We keep hearing that Bitcoin solves the inflation problem. Inflation seems to be our main problem. The funny thing is that (US) inflation has been pretty stable for the past few decades. A period known as “Great Moderation”. The average inflation rate so far has been 2% per year. An ideal number for most economists. Even in the 1970s, during the Jimmy Carter inflation crisis, inflation in the United States did not exceed 20%. Bitcoin has multiplied by several Xs since March last year. Obviously something is wrong here.
It is no secret to anyone that libertarians speak of this 2% annual inflation as if the United States were Venezuela. Like a broken record, they always talk about inflation. Then, like in the story of Peter and the Wolf, nobody takes them seriously anymore. The truth is that solving the inflation problem is not that complicated. The solution is to buy assets. Each bond offers more than 2% per year. Smart. Problem solved.
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However, the investor’s goal is not to solve inflation per se. The reality is that the goal is for your portfolio to exceed the SP 500 in most years. So the investor moves between his desire not to lose money and his desire to grow by more than 10% or 20% annually. “Don’t lose money” means that you should look for stable assets. But to grow? You have to take some risks. Why? Because, in general, the most profitable assets are the riskiest. In this case, risk is synonymous with volatility and contradicts stability.
In the panic of the coronavirus, investors withdrew from equity and looked for stability in “safe havens”. (Cash, government bonds). The lockdown led to a huge drop in demand. Which led to a deflationary picture. Especially in the service sector. During a crisis, uncertainty makes the investor conservative. Then the monetary authorities have to provide liquidity to increase demand. This way the investor becomes more reckless and takes risks again.
To contain deflation, the dollar is weakening. This is a measure taken on purpose to stimulate the economy. A strong dollar encourages saving. A weak dollar stimulates spending. And more spending is required during a deflationary crisis. More spending because spending means income. E “Income” means employment. This process is known as “reflation”.
All this cheap money has created an artificial boom in the financial markets. Obviously, valuations are inconsistent with fundamentals as this is an artificial boom. Essentially driven by the capital markets, which in turn are dominated by the US Federal Reserve. Fundamentals are inconsistent as the real economy is still in a major crisis. In other words, we have a weak dollar, low to moderate inflation, high unemployment, modest economic growth, but a buoyant financial market. It’s definitely a K-shaped recovery.
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The dollar’s weakness is closely related to optimism and rally in the stock markets (including Bitcoin). The strength of the dollar, on the other hand, is related to pessimism and declines. In other words, the weaker the dollar, the more risk tolerance increases and the more Bitcoin increases. We have to remember that Bitcoin is essentially an exchange rate. The main pair is the dollar / bitcoin pair. Hence, the weakness of the dollar stimulates the rise in the price of Bitcoin.
All of this is now possible because of the flexible monetary policy of the Federal Reserve to combat the deflationary image of the crisis. That said, it is possible due to injections of liquidity. The moment the economy overheats and the Fed has to withdraw liquidity from the system, the dollar will become scarcer and the markets will suffer severely. In other words, once inflation gets out of hand, sooner or later the Fed will have to cut back. At this point, investors are becoming more conservative. That said, they’ll be looking for more stable assets. Very bad news for volatile (risky) assets like Bitcoin.
In this context, a high rate of inflation does not necessarily mean an increase in the price of Bitcoin. Contrary to what crypto-libertarians suggest. We know that liquidity is the fuel of this market. And this will continue to decrease because of the incentive as long as inflation stays relatively low.
There is a strong correlation between the weakness of the dollar and the rise of Bitcoin. This trend is pretty easy to spot. By examining both graphs, the evidence can be found. Of course, this statistical correlation does not imply 100% similarity. For example, during the Coinbase news sale, the dollar weakened and the Bitcoin market fell, bucking the trend for a few days. We see an exception here. It is likely that during the anticipation period of Coinbase’s initial public offering (“the rumor”) the price rose too much due to the FOMO and then during the period above the event (“??”. ?? the newsâ ????) the price fell due to profit-taking from dealers who sold the news.
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It is possible that Bitcoin is currently showing exceptional independence due to purely technical factors. I mean breaking an all-time high prematurely. And now you need to rediscover the price. However, I dare say that this detour is only temporary. Sooner than later, Bitcoin will again submit to current macroeconomic forces.
In terms of price, the best that can happen to us is for the Federal Reserve to stick to its current policy. In other words, liquidity continues to fall like rain. And that will depend heavily on the macroeconomic data. In particular inflation and unemployment. The most radical bitcoiners want an out-of-control inflation spiral, only to say they were right. That is the problem with falling into ideological passion. But the day the Fed starts slowing the flow of liquidity to stop inflation, that day will be the end of that financial boom. The least we want is an overheated economy right now. We don’t want to be right in this case.