Feature Stories | May 31 2021
Can bitcoin replace gold as a store of wealth in the face of inflation and times of uncertainty?
-Gold’s history as inflation hedge
-Gold’s history as a safe haven
-Bitcoin’s short history
-Arguments for and against cryptos
By Greg Peel
This is the second in FNArena’s series examining crypto-currencies. A link to Part 1 is provided near the bottom.
Since ancient times, gold has been seen as indicative of wealth and power. The first currencies were coins made of gold and silver – their value determined by their actual metal content.
The key to precious metals being used as currency is their rarity. They were a store of wealth because they were difficult and costly to find and mine.
Eventually, coins made of precious metals were replaced by coins made of lesser metals and banknotes, which were backed by the issuer’s holdings of those metals. Gold was the primary store of wealth, and a currency’s value reflected the extent of gold holdings.
In recent centuries, as economies developed across the world, gold-backing of a currency was an on again, off again affair. At the end of World War II America and its allies convened at a meeting at Bretton Woods at which it was agreed currencies would indeed be backed by gold. At the time, the US held two-thirds of the world’s gold. The US dollar became the global reserve currency.
At the time, gold was US$35/oz.
With economic growth came economic cycles, and with each recession came fiscal spending, funded by money printing. Given currencies were backed by gold, money printing led to outflows of gold to other economies. The US became the most powerful economy on earth after World War II, but by the 1960s and 70s the defeated powers of Germany and Japan had swiftly begun to catch up.
The tipping point came in 1971 when, amidst other hefty spending programs, the US was bleeding money to fund the Vietnam War. Then President Nixon made the unilateral decision to end the Bretton Woods agreement. From then on, the reserve currency would be backed only by the US economy, and currency would effectively become a “promissory note” from the US government. Other countries had no choice but to follow suit.
The decoupling of currencies from gold sowed the seed for today’s crypto currencies. It just required the growth of digital technology in the meantime.
Gold as a hedge against inflation
Printing money adds to the supply of that money and thus devalues that currency. It stands to reason, mathematically, that the more a currency is devalued the more of it is needed to buy the same pint of milk, the same family car and the same ounce of gold. The more money consumers require to buy the same items, the more wages must increase to cover that loss of spending power.
In the 1970s, central banks had no mandate to control inflation.
The post-war US economic boom meant a greater demand for oil, which made the US reliant on imports from Arab oil producers. Printing money devalued the dollars received by oil producers. Not happy with the situation, in 1973 those oil producers (OPEC) placed an embargo on exports to the US and other countries. If inflation was not already becoming an issue, it certainly was now. The price of oil skyrocketed as domestic supply could not meet demand.
The inflation shock also sent the US dollar gold price skyrocketing. OPEC ended its oil embargo in 1974, but without central bank control, inflation is a difficult beast to restrain once it’s let out of the cage.
The US dollar gold price surged accordingly.
Just when it looked as though things couldn’t get any worse, the Iranian Revolution of 1979 shut down the world’s biggest oil producer. The price of oil again shot up, and the price of gold again responded accordingly. Having gone “parabolic” in the late seventies, the US dollar gold price hit US$850/oz, up from US$180/oz only five years earlier.
The US inflation rate surged into double digits (as was also the case in Australia).
At the time, the US Federal Reserve’s funds rate was 13% (compared to effective zero today). To cap the upward spiral of inflation and the resultant recession, then Fed chair Paul Volker raised the funds rate to 20%. The US CPI peaked in March 1980 at 14.8%. Three years later it was back at 2.6%.
Markets that go “parabolic” tend to end with a blow-off top. At the same time Volker was intervening to curb inflation, the Hunt brothers attempted to corner the silver market. They failed. The price of silver collapsed. The price of gold now had plenty of reason to collapse as well.
Clearly there were plenty of buyers of gold burned in 1980. But at the very least we could say gold did indeed play its role as a hedge against inflation, if only briefly.
Not so brief was the period 2009 to 2013. In the wake of the GFC, the Fed announced in late 2008, having cut its funds rate to near zero, it would further loosen monetary policy by implementing quantitative easing, which is money printing by any other name. Coincidentally, at the end of 2008 gold was trading around US$850/oz.
US money printing devalues the US dollar, which again implies inflation. But QE1 was not enough. The Fed was to follow with QE2, QE2.5 and QE3. In 2011, gold hit US$1900/oz.
