A Wrong Take On Bitcoin As A Macro Hedge
Last week I posted on my LinkedIn Matt Levine’s article titled “The Crypto Story: Where it came from, what it all means, and why it still matters.”(The article was published at the end of October). It’s a long read, so over the past two weeks, I’ve been going through the story, re-reading various parts and have decided to express my opinion about some points raised by Matt.
My intention is not to criticise the article, I just want to elaborate on a few ideas and points in the article as they resonated with the readings and research I’ve been doing lately. Besides, when traditional media talks about Bitcoin or crypto, they tend to whiz through crucial and occasionally controversial points without giving them proper attention.
The plan is simple, and hopefully, over the next few weeks, I’ll write up and publish all of the notes I made from reading Matt’s piece. Let’s begin:)
In the second chapter (“Part II: What Does It Mean?”), Matt mentions two reasons for bitcoin’s appeal to institutional investors from a diversification point of view — a hedge against inflation and a more convenient form of a store of value than gold. Matt then follows with:
In practice, it turns out that the price of Bitcoin is pretty correlated with the stock market, especially tech stocks. Bitcoin hasn’t been a particularly effective inflation hedge: Its price rose during years when US inflation was low, and it’s fallen this year as inflation has increased.
Today I would like to unpack these two sentences as they raise a debate. Firstly, a higher correlation between bitcoin and tech stocks should not be immediately considered bad. It’s definitely unpleasant if you’ve been trying to diversify your tech portfolio with bitcoin. But let me explain.
In the 2020 “Bitcoin As An Investment. Part 2” report, ARK Invest looked at the correlation between bitcoin and nine other asset classes over 10 years. They found little to no correlation between bitcoin and these asset classes. The research from Man Solutions corroborated ARK Invest’s view. I’ve borrowed the following chart from their report, which shows nearly zero correlation between crypto (a proxy used for bitcoin) and other assets.
Source: Man Institute
This means that a significant stock or bond price fall should not impact the bitcoin’s value — exactly what diversifiers do. However, it was not the case this year. Bitcoin has shown a strong correlation with tech stocks since the start of the year.
Source: TradeView
This is consistent with Man’s findings — the correlation between bitcoin and other assets during the mass-market drawdowns, similar to what the financial markets have experienced this year.
There is another part of this story. The increase in the correlation between crypto and equity in 2020 happened because bitcoin was becoming mainstream, according to Ric Edelman. As Ric explained in the interview back in March, in the early years of crypto and most of its history, most investors were individuals and vanguard investors. Over the recent year and a half, institutional investors engaged in trading and recognising bitcoin for its diversification potential. But these institutional investors include bitcoin in the equity arm of their portfolio. When these investors sell equity during market downturns, they also sell crypto which then leads to a spike in correlation. Ric also pointed out that if institutional investors continue this trend, we might see a further increase in the correlation between crypto and stocks.
So, although a higher correlation with stocks hurts many in the short-term, the network and hodlers could reap the benefits in the long-term as Bitcoin gains momentum. (A quick side note, I wrote a post last year about portfolio considerations when investing in bitcoin. The post is not financial advice! Please consult your financial advisor and do your own research.)
Shall we move to the not “particularly effective inflation hedge” point now? I’ve seen several articles written on bitcoin’s relationship with inflation over the six months, and I’m going to leave some of them here:
Unpacking the Intricate Relationship Between Bitcoin and Inflation
3 certainties in life: Death, taxes, and ever-increasing monetary intervention
Bitcoin didn’t “work” as an inflation hedge this year because of the nature of inflation. This year we have witnessed sharp increases in energy, food and other commodity prices for a vast array of reasons. However, as Steven Lubka from SwanBitcoin pointed out, inflation does not mean an increase in price levels. The original definition refers to the increase in the paper money quantity against the supply of fixed collateral that backed it. Since we have a fiat monetary system, inflation would imply an increase in money quantity relative to the output of goods and services. These days, we tend to include rising price levels in the definition of inflation. Let’s look at what can cause prices to increase.
Prices could go up either because the supply of goods has been disrupted, while the money supply stays the same, or when the money supply increases, e.g. rapid money printing, with a stable output in the economy. Take a guess which one is more relevant to us in 2022. (The former.)
Now to the point. Surprisingly or not, financial assets will not appreciate in a world experiencing the contraction of output due to supply-side distractions.
As Steven puts it:
Demanding that a financial instrument appreciates in value against concrete real-world disruptions is expecting to own something which makes you wealthier in a world that just became dramatically poorer.
And,
You don’t suddenly gain a larger percentage of the wealth of the world solely by holding hard money when, for example, copper mines go offline.
So, bitcoin should not protect us from increasing prices caused by supply-side factors similar to assets like stocks.
In contrast, bitcoin provides a hedge against the monetary expansion, i.e. the actual inflation, not rising consumer price levels. Bitcoin acts similarly to other financial assets - benefiting when the market is awash with liquidity from the monetary expansion.
Brent Donnelly, the president of Spectra Markets, concluded that bitcoin is a hedge for loose monetary and fiscal policies (not the price level hedge).
Let me reiterate: I’m not picking wholes in Matt’s article, which I think is brilliant and definitely a must-read for anyone interested in Bitcoin and crypto or researching the industry for quite some time. Yet I believe the topics discussed in this post are essential and need to be talked about and explored further.
I do have one more area to discuss from Matt’s article, and hopefully, it won’t take me four months to write up.
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It may even prompt me to write more often :) And now to the new post!