In today’s Exponential Investor:

  • What kind of “hedge” is crypto?
  • The link between crypto and inflation
  • How to invest when inflation is high

Does inflation affect cryptocurrency?

A war hedge. A financial crisis hedge. An inflation hedge…

These are some of the labels that have been given to crypto over the past couple of years.

There’s evidence supporting the first two labels.

For example, Russia’s invasion of Ukraine led to a surge in crypto trading activity in the latter. Trading volumes increased by 107% between the start of the war on 24 February and 11 March, showing how bitcoin can become an escape route for capital during uncertain times.

During the pandemic, bitcoin’s price sky-rocketed, rising from $5,165 on 13 March 2020 to its all-time high of $68,800 on 12 November 2021.

As you’re probably aware, inflation is surging in the global economy right now. In the UK, the current inflation rate (year on year) is a notch above 10%.

In response, central banks are hiking policy interest rates in an attempt to cool inflation down.

Higher policy rates mean you can get a better return on “safe” assets, such cash or bonds, so investors flock to these. Riskier, more volatile assets, such as crypto, then become less popular. So demand for crypto assets then falls, leading to lower prices. We’re seeing elements of this in the crypto market now.

Of course, there are other reasons for crypto’s demise, such as a broader risk-off sentiment and a changing regulatory landscape, but that’s for another day. Conversely, meagre returns on safe assets, caused by low interest rates and low inflation, may lead to higher demand for riskier crypto assets.

Therefore, inflation does affect cryptocurrencies. But considering crypto a hedge is rather more subjective.

Think about what a hedge is. A hedge is designed to protect the declining purchasing power of money.

Put it this way: if you had bought one bitcoin on this day one year ago, it would’ve set you back $46,300. Right now, that $46,300 has become $21,080 due to the decline in bitcoin’s price.

That’s a drop of 54.5%.

If you left $46,300 in your current account, and assuming an inflation rate of 10%, in real terms it would be worth $41,670.

Given market conditions, it’s fair to say that bitcoin isn’t an inflation hedge at the moment, particularly when it’s drained your purchasing power at more than five times the current rate of inflation.

However, this is why it’s very important to consider time horizons. Although bitcoin isn’t an inflation hedge now, in three years’ time, it could be.

Say you bought a whole bitcoin today for $21,080. Imagine it goes on a bull run, and reaches $63,240 three years from now. That’s a 200% gain from its current price.

Then you put $21,080 into your current account. Assuming inflation gradually tapers off and hits an average rate of 6% over the three years, in real terms this will be worth $18,300.

Clearly, in this instance, bitcoin has preserved, and even increased, your purchasing power, whereas inflation has brought it down.

So whether bitcoin is an inflation hedge is purely subjective. It all depends on how long you seek to hold it.

The longer you hold it, the more of an inflation hedge it could turn out to be.

Will crypto cause inflation?

Not really.

If bitcoin increased in price, it would create “paper” (or unrealised) wealth for the cryptocurrency’s  holders. This wouldn’t directly create any inflationary pressure, for example in terms of the US dollar, because a rising dollar value of bitcoin doesn’t lead to the creation of new dollars.

If someone realised their paper gain from bitcoin, they would be taking the dollars from the new bitcoin buyer, who would then be left without that amount in dollars. So, any direct impact on inflation would theoretically be negated.

However, crypto could indirectly affect inflation.

If bitcoin holders sold bitcoin after its price skyrocketed, each would be left with more disposable income. They could then spend this extra income on goods and services, leading to an increase in prices if the economy is operating at full capacity.

To have any meaningful impact on inflation, this would nonetheless have to be done by thousands, if not millions of people.

Even so, it assumes that most of the gains from bitcoin would be used for spending rather than saving. So it’s more of a hypothetical extreme.

In the main, crypto will not cause inflation.

What are the risks?  

Investing in cryptocurrency brings some inherent risk.

Due to their decentralised nature, cryptocurrencies are prone to volatility. By de-centralised, we mean there is no central authority (such as a central bank) to bring price stability when things get a little wild.

Crypto is open source, with its value being left to market forces. You can learn more about what affects the prices of cryptocurrency here.

With this in mind, you should approach the crypto market with respect and caution.

And, given the ongoing crypto winter, with bitcoin trading at a figure three times smaller than its all-time high, there’s even more reason to tread carefully.

Only invest money that you can afford to lose, and, if you can proceed, think long term.

Are there alternatives to invest in as well as cryptocurrency?

There are several other investment alternatives aside from cryptocurrencies. These include stocks, exchange-traded funds (ETFs), bonds and investment funds.

For simplicity, we’ll consider which type of stock can provide the best hedge against high inflation.

According to investment bank Goldman Sachs, dividend-paying stocks tend to fare better than the rest of the market during periods of high inflation (above 5%).

Typically, many dividend-paying companies are utility and consumer-staples companies. Because they have reliable revenue streams, they can afford to pay consistent dividends to shareholders, whatever the weather.

For example, if you look here, you can see a list of companies’ dividend yield predictions over the next 12 months (known as the forward dividend yield). The dividend yield is the yield paid out as a percentage of the company’s share price.

As you can see, some dividend yields are predicted to go at a faster clip than the UK’s current inflation rate of 10.1%. As a result, investing in dividend-yielding companies can offset the impact of inflation. Regardless of whether the company’s stock price goes up or down, you’ll receive dividend payments as long as the company continues to disburse them.

However, bear in mind that the shares can also drop in value, so a dividend yield may be offset with a capital loss.

Should you invest in cryptocurrency as a hedge against inflation?

As shown above, if you are a short-term investor, then you should not invest in crypto as a hedge against inflation.

Given the current state of the crypto market, it’s likely that losses on crypto assets could outstrip losses from inflation.

However, if you’re a longer-term investor, crypto could provide more of a hedge, especially when you consider its long-term potential.

Crypto is now being adopted at a retail, institutional and sovereign level. It’s a new system of money that provides a better way of transferring value in terms of speed, security and cost.

When buying crypto, you should think of it as something that allows the secure and efficient transferring of value. The potential capital gain to be had is a by-product of this.

Until next time,

Elliott Playle
Contributing Editor, Exponential Investor