Driving the rush into gold was an assumption QE could only lead to inflation, and even hyperinflation. Comparisons were even drawn with Germany’s Weimar Republic, which in order to make good on World War I reparations, simply printed money.
But a funny thing happened. Despite the Fed feeling it necessary to continually top up monetary support for a slowly recovering economy, the resultant level of inflation feared never materialised. To explain this we might point to everything from automation of the workforce and an ageing population to the US dollar still being seen as the safest bet when there was nowhere much else to go.
The gold price wallowed around for a year up to late 2012, when finally the Fed decided it was time to wind back monetary support – to “taper”. At the end of 2013 gold was trading at US$1200/oz.
This period of history supports the argument that gold does indeed act as a hedge against inflation.
But let’s look at more recent movements.
In 2019, the US posted headline CPI inflation of 2.3%. In 2020, that figure was 1.4%. At the end of 2019, gold was trading at US$1500/oz. In August of 2020, the price traded over US$2000/oz.
What happened in 2020 to upend gold’s inflation hedge equation?
Gold as a Safe Haven
As a store of value, gold wears two hats. The discussion above reflects gold’s status as a hedge against inflation and currency debasement. But gold also acts as a store of wealth in times of uncertainty. The two do not necessarily correlate.
We recall that the 1973 OPEC oil embargo and the 1980 Iranian Revolution and subsequent shutdown of Iranian oil production had sent the gold price soaring by the beginning of 1980. This was a reflection of real inflation, as the oil price (WTI) ran from US$21/bbl in 1973 to US$120/bbl by August 1980.
Five years later, with Iran back on line, oil fell to back to US$75/bbl. In the first three months of 1986, it fell to US$25/bbl. This was because having been united in imposing the oil embargo of 1973, by 1986 OPEC members could no longer agree to control the production levels required to maintain prices where they wanted them.
In 1985, the US CPI was 3.8%. In 1987, it was 4.4%. In between, in 1985, it fell to 1.1%. But this is what the gold price did:
In April 1986, the Chernobyl reactor blew up.
Ten years later, US hedge fund Long Term Capital Management, having taken bets on Asian currencies (Asian Currency Crisis 1997) and Russian debt (Russian default 1998), went under, owing an estimated US$6bn.
When we put this figure up against the sort of money being thrown around by governments today, and in the GFC, and even this year private hedge fund Archegos going under owing $10bn but causing barely a ripple, US$6bn seems trivial. But in 1996, it was sufficient to threaten the entire global financial market.
If ever there was a time to rush to the safe haven of gold, with the LTCM crash followed by the Asian Currency Crisis in ’97 and Russian debt default in ’98, this was it. But:
We could point to US inflation dropping from 3.3% in 1996 to 1.7% in 1997 and 1.6% in 1998, but the major influence on gold over the period was an agreement by the world’s major economies to sell large amounts of their sovereign gold holdings to prop up global financial markets in such a time of turmoil.
Turmoil requires a safe haven, and gold wasn’t it. With currencies collapsing in Asia and Russia, the rush was on to buy the reserve currency instead. The US dollar index rallied 25% over the period.
The Global Financial Crisis began in 2007 when two US hedge funds failed to find buyers for their sub-prime mortgage funds, and culminated in 2008 with the collapse of Lehman Bros. Initially, gold played its role as both safe haven and inflation hedge, with US CPI at 2.5% in 2006 and 4.4% in 2007. Gold rallied from US$650/oz at the beginning of 2007 to over US$1000/oz in March 2008.
Lehman collapsed in September 2008, but by October gold was at US$700/oz.
Again we can point to inflation, or lack thereof, given the US CPI was a mere 0.1% in 2008. But again we can say: surely if ever there was a need for a safe haven it was at the depths of the GFC?
The problem this time was the amount of leverage in US financial markets – not just the holders of mortgage instruments but the holders of stock. When Wall Street took its final and most pronounced dive post Lehman, leveraged stock investors had to sell something – anything – to cover their margin calls. They chose gold.
And again the US dollar became a global safe haven.
Fast forward to now and again we are witnessing inflation fears brought on by a rapid recovery out of covid and stubborn Fed monetary support.
From January to August 2020, gold rallied from around US$1500/oz to over US$2050/oz as the Fed responded to covid with immediate rate cutting and QE. By early this year, a rapid US recovery sparked inflation fears, as evidenced in US bond yields spiking in February.
Inflation fears? Gold fell to under US$1700/oz in March.
