Bitcoin as a Hedge Against Inflation

In order to properly assess the suitability of bitcoin as a hedge against inflation, we first need to look at how this strategy is used and what it seeks to accomplish. There are two main ways to hedge against inflation, one that seeks to hedge against it with a blanket strategy which does not vary according to the amount of inflation present, and one that does vary its approach depending on the circumstances and the particular inflation risks that are actually present.

Almost all the hedging that is done is of the general variety, where one simply holds the hedge in some proportion of one’s portfolio to look to ease the risk of inflation should it manifest. This static approach is well loved by investors and advisors generally, where you simply set a path for yourself and just stick to it regardless of how circumstances change.

Bitcoin as a Hedge Against InflationThe rationale that is used here is that it is never seen as suitable to adapt your strategy to anything, whether that be with timing your stock positions or timing your hedges. To justify this, it is assumed that trends cannot be predicted and therefore the best approach is to just try to build in hedges to handle these future events.

However, this is not really a sensible view, as we can certainly know quite a bit about the trends of various things, and if we can never predict trends we should never be investing either if it is all a crapshoot, it is a view that the overwhelming majority of investors buy into.

We could call this blanket approach general hedging, where for instance, we might want to hold a certain percentage of our portfolio in bonds, or precious metals such as gold, or nowadays, even cybercurrencies such as bitcoin. With general hedging, neither the degree of need or appropriateness of the hedge or the performance of the hedge factors into the decision process.

These decisions are made once and for all depending on how much protection we are seen to need, and there are cases where this gets adjusted according to one’s particular situation, hedging more as we get older for instance, but we never use any sort of market data as an influencer.

In spite of our having a very good idea about the state of inflation, with a lot of effort and resources being put into forecasting it, general hedging does not concern itself with such things, and will look to hedge the same way against inflation when it is very low, and presumably, when it is very high as well.

What does tend to happen if inflation gets too high is that people will abandon their general approaches and purposely hedge more, in the same way as they often will try to time markets when things get bad enough. Without the proper skill though, this usually does not work out too well, but the biggest problem with these interventions when in crisis is that they wait far too long to intervene.

If we wish to actually hedge against inflation, this should not be a mindless effort where you do things like run a calculator based upon your age and arrive at a magical figure that is going to protect you appropriately in all circumstances. The very idea of such a thing doesn’t even make much sense actually as the need for hedging does vary and does vary a lot.

How Particular Investments Need to be Hedged Against Inflation

The first step though is to decide how much hedging that we actually require generally with a given asset. Companies who we may hold stock in are themselves somewhat sensitive to inflation, and we may therefore see stocks as needing to be hedged against it. As it turns out, stocks are the best hedge against inflation there is, as they widely outperform inflation over time.

The price of stocks actually is a function of how much money people are willing to put into them, and especially into stocks in general, and inflation increases the amount of money available to be invested in stocks. As long as the market is in an upward trend, that’s what matters here.

We do need to hedge stock positions though, but we aren’t hedging against inflation, we are hedging against price declines, bear markets in other words. When stocks are in bull markets, there’s nothing better to be in, but when they are in bear markets, there’s nothing worse to be in.

Inflation can play a role in bull and bear markets but it’s not the inflation that’s the danger here, it’s the bear market itself, so that is the appropriate focus for any stock hedge.

Bonds actually do need this hedge, and needs it like nothing else does, because there’s nothing that will devalue the price of bonds and water down their interest payments like rising inflation. Buying bonds is actually a bet that inflation will go down rather than up.

Cash is also very much exposed to inflation, as inflation devalues it directly, and inflation is actually the only thing that devalues it. A big reason that we invest in things like savings accounts and certificates of deposit is to lessen the losses that arise from inflation, where the buying power of a certain amount of money is reduced each year by the inflation rate.

Savings vehicles don’t really hedge that well against inflation though. Certificates of deposit don’t change with higher interest rates or inflation, and function more like bonds, but bonds that you have locked in, locking in your exposure to the risk of increasing inflation essentially.

Savings accounts do have their rates move with inflation, but just lessen the blow of it, instead of making up for it in total and perhaps even providing benefits that exceed it. In order to receive even a meaningful degree of protection from inflation in a savings account, we would need to have most of our money in these accounts, which is not a good idea generally due to their losing ground to inflation regardless of the circumstances as well as their very low yields.

