Testing Times for Gold and Bitcoin By Investing.com

© Investing.com

By Geoffrey Smith

Investing.com – These are testing times for the prophets of dollar alternatives.

After nearly two years of furious money printing to keep the US economy going during the pandemic, it appears that the US Federal Reserve is increasingly willing to take aggressive action to defend the value of the world’s reserve currency.

That’s bad news for all those who have bet that the pandemic would herald the final debasement of fiat currency. Cryptocurrencies, led by, are down more than 40% from their highs last year, while the – the most traditional asset as a “store of value” – is down almost 10%. And the news, for them at least, is likely to get worse before it gets better.

Inflation hedges work best not when inflation is highest, but at times when the central bank is perceived to be more “behind the curve,” too slow to stop a chain of events in the process. that wages and prices chase each other up.

That moment surely passed when Fed Chairman Jerome Powell told Congress in early December that it was “time to withdraw” the word “transitory.” The central bank had previously believed that the distortions generated by the pandemic in consumer prices would correct themselves in less time than it took for increases in interest rates to have an effect on the economy.

Since December at the latest, the Fed has been in catching-up mode, speaking harshly to persuade the market that it will not let the dollar lose its value. Powell told the Senate Tuesday in confirmation for his second term at the Fed that he will not let inflation “freak out.” That message is more important than the 40-year high that US inflation likely hit in December.

The market has only begun to make such compromises reluctantly, but it is already starting to make up for lost time. According to data from the Fed, market expectations for inflation in the five years ahead peaked in mid-October at 2.4%. By the end of last week they had already fallen to 2.15%.

Bitcoin’s poor performance against gold at this time – after an equally strong performance in the previous 12 months – has led many to conclude that digital currencies are not hedging assets at all, but rather risk assets, that they are they move more in line with equities and other speculative investments.

In a note to clients Monday, Morgan Stanley analyst Sheena Shah noted that Bitcoin traded with a 0.34 positive correlation with it over the past six months (a correlation of 1 would represent a perfect overlap), while it tended to move. in the opposite direction to gold. The negative correlation in this case was 0.1.

Shah illustrated that Bitcoin, in particular, appears to be more closely correlated with the global M2 money supply, a relationship that has been consistently maintained for the past eight years. This is a clear red flag for cryptocurrencies at a time when central banks that account for more than half of the world’s money supply are tightening their monetary policy.

This can frustrate anyone who has bought cryptocurrencies for their portfolio in hopes of diversifying their risk, but the fact is that portfolios in general have been significantly more leveraged in the last two years thanks to free money from central banks. Margin balances alone tracked by the US Financial Industry Regulatory Authority (FINRA) have risen 63% in the two years since the onset of the pandemic, reaching nearly $ 920 billion. Rising interest rates raise the cost of holding any asset through leverage, and cryptocurrencies – with no coupons or dividends to generate returns – are especially vulnerable to these cuts.

The same is, of course, with gold. Analysts at JPMorgan estimate it will be back at $ 1,520 an ounce – 16% below current levels – for the final quarter of this year, as rising real yields incentivize the switch to income-generating bonds. .

The difference, however, is that the use case for gold is much better established. Data from the World Gold Council suggests that the two major categories of end buyers, jewelers and central banks, were net buyers again by the end of 2021. Purchases by Indian jewelers increased above pre-levels. pandemic in November, while China’s gold imports reached their highest level since 2019 in October. Central banks in advanced economies were net buyers of gold in November for the first time since 2013.

The use case for Bitcoin, as we have argued here before, is totally less compelling. The only functions for which it consistently outperforms fiat currency in terms of ease of use are – even now, after a decade of rapid and well-funded innovation – for illicit transactions such as ransomware attacks and money laundering. Short-term demand is dictated by momentum or, in other words, speculation.

In the medium term, better regulation and a growing ecosystem of related assets, such as NFTs, can expand the use of cryptocurrencies to a point that puts a firmer footing under their valuation. Generational shifts can also mean that that segment of the population that simply doesn’t trust banks and central banks will eventually turn away from Keynes’s “barbaric relic” and turn to digital assets.

But in the short term, neither asset looks like it’s going to perform particularly well. The best that can be said is that the downside is more clearly limited for gold lovers than cryptocurrencies. Gold is best supported by fundamentals, momentum, regulatory certainty and, not least, history. While cryptocurrencies are about to be put to the test by a particularly sharp tightening cycle for the first time, gold has weathered all such cycles since the dawn of civilization.

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