When it comes to innovation and change, humanity in general has a tendency to want to think of the new in terms of the old. While this is understandable as the old is familiar and serves as a useful analytical springboard, it is also harmful; as we automatically attempt to shoehorn the new into frameworks that are not suitable for it.
Is this the case with Crypto?
QE has been a popular reason cited for the rise in cryptocurrencies.
But we know that QE doesn’t work and reserves don’t reach the broader population, so what is happening?
Another popular reason cited for cryptos’ rise in price and popularity is that the low yield environment created by central banks has forced investors to move into ever more risky assets in order to earn some kind of meaningful return.
This does have a ring of truth to it, after all interest rates are at historic lows and investors are pushing into assets they would have previously classified as “too risky”.
However, this does not take into account the fact that cryptos began as, and at this point continue to be, an asset that is primarily held by individual investors.
Individual investors simply do not have the same kind of access to the financial markets as professional money managers do.
Even if they did, very few have the time and resources to not just educate themselves on the subject matter, but also to be involved in markets to an extent where they gain enough experience to properly understand how everything works.
Consequently, individual investors think of investing very differently from institutional ones.
The primary consideration for most is how much interest they earn in their bank accounts; those who are more adventurous venture into stocks and/or real estate.
From this standpoint, would individual investors move into crypto assets because their banks are paying pitiful interest rates?
Possibly, but there is another way to look at it, which is that investors who have relatively low levels of capital tend to be more willing to jump at opportunities to make a quick buck.
Consider the reality:
An asset manager with $100 billion in assets, who owns a “safe” portfolio in this age of ultra low rates which yields 1%, will generate $1 billion.
For an individual investor with $100,000 in savings, that same portfolio will generate just $1000, which, obviously, will not have much impact on the individual’s life.
Absolute amounts matter a lot more for individuals than they do for institutions; it’s money that can fund the purchases of cars, houses, holidays, college tuition for kids, etc.
Hence, individual investors rarely think of yields in the same way financial institutions do, simply because the absolute amount they earn in interest income doesn’t really move their financial needle.
They don’t buy cryptocurrencies because their banks are paying low interest rates, they buy cryptocurrencies because they think their investment will net them a large multiple of profit – an amount large enough to change their lives.
As such, to the individual investor, owning crypto really isn’t about yields.
For better or worse, it’s about the hope and potential of making a life changing amount of money which allows them to break out of the wealth inequality trap that QE has exacerbated.
To be continued…
There is, of course, an even more important driving force behind the mind-blowing rise in the values and popularity of crypto assets – some investors actually believe in it.
Even then, QE has had some role to play in crypto’s meteoric rise… it just isn’t what everyone thinks it is.
The narratives that mainstream commentators have constructed around crypto focus on conventional economic views and thinking, erroneously brushing off crypto price moves as unintended consequences of central bank action.
Because of this central-bank-centric worldview, such commentary fails to see that crypto assets could actually be worth something to someone. Here, QE, bank reserves, and low interest rates have absolutely nothing to do with crypto’s value.
First of all, anything can be an asset, simply because anything can have value, even if it has little to no actual use. All that is needed is for enough people to believe that it has value and hence be willing to pay money to own it.
Yes, it is all about Paradigm again.
Similarly, the biggest (and loudest) criticism of crypto assets is the consequence of holding on to a different paradigm. Those who consider cryptocurrencies to be worth nothing because of their lack of intrinsic value are simply folks who firmly believe in the notion of assets needing to have value in and of themselves.
Because they cannot, or choose not to see perspectives that lie outside of their paradigm, they cannot see things from the crypto believer’s standpoint.
Through the eyes of the true believer, cryptocurrencies represent independence from a financial system that is built on flimsy fiat foundations. With this as the foundation of their worldview, it is only natural that they would seek an alternative asset with which to reduce their exposure to fiat currencies.
This leads us to where QE has had an effect on crypto, which is also, ironically, what both camps can agree on.
However, and even more ironically, their agreement is based on a common misconception of what QE is and does!
Broadly speaking, both camps are big believers in the narrative that QE = money printing; and therefore jacks up equity prices, gold prices and crypto prices, while grossly debasing the USD.
They aren’t, and are stuck on banks’ balance sheets.
