Inflation. The word has dominated discussions about the economy and financial markets since Fed Chair Powell first suggested it would be “transitory” in March of 2021, before he retired the term late last year and admitted last month inflation is here to stay for the foreseeable future.
As bitcoin and the broader crypto ecosystem have developed, there has been much debate about whether crypto can be a hedge against inflation. Earlier this year, Mark Cuban emphatically stated that bitcoin is “not and will never be” an inflation hedge. But several other prominent investors see this in a different light. Bill Miller has called it an “insurance policy against financial catastrophe,” Paul Tudor Jones said it’s a “reliable” hedge against inflation, and Stanley Druckenmiller has said he expects his bitcoin holdings to “work better” than gold.
So, with inflation as high as it’s been since 1981 and crypto prices well below the all-time highs hit last year, who is right?
Some historical context: from the k-percent rule to a digital currency
Milton Friedman, a Nobel Prize economist and the most influential person regarding monetarism, published A Monetary History of the United States in 1963. The book defends a very simple and powerful idea: money supply should have a predetermined growth rate. This proposition came to be known as the “k-percent rule” and was based on the understanding that attempts by monetary authorities to actively control growth of the money supply (the “k” variable) throughout business cycles had adverse effects on the stability of the economy.
The rule is not something central banks have ever viewed as appropriate for their mandates. This is not surprising because if followed, the k-percent rule would make a monetary authority a mere executor without discretion. Instead, the inflation-targeting system has become the standard for central banks’ monetary policy. This approach provides central bankers a framework to keep inflation within a pre-established band, using its main tool—the short-term interest rate.
After the 2008 financial crisis, however, some of the cornerstones of this system and the monetary economy were shaken. The developed world went through a decade with very low—or even negative—interest rates and other monetary stimuli, without having to deal with the consequences of inflation during this time.
It was also in the wake of the financial crisis, when a new form of currency emerged. The Bitcoin blockchain went live in January 2009 and its new currency was fully digital and decentralized, that is, independent of any government or institution. Bitcoin was created following Friedman’s k-percent rule, with a money supply almost perfectly predictable and on schedule. Currently, the total number of bitcoins mined per year is around 328,000, which is equivalent to a “k” of around 1.8%. This rate of expansion of the monetary base falls over time. Around the year 2140, the last of the total 21 million bitcoins will be mined and the “k” will converge to zero. Unfortunately, Friedman died just over two years before Bitcoin’s creation, but his theory had essentially predicted the rise of the world’s first cryptocurrency.
Since Bitcoin’s launch, there have been several dramatic macroeconomic environments. In 2020, with inflation dormant for about a decade in developed countries, the world was swept away by the COVID-19 pandemic. Governments and central banks promptly mobilized to implement stimulus policies aimed at containing the economic effects of the pandemic. In developed countries in particular, these policies have had unprecedented impact.
In May 2020, Paul Tudor Jones became one of a number of investors publicly citing their concerns over the impact of these policies on inflation. In his paper “The Great Monetary Inflation” he cites concerns over massive government debt and money printing. He also points out the growing role for Bitcoin and why, given its adherence to the k-percent rule, it may be the best safeguard in the emerging scenario.
From Jones' letter to here, a lot has happened. Bitcoin experienced a strong rally at the end of 2020 and hit a new all-time highs in 2021, driven by the influx of a large number of institutional investors and crypto-specific factors such as the rapid growth of DeFi protocols, the popularity of stablecoins, and the boom in NFTs. During this time, governments approved record levels of fiscal spending while interest rates moved toward zero. This year, the war in Ukraine has upended energy and other commodities markets while ongoing lockdowns in China continue to disrupt global supply chains. And the inflation that Jones predicted did, in fact, come around the world. The US consumer price index reached 8.6% through May 2022, the highest level in more than four decades. Given this scenario, we can ask ourselves if the thesis of bitcoin as a hedge against inflation has merit.
Three considerations for investors
While data analysis regarding the link between bitcoin and inflation can be informative, much of what we can currently observe is inconclusive. However, regardless of bitcoin’s short-term price movements, we believe there are three important factors investors should consider when evaluating the cryptocurrency as an inflation hedge.
Understand bitcoin’s unique attributes.
Nothing like bitcoin has ever existed before: a borderless and completely digital currency with a fixed supply. Its scarcity and immutability have made it an emerging store-of-value asset and potential inflation hedge. Nevertheless, due to its infant stage in terms of adoption, bitcoin behaves like a risk asset with very high volatility. But we believe these characteristics are also responsible for bitcoin’s incredible growth potential.
One of the strongest arguments for bitcoin helping to combat inflation’s deleterious impact on investment portfolios is that there will only ever be 21 million bitcoin, making it one of the world’s truly scarce assets. The supply of bitcoin rewarded to miners is cut in half approximately every four years. This will continue until eventually no more supply is issued, a process anticipated to take more than 100 years. Price spikes will never lead to more than 21 million bitcoin being issued. This fixed supply cap gives investors confidence the value of the underlying asset will not be diluted by an increase in supply. This can help make bitcoin’s inflation schedule more predictable than fiat currencies.
Appreciate the differences between developed and emerging markets.
Countries that have experienced persistently high inflation and capital controls (e.g., Venezuela, Argentina) have embraced bitcoin and other crypto assets more than most developed markets with more stable currencies. For individuals in emerging markets with highly uncertain currencies, used to seeking stability in the dollar or euro, a digital asset outside of government’s control can provide an attractive alternative. As inflation hits levels not seen in over 40 years in developed markets, it can also be argued that bitcoin may provide an attractive long-term alternative in developed countries, especially considering those in the US and EU have no stronger currency to run toward in this environment.
View bitcoin’s growth potential as a tool to help “inflation proof” portfolios.
In a high inflation environment, investors will need assets that generate high returns. We believe that bitcoin has an important role to play within a portfolio to help offset inflation in a different manner than current inflation-hedging assets like real estate or private credit investments. This is because bitcoin’s growth potential, as well as the growth potential of the crypto industry more broadly, can help generate returns high enough to stay ahead of inflation and help protect an individual’s purchasing power.
We recently compared bitcoin to a global set of equity indices from 2017 to 2021, one of the strongest historical performance periods for stocks. While bitcoin’s volatility over this period was more than double the next most volatile equity index, its annual return of 117.5% was nearly five times as high as the next best performing equity index. Bitcoin had the highest Sharpe Ratio—a measure of risk-adjusted return—over this period, rewarding investors more than any other asset class per unit of risk.
While today’s levels of inflation have not been seen in decades, the challenge of how to prepare and respond to inflation is nothing new. Milton Friedman’s work from nearly 60 years ago is as instructive today as it was then, that is, accommodative monetary policy and rampant fiscal spending are not without consequences.
What is different today is that bitcoin is presenting a new tool to help deal with inflationary pressures. While uncovering whether an asset is a good inflation hedge can only be done in hindsight, our team believes that bitcoin’s unique characteristics, global reach, and growth potential are making it a promising alternative to the current tools available to hedge against inflation. As the world faces an extended inflationary environment, we believe investors should consider the role bitcoin can play to help protect portfolios over time.
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