Welcome to the new year!
Well, it is happening again, we are being flung headfirst into a new year. A brand-new year is upon us after a rise in inflation throughout the COVID-19 pandemic, an inflation rate that has broken a decade long historically low inflation rate. As investors one of our primary goals is to beat inflation. That is why any one of us will tell you that a fool leaves his money in a savings account long term ESPECIALLY with crazy low interest rates banks are dishing out as of recent. The interest you earn in a low interest savings account literally loses you money in the long term. With U.S. inflation reaching 7% (which is the fastest pace since 1982) and savings accounts making as low as 0.01% you are effectively taking a near 7% loss for the year. This, over time, will deplete your money as your money is depreciating due to inflation. Which brings me to a fundamental question. What is a hedge against inflation and what would it mean for an asset to be a good hedge against inflation? Hedging against inflation means taking steps to protect the value of an investment from the effects of inflation. So, in order to be a good hedge against inflation your asset or overall portfolio must make a return that is higher than the current inflation rate. For instance, inflation is at 7% therefore for an asset to be considered a good hedge against this inflation the asset itself must make a return of at least 8% year over year, but preferably greater. Now let’s dive in and see if Bitcoin fits this definition and if it truly is a good hedge against inflation as we proceed further into 2022.
The theory behind Bitcoin's promising inflation hedge
Theoretically, Bitcoin seems to be a great hedge against inflation. This first observation is made entirely on the fact that, unlike the U.S. dollar (USD), Bitcoin has a finite number of coins that will reach circulation. Once all Bitcoin are minted there will be 21 million of these coins in existence, no more, no less. Therefore, in theory, this limited supply will inadvertently increase the value of Bitcoin and over time will beat out the value of the ever-increasing supply of USD. Another argument for Bitcoin is that it can also be a hedge against systemic failures. Bitcoin is what is considered “self-custodied” meaning that the owner of the cryptocurrency has full and absolute control over their funds. A great concept since there is no need for individuals to rely on third parties such as banks to complete transactions. This is where the term “decentralized” comes from and in times of doubt people lean against these self-custodied assets so that the investor does not have to worry about banks freezing funds or failing altogether. This is possible because Bitcoin runs off the Bitcoin blockchain. With all this information, theoretically Bitcoin not only looks like a great monetary hedge against inflation, but it is also a hedge against the failure of the modern financial infrastructure. However, I must include a disclaimer. Bitcoin held in derivatives or on exchanges are NOT a systemic hedge as they have been incorporated into a centralized financial system. So, tread carefully if it is your goal to hedge against our systematic processes. I am not a doom and gloom type of person, and I don’t believe that the sky is falling as of now, but systemic threats can occur as it did in Lebanon 2020 and Cyprus 2013. I have included additional references if you would like to know more about these events.
Unpacking the data
Now we must look at our data. Taking a glance at Bitcoin’s price history it does not look like it fits the same theoretical arguments made above. Bitcoin began its rise to fame in 2017, where after a significant increase it was met with a drastic correction that lasted through early 2019. However, during this same period of time the M2 money supply rose 25.3% (M2 is a measure of the U.S. money stock) and apples to apples (Bitcoin to gold) gold would have been a better choice of a hedge against inflation, rising nearly 52%.
Another club taken to the dying horse. Once the pandemic was in full effect the federal government, in fear of what the pandemic would do to the U.S. economy, issued an idiosyncratic stimulus package to the American people. Strumming right alongside the pandemic were unheard of supply chain kinks compounded with global product demands increasing as COVID-19 precautions were loosened (or just outright ignored). This consequently resulted in many businesses not being able to meet this increasing demand and just like that our fair mistress inflation began once more. The time was now. Was Bitcoin going to rise to the occasion and show us just how good of a hedge against inflation it can be? Well, over the last year the inflation rate has more than quintupled and during that same time period Bitcoin’s price has ebbed and flowed in >20% waves. Bitcoin just has not shown us that it can truly act as a hedge against inflation and in fact is currently near its lowest price in 7 months. Looking further out, over the last decade to be exact, we see that Bitcoin’s price is still very volatile and has not been correlated with inflation at all.