Which means that the most likely effect QE has had on crypto markets is to increase the number of crypto buyers who are buying because of a false belief!
And therein lies the irony – who is doing whom a favor here?
The mainstream non-crypto believer driving up the price of crypto assets because they believe the Fed leaves them no choice, thereby enriching crypto believers in the process?
Or the crypto enthusiast who is providing these “fiat refugees” with a crypto safe haven away from fiat insanity?
In this mad world where even the people in charge don’t understand what they are doing, who really knows?
A major cognitive hurdle modern humans face is our strong predisposition towards categorization.
There are undoubted benefits to doing so, not least of which is that it aids in our evolutionary survival (Big teeth + Big claws = Category: DANGER!), but there are huge drawbacks as well, especially when it comes to dealing with innovation and new creations.
Cryptocurrencies provide an excellent example.
One of the (many) issues that Cryptocurrencies and their enthusiasts face in trying to bring the new technology mainstream is that the mainstream can only view Crypto in, well, a mainstream way.
A classic example of this is how Crypto is thought of in mainstream finance terms.
- Is it a “safe haven” asset?
- Is it a risk asset?
- Is it an asset that hedges against inflation?
- Is it a non-correlated asset?
- Is it a currency?
These questions all stem from the same source – the need to categorize; and not just out of habit or mechanical practice. It is the need to categorize in order to understand.
Put in another, very uncharitable way, mainstream folks cannot understand Crypto without first categorizing it into something familiar.
This can be generalized to: humans have great difficulty in understanding new concepts or inventions without first categorizing them, and therefore have to benchmark them against something that is already familiar.
But, is Crypto any of those things listed above? Unfortunately for people who can only think in terms of categories, the answer is ambiguous and quite possibly one that will infuriate them – it depends.
1. Is it a “safe haven” asset?
This truly is a matter of perspective, the question really should be – safe haven from what? Firstly, from a more general perspective, for those who consider very high levels of volatility the antithesis of what a safe haven asset is, and there are many who do, then Cryptocurrencies are not a safe haven.
However, for others who consider fiat currencies to be inherently self-destructive of their own value, and there are also many who do, then Cryptos can be a safe haven from fiat.
Interestingly, this point of view is also relevant to the traditional financial markets understanding of what a safe haven is. Conventional thinking views sovereign bonds as safe havens, especially those of major developed economies like Japan, Germany and the US.
Which is why every time there is a sell off in what the media deems to be “risk”, or “risky” assets, headlines will always include some reference to “strong buying in safe havens”, or “safe havens rallied in response”. They basically mean that the sell off was accompanied by strong buying in government debt, especially in US Treasuries.
Mainstream rationale is that these countries have large economies, are stable, and more importantly, can always tax their citizens more in order to pay off outstanding debt. Which is, if you think about it, an indirect way of saying that they do not believe that these countries will default on their borrowings.
But, that does not mean the probability of default is zero. The presence of fiscal hawks, and concern over high levels of borrowing in these countries clearly demonstrate this. (In Germany, the idea of borrowing is a debate in itself)
The more these countries borrow, the larger the specter of possible default will loom, and with default, or even a perception of possible default, comes massive currency devaluation.
Which is where Crypto-as-a-safe-haven comes in.
Bitcoin cannot default. Other “pure play” Cryptos (those that are built to be currency-like, excluding stable coins) are the same. They cannot default because the blockchain is not an entity that has creditors.
From this point in the thought process, if one is already a believer in Crypto, thinking of Cryptocurrencies as safe havens is only a small step away, volatility or no volatility.
To be continued…
Implicit in the question “Is Crypto a safe haven?” is another question: “Is Crypto a risk asset?”
Of course, how one answers the first will determine their answer to the second, at least when thinking about the question from a simple either/or standpoint.
Does it have to be either/or?
2. Is it a risk asset?
As explained in part 1, Crypto can be seen as a safe haven asset even with its heart stopping levels of volatility.
It simply depends on what one is seeking a haven from.
That being said, an important aspect of safe haven assets is their ability, or at the very least their perceived ability, to retain their value.
This makes intuitive sense, since an asset that could lose all its value can hardly be considered to be “safe” – investing capital into an asset for the express purpose of not losing that capital becomes a pointless exercise if so.
