The Inflation Hedge that Never Was

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In this article you will learn:

• Why people thought bitcoin was an inflation hedge

• What is a hedge

• and why Bitcoin didn’t work – this time around

Bitcoin as an Inflation Hedge

In November 2021, Bitcoin reached an all time high in price ($67K). Every week the cryptocurrency seemed to be breaking through new record prices. The run up in bitcoin’s price was due to:

1. Momentum trading

2. Investors bets on the future uses of the cryptocurrency in our economy

3. One of those uses: a store of value

At the same time bitcoin was hitting all time highs,

• Broader financial markets were also hitting all time highs (NASDAQ, Dow Jones, S&P500, etc.)

• Inflation seemed inevitable due to various policies by the government and the federal reserve (e.g. stimulus checks, low interest rates)

To fight rising inflation, the federal reserve increased interest rates which caused equity valuations to drop. Despite equity valuation decreases, bitcoin investors said the cryptocurrency should hold its value (“store of value”) during a downturn of the economy. Which would in turn drive more investors to bitcoin and raise its price. This would mean that bitcoin would hold its value and offset the negative impacts inflation has on other assets.

The logic was that bitcoin is similar to gold in that:

• Limited supply (scarce)

• Widely accepted (durable)

Risk Management & Hedging

Stocks are risky assets that can have large changes in value daily. Holding a basket of equities means you, as an investor, are exposed to the risk of declines in those asset values. Protecting yourself against declines in asset values (losses) is called hedging your risk.

One way to hedge your risk is to purchase an asset that will increase in price if the stocks in your equity portfolio lose their value.

For example, if you hold stock in a high growth technology company, then fears of inflation enter the market hurting growth estimates, causing growth stock valuations to decline, the stock then sells off, and the price drops. In this scenario the value of your tech stock holdings would be worth a lot less and you would want to hold another security that will increase in value during the sell off. Holding a security that minimizes your losses during a selloff is an effective hedge.

Many thought that bitcoin would be that security that would increase in value (or at least hold its value).

Why Bitcoin didn’t work as a Hedge…this time around

During the pandemic, many new retail investors entered the stock market because:

• They were stuck at home with not much to do

• Given stimulus money

• The stock market was booming and seemingly everyone was getting rich

• Fintech companies made trading easy and free

The problem was that institutional investors don’t own bitcoin. Bitcoin was predominantly held by newer retail investors. These newer retail investors also held the risky technology stocks that boomed during the pandemic. Therefore, when the retail investors started to lose all their gains in technology stocks, they had to sell Bitcoin to capture profits in their cryptocurrency and cover their losses. At the same time, institutional investors (who are typically better positioned to handle losses) weren’t flocking to bitcoin as a store of value due to regulatory and technology uncertainty.

That has been the story for this imminent recession: Bitcoin appears highly correlated to tech stock prices. The next downturn could be different. Once regulatory bodies give bitcoin and other cryptocurrency a green light, institutional investors will flood in to purchase bitcoin at the next downturn of the economy.

The consensus on Wall Street is that Bitcoin will reach $100k in the not-so-distant future. For now, that price target will have to wait until the Nasdaq recovers. Once the Nasdaq recovers – watch out!