What about historically? We didn’t have supply problems until very recently, so was bitcoin acting as an inflation hedge earlier? After all the narrative is that “currency debasement” has been going on ever since QE began in 2009.
The answer is still no: bitcoin has actually done quite poorly in the past when rising inflation expectations appeared to be hurting growth prospects. The chart below shows the average daily returns of bitcoin on days when inflation expectations went up and cyclical stocks went down - a crude proxy for times when “inflation hurt growth”.
It is stunning how consistent this pattern is over the years - the bitcoin market really did not like anything that seemed like stagflation! Btw there is a reason why I chose 2018 as the starting point: bitcoin futures began trading on CME at the end of 2017. Until then bitcoin was not traded much by professional investment firms.
To make things worse for bitcoin’s inflation-hedge case, commodities showed much better behavior in the same time period:
I agree that defining “stagflationary days” as above is a bit of a stretch. But at the end of the day what one cares about is market expectations and market prices - because that’s where the money is. The true economic realization of stagflation is not strictly relevant, at least from an investment point of view. I think the pattern is compelling.
There is a very large elephant-in-the-room here that I need to acknowledge. Bitcoin has returned 35% per year in the period of this analysis so one could well ask - who needs an inflation hedge given such returns? Well, returns are not the end of the story. Bitcoin’s 35% per year return has been achieved with a volatility 3.5 times that of the stock market. Since 2017, the S&P 500 has had excess returns of 16% per year, so if a bitcoin investor had been willing to take on the same volatility with the S&P 500 as he or she was with bitcoin, they would have made 3.5 x 16% = 56% per year, comfortably beating bitcoin! True, that would have involved leveraging 3.5 times with futures contracts or margins which I most definitely do not recommend. My point is that apples to apples, the S&P 500 has been a better investment than bitcoin since 2017, so bitcoin’s extraordinary run-up is more a sign of implicit leverage than any innate inflation fighting ability.
All this said, I am no crypto-sceptic (or believer) at this point. I just don’t think investors should count on bitcoins (or other tokens) as an inflation hedge. The ultimate fate and use-case of this asset class still hangs in the balance and things are going to stay interesting in crypto-world for a while!
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