How Bitcoin reacts to U.S. dollar inflation and economic turmoil?

Precious metals used to be the best way to protect your portfolio from natural value deterioration, but Bitcoin is changing the game.

As inflationary monetary economics and liquidity traps come into focus with zero-interest rate policy or even negative interest rate policy spreading throughout the world, many are looking to Bitcoin as an inflationary hedge.

Panic over the coronavirus pandemic, which has been going on for more than several months in the world markets, was stopped only by a massive intervention by the U.S. Federal Reserve and a reduction in interest rates in the United States. The disease factor is superimposed on the cheap oil and the lending of the financial sector. Bitcoin, along with other assets, got into this “perfect storm” and lost almost half its value in just two days on March 12–13. For some, it was proof of inability of the first cryptocurrency to play the role of “digital gold”, while others insist that with continuation of the crisis BTC will become a safe asset for investments.

The global stock market had been in a rapid decline almost for a month. Initially the main negative factor was the fear of fast virus spread and, consequently, a decline in economic activity. However, on March 9, Black Monday occurred in the markets, when the leading indexes closed with a drop: Dow Jones and S&P 500 lost about 8%, Nasdaq — 7% and FTSE — 8%. Asian markets behaved in the same way.

The blame for all this lies in the sharp drop of oil prices (from 25% to 34%) due to Russia’s exit from the OPEC+ deal. Russia refused once again to reduce the volume of oil production at the suggestion of Saudi Arabia, which was caused by the reduced demand for oil in China due to the pandemic. On March 9, after a weekend, the stock market reacted with a collapse.

Crypto market capitalization: 60% decline in two days

For a long time, cryptocurrencies kept out of panic on the stock markets, and even the decrease of Bitcoin price from $9000 to $7800 on March 9 could not be called dramatic. However, everything changed a couple of days after “Black Monday”.

On March 11, the World Health Organization (WHO) recognized сoronavirus as a pandemic (global spread of the disease). After that, from 12 to 13 March, the crypto market collapsed by 60%, and the price of Bitcoin sank to the key support area of $3900-$4000.

For a long time, Bitcoin was seen as “digital gold”, a risk hedging instrument with a negative correlation to the stock market. According to this logic, if the stock market goes down, capital should flow into BTC, increasing its value.

However, the events of March 12–13 showed that regardless of the reasons on the global level, Bitcoin is considered a high-risk asset, which is disposed of during the crisis, not vice versa. Accordingly, the first crypto asset is closely correlated with the stock market.

Not “digital gold,” but an alternative asset

CoinDesk Research Director Noel Acheson believes that due to this behavior Bitcoin has lost the title of “digital gold” and possibly forever. What’s more, it was only like this for his followers. However, in her opinion, the “Black Monday” showed that there are no “safe havens” in the financial world:

“Gold and U.S. government bonds, assets that the market traditionally turned to during the turmoil, also fell, largely due to shrinking liquidity. Investors have struggled to get into the dollar, but even such an asset, which has the status of a “safe haven,” can be threatened as the world economy slips into recession and geopolitics challenges monetary policy and belief in sovereign debt.”

“In a world worried about income”, a Bitcoin-type asset, the value of which does not depend on current cash flows, may take a firm place among so-called alternative assets. Investors perceive such assets as an opportunity to compensate for the forthcoming “market fundamentals shift”, and Bitcoin, independent of macroeconomic indicators, will come in handy.

As CEO of Xapo Wences Casares said in a comment for Fortune, Bitcoin is a very young asset. Once it will become “digital gold”, but now it is “baby” and it is unknown how long the period of maturation will last. Scalar Capital’s managing director Linda C. also agrees with this view: in the long run, Bitcoin will become a “safe haven”, but now it behaves like something paradoxical — both a safe and speculative asset.

A big opportunity amidst the era of inflation

But not everyone agrees that the first cryptocurrency lost the role of “digital gold”. Founder of Avanti Financial Group Caitlin Long in a podcast with Anthony Pompliano expressed the opinion that it is impossible to judge the ability of Bitcoin to be a “safe” asset for a period of 1–2 weeks. She also noted that this type of assets are usually sold out in the first place because they are not tied to derivatives, which means that they can be cashed:

“Margin trading has really affected [such assets]. If you own physical gold or private keys to your crypto assets, they are yours. You have full ownership of these assets.”

The excess of leveraged instruments as early as 2019 was noted by BitMEX analysts. According to their research, the volume of margin trading by asset management companies in the U.S. bond market and derivatives based on fixed income securities has reached critical values. Under such conditions, a sharp drop in the markets will lead to a massive liquidation of positions and lack of liquidity.

BitMEX recently released a new study stating a “new economic reality”. According to the researchers’ findings, central banks have exhausted their ability to influence the economy through interest rates (on March 15, the U.S. Federal Reserve reduced interest rate to 0–0.25%). However, the social obligations of the states are growing, and with them the state debt, which will be covered by the emission of currency by financial institutions. In the U.S. this will lead to constantly rising inflation, as in the 70s. For example, in 1979–1980, dollar inflation reached 15%.

This will be a “shock” for Western economies that do not remember high inflation for the past 30 years. In the new environment, traditional safe assets, such as gold, will take on special significance.

“This could be the greatest opportunity that Bitcoin will have in its short life”.

What about a stock market?

The high correlation between Bitcoin and traditional finance in recent months remains a fact. Although there are some nuances.

Firstly, Bitcoin is not always so closely linked to the stock market, as noted in a study by Longhash. And this trend has been observed for several years. In 2014, the correlation was quite the opposite, and since 2018 it has been consistently approaching zero:

Secondly, since the beginning of the year, the returns of BTC and ETH have been moving in the positive zone, while both gold and stock market had lower returns. Compared to the price at the beginning of the year and even after the collapse of March 13, Bitcoin lost less than stocks (the same S&P 500 index) or WTI oil:

As Bitcoin is now “tied” to financial markets, the Federal Reserve’s measures have been beneficial to the crypto market: a reduction of interest rate on March 15 and massive purchases of government bonds as part of a “quantitative easing” policy have stopped panic and closed stock markets in the “green zone”. At the same time, by March 20 Bitcoin price had recovered to the level of $6500.

Last few months give hope for the recovery and rapid growth of a crypto market thanks to the correlation with the stock market. However, BTC continues to swing on waves of high volatility, and if the high correlation persists, new crashes in the global economy will respond more strongly to cryptocurrencies.

Regardless of the price of digital assets, the business associated with a blockchain and cryptocurrencies is at risk of being affected: Morgan Stanley and Goldman Sachs predicted a recession and adjusted the global economic growth to 0.9–1.25% in 2020. It is not yet known how the economy will behave when the coronavirus pandemic continues and when the spread of the disease will end. Some observers point out that Bitcoin could not protect itself from coronavirus panic, but it should play its role as a protective tool after the Fed turned on its printing press, and government bond yields are approaching negative values.

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Andrey Costello

Andrey Costello

Bitcoin-maximalist. Optimistic family man and miner with six years of age. I write about complicated things from the future for people of our days.