Does Bitcoin’s Rally Vindicate the ‘Inflation Hedge’ Thesis – or Is Risk Back on the Menu?

Bitcoin (BTC) has rallied stupendously this week, up 38% since March 11. It has outperformed basically every altcoin, including Ethereum. All of this has happened as various banks were self-immolating in protest of Jason Calacanis’ hairline.

Some have argued this is a vindication of bitcoin’s “inflation hedge” thesis, which was looking very battered, if not dead, just nine months ago. Bitcoin was going down as inflation was at its peak. But the argument is that we are only now seeing the real impacts of that inflation on the financial system, and Bitcoin is finally reacting. This would broadly track with crypto’s thinner market, making it less likely to respond, so to speak, ahead of time to various leading indicators.

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That systemic chaos, not the erosion of consumer spending power, is what bitcoin is a “hedge” against. The idea that bitcoin would move neatly in response to dollar inflation was always at best a simplification of the actual argument. For one thing, as I’ve argued elsewhere, bitcoin will need wider adoption before those mechanisms can possibly work. There’s just too much speculation baked into the price right now for it to respond linearly to inflation, a problem we’ll dig into more here.

But beyond that, a more nuanced version of the inflation hedge thesis would spell out that the real risk bitcoin can hedge is the structural chaos of a financial crisis – say, the shutdown of a bank holding your savings. As we’re seeing right now, financial crises are increasingly tied to interest rates and other central bank maneuvers – about half of which come in response to inflation.

Joe Wiesenthal at Bloomberg noted bitcoin’s performance and very tentatively hinted that it was performing as advertised. Galaxy Digital’s Alex Thorn pointed to this version of the thesis in a brief appearance on Castle Island’s ”On the Brink” podcast last week. Thorn will be talking in more depth about the bitcoin and inflation question at Consensus 2023 next month. I’ll certainly be checking it out.

Not so fast

But there’s also a case that this was a misinterpretation of the bitcoin price signal. Rather than spiking because of the long-tail impacts of inflation, maybe it’s spiking because markets see the opposite: an end or pause in central bank rate-hiking, signaling a glorious return for risk assets of all kinds.

The sharpest part of bitcoin’s rally, after all, has come since Monday, March 13, when it was announced that the floundering Silicon Valley Bank would get a bailout. In a second newsletter this morning, Joe Wiesenthal has changed his mind – “MAYBE YOU DON’T GOTTA HAND IT TO BITCOIN,” he tweeted.

Wiesenthal points to this piece by Bob Elliot of Unlimited Funds, on recent hedge fund losses, as helping shift his thinking. Broadly, Elliot describes hedge funds getting beaten up because they’ve suffered a double reverse. First, they ate the 2022 risk-off battering that nuked tech stocks under interest rate hikes. This is effectively what caused the crisis at Silicon Valley Bank, which foolishly bet on interest rates staying low far into the future.

Then in the past week, newer trading positions premised on higher rates for longer also got blown up. Basically, that’s because the bank failures are being seen as a red light for Fed rate hikes, a signal that the economy has slowed down enough.

“Many of these funds were positioned for a continuation of the inflationary, late cycle tightening of monetary policy,” Elliot writes. “The deflationary risk from a banking crisis quickly drove a change in fundamental conditions and market action, which caught many of these funds offside.”

That dynamic may also be helping bitcoin rally. After three banks blew up in a week, markets might be thinking the Fed is likely to stop hiking rates or even reverse, leading to a renewed risk party. That might have simply added to the deeper shift to bitcoin by those anxious about banking.

We’ll find out more on the question this week. The Fed’s Federal Open Market Committee is meeting Tuesday, and is expected to announce any interest rate hikes Wednesday. If the FOMC decides the threat of further financial calamity is high enough it could pause interest rate hiking. On the other hand, we’re still staring down 6% inflation, so I personally think another hike is still likely – maybe 0.25% to split the difference, but definitely not nothing.

If we get no hike, markets could interpret that as renewing the cheap-money bonanza, and bitcoin could truly go wild as a risk asset even as the Fed renews its commitment to fighting inflation at any cost.

The real test for a more nuanced version of the “inflation hedge” thesis will be whether further bank trouble leads to further bitcoin price rises, without interest rates directly in the mix. Until then, it’s all (in multiple senses) speculation.

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