Headline: Is cryptocurrency a good hedge against inflation?

Date: 9/3/2022

Body:  I don’t need to tell anybody that inflation is rapidly deteriorating  financial positions of citizens almost everywhere.  Wouldn’t it be nice if we could find an investment vehicle that would accelerate earnings as the inflationary environment worsened?  One such investment (we’ve seen these before) are TIPS, or Treasury Inflation Protected Securities.    The face rate does not change for these securities, but, as the inflation rate goes over a threshold value, the principal gets added to, so you are now multiplying by a higher number.  Sounds pretty good, doesn’t it?   I think it does.  But it would be even sweeter if we could get this feature within an appreciating security… like maybe cryptocurrency?  Could cryptocurrency serve as that hedge against inflation?   Let’s discuss this further.

No, cryptocurrency is not a good hedge against inflation

Bitcoin has lost significant value over the past year, and this would argue against the hypothesis of cryptocurrency hedging inflation.  In order to serve as an effective hedge against inflation, cryptocurrency would have to be a significant store of value, long-term.   Said one expert, With crypto, “the extent of [price] volatility is so significant, it’s very hard for me to view it as a long-term store of value,” Anjali Jariwala, certified financial planner and founder of Fit Advisors.  “It’s tricky because it’s supposed to act like a currency, it’s taxed like property and some people compare it to a commodity. At the end of the day, it really is its own asset class that doesn’t have a pure definition.”

So, how does it become a genuine store of value?

First, the market needs to mature and long-term investors need to become involved.   These might be traditional large banks or institutional investors, but they don’t have to be.  There are crypto-focused ETFs and mutual funds that are arguably prepared to take part of this responsibility.  Another symptom of a mature market is that participants have an agreed-upon set of metrics.    In this very moment, consultancies like Chainalysis and others are in discussions about this.  I think that in the next 2-3 years, there will be a generally agreed-upon framework of market metrics.

The authors also make the point that Bitcoin needs to be broken out from the pack, to help cement the idea of a mature market.  Currently, when cryptocurrency is breathlessly covered by the mainstream media, all of the hundreds of currencies are grouped together, and spoken of, as if their average is truly meaningful.   Bitcoin is so much larger than the rest, it can really be the tail that wags the dog, within cryptocurrency.  So, for the market to mature, the level of understanding within the media also has to mature.   As of now, at least Goldman Sachs is separating Bitcoin out from other cryptocurrencies within their reports.  We’ll see how long it takes the media to take notice.  I will try to introduce some of the most often encountered characters.

Market capitalization

Market cap (for the cool kids) is really easy to compute for cryptocurrencies.   It is simply the value of one unit of that cryptocurrency, multiplied by the number of units available in the market.  For example, if a cryptocurrency is priced at $10,000 per unit and there are a total of 20 million coins in circulation, the market capitalization for that cryptocurrency would be $200 billion. This metric is important because it gives you a sense of the size of the cryptocurrency market. It can help you determine whether a particular cryptocurrency is overvalued or undervalued.

Funding rates

Funding rates are payments made on a regular basis between traders to keep the price of a perpetual futures contract close to the index price.  A perpetual futures contract is an agreement to buy or sell an asset where the contract doesn’t have an expiration date. Positions may be kept for as long as the trader wants, but the trader must pay holding fees, also known as the funding rate.  Think of this as an option to buy a cryptocurrency at a certain value on a daily basis until the buyer wants to quit.   Certainly, the exchange will charge a fee to keep this option open, and they do.  But, if a lot of these “options” are being exercised, it’s a sign of optimism in the market for cryptocurrency.

Bitcoin heat map

This cryptocurrency indicator looks at past price data and creates a color heat map based on the percentage of increases over the 200-week moving average (MA).   Red or orange areas of the map indicate intense trading activity and might signal a good time to sell cryptocurrency into an active market.    A blue area indicates that activity is low, and might sugges a buying opportunity.

But, in the future, cryptocurrency might become a good hedge against inflation.

On the other hand, when the price dots are purple and close to the 200-week MA, it’s usually a favorable moment to purchase Bitcoin.

Other experts take a more cautious point of view on this matter.  Many of their arguments center around the fact that cryptocurrency is very new and does not yet have a track record.  Said one expert, “Once volatility smooths out, we will have a better picture of how it responds to macro developments, like the rate of inflation or what the Fed is doing,”   People in this camp even cast doubt upon the ability of gold to serve as a hedge against inflation.  To corroborate this view, they cite the 1980s.  In this period, the inflation rate was 6.5% and owning gold, the investor would’ve lost 10%.  Not a very good hedge at all.     But, in the current era, since the beginning of 2022, the value of gold has increased 3%, suggesting a real hedge against inflation.   As proof that cryptocurrency might provide a good hedge against inflation, they point to the 1,100% increase in Bitcoin value over the last 5 years and compare that to the CPI increase of only 18.5% in the same period.

The authors go on to suggest that the bouncing ball we SHOULD be following is economic growth.  Cryptocurrency does not directly help to employ anybody or produce a product or service.  Investments in companies that produce goods or services, this does support jobs directly.  Further, a potent inflationary stimulus is international armed (and unarmed) conflict.  Use of cryptocurrency seems impotent compared to these issues.

The Verdict

“Overall, I think anyone seriously worried about inflation should put crypto on the table as an option that can protect against some inflation scenarios and take advantage of others. It’s not a magical hedge against inflation. Nearly all crypto assets have so much non-inflation-related risk that they are appropriate only as small parts of diversified portfolios rather than either core holdings or pure hedges.”  These are the words of an author cited, and I can put them no better.  Right now, it appears to be a bad hedging strategy, but in the future, it might represent a valid portion of a good plan.  Am I hedging a bit?   Perhaps.







Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

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