While some analysts are pointing to inflation fears to explain bitcoin’s recent rally, there are so many other factors at play that affect the cryptocurrency’s rise.
Neil Johnston was a creature of habit, and it was one of the things which his wife of twenty-four years Dorothy, both loved and loathed about him. While Dorothy appreciated Neil’s dependability, she was wondering if things were getting a little stale.
So naturally Dorothy grew a little worried when Neil, who would walk through the door almost like clockwork at 7 pm every evening for dinner, started to get home late from work.
“Late from work?” she thought to herself.
Neil was a man of schedule and precision.
As the quality manager at plastics molding company, Neil’s routine was more precise than a German train schedule.
Yet over the last few weeks, Neil kept coming home later and later and Dorothy started to get suspicious.
Were her worst fears coming true? Was Neil having an affair?
Try as she might, she just couldn’t get the nagging suspicion out of her head husband might be cheating on her.
So one evening, when the children were staying over at a friend’s house, she went early to Neil’s office to follow him home.
True enough, he got off work exactly on time but instead of making his way home, he boarded a bus in the opposite direction, with Dorothy following at a distance.
After a few stops, Neil got off the bus and disappeared into a dance studio.
“Dance studio?” Dorothy thought.
But instead of confronting Neil, she peeked through the window of the studio and saw a tall blonde and very attractive woman smile to greet him.
“So that’s who he’s been seeing!”
Before she could charge into the dance studio with indignation, to Dorothy’s surprise, the tall blonde started to put Neil through some warm up paces — she was teaching him to ballroom dance!
But why keep it a secret?
Dorothy, her face pressed against the glass window of the dance studio, watched as her husband practiced the Waltz, the Tango, the Foxtrot and the Bolero, and each move was taken with precision and determination.
When he was finally finished with his personal class, Neil was shocked to find his wife waiting outside for him,
“What are you doing here?” he asked, somewhat shocked.
“I should be asking you that.”
Sheepish, Neil looked at the ground,
“You’ve ruined the surprise.”
“The surprise?”
“Remember how you said when we were first dating that you wish I knew how to dance, how you wished we could maybe one day go on a glamorous cruise and dance in the ballroom. So I wanted to surprise you on our 25th wedding anniversary. I wanted to learn how to dance.”
Dorothy, by now tears welling in her eyes, reached out and kissed her husband, a long passionate kiss of the sort that the couple had not shared for a long time.
Because nothing is ever as it seems at first blush.
And often times the explanations we come up with to explain our circumstances, can be far removed from the reality of the situation.
Inflating The Price Of Bitcoin
Which is why bitcoin watchers who have witnessed the most recent surge in the dollar-price of bitcoin may have inadvertently noticed that it also coincided with a period when investors became increasingly concerned over inflation.
But are fears of inflation fueling bitcoin’s ascent?
The short answer is yes, and no.
Since the beginning of this year, bitcoin has rallied some 57%, and over 130% from its low in March, after investors digested the havoc caused by the coronavirus pandemic.
Although the computational design of bitcoin is deflationary — there can never be more than 21 million bitcoins ever created, and the rate of mining that bitcoin halves on average once every four years — that in and of itself doesn’t immediately make bitcoin a hedge against inflation.
Given bitcoin’s relatively short history — about 11 years or so — its relationship with its dominant trading pair, the dollar, has not been consistent.
Yet that hasn’t stopped some of the biggest names in the investing world, including billionaire macro hedge fund investor Paul Tudor Jones from allocating a portion of their vast investment portfolios in bitcoin, as a hedge against inflation.
To be fair, Tudor Jones termed his bitcoin investment a “great speculation,” particularly with regards to its value as a hedge against inflation.
And in many ways Tudor Jones is right.
The Great Inflation Speculation
When interest rates fall, non-yielding assets such as bitcoin typically become more attractive because the opportunity cost of leaving money, in the cryptocurrency, become lower.
And when inflation rises, the narrative that fuels demand for these non-yielding assets also gets a boost.
But where inflation really matters is as a component of expected real rates — a closely watched measure of interest rates which are adjusted for inflation.
The market’s favorite gauge of real rates are yields on the U.S. Treasury Inflation-Protected Securities or TIPS, which provide investors built-in compensation for the effects of rising price levels.
To figure out whether investors think that inflation will rise in the future or not, breakeven inflation rates — measured by the gap between nominal yields on U.S. Treasuries (bonds) and TIPS yields, serve as a proxy for future inflation.
