With inflation tracking at the highest rate in the last 30+ years, it now has become something we actually have to talk about. We could always recite the dictionary definition of inflation, but for us “young” professionals, inflation was just that; a dictionary definition for when the supply of fiat currency surges and pushes prices of goods and services higher. But we’ve never really seen it in practice before.
When the US and other parts of the world were on the gold standard, we had less to worry about in terms of inflation. In theory, since our fiat was pegged to gold, the supply of fiat could only grow nominally each year, in line with the potential increase in supply of gold itself. Gold is difficult to mine so inflation difficult to achieve. As we moved off the gold standard there are now less restrictions on the supply of fiat currency which is controlled by central banks and leads to a greater potential for inflationary periods.
Using Bitcoin as an inflationary hedge has been a touted feature of the cryptocurrency since its early days. Theoretically, yes, Bitcoin is a
good hedge against inflation since the supply will only ever be 21 million Bitcoin. Because control is not centralized with a government who would otherwise have the ability to create/print excessive amounts of currency, the value of Bitcoin cannot theoretically deteriorate based on supply itself. Like gold, Bitcoin is hard to mine (or in this case, impossible once it hits 21 million) so inflationary pressure on the currency is difficult to achieve. In addition to hedging against inflation, Bitcoin and other cryptos are touted as assets uncorrelated with the stock market which could make it a good holding for a diversified portfolio. So how has Bitcoin and the crypto market faired at delivering on these initial use cases? A few thoughts:
1. Volatile prices
With significant price movements in Bitcoin, holding it today could be worth significantly less tomorrow, or a year from now, thus defeating the purpose of holding it to protect against inflation – it has not held its value well over time. If I bought Bitcoin at $60k at the beginning of 2021 as an inflationary hedge, how am I doing now as it trades below $30k? An inflation protected asset needs to be stable and trade in a relatively tight band over time. We just aren’t there yet with Bitcoin.
2. Higher correlation with public equity market
When interest rates rise, public equities decrease because future cash flows of companies are now worth less. While determining valuation through discounting future cash flows wouldn’t work for valuing crypto for crypto (since outside of staking, there are no cash flows generated which directly accrue to the holder of the coins), the crypto market is sinking along with public equities and we’ve seen this increased correlation more over the last few years. While crypto assets could provide some diversification alongside public equities, the more correlated price movements do not necessarily provide protection when public markets sink.
3. Stable coins aren’t so stable
Moving away from Bitcoin for a moment, many people, especially those in developing countries with high inflation, invest in stablecoins. A stablecoin is essentially a cryptocurrency which is pegged to an underlying asset in order to maintain it’s value. So someone in Argentina, for example, would buy stablecoins with their Argentine pesos and that stable coin would hold its value which is a much better option than holding the hyper inflationary pesos. Or at least that’s the theory. Some stable coins are pegged to the USD and have $1 reserve for each of the outstanding stablecoins. Other coins could be backed by short-dated Treasury bills, other crypto assets, or a mix of assets. While a third group of stable coins are called “algorithmic” stable coins in which the peg is held together by algorithms and smart contracts to control the supply of the currency to keep it valued at $1. With the collapse of the Terra stablecoin (UST), we’ve seen that algorithmic stable coins are ticking time bombs – at some point confidence in the mechanism deteriorates causing large outflows from the stablecoin and breaking the peg. The coin is not collateralized by any hard assets. While stablecoins backed my real assets such as USD appear safer (if they really are backed dollar for coin), at what point could the currencies decouple from the underlying USD asset causing a crash in the coin value? Have we just graduated from dollars backed by gold to crypto backed by dollars with the inevitable peg removal like we saw in the 70s with gold? It doesn’t seem like stable coins are all that stable over the long-term, but here’s to hoping because I think they can be very useful upgrades to the payment infrastructure in our slow banking systems today.
As the crypto market matures and we develop a better set of use cases for Bitcoin and other tokens which are accepted by a wider portion of the population, Bitcoin could become an inflation-protection security with other cryptos decoupling from the market. But in the short term don’t treat Bitcoin like gold, don’t assume crypto is uncorrelated with public equities, and don’t put your life savings into stable coins.
Is the best inflation hedge the asset you just bought? There is more at stake as prices rise than talking your own book.