Crypto May Be An Imperfect Hedge Against Inflation

Cryptocurrency has now become a highly popular refuge against growing rates of inflation. The effectiveness of cryptocurrency as a form of investment is what people fear the most.

Can cryptocurrency protect against inflation?

In the 1980s, the main thing that Wall Street investors were concerned about was inflation. In the past, we knew about inflation triggered by abandoning the gold standard in 1971; misguided monetary policies; supply-side shocks because of the oil embargo of 1973, and perverse government policies like the controls on prices and wage interest rates.

For investors, the message became clear -- they need to abandon bonds and stocks; choose hard assets such as real estate and gold; avoid relying on financial institutions and invest in nations with stronger currencies like Germany, Japan, and Switzerland.

Nowadays, fears about inflation are different, and numerous investors are unsure if they can still rely on hedges from the 1970s. For investors afraid of inflation, cryptocurrency has become a refuge that is increasingly popular as both the newer crypto assets and Bitcoin's "digital gold" are designed to not just be inflation-proof but can also capitalize on the increasing prices.

Could crypto be a speculative play or is it here to stay?

In recent years, cryptocurrencies have attracted speculators due to their dramatic price movements. Yet, for traditional investors, can crypto be a long-term case from a practical standpoint? A question most people want the answer to.

Since 2011, the price of bitcoin has surged from less than $1 to more than $60,000. There are numerous factors why bitcoin had a strong long-term performance. Even if the path was not certainly straight up, as there were several bull and bear markets along the way, demand has significantly increased in the past decade. Yet, there is now just a fixed supply of 21 million bitcoins and most of it is already mined. Because of this, the price increases.

However, at a granular level, numerous factors have driven the run-up in recent quarters. When it comes to technology, there have been recent developments like the rise of DeFi (decentralized finance), which is the alternate financial system that uses public blockchains instead of financial intermediaries like banks, custody advancements that drove up the demand and the recent bitcoin halving.

When it comes to the ecosystem, large businesses have announced to invest in bitcoin, the initial public offering of Coinbase drove a lot of attention to the space, and famous consumer fintech apps allowed it to become easier to pay, buy, and sell with crypto. Because of all these, crypto is here to stay.

People may undoubtedly experience bull and bear markets in the future. Still, the technological feat involved in solving digital innovations and scarcity is now happening in space. Cryptocurrency has brought about new internet and financial system that would coexist with the existing one. Even if the ecosystem has rapidly grown in the past few years, it is still in a nascent stage.

The most innovative cryptocurrencies nowadays are those that use tokens to build new communities or networks and give incentives for adoption. The two applications that are recently in high demand are non-fungible tokens and "yield farming."

Yield farming is a kind of lending activity wherein a person with crypto assets lets another person borrow them to generate profit. It can be a vital building block of the financial ecosystem to have a liquid market that has active lenders and borrowers. Because of that, yield farming can help build a leg on the crypto stool.

Since non-fungible tokens are not interchangeable and unique, they can consider innovating around digital scarcity and have this applied to the use case of collectables.

People's interest in crypto investment

Just like what people witnessed in the traditional markets of equity in the past, many new investors are entering the crypto market. This is great in the long run as market participation is vital in compounding wealth over a lifetime. It can certainly be risky for some if they are not fully aware of what they are investing in. However, at the same time, since it is relatively easy to understand cryptocurrency's use case as digital storage of value, it can be something that investors want to have in the existing market environment.

Crypto's first significant use case is that it digitally stores value. In the upcoming years, we may see other use cases turn into something more prevalent, especially now with large platforms like Square and PayPal are allowing users to get into the ecosystem by accepting it as a form of payment.

Moving in tandem

Cryptocurrencies have tracked inflation higher this year because of disruptions in the supply chain. However, a lot of people believe that this may be transient. If that may not be true, and if cultural changes and elevated rates of disease infections because of the pandemic have permanently disrupted the people's willingness to work in large groups and reduce economic efficiency, there will be fewer and fewer services and goods available.

In case this may be your fear, slow economic growth is the biggest concern and not inflation. Crypto may protect the inflated supply of money, but it cannot create more services and goods. A lot of crypto ideas are technology start-ups that were implemented to be decentralized autonomous organizations instead of traditional corporations. Start-ups can only thrive in expanding economies and not stagnant ones.

These crypto ideas are dedicated to bypassing or improving supply chains, and workers may prefer those that offer employment after the lockdowns. These can be great investments for venture capital, but they may be too risky to become inflation hedges. Global Issues in the supply chain can drive inflation in emerging markets like Europe and China as they are all elevated. The other global threat to the currencies' value is international tension.

Compared to traditional finance, crypto is advantageous as it can soar whenever there is financial conflict. In this aspect, it may be best to bet on the most established coins, which are Ethereum and Bitcoin, as there are large holders in every country. It would also be great to invest in crypto with strong privacy protections like Dash and Monero.

In the U.S., most investors are focused on U.S.-centric fears of inflation like loose monetary policy and increasing government budget deficits. For 10-year treasuries, the breakeven rate of inflation is at 2.5% annually. This suggests that the market thinks that future inflation could likely be at levels that were considered normal before the financial crisis of 2008. Even if recent inflation rates were high, the average rate annually since 2006 was only at 2.2%. The treasury yields on securities have remained quite low, and in some key areas like energy, they appeared to have peaked and may be in decline.

People who are concerned about the inflation of the U.S. dollar may simply choose to move their investment to other currencies and countries that are better at monetary and fiscal management. For any nation, it would be best to consider crypto, which is why Bitcoin was created in 2008.

All in all, it is believed that anyone who feels worried about inflation should consider crypto as an option as this can protect against some scenarios on inflation and take advantage of the others. It may not be a magical hedge that can be used against inflation.