As the U.S. Federal Reserve took unprecedented monetary and fiscal policy measures to battle the economic effects of the coronavirus pandemic, real rates fell to historic lows at a time when nascent assets like bitcoin started to appreciate dramatically.
Feeding the inflation-hedge narrative, some investors suggest that the dollar has been losing ground to assets like bitcoin this year, in part at least, because the Fed has been purchasing so much of the U.S. government’s record debt sales — potentially debasing the dollar and diminishing its allure as a haven.
But if that argument were valid, Japan, where over 70% of Japanese government debt is owned by the central bank, would have experienced runaway inflation by now, and the Japanese yen would be near worthless.
Instead, inflation has remained low in Japan, and the Japanese yen is seen as a safe haven currency in times of economic turmoil.
So is real yield all we need to forecast bitcoin’s price?
If only.
Right now the inflation story is the one that has taken over the dollar-bitcoin narrative.
Over the past four months, real rates have been observed to be correlated with bitcoin’s ascent.
When bitcoin crashed in March, it demonstrated a strong negative correlation with the dollar.
And since that time, the dollar has slid against other major currencies, while bitcoin has continued to rise.
But the correlation isn’t so simple.
Complicating the correlation between the dollar and bitcoin is that the dollar itself is affected by a slew of factors, including geopolitics, social issues, economics, health and elections.
And this year has provided a plethora of factors to upset the dollar, including, in no particular order of panic, the coronavirus pandemic, rising unemployment, racial and social unrest, law and order issues, political gridlock, economic recession and Sino-American tensions.
On any given year, America usually has to deal with one or more of these crises —but it’s never had to deal with all of them at once and at the worst possible time as well.
At a time when strong leadership is needed from Washington (and it’s not just the White House), politicians on both sides of the aisle are demonstrating just how inept the American political system has become at dealing with crises on a national level.
In the past, times of national crises have tended to unite Americans, not highlight their divides.
No such luck this time.
At the worst possible time, the current occupant of the White House is accentuating American differences, instead of focusing on what should unify the nation.
What should have been a health and safety issue — something as simple as wearing a mask — has been hijacked by ideologues to be recast as a battle for personal freedom.
But surely the right to be free from the coronavirus is a freedom as well?
And while America debates whether wearing a mask is a political statement or not, the coronavirus has completely ignored the argument and ripples through the population virtually unchecked, leaving an ocean of caskets in its wake.
Against this backdrop, policymakers have had to undertake unprecedented fiscal and monetary policy measures, essentially printing money that flows into the financial system.
But although America has never had to deal with so many crises simultaneously, its institutions have proved resilient in the past, so the jury is out on whether they will persist in the future.
And the U.S. economy is still the world’s largest.
Try as the rest of the world might, American consumption and profligacy is still the perpetual motion machine that keeps the rest of the global economy running.
Which is why the dollar hasn’t completely collapsed worthless.
It’s why Japan and Germany which have negative interest rates and a high level of sovereign debt (in the case of Japan) haven’t seen the implosion of their economies the way Zimbabwe and Venezuela have.
And it’s for that reason why the dollar won’t implode suddenly, but some are buying bitcoin, just in case.
No Easy Answers
Which is why there’s no easy answer for whether or not bitcoin’s rise is due to inflation fears.
Over the past four months and based on its correlation with real rates, bitcoin has demonstrated its value as an asset to hedge against future inflation.
But four months do not an inflation hedge make.
And while investors who doubt the dollar may move into other assets, that doesn’t necessarily mean that they’ll be moving lock stock and barrel into bitcoin either, especially not purely on the basis of inflation.
Because bitcoin is a Veblen good — which means that as its price increases, it can become even more desired — when bitcoin rallies, it excites analysts and investors, it makes headlines and generates buzz.
With everything in the world so uncertain right now, that bitcoin is rallying speaks to the investor consciousness that it is a desired and desirable asset — because it is perceived to be resilient.
It’s sort of like why the rest of the stock market rallied on the news of tech stocks delivering better than expected second quarter results in 2020 — everyone loves a winner.
And right now, bitcoin looks like a winner.
So more is written about bitcoin, more analysis is done, and more money flows in.
At times like these, the bitcoin rally can be self-perpetuating — which provides incredible opportunity, but also increases risk.
And unlike in 2017, a lot more people are paying attention in the bitcoin rally with institutional investors throwing their hat in the ring in a way not seen before — institutional bitcoin trust Grayscale saw inflows of US$1 billion, half of which were in the first three months of this year alone.
Which might help explain bitcoin’s propensity to trend upwards.
Like so many things in life, things are almost never what they appear to be, even something as simple as coming home late from work.