What Bitcoin’s Inflation Hedge 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. Due to 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 once all the bitcoins have been mined. Many investors and bitcoin advocates believe that this economic design makes the cryptocurrency far superior to other permanently inflationary cryptocurrencies and fiat currencies.
You're reading Crypto for Advisors, a weekly look at digital assets and the future of finance for financial advisors. Subscribe here to receive the mailing every Thursday.
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 U.S. dollar. Another way to think about inflation is in the purchasing power of the dollar decreasing. As a currency inflates, the purchasing power of that currency declines over time.
On one hand, many economists believe that by creating an inflationary currency they can spur economic growth and encourage spending in the market – which they believe strengthens the economy and business cycles.
On the other, 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 contrarian belief has 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
Evidence of bitcoin as an inflation hedge
Bitcoin has certainly outperformed fiat currencies over the last decade. But while many fiat currencies were stable over the last decade, bitcoin’s price was not.
Bitcoin has become incredibly popular around the world, has been adopted and used in large parts of the global economy and has seen a very impressive growth rate. Bitcoin was trading under $100/coin in 2012 and reached an all-time high of nearly $70,000 in 2021, under a decade later.
The performance of bitcoin over the last decade served as further evidence of the asset being a hedge against fiat currency devaluation and strengthened its store of value investment theory.
Inflation hedge narrative shifts
In 2022, however, it has been a different story. Beginning in 2022, the U.S. Federal Reserve began to raise interest rates and pull liquidity out of the market. Spurred by record high inflation, the U.S. Federal Reserve took these extreme measures in order to combat inflation in the economy.
By raising interest rates and decreasing market liquidity, the Fed caused assets like stocks, bonds, real estate and even cryptocurrencies to see tremendous headwinds. U.S. 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’re seeing in 2022 as a “risk-off” environment.
Bonds reassert inflation hedge precedence
US Treasury bonds are considered the safest investment in the world. Often described as the “risk-free rate,” these bonds provide investors with a guaranteed yield and protection of principal.
Because the Federal Reserve has raised interest rates significantly this year, the risk-free rates of U.S. 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 consequently, they have been purchasing and investing in government bonds over other assets like stocks and crypto.
In fact, individuals were so eager to invest in these bonds and the web traffic of people visiting the Treasury Direct website was so high, the website couldn’t handle the traffic and crashed.
Bitcoin loses ground as inflation hedge
As the market shifted from a “risk-on” environment, where bond yields were low enough that individuals preferred 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 theses behind bitcoin have been invalidated. 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. government bond yields are trivial, as they were for most of the last 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 investors will flock to bonds over speculative assets like crypto.
Watch: Bitcoin Is Not a Pure CPI Hedge: Strategist
Bitcoin’s future as a risk asset
While cryptocurrency is still very young compared with other asset classes, these markets are helping 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 where the risk-free rate has been this high, and the eventual outcome will be very helpful for investment managers in the future. Whether or not Bitcoin and other cryptocurrencies are long-term inflation hedges and a store of value or simply a “risk-on” speculative assets preferred in times when bond yields are unattractive is yet to be perfectly understood.
This year has been significantly different than most of the last decade and the market we are currently seeing will be very beneficial to advisors who wish to better understand this new emerging asset class.