Here we see another battle of the safe havens. Longer dated US government bonds are another safe haven, but the difference in bonds and gold is one pays interest and the other doesn’t. Thus if the interest rate available on bonds becomes more attractive (bonds sold on inflation fears), gold loses.
Most recently, with US bond yields stabilising, gold has begun to rally again.
So, what’s the conclusion?
The conclusion is that gold is most often a hedge against inflation, but not always, and a safe haven, but not always, and can be influenced by a wider spectrum of factors than just inflation and global uncertainty. Gold can also suffer from bouts of volatility.
Nothing in financial markets is a given.
Bitcoin v. Gold
Bitcoin was born from the GFC. There’s no point in comparing bitcoin’s (highly volatile) early years, as it was a while before anyone outside of a specific few had even heard of it, and a longer time before anyone much understood it.
Arguably that’s still the case, but either way bitcoin hit the headlines in 2017 when it rallied from US$1000 to US$19,000. Two years later it was back at US$4000.
From September 2020 to April 2021, bitcoin rallied from US$10,000 to US$60,000, before correcting -50%.
The 2017 rally was driven by millennials, who live in the world in which bitcoin exists. It was a classic, “fear of missing out”, momentum-driven bubble that eventually burst. The established financial world scoffed.
But by last year the established financial world had to admit bitcoin was likely not just a one-day wonder. Having fielded so many enquiries from investors, large fund managers and banks began offering crypto allocations to clients. Previously burned millennials were less present this time, institutions were the main drivers.
Millennials nevertheless paid attention when their hero, Elon Musk, announced Tesla had bought a large bitcoin holding and one could now buy a Tesla with bitcoin. But Musk went from millennial hero to villain recently when he completely about-faced, denouncing crypto as “bad for the environment” – a reference to the enormous amounts of energy required for crypto mining.
It is this energy requirement that may yet spell the death of crypto, or at least render it insignificant.
We have noted gold is not without its bouts of volatility, but so far these pale into insignificance compared to bitcoin. This renders bitcoin questionable as a store of wealth, a hedge against inflation or a safe haven in uncertain times.
Note the following chart:
Source: Coinbase (published with permission)
This chart, courtesy of Coinbase, covers the period from the beginning of 2020 to August of that year. It captures covid crash and initial recovery.
Bitcoin may well have been the “winner” over the period in percentage terms, but how did it fare as a “safe haven”? Not too well.
Gold – the recognised safe haven – did dip at the time as well, which we can attribute once more to forced selling to pay margin calls, as was the case aforementioned in late 2008. Otherwise, gold, by comparison, performed its role rather well.
The Argument Against
“When we examine Bitcoin,” note analysts at asset manager Bridgewater Associates, “we believe it shares some but not yet all of the qualities we would consider necessary to act as a storehold of wealth. Certainly, Bitcoin has merit: similar to gold, it cannot be devalued by central bank printing and its total supply is limited. Further, it is easily portable and exchangeable globally, especially for individuals. It also has the potential to provide diversification, though to date this is more theoretical than realized”.
Bitcoin remains an extremely volatile asset. Compared to traditional stores of wealth, such as gold, real estate or “safe haven” fiat currencies, bitcoin faces a much greater range of outcomes as to its future value, suggests Bridgewater.
Bitcoin still faces meaningful regulatory risk. While greater regulation might help bitcoin gain broader institutional acceptance, it could also trigger selling by some of its largest existing owners who prioritise a lack of public oversight of the asset.
And, while there have been improvements, current levels of liquidity still constitute real structural challenges to holding bitcoin for large traditional institutions such as Bridgewater and its clients, the analysts warn.
Then there’s the matter of turnover.
Turnover as a percent of total outstanding is tiny for gold in comparison to bitcoin, in part as central banks around the world hold a large share of total gold supply as a long-term store of value in their reserves. By contrast, bitcoin volumes have exploded in recent years, due to the emergence of high-frequency traders, a booming derivatives market, and a surge of new coins that trade against bitcoin.
This, warns Bridgewater, combined with questionable volume data reported by unregulated exchanges, creates the illusion of increased liquidity. In reality, this liquidity is much more representative of high churn and speculative trading rather than longer-term risk taking.
Another issue for cryptos relates to their very raison d’etre of being “outside” the global banking system and offering anonymity. As ECB President Christine Lagarde noted recently:
“It’s a highly speculative asset, which has conducted some funny business and some interesting and totally reprehensible money laundering activity…There has to be regulations…It’s a matter that needs to be agreed at a global level, because if there is an escape, that escape will be used.”
