By Geoffrey Smith
Investing.com — These are testing times for the prophets of alternatives to the dollar.
After nearly two years of furious money-printing to keep the U.S. economy going through the pandemic, it seems that the U.S. Federal Reserve is becoming more and more open to aggressive measures to defend the value of the world’s reserve currency.
That’s bad news for all those who have bet that the pandemic would herald the final debasement of fiat currency. Cryptocurrencies, led by Bitcoin, are more than 40% off their highs of last year, while gold – the more traditional ‘store of value’ asset – is down nearly 10%. And the news – for them at least – is likely to get worse before it gets better.
Inflation hedges perform best not when is inflation is highest, but at times when the central bank is perceived to be furthest ‘behind the curve’, too slow in stopping a chain of events in which wages and prices chase each other higher.
That moment surely passed when Fed Chair Jerome Powell told Congress at the start of December that it was “time to retire” the word “transitory”. The central bank had previously believed that the pandemic-generated distortions in consumer prices would correct themselves in less time than it took for interest rates hikes to have an effect on the economy.
Since December at the latest, the Fed has been in catch-up mode, talking tough to persuade the market that it won’t let the dollar lose its value. Powell told the Senate at the confirmation for his second term at the Fed on Tuesday that he won’t let inflation become “entrenched”. That message is more important than the 40-year high that U.S. inflation probably hit in December.
The market has only reluctantly started to take such commitments at face value but is starting to make up for lost time now. According to Fed data, market expectations for inflation five years in the future peaked in mid-October at 2.4%. They had already fallen to 2.15% by the end of last week.
Bitcoin’s underperformance against gold in this time – after an equally sharp outperformance in the previous 12 months – has led many to conclude that digital currencies are not hedge assets at all, but rather risk assets, which move more in line with equities and other speculative investments.
In a note to clients on Monday, Morgan Stanley analyst Sheena Shah pointed out that Bitcoin traded with a positive correlation of 0.34 to the S&P 500 over the last six months (a correlation of 1 would represent perfect overlap), while it tended to move in the opposite direction to gold. The negative correlation here was 0.1.
Shah illustrated that Bitcoin in particular looks most closely correlated to global M2 money supply – a relationship that has held consistently over the last eight years. That is a clear red flag for crypto at a time when central banks accounting for well over half of global money supply are tightening monetary policy.
This may frustrate anyone who has bought crypto for their portfolio in the hope of diversifying their risk, but the fact is that portfolios in general have become significantly more leveraged over the last two years thanks to free money from central banks. Margin balances tracked by the U.S. Financial Industry Regulatory Authority (FINRA) alone have risen by 63% in the two years since the start of the pandemic to nearly $920 billion. Higher interest rates squeeze raise the cost of holding any assets through leverage, and crypto – without coupons or dividends to generate returns – is particularly vulnerable to such squeezes.
The same is of course true for gold. Analysts at JPMorgan reckon it will be back at $1,520 an ounce – some 16% below current levels – by the final quarter of this year, as rising real yields incentivize switches into income-generating bonds.
The difference, however, is that gold’s use case is so much better established. World Gold Council data suggest that the two big categories of end buyers – jewelers and central banks – both reverted to being net buyers in the latter part of 2021. Indian jeweler purchases rose to above pre-pandemic levels in November, while China’s gold imports hit their highest level since 2019 in October. Advanced economy central banks were net buyers of gold in November for the first time since 2013.
The use case for Bitcoin, as we’ve argued here before, is altogether less convincing. The only functions for which it consistently out-competes fiat currency in ease of use are – even now after a decade of rapid and well-funded innovation – for illicit transactions, such as ransomware attacks and money-laundering. Short-term demand is dictated by momentum or, in other words, speculation.
In the medium term, better regulation and a growing ecosystem for related assets such as NFTs may yet broaden the use case for crypto to a degree that puts a firmer floor under its valuation. Generational shifts may also mean that that segment of the population that just doesn’t trust banks and central banks will in time migrate away from Keynes’ ’barbarous relic’ to digital assets.
But in the short term, neither asset looks likely to perform particularly well. The best that can be said is that the downside is more clearly limited for gold bugs rather than crypto bros. Gold has better support from fundamentals, momentum, regulatory certainty and, not least, history. While crypto is about to be tested by a particularly sharp tightening cycle for the first time, gold has withstood every such cycle since the dawn of civilization.
Weekly Comic: Testing Times for Gold and Bitcoin