The significant increase in disagreements over inflation expectations has been warning us that investors could be surprised by a sudden unexpected rise in inflation within the next 12 to 18 months. It is clear that the massive increase in money supply coming from the aggressive liquidity injections from major central banks combined with the sharp fiscal deficits will end up to be inflationary in the medium to long term, which could benefit to traditional inflation-hedged assets such as gold, housing and even Bitcoin. Even though we are strongly bullish on the cryptocurrency in the long run, we are still convinced that Bitcoin looks vulnerable in the short run, especially now that we see limited upside gains in equities.
Bitcoin and equities
Even though the relationship is far from being perfect, figure 1 (left frame) shows that Bitcoin prices have co-moved strongly with US equities in recent years, especially in the last two selloffs (Q4 2018 and Q1 2020). We saw that the cryptocurrency can experience significant losses when equities get sold aggressively; for instance, Bitcoin plummeted by 42% in the last quarter of 2018 when equities went down by 14%.
Figure 1 (right frame) clearly shows that Bitcoin is usually vulnerable to an increase in price volatility and tends to prefer ‘low-volatility’ regimes. In this chart, we compute the average daily performances of BTC in different pockets of price volatility (VIX). We can notice that Bitcoin has averaged -0.9% in daily returns when volatility was trading between 20 and 25. We do not doubt that Bitcoin can experience positive returns in the new ‘high-volatile’ regime due to the rising uncertainty coming forward, but it is still vulnerable to an equity shock.
Rising real rates: a major risk for BTC
Even though an inflationary scenario is highly likely in the medium to long term, we must not ignore the short period of deflation coming forward. Figure 2 (left frame) shows that the annual change in the velocity of money has been acting as a good 20-month leading indicator of core inflation in the past 20 years, and is currently pricing in further deceleration in prices in the coming months.
In addition, even though oil prices have recovered sharply since their April ‘episode’, the dramatic 70%+ plunge in oil in the first quarter of the year will continue to weigh on consumer prices in the months to come (figure 2, right frame), emphasizing the deflationary forces in the near term. It is difficult to look at the dynamics of inflation due to the lockdown imposed by most governments, but we will first experience a deflationary shock before moving on to the inflationary regime amid the rise of protectionism and isolationism.
As a result, we do think that there is a high probability to see an increase in real interest rates at first before real rates reach new lows due to rising inflation. As for gold or silver, Bitcoin is a non-interest bearing asset that carries no fundamental value and therefore investors only benefit from capital appreciation. Hence, the direction of real interest rates is really important when analysts build an outlook on the cryptocurrency. For instance, figure 1 shows the strong relationship between gold prices and the US 5Y real interest rate over time; it is important to notice that real rates increased significantly during the Great Financial Crisis, from nearly 0 percent in February 2008 to 4.2% in November 2008, leading to a correction in gold prices by 35% that year. Even though the co-movement between Bitcoin and US real rates is less sparkling, we can still observe that Bitcoin prices tend to rally when real interest rates crater (figure 3, right frame). Hence, in addition to being vulnerable to a sudden equity selloff in the near term, the cryptocurrency could also suffer some losses if real rates start to rise in the coming months.
Bitcoin versus gold
Even though we expect Bitcoin to capture a little share of the gold market in the long run (a 3 to 5 percent of the total gold market cap would price a unit of Bitcoin between $17,000 and $30,000 approximately), we could see a significant divergence between the two assets in the near to medium term. While the two assets will probably both be impacted by a sudden rise in real rates, gold would benefit from an equity shock as it usually tends to perform positively when equity falls sharply. For instance, we saw that gold prices were up in Q4 2018 and Q1 2020 by 7.6% and 3.6%, respectively, in two extremely negative equity quarters.
Hence, the Bitcoin-to-gold ratio could test new lows in the short run and trade below 4 in case of a sudden rise in price volatility.
In the medium term, we think that Bitcoin will become a ‘high-beta’ gold stock that will generate more interesting returns than the precious metal in trending periods. Figure 4 (right frame) shows that gold and Bitcoin have already shown signs of co-movement in the past 3.5 years; if we regress the weekly changes in Bitcoin prices on the weekly changes in gold prices during that time period, we find that a 1-percent change in gold prices is associated with a 1.13 percent change in Bitcoin prices (significant at a 5-percent level, and the Durbin Watson test is very close to 2, which implies no autocorrelation among residuals).
Gold still wins as a diversifier
Following the recent article entitled Bitcoin as a portfolio diversifier, we thought it would be interesting to include a 5-percent allocation in gold also and compare the results with Bitcoin. Hence, we look at the performance of four different portfolios since August 2014:
- A long-only equity portfolio
- The traditional 60/40 equity bond portfolio
- A 55/40/5 equity bond gold portfolio
- A 55/40/5 equity bond bitcoin portfolio
We used the SPY ETF for equities total return and the Bloomberg Barclays US Treasury Total Return Unhedged USD for Treasuries returns.
Due to the rising uncertainty coming forward, we chose to reduce the equity exposure by 5 percent and replace it by either gold or Bitcoin and see which portfolio offers the best diversification.
Results are shown in figure 5. As expected, the long-only equity portfolio offers the highest returns (8.74% annualized) but is also the most volatile and therefore has the lowest Sharpe ratio among the four portfolios. It is also the portfolio that experiences the highest drawdowns.
It is interesting to see that both portfolios with 5% gold or bitcoin (instead of equities) generate better results than the traditional 60/40 equity bond one and have both very similar results; the one with 5 percent gold actually performs slightly better (a Sharpe ratio of 0.87 instead of 0.83 and a max drawdown of 4.3% instead of 4.33%, respectively). Hence, traditional investors would have been better off holding a 5 percent allocation in gold rather than Bitcoin in the past 6 years.
We understand that it is much more interesting to look at the behavior of assets during periods of crisis and that a more rigorous analysis would be to study portfolio diversification in the past at least 50 years, but the longevity of Bitcoin does not allow us to do that exercise.
Source: RR calculations
Overall, we continue to remain cautious on Bitcoin in the near term as the rising uncertainty generated by the COVID-19 shock will certainly lead to another little equity selloff episode. Given the high valuations of equities, the stock market remains vulnerable in the near term and therefore a new rise in price volatility could also generate a little correction in Bitcoin. In addition, even though Bitcoin may become a ‘high-beta’ gold stock in the medium term, we would rather own gold than Bitcoin in the current environment.
Disclosure: I am/we are short EURUSD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.