As the year that felt like a decade on speed starts to draw to a welcome close, some of us are starting to try to make sense of the timeline of narratives and events. Most of us (myself included) are failing. And that in itself is an intriguing narrative, that sheds light on bitcoin’s rally.
Bear with me while I try to explain.
On the one hand, we have a rapid rise in the bitcoin price, and coalescing institutional support from traditional investors and companies that see potential in crypto assets and markets.
On the other hand, we have conflicting economic and social trends. We have blind faith in the power of vaccines combined with rejection of the science of virus transmission; monetary policy designed to encourage lending combined with banks that are unwilling to do so; growing interest in the value of emerging markets combined with escalating risk of default; widening inequality combined with greater power of protest; I could go on …
These conflicting forces and the uncertainty swirling around them should encourage us to look closely at prevailing narratives. Yet those of us watching the growing institutional interest in bitcoin markets have accepted without question the assumption that bitcoin’s inflation hedge qualities are behind it.
Let’s pick that apart.
The deflation debate
First, let’s look at another pair of conflicting economic trends.
Most economists seem to believe that a resurgence of inflation is unlikely. Depressed consumption and excess supply, the continuing impact of technology and demographic shifts, the low velocity of money and the weak labor market are just some of the factors they point to. These have already led to deflation in some key economic areas.
The bond market, on the other hand, tells us that inflation concerns are real. The five-year breakeven rate, a proxy for inflation expectations calculated by taking the difference between five-year U.S. Treasurys and Treasury Inflation-Protected Securities, is close to its five-year high.
5-year breakeven inflation rate
What’s more, the yield curve continues to steepen, signaling expectations of higher interest rates in the future as central banks tackle a looming inflation problem. Taking into account the damage rising interest rates would do to debt-laden economies, this is the bond market telling us that they see trouble ahead.
Yield curve (10-year minus 2-year Treasury yields)
An inflation hedge
But does that really matter for bitcoin?
Bitcoin is seen as an inflation hedge mainly because of its limited supply, which is not influenced by its price, and because of its relative attractiveness when real yields head to zero or lower.
Yet when you buy bitcoin, you’re not just doing so to hedge inflation. You’re buying bitcoin to hedge all the other negative consequences that usually accompany it.
True, inflation is not always bad. “Good” inflation, a result of economic growth and low unemployment that helps to close the gap between supply and demand, encourages investment and even more economic growth.
Runaway inflation, however, exacerbates poverty, heightens uncertainty, demolishes trust in institutions and can lead to the breakdown of social order. This is not isolated to post-WWI Germany – we see it today in Venezuela, Zimbabwe, Lebanon and Argentina, to name just a few.
Bitcoin is also a hedge for unstable governments that close bank accounts, police states that want to seize private wealth, broken payments rails due to corrupted systems or outside cyber attack threats, paranoid leaders that want to disenfranchise opponents, export-protecting devaluations that trigger more inflation …
These are less likely in developed economies. But let’s not forget that tipping points lurk around unexpected corners, and that Venezuela was once one of the wealthiest countries in the world and one of the more stable democracies in Latin America.
Bitcoin is a hedge against inflation, but also against political instability and social disruption, which – if inflation comes roaring back – is not a ridiculous thing to prepare for.
A dollar debasement hedge
Bitcoin is also a hedge against a more gentle but just as pernicious debasement of currency through a loss of trust.
Traditionally, inflation moves in tandem with the strength of the local economy. But it can be triggered by currency weakness, which raises the prices of imported goods.
This is usually corrected when the central bank raises interest rates to combat rising inflation, which increases the attractiveness of the currency compared to others.
But in the current environment, an increase in interest rates may have the opposite effect, given the potentially catastrophic impact on debt-ridden economies. The U.S. bond market is telling us that it thinks interest rates will rise. The dollar continues to head lower, however, and could continue to do so even if those rate increases materialize, as faith in the capacity of the U.S. to employ traditional tools to good effect could be shaken.
And, most bitcoin trading is denominated in dollars. Therefore, if the dollar heads lower without a corresponding fall in the value of bitcoin (and since it’s unrelated to the economy, there’s no fundamental reason why it would), the BTC/USD ratio heads up.
Bitcoin is a hedge for not just the macroeconomic ills that we have been trained to watch out for. It can also provide ballast against the unforeseen problems waiting to be triggered.
The ‘crazy’ thesis
This highlights another hidden strength of bitcoin as an investment asset.
It is unlike any asset that we have seen before: programmatic supply, decentralized governance, fragmented market infrastructure that runs on technology developed by an unknown entity yet maintained by miners, developers and validators distributed across many geographies.
It doesn’t fit into standard economic thinking – and for that reason, it is perfect for our times.
In a world where you’ve gone from orthodox monetary policy to Keynesian economics to MMT in a few months, there is no longer any trust in the traditional recipes.
To paraphrase G. K. Chesterton, when you stop believing in traditional recipes, your mind is more open to new ones.
Bitcoin in portfolios represents more than a new recipe. It represents the need for a new recipe. It represents a safety play against a world in which old ideas are up in the air, and new ones have yet to take root.
It represents more than a hedge against inflation: it also represents an acceptance that politics and economics can get weird, and that untested ideas that are untethered to macroeconomic features and past assumptions are worth considering.
It represents a hedge against “crazy,” which is hopefully not what awaits us – but the risk of not preparing for that possibility is verging on irresponsible, and not even thinking about it is likely to end up being prohibitively expensive.
Anyone know what’s going on yet?
The outperformance of bitcoin in 2020 has to set up the asset for even more professional investor attention next year, even though we all know that past performance is not an indicator of future performance. Or is it? The momentum trade seems to be the predominant strategy this year, and given the amount of money sloshing around markets looking for a good return, there is no indication that will end soon.
Then again, all bull markets have to end some time, although the underlying fundamentals and investment theses of bitcoin do not get worse with vaccine disappointments and worse-than-expected economic figures – unlike with stock and bond markets.