Bitcoin: What it Is, and What It’s Not!

20 May 2021

In the next few weeks, I will consider the future of money. In particular, I will evaluate the evolution of Central Bank Digital Currencies (CBDC), as well as the potential role crypto-currencies may play in the future monetary system. Today, let’s deal with the elephant in the room: Bitcoin! The world’s largest digitial currency has had a tough week, allegedly after Elon Musk discovered belatedly that Bitcoin mining is energy-intensive. Perhaps miners should relocate to Paraguay where hydro-power generates 100% of the nation’s electricity! It seems implausible the reknowned sustainability entrepreneur was unaware of this well-known fact. Hopefully, this is not reflective of the level of analysis of the participants in this space! A good starting point in identifying the fundamental drivers of its future value may be to consider what Bitcoin is, and equally importantly what it is not (at least not at the moment).

Is Bitcoin A Currency?

To be sure, Bitcoin has many qualities required of a currency: portability, divisability, limited supply, uniformity, and even its acceptability appears to be increasing. However, Bitcoin’s extreme volatility prevents it from playing the key roles of a currency: medium of exchange, store of value, and unit of account.

I am reminded of my Brazilian partner’s stories of her bus rides to school as a girl in Rio. As a result of the nation’s hyper-inflation, the pocket money her mother provided for the bus fare proved to be insufficient for the trip home in the afternoon (road trip tickets would have been a good hedging innovation!). Price volatility prevented the currency from being a store of value or medium of exchange. Not surprisingly, the cruzeiro gave way to the cruzado before the Real returned in its current form. Likewise, would one plan to buy a Tesla denominated in Bitcoin, if one is paid in another currency? As in Brazil, Bitcoin’s extreme volatility prevents it from fulfilling the key roles required of a currency (the Chart perhaps over-makes the point of Bitcoin’s volatility relative to the US dollar)

Similarly, Bitcoin’s fluctuations prevent it from being a reliable store of value. As central bank liabilities, mainstream fiat currencies can always be redeemed at par at the monetary authourity. In the past, currencies were backed by gold, which ensured money’s value. Now, we rely on trust. The intrinsic value of the US dollar, for example, relies on our acceptance of the US government’s pledge to always ensure redeemability. To be sure, this trust was not gained overnight, and would be lost quickly if monetary policy undermines the currency.

Bitcoin, on the other hand, is neither issued by a trusted authourity (some regard this as a virtue), nor backed by a valuable asset. Therefore, many believe the crypto-currency lacks any intrinsic value at all. Potentially, however, the transparent (albiet complicated and energy-intensive) block-chain technology used to verify Bitcoin transactions will gain public trust; thereby, allowing the coin to fulfill the role of a medium of exchange. However, at best, this will take time.

Digital Gold: Does Bitcoin Hedge Against Inflation?

If it’s not a currency (yet), some pundits have suggested that Bitcoin would replace gold in the digital world. Indeed, Bitcoin’s value is quite highly correlated with the gold price (0.65). But, is this plausible? Gold often plays an important investment role as a safe haven. Again, Bitcoin’s volatilty, particularly relative to gold, disqualifies the crypto from this function (Chart above).

Bitcoin’s finite supply, by design capped a 21 million units, is one of its limitations as a currency (unable to provide liquidity to an expanding economy). Once a flaw, enthusiasts now suggest the paucity of supply will allow Bitcoin to supplant gold as an inflation hedge. First of all, does gold provide protection against rising prices? The Chart above indicates there’s virtually zero correlation between inflation and gold prices.

Given BTC’s short history, it’s tough to be definite. But, the Chart above illustrates the link between Bitcoin and inflation is also very weak, although the correlation is higher than gold’s (0.25 versus 0.01 respectively). BTC’s link is better with high-frequency market-based measures of breakeven inflation (correlation 0.4). Overall, therefore, neither commodity is a good inflation hedge, but Bitcoin does a slightly better job than gold. The S&P 500, however, provides a roughly similar inflation hedge, without Bitcoin’s volatility.

Bitcoin bulls hail the crypto-currency’s independence from a centralised authourity, which may conduct profligate monetary policies leading to inflation and undermining the currency . Indeed, the rapid expansion of the US Federal Reserve’s balance sheet and the acceleration of the M2 monetary aggregate has coinicided with Bitcoin’s rally this year (Chart above). However, there are several things wrong with this theory. Firstly, the link between money supply and inflation has weakened in recent decades (see my blog “Global Money: Will the Bubble Burst?” for background). In addition, I expect the growth in the Fed’s assets and M2 will slow sharply in the coming year. Indeed, this has already begun. Finally, Fed policy has not undermined the US dollar, which has strengthened during much of the post-GFC QE period. When the history of the era is written, I expect the Fed will receive high praise, not criticism!

Speculative Asset…and a Volatile One!

If its not a currency (yet) nor an effective inflation hedge, what is Bitcoin? A speculative asset, which despite its elevated level of volatility (Chart above), has produced very high risk-adjusted returns (its Sharpe ratio is 4 times higher than the S&P 500).

The Chart above helps identify key Bitcoin price determinants. For example, BTC has especially high levels of correlation with the S&P 500 (another “risky” asset), gold prices, and inflation-adjusted US bond yields (high negative link).

What are the implications for Bitcoin and other risky assets in the period ahead? The Chart above indicates this year’s rise in US bond yields has been completely driven by rising inflation expectations (presumably beneficial for BTC). In the coming year, however, I expect US real bond yields will rise up to 100bp, reflecting booming global economic growth and bloated budget deficits (nominal yields could also rise towards 2.5%-3%).

The Chart above illustrates real US bond yields are the key determinant of the gold price. To be sure, gold may benefit from its safe haven status, if overall market conditions become more volatile. However, rising inflation-adjusted interest rates present a powerful headwind.

In recent years, while lofty P/E ratios suggested US equities were expensive, stocks appeared cheap relative to bonds. Morgan Stanley’s chart above, however, illustrates this is no longer true. Rather, the very low equity risk premium suggests US stocks will be more vulnerable to rising bond yields than in the past.

Therefore, financial market volatility is likely to increase in coming months, as bond yields rise and speculation widens regarding the tapering of Fed asset purchases. So-called risky investments will be most vulnerable, especially high-beta, speculative assets, e.g. Bitcoin.

Strategic Considerations

  • Crypto-currencies, including Bitcoin, may have an important role to play in the future monetary system. I will consider this issue in future blogs, although at this stage I favour Ethereum.
  • For now, Bitcoin should be valued and held as a high-beta asset, rather than as a currency or gold replacement.
  • Rising inflation-adjusted US bond yields are likely to lead to greater overall financial market volatility in the months ahead. Speculative assets, such as Bitcoin, would be at greatest risk, especially given its high correlation with real US bond yields and the S&P 500. Eventually, confidence in BTC’s verification procedure may grow; adding to its intrinsic value, which currently appears very low at present.