Precious metals have long been considered hedges against inflation.
Even stocks have been regarded as a good asset class that protects investor wealth against inflation. However, it seems that these traditional views are being altered, as a new breed of investors believe that cryptocurrencies can fulfill the role of an inflation hedge.
Crypto investors and enthusiasts tout cryptocurrencies such as Bitcoin and Ethereum as good hedges which one should add to their portfolio.
This viewpoint has of course led to heated debates within financial circles pitting analysts and portfolio managers against each other on the notion of cryptocurrencies being a viable way to protect wealth and purchasing power.
Though both sides of the argument seem to have valid reasons to support or be against using cryptocurrencies as an inflation hedge, the onus rests on the investor to take the most financially responsible decision that would enable them to achieve their investment objectives.
To do this, let us look at reasons why and why not cryptocurrencies can be used as a hedge in your portfolio.
3 Reasons Why Cryptos Make a Good Inflation Hedge
Higher return rates: The return rates from cryptocurrencies have far outperformed other traditional inflation hedges such as gold and silver.
While Bitcoin and Ethereum have returned 25% and 200% respectively YTD, gold has largely traded flat. In the last 5 years, investments in Bitcoin and Ethereum have returned over 6000%, (Ethereum has appreciated by over 19,000%) while investment in gold has just 50%.
1. Value of dollar is falling
It is an open secret that the dollar is losing its purchasing power.
Perhaps the pandemic exacerbated the weakness of a currency without the backing of gold. 20% of all dollars in circulation was printed in 2020. Excess dollar liquidity from the Federal Reserve has meant that more money is chasing few goods due to the drop in production rates in the United States.
This has led to prices of commodities and staples increasing, without a corresponding drop in purchasing power.
2. Cryptos are scarce and limited which increase the value
Some cryptocurrencies such as Bitcoin derive their value from their limited supply.
This scarcity is what would make Bitcoin’s value increase over time. This is unlike fiat currencies which have an unlimited supply. The world reserve currency, for example, is not backed by gold.
This implies that the Federal Reserve can print money out of thin air as we have seen during the pandemic. This lack of limited supply would affect the value of fiat currencies in the long run.
3. Traditional assets are becoming more correlated with each other
Apart from gold, other asset classes such as stocks and real estate have proven to be good hedges against inflation.
However, new research is showing that these assets are becoming more correlated i.e., assets are now reacting the same way to macro-economic conditions. This has dampened the benefits of portfolio diversification, and reduced long-term gain for investors.
As such, Bitcoin and other cryptocurrencies make up a good investment which can be inversely related to prevailing economic conditions or any other asset class.
3 Reasons Why Cryptos Don’t Make a Good Inflation Hedge
1. Volatility
This has been the most potent argument against cryptocurrencies being used as a store of value.
The volatile nature of cryptocurrencies which could drop as much as 305% in a single day has raised questions on its ability of being used as a store of value that is meant to preserve value.
2. Concentrated ownership
Though cryptos thrive on decentralization, there is nothing about their ownership structure that suggests that they are decentralized.
About 95% of Bitcoin is controlled by about 2.4% of accounts. This high ownership concentration makes the asset vulnerable to volatility and sharp price swings when any of the whales decide to take a position.
3. Not a proven inflation hedge
While other inflation hedges such as Gold and commodities have proven over centuries that they can be a good store of value, Bitcoin has yet to do so.
If recent data is considered, the crypto enthusiasts seem to be losing the store of value argument. Inflation has been on the rise in 2021, which has seen commodities enter into what analysts describe as a super cycle.
While prices of commodities such as copper, wheat, lumber, and oil have been on the increase, Bitcoin on the contrary has been plunging. The crypto asset lost about 30% of its value in the month of May while inflation was ticking up.
As such, Bitcoin and other cryptocurrencies do not make a compelling case as inflation hedges when compared to commodities and equities which seem to provide better correlations to inflation.
How to Play it
As investors, you are wondering if Bitcoin would make a good inflation hedge for your portfolio.
It all comes down to how you decide to play it. If your perspective is short-termed, then cryptocurrencies are not a good hedge for your portfolio. This is because the asset has shown repeatedly that it is volatile with sharp price movements.
As such you need to have an iron stomach to be able to maintain your position in cryptocurrencies. The asset has also been quite sensitive to tweets, and price action rather than fundamentals which could cause serve losses to your portfolio in the short term.
On the contrary, if you have a long-term view, then cryptocurrencies are a good hedge for your investments. If we consider the average return for bitcoin, Ethereum, and dogecoin in the last five years, the gains are exponential.
Litecoin has returned over 3,500% in the last five years, while Ethereum has surged by over 19,000%. Dogecoin has a whopping 160,000% return. A long-term perspective enables you to stomach the near-term volatility.
As such, depending on your investment objective, cryptocurrencies can either be a good inflation hedge for your portfolio or not.