US Treasury Secretary Janet Yellen had previously raised similar concerns:
“We really need to examine ways in which we can curtail [crypto] use and make sure that money laundering doesn’t occur through those channels.”
But the wheels of regulation turn slowly. And just this past couple of weeks, from the time of writing, bitcoin has suffered two significant plunges and rebounds. Respected fund manager and CNBC “personality” Jim Cramer puts this down simply to too much leverage being on offer in a market regulators do not control.
“That's why it is imperative that either Treasury Secretary Janet Yellen or SEC Chairman Gary Gensler simply come out and say they are uncomfortable with all of the leverage they are seeing in the crypto markets. Today we saw Treasury opine on shifting income tax-free via cryptocurrencies, and that's all well and good, but it has nothing to do with what really matters: stopping a train wreck before it happens.”
Cramer’s point is that when it comes to financial markets, words can speak louder than actions. Markets adjust immediately to words, well ahead of actual actions.
The Argument For
“We believe Bitcoin is creating the possibility of a global monetary system controlled not by nation-states but by individuals. By eliminating the need for a trust-based model, Bitcoin is calling into question the current foundation of economic organizations and is paving the way for a more predictable financial system.
Bitcoin presents investors with a unique opportunity. While many investors question its merit, in our view bitcoin is the most compelling monetary asset to emerge since gold.”
Yassine Elmandjra is the blockchain/crypto analyst for ARK Invest. ARK Invest sponsors a wide variety of exchange-traded funds, and even EFTs of ETFs, with the one underlying theme of “innovation”. ARK initially caught the attention of investors in being an outspoken champion of Tesla, setting price targets that had Wall Street in disbelief.
Eyebrows were raised when Tesla did indeed surge in value, either side of covid. More recently, ARK has become known for being the leading supporter of crypto.
Elmandjra in particular elicited a lot of eye rolling when recently he suggested crypto mining is actually good for the environment, as it will encourage more renewable energy investment. Shortly afterward, the other great champion of crypto, Elon Musk, completely about-faced on his support for crypto, declaring it “bad” for the environment, given the extent of energy required for crypto mining. In so doing, Musk set off the most recent bitcoin rout.
“We believe its rapid growth has positioned bitcoin to earn an allocation in well diversified investment portfolios. Bitcoin offers one of the most compelling risk-reward profiles among assets, as our analysis suggests it should scale from roughly $200 billion today to $1-5 trillion network capitalization during the next five to ten years. In our view, capital allocators must consider the opportunity cost that will be associated with ignoring bitcoin as a new asset class.”
Supporters of bitcoin shrug off its volatile history to date. Indeed, ARK Invest founder Cathie Woods, when confronted on CNBC about plunges in both bitcoin and Tesla shares, responded “I love this set-up”.
Throughout history, longer term investors in any asset class – the stock market in particular – have loved sharp corrections of a market that has become too frothy, and thus overvalued. They serve to shake out the fly-by-night speculators and restore valuations to a more measured assessment of risk/reward, thus providing a more attractive buying opportunity. Cathie Woods is no exception.
Crypto fans are not concerned about bitcoin volatility, seeing it more as a sign of growing pains in a new asset that will increasingly gain acceptance as time goes on, at which point volatility will ease off.
Having studied the bitcoin assessments of his own analysts, Bridgewater founder and respected investor Ray Dalio concludes:
“Bitcoin looks like a long-duration option on a highly unknown future that I could put an amount of money in that I wouldn’t mind losing about 80% of.”
In other words, Dalio is not prepared to dismiss bitcoin with a wave of a hand, rather he is prepared to acknowledge its merits. However, with the future of crypto highly uncertain, Dalio sees it as a potential opportunity, but one of significant risk.
This article has looked specifically at the bitcoin versus gold debate, but bitcoin is not the only kid on the crypto block. Most recently, blockchain fans have acknowledged Ethereum as a far more useful blockchain platform, and hence the prospects of its underlying “ether” currency as potentially more plausible than those of bitcoin.
Remember that scepticism and criticism of bitcoin does not imply the same for blockchain technology. In fact the opposite is true.
The third article in this series will examine the Bitcoin versus Ethereum debate, and its implications.
Part 1, Bitcoin: What’s That All About? (https://www.fnarena.com/index.php/2021/04/30/bitcoin-whats-that-all-about/)
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