Does Bitcoin’s Rally Prove the “Inflation Hedge” Theory?

Bitcoin (BTC) has surged this week, up 38% since March 11. It has outperformed virtually all altcoins, including Ethereum .

Some see this as proof that Bitcoin’s “inflation hedge” theory is correct. But just nine months ago, Bitcoin’s “inflation hedge” theory suffered a major blow. When inflation peaked, Bitcoin prices fell. Now we are really seeing the impact of inflation on the financial system, and Bitcoin is finally responding. Bitcoin’s response will roughly follow the trend of the cryptocurrency market, so it is unlikely to react in advance to various leading indicators.

Bitcoin is “hedge” against systemic dislocations, not erosion of consumer spending power. The idea that Bitcoin will flex with dollar inflation is, at best, a simplification of the actual argument. For one thing, Bitcoin needs wider adoption for these mechanisms to work. There is too much speculation baked into the price right now for it to respond linearly to inflation.

Beyond that, a more refined version of the “inflation hedge” argument would detail that the risk that Bitcoin can actually hedge against is the structural dislocation of financial crises. As we are now seeing, financial crises are increasingly tied to interest rate and other central bank manipulations, about half of which are designed to combat inflation.

Noting Bitcoin’s performance, Bloomberg reporter Joe Wiesenthal suggested that it was performing as expected.

Not so fast

But there is also an argument that this is a misunderstanding of Bitcoin's price signals. Its surge is not due to the long-term impact of inflation, but because the market sees the opposite signal: the end or pause of central bank interest rate hikes, which indicates that various risk assets will usher in rich returns.

After all, Bitcoin’s biggest gains came on Monday, March 13, following the announcement that impending Silicon Valley Bank would be bailed out.

Wiesenthal said an article titled "A Tough Week for Hedge Funds" written by Unlimited Funds co-founder and CEO Bob changed his view on Bitcoin.

Elliot believes that hedge funds were hit hard because they were hit twice. First, they were hit by the risk of 2022, and in the case of interest rate hikes, technology stocks were hit by a nuclear attack. Silicon Valley Bank's foolish bet that interest rates would remain low in the future was actually the main cause of the bankruptcy.

Second, new trade positions that signal a longer period of higher interest rates have also been destroyed over the past week. Basically, this is because bank failures are seen as a red light for the Fed to raise interest rates, which is also a sign that the economy is already slowing.

"The deflationary risks posed by the banking crisis have rapidly led to changes in fundamental conditions and market behavior that have forced many funds to deviate from their original plans," Elliot wrote in the article.

This change may also help Bitcoin's rise. After three bank failures in a week, the market may think that the Federal Reserve is likely to stop raising interest rates or even reverse the situation, which has also led to a surge in people who are keen to invest in "risk assets". This may make those who are anxious about the banking industry turn to Bitcoin more firmly.

We will find out more about this this week. The Federal Open Market Committee (FOMC) of the Fed will meet on Tuesday and is expected to announce a rate hike on Wednesday. If the FOMC believes the threat of further financial disaster is high enough, it may pause its rate hikes. On the other hand, we are still facing 6% inflation, so I personally think that another rate hike is still likely to happen, perhaps by 0.25% to balance the difference, but definitely not doing nothing.

If there is no rate hike on Wednesday, markets may interpret it as a new boom in cheap money, and Bitcoin may truly become a risk-on asset even as the Fed reiterates its commitment to fight inflation at all costs.

The real test of the more refined version of the “inflation hedge” argument will be whether further trouble for the banks leads to further gains in the price of Bitcoin, independent of rate hikes. Until that happens, it’s all speculation.