BT Explains: Are cryptocurrencies a good hedge against inflation with their prices falling?

IT’S a bloodbath in the cryptocurrency world, as investors get jittery over riskier assets amid heightened inflation and fears of a recession.

According to data from CoinMarketCap, the global market capitalisation of digital coins shrunk below US$1 trillion to US$934 billion in June this year. The most well-known cryptocurrency, Bitcoin, has fallen by about 70 per cent from its high of over US$67,000 in November last year, to just slightly above US$20,000 on Wednesday (Jun 29).

And critics are now saying that cryptocurrencies are not the safe hedge against inflation as crypto enthusiasts had made them out to be.

The Business Times (BT) examines why some crypto advocates have made this claim and whether it is standing on shaky ground.

Why do some say that cryptocurrencies are a potential inflation hedge?

If one were to consider the fact that Bitcoin has a limited supply of 21 million coins, with 19 million already mined, then in theory, high demand for something scarce should lead to rising prices.

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This is similar for gold, and why it has always been considered one of the strongest inflation hedge.

It stands in contrast with traditional fiat currencies issued by governments, as central banks are able to increase the supply by printing more of these, thereby decreasing their value.

However, the picture is more complicated than that.

To begin with, not all cryptocurrencies are the same, said Chia Hock Lai, co-chair of Blockchain Association Singapore.

While Bitcoin has a fixed supply, ether - another cryptocurrency used to power the ethereum blockchain - is inflationary as its supply grows every year.

Whether cryptocurrencies serve as an inflation hedge also depends on where one is living.

In countries where governments have not been able to manage their money supply so well, thus leading to hyperinflation, such as Venezuela, people have turned to holding cryptocurrencies.

“If the government cannot collect taxes, cannot control hyperinflation, and you are left alone to take care of your own affairs, people will lose confidence in the country’s currency and switch to something else,” said finance professor David Lee from the Singapore University of Social Sciences.

Does the claim still hold with crypto prices falling?

Before the crypto market crashed, it did seem that cryptocurrencies were a safe bet against inflation, as their soaring prices meant that crypto returns in 2021 came in higher than for energy, real estate and financial stocks on the S&P 500, as well as gold, according to data compiled by The Financial Times.

This also brought about a lot of interest from institutional investors in the cryptocurrency space, noted Chia and Lee.

“It’s likely due to the entry of more institutional investors in the recent 1.5 years, mainly looking for outsized returns, which has altered the structural relationship of crypto vis-à-vis other asset classes. It is now treated more as a risk-on asset by institutional investors than an inflation hedge, and more affected by macro developments such as expectations of interest rate hikes,” said Chia.

Data from the Bank of America showed that Bitcoin’s prices have largely correlated with movements in the S&P 500 as well as the Nasdaq since 2020.

“When (Bitcoin) prices behave more and more like Wall Street assets, when prices behave like the kind of asset classes fund managers invest in, the hedge against inflation will not be as effective,” said Lee.

“How much of the price is speculation, and how much of the price is a reflection of the value of the technology itself, which is trust,” he added.

If the correlation with stock market indices drops over a longer period of time, then the concept of cryptocurrencies as an inflation hedge could hold. This narrative is being tested now in the real world for the first time, hence more time is needed to see if it will pan out, noted Chia.

For him, the verdict is still out.

What does this mean for cryptocurrencies over the long term?

The main reason preventing cryptocurrencies from being a hedge against inflation is their volatility, said Chia. Cryptocurrencies are known for their huge swings in their short history.

However, Anson Zeall, former chair of the Association of Cryptocurrency and Blockchain Enterprises and Start-ups Singapore, said that investors should be focused on putting their money in assets they believe can generate returns higher than inflation to keep their purchasing power.

Pointing to how the US dollar has lost over 95 per cent of its value since the 1900s due to inflation, Zeall, who is also the former chair of International Digital Asset Exchange Association, said that every investor should be aiming to find assets that can beat the depreciation of the dollar. And that could include cryptocurrencies.

“That should be the mindset, and not to find something stable,” he said.

While the S&P 500 has an annual compound growth of between 8 and 9 per cent over the past 200 years with a downside volatility of around 40 per cent on average, Bitcoin’s compound growth per annum is over 150 per cent with downside volatility of around 70 per cent on average in the past 10 years.

“To beat the S&P 500 with Bitcoin, you simply need to invest a fairly small amount over the long term,” said Zeall.

“If you only put even just 1 per cent of your portfolio in Bitcoin, you wouldn’t feel the pinch (when prices drop). But it would be a good hedge on inflation over the long run,” he added.

At the end of the day, whether cryptocurrencies are a good hedge or not ultimately boils down to investor perception. If an unlimited supply of gold were to be discovered this day, normal investors would still view the asset as a hedge against inflation, said Zeall.

“The average investor needs to get more financially educated. They need to know historical returns and drawdowns, and use that to see how much to allocate.”