Hedging Against Inflation with Bitcoin

To hedge against inflation successfully, we need something that actually tends to go up in value during inflationary periods. In particular, we’re looking for things that tend to go up in value generally and actually are going up in value at the time of consideration, meaning that we are trading with the trend and not just guessing or assuming too much.

Investors will generally rely on precious metals, especially gold, to provide this benefit. If we really want to hedge with gold though, we can’t just hold a bunch of gold through low inflationary periods, in a way that sets it aside for a rainy day.

If we do need a hedge like this, we’re going to have to devote a large portion of our assets when it actually is raining, or at least starts to rain hard enough, and when the skies are sunny, there’s no need for a hedge at all so if we hold one it has to be for reasons other than for hedging purposes.

Bitcoin works the same way, and there may be some good reasons to invest in bitcoin at any given time, but in low inflationary periods, hedging against inflation is simply not one of them, nor does it make sense for it to even be seen as one.

If your currency is experiencing extreme inflation, such as what is happening in some countries where there have been movements from domestic currencies into bitcoin as a flee to safety, then using bitcoin as an inflationary hedge does make a lot of sense, and it’s better to make these transitions earlier rather than the later approach that most people take, when losses become more extreme.

There are other ways to do this of course, to manage the risk of high inflation by investing in more desirable foreign currencies, particularly the U.S. dollar, but one of the most interesting things about these recent flights to bitcoin is that bitcoin is seen as quite a bit more accessible than foreign currencies in some countries.

There are a lot of people who may not even be aware of the ability to exchange their currency for other currencies, and are much more aware of the ability to buy and exchange bitcoin. While we really don’t have much of a global economic ecosystem built around bitcoin yet, and this may be quite far off, in times of need, people can develop some pretty effective more localized ones.

If the domestic currency becomes shunned for the most part, this can really provide an impetus towards bitcoin and we can see its popularity really take off in some countries. This is perhaps where bitcoin really shines, as the domestic currency is the legal tender, and that can be enforced, but since bitcoin is unregulated, people can set up so called black markets with it with relative ease.

When Bitcoin Inflation Hedging is Appropriate

This is a good example of the intervention, the hedging, being in accordance with the need, as one would not want to own bitcoin just to protect against high inflation with one’s domestic currency with no indication of need or meaningful risk.

For any hedge to make sense, we need both the conditions for the hedge and at least some corresponding relative value of the hedge over what is being hedged.

The reason why bitcoin can be a good hedge against inflation in certain circumstances is that the performance of bitcoin is superior and often greatly superior to what it is hedging, for example a certain currency which is experiencing high inflation.

In order to even have a good sense of this relative value though, we need to be paying attention to the performance of both what is sought to be hedged against inflation and the hedge itself.

In terms of hedging against inflation, we need to first have a particular need to do so, at the present time, and if the need is only forecast or guessed at in the future, the need is not required now, and if the need does actually arise, we can assess our needs then.

If we do need an inflationary hedge, this has us assessing the relative desirability of the various potential hedging candidates, gold versus bitcoin for example, to decide what would serve our purposes.

We need to both look at the historical performance of each as well as their particular recent performance to decide all this, and the historical side of things would certainly favor gold, but if inflation is rising, gold is going down in value, and bitcoin is going up, this can certainly have us taking a harder look at bitcoin as a hedge here.

We could say though that, based upon the extreme instability of bitcoin, inflation would have to be pretty severe indeed to cause us to take on the very high risk of holding bitcoin and having us feel more comfortable with that than the inflation risk. Hyperinflationary times would probably qualify, although we may wonder why we just don’t go with another currency instead, and only trade bitcoin if we desire to do so independent of inflationary concerns.

Unless you live in a situation where your domestic currency is under enough fire that the people are migrating over to bitcoin, and you then can both get paid and spend your money in bitcoin, r or if and when bitcoin becomes so widely used that this becomes an option, using bitcoin as a hedge against inflation really doesn’t make much sense.

There are other reasons to want to speculate on bitcoin though and just because something isn’t that appropriate as a hedge certainly doesn’t mean that it doesn’t make sense to speculate on. It is interesting that it is taking on a bigger role in some countries these days and many people are very glad that they have been able to escape the risks and losses of their own currencies and have somewhere else to go and hold their money in like bitcoin.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: [email protected]

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