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Can Cryptocurrencies Protect the World from Inflation?

Cyclically, inflation has become a hot topic in different economies. After years of near-zero (or even negative) inflation rate, the world is entering a new inflationary phase. Consequently, investors need to find ways to protect their portfolios during such periods.

Our article will briefly explain how inflation can damage investment portfolios, a fundamental premise to the rest of the analysis. Going on, we will try to assess the power of cryptocurrencies to hedge inflation.

How Inflation Puts Investments at Risk

As many know, inflation is the overall increase of prices in an economy. Grasping the exact causes and effects of inflation is a complex topic that would deserve long and deep analyses.

Considering that the scope of our article is far more practical than that, we will keep the topic simple. We believe that the easiest way to understand how inflation works is by providing a real-life example.

Imagine you have invested $10,000 on the U.S. stock market and that the yearly inflation rate is 7%. If you manage to gain 5% on your portfolio in a year, you may find yourself losing money.

Your nominal rate of return of 5% is lower than the annual inflation rate (7%), leading to a real return of -2%. Again, we ask the reader to consider this example as a mere school-book exercise to simplify how inflation works.

Inflation may create a monetary illusion, increasing nominal investment returns and higher wages. We lose money whenever the nominal return or salary increase is lower than the inflation rate.

Inflation leads to a loss in the purchasing power of money, pushing humanity to find a hedge asset against it. Before mentioning cryptocurrencies, we’ll spend a few words on the most popular hedge asset in the world: gold.

The Role of Gold in the World Markets

When we read analysts mention that Bitcoin may be the new gold, we may find it hard to understand the concept. For this reason, we need to take a step back and understand the exact role of gold in the financial markets.

Several studies prove a positive relationship between gold prices and inflation rates in the United States.

In 1944, the gold rate equaled $35 per ounce with the coming into effect of the Bretton Woods Agreement. In the 70s, the U.S. decided to abandon the system, leading to a devaluation of the Dollar and gold appreciation.

During periods of inflation and crisis, the price of gold tends to climb. After the global financial crisis that began in 2007, for example, it peaked at $1,900.

Owing to several geopolitical problems such as Brexit, gold entered a rally mode since the end of 2018. Recently, Covid-19 consequences and geopolitical instability have brought a new increase in the metal’s price.

Many investors seek to move their money into safe-haven assets in high volatility periods on the market. Consequently, when analysts wonder whether Bitcoin can be the new gold, the matter is straightforward.

Experts have different opinions on the role of cryptocurrencies to hedge inflation. The following section proposes a rational comparison between gold and crypto-assets.

A Comparison between Crypto and Gold

Gold has been a medium of commerce and wealth storage for thousands of years. Cryptocurrencies appeared only in 2009 and quickly gained worldwide awareness.

The gold trading, weighing, and tracking system is flawless. In other words, it is hard to fake the system and heavily influence it. Generally, traders do not buy physical gold but derivative products on precious metals.

Crypto’s encrypted and decentralized architecture makes it harder to steal or counterfeit. The regulatory infrastructure to assure user safety is lacking, and cryptocurrency’s pseudonymity does not make authorities’ work easier.

Gold is a popular asset in various areas, including cash, luxury products, electronics, etc. Gold’s capacity to hold value when other assets collapse is due to its large utility.

Crypto utility is limited. At the moment, we appear to be quite far from cryptocurrency mass adoption. However, no one can deny that crypto made essential steps towards becoming a payment system.

Let’s think, for example, of stablecoins. The idea of introducing a coin with a stable value based on a fiat currency helped businesses adopt it. Furthermore, there are particular situations in which fiat money is out of reach, and crypto can help small economies.

Therefore, dismissing entirely crypto utility would be a mistake, as it would be ignoring several factors. However, what is history teaching us on the role of cryptocurrencies against inflation risks?

Looking at the Data

So far, cryptocurrencies have not given a particular sign of being an inflation hedge. If we exclude limited cases, traders are not treating BTC and other coins as gold.

The data clearly points at the lack of correlation between Bitcoin and gold prices. As analysts at BofA put it, BTC acts more and more as a risky asset in investors’ portfolios.

When the market turns bearish and the inflation rate increases, traders tend to avoid risky assets. Typically, investors prefer to move their money toward safer and more stable markets, such as gold and bond assets.

The fact that BTC and other crypto tend to collapse when Wall Street records a bad day is an interesting behavioral indicator. BofA uses this evidence to support the idea that the crypto industry is not ready to act as an inflation hedge.

Final Thoughts

The crypto market must mature, with a fundamental transformation that must occur for coins to become a store of value. When the crypto market has more long-term investors than short-term speculators, BTC will play a new role.

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The long-term involvement of institutional investors may help the transformation of the industry. The same is true for regulation, which is currently lacking globally. In the meantime, the role of crypto as an inflation hedge appears limited.

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