Why doesn’t Bitcoin seem to be better at hedging inflation?
Could it be that an excess supply of Bitcoin has entered into circulation driving down the price? No, there has only been a 1.8% increase of Bitcoin in circulation over the past year. A main belief held is that for any asset to be a hedge against inflation the investors must believe that it will hold its value long term despite inflation rising. If the last year has shown us anything it's that investors do not have faith that Bitcoin will hold its value and may be the cause of furthering decline as people doubt Bitcoin’s value long term. Bitcoins are only worth what we assign them, unlike the intrinsic value stocks and more tangible assets hold. Motley Fool’s Travis Hoium’s opinion is that Bitcoin’s recent rise is a speculative move driven by millions of people with excess stimulus and ample time to trade in the cryptocurrency market. Which brought in more institutional money driving prices higher and at the end of the day it is not clear whether Bitcoin is like digital gold, providing utility, or just a speculative asset. From what he can see based on the fact that inflation rose so much in 2021 while Bitcoin is headed lower, Bitcoin is not a good hedge against inflation and investors should seek a better investment thesis for this digital asset.
My opinion: Given the historical data and Bitcoin’s high volatility, owing to the fact that Bitcoin has had a 50% or greater reduction in USD value 4 times in its lifetime, we must take these data with a grain of salt. I should mention that each time Bitcoin has fallen 50% or more from its new peak, it has always exceeded its previous high during the next peak. Just as can be seen in the stock market. Would we not have been fools if we stopped investing in the stock market after every crash? I see Bitcoin in the same light. It is volatile and a new and digital asset. This scares a lot of people especially older individuals who cannot understand and/or cannot see cryptocurrency’s broader applications. Once younger investors start flooding the market or maturing into great investors, I believe we will undoubtedly see the rise of Bitcoin once more and given another 10-20 years I do believe Bitcoin will come into its own as a hedge against inflation.
Bitcoin in theory is a great hedge against inflation and against systemic turmoil but looking at our data we have a strong argument that Bitcoin is not a good hedge against inflation as we head into 2022. However, we must realize that even though this data spans the last decade, a decade’s time is surely irrelevant to that of the history to come. We have such a little window in which to peer into and see what Bitcoin is. Bitcoin has much maturing left to do and just as you would not have wanted to be judged by your appearances and actions as a child, maybe we should give Bitcoin the same respect. We must let Bitcoin mature and give people time to realize Bitcoin’s, and other cryptocurrency's, broader applications.
References:
Banking crisis in Cyprus: Causes, consequences and recent ... (n.d.). Retrieved February 2, 2022, from https://www.mfsociety.org/modules/modDashboard/uploadFiles/journals/MJ~0~p1dg2hfl4fdhu1i4g1a4vu441ejj4.pdf
Google. (n.d.). U.S. inflation hit 7% in December, fastest pace since 1982. Google. Retrieved February 2, 2022, from https://www.google.com/amp/s/www.wsj.com/amp/articles/us-inflation-consumer-price-index-december-2021-11641940760
Is bitcoin a good inflation hedge? MSN. (n.d.). Retrieved February 2, 2022, from https://www.msn.com/en-us/money/markets/is-bitcoin-a-good-inflation-hedge/ar-AARQrSM
Neuman, N. (2020, July 14). Bitcoin: More than an inflation hedge. Bitcoin Magazine: Bitcoin News, Articles, Charts, and Guides. Retrieved February 2, 2022, from https://bitcoinmagazine.com/culture/bitcoin-more-than-an-inflation-hedge
Person, & Blair, E. (2022, January 23). Explainer: Lebanon's financial crisis and how it happened. Reuters. Retrieved February 2, 2022, from https://www.reuters.com/markets/rates-bonds/lebanons-financial-crisis-how-it-happened-2022-01-23/
Speights, K. (2022, January 30). Why the case for Bitcoin as an inflation hedge has crumbled. The Motley Fool. Retrieved February 2, 2022, from https://www.fool.com/investing/2022/01/30/why-the-case-for-bitcoin-as-an-inflation-hedge-has/
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