Which puts Cryptocurrencies in a strange position. On one hand, they provide an alternative to fiat currencies, but on the other, their levels of volatility puts the capital invested in them at risk.
For those who truly see Crypto as a refuge from the fiat system, the volatility isn’t much of an issue. This is because their alternative is a safe haven denominated in fiat, which in their minds is going to zero anyway (gold is a notable exception).
Of course, implicit in this rationale is that Crypto isn’t going to zero, which is what helps them ride through the volatility. However, from the standpoint of someone who does not share that same opinion or belief, i.e non-true believers, Crypto’s volatility precludes it from being a safe haven.
It is important to note that volatility tends to be a cyclical phenomenon across asset classes. As the Cryptocurrency market matures, we might well see levels of volatility come down from current levels, at least for the more established Cryptos.
Furthermore, during times of crisis, even the most stable of assets can experience extreme volatility. US Treasuries, for instance, experienced high levels of volatility when Covid shutdowns first swept across the world in March 2020.
This was due to a severe drop in liquidity as everyone hoarded their “safe haven” USTs, leading to one of the most liquid financial markets in the world seizing up.
Which raises an important question: does this mean USTs cannot be considered a safe haven? Clearly not, since many folks wanted and needed to get their hands on them, but no one was willing to sell.
Consequently, viewing an asset’s suitability as a safe haven is not as simple as just looking at how volatile it is – one has to understand the systems that underpin the asset, and how they are structured.
If, after gaining a thorough understanding of these systems, structures, and paradigms, an individual concludes that an asset’s volatility does not preclude it from protecting against larger systemic risk; then why can’t a safe haven also be a volatile risk asset?
To be continued…
Moving on with our discussion of the problems of categorizing Crypto, we come to what has emerged as an important question – do Cryptocurrencies serve as a hedge against inflation?
This question has become ever more pertinent over the decade or so of Bitcoin’s existence, as the world’s major central banks, the Fed, ECB, and BoJ have implemented round after round of QE. Since QE is widely thought to be money printing, even though it is not, mainstream narratives have become focused on the idea of fiat debasement, and the inflationary threat that poses.
A natural extension of that discussion is what assets to own as a hedge against such inflation – other than silver and gold, what could be better than decentralized Cryptocurrencies not issued or controlled by governments? Which of course begs the question, do Cryptocurrencies really hedge against inflation?
3. Is it an asset that hedges against inflation?
In order to investigate this question, we calculated the correlation between BTC and Personal Consumption Expenditures (PCE), as well as the correlation between Gold and PCE.
However, it is important to understand that Bitcoin has only been around for about a decade, and BTC is the oldest Cryptocurrency on the block. Out of those ten years, it has only been part of mainstream financial discussions for somewhere around 5.
Which means that there simply isn’t enough data with which to calculate longer term correlations between BTC and inflation.
As such, our little thought exercise is focused on 1 year rolling correlations over a period of slightly less than 10 years for both BTC vs PCE, and Gold vs PCE.
Correlations were calculated using the YoY returns of BTC and Gold (using monthly price data), and the YoY change in PCE; not real PCE, since real PCE is constructed to account for inflation.
As a side note, the choice of index between PCE and real PCE does not make much of a difference in how the trend in rolling correlations change for both BTC and Gold.
For those unfamiliar with how correlations work: in order for an asset to be considered a hedge against inflation, its price needs to increase as inflation increases.
This means a correlation coefficient above 0, with a maximum value of 1. Higher values represent a higher positive correlation.
Should an asset be negatively correlated with inflation, its correlation coefficient will be below 0, with a minimum value of -1. Lower values represent a more negative correlation. This means that the asset’s price moves opposite to inflation, and as such is not a good hedge against it.
As can be observed from the chart above, BTC has become increasingly positively correlated with PCE over the last 18 months or so.
The 1 year rolling correlation climbed from just above 0 in 2020, to reach a high of 0.7 in the first quarter of 2021.
This indicates that BTC has indeed proved to be a useful hedge against inflation, at least for the past 1 and a half years. (and on the basis of 1 year rolling correlations)
However, from a longer term perspective, correlations between BTC and inflation have constantly shifted between 1 and -1. That is, over the past 8 years, Bitcoin has spent some periods moving in tandem with inflation, and other periods moving opposite to inflation.
To be continued…
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