Bitcoin’s crash wasn’t about Elon or China – it was about inflation

Bitcoin and the crypto market endured a sharp sell-off last week. John Stepek looks at what caused the plunge.

Bitcoin’s travails have captivated investors in the past week.

That’s not surprising. A lot of new investors discovered the thrills of trading cryptocurrencies on the way up, and now they’re equally absorbed by the spills (though in a less pleasant manner).

But what does it mean for those of us who aren’t big crypto investors? Does the crypto crash have any significance for wider markets?

Why did bitcoin really fall?

I hesitate to suggest that bitcoin has bottomed out (I have no idea), but for the time being at least it seems to have found a floor at around $30,000. (If you’re interested in that sort of thing, my colleague Dominic is much better on the charting side – you can read his view here).

Anyway, what I want to think about today is not where bitcoin is heading next. What I’m really wondering about is why it crashed in the first place.

There are plenty of proximate reasons. China cracked down on bitcoin. Elon Musk said a nasty thing about bitcoin. The Federal Reserve got a bit excitable about the digital dollar again.

The thing is though, if you look at the bitcoin price, it peaked in mid-April, at just under $65,000. It then drifted somewhat (I say “drifted”, but only by bitcoin standards – it fell below $50,000 at one point before the end of April, before rallying).

It then took a proper knock on the head on 12 May. It slid from just under $60,000 to just under $50,000 in a single day. What else happened on 12 May? That’s when US inflation came in way above expectations, and markets suddenly started to take it all seriously.

So to my mind at least, there’s a pretty clear link there. Bitcoin has crashed because investors are worried about inflation. And why are they worried about inflation? The main fear is that central banks – and the US central bank in particular – will pull out all the lovely liquidity that it’s been pumping into markets.

The risk then is that an asset like bitcoin – which thrives on the money-printing/debasement narrative, but also in an environment in which everyone is enamoured with tech – becomes a lot less appealing.

I’d say this view seems to be backed up by the fact that bitcoin also had an awful session on the 19 May, which is when the Fed released a set of meeting minutes that suggested it might just be time to think about considering the idea that the money-printing pace should ease off a little.

So this, I think, is where the significance lies. I don’t believe that crypto has any systemic importance (not yet at least). I don’t think there’s enough of a “wealth effect” here (where people thought they were rich and now are worried that they’re poor) to have a big impact on other markets.

Indeed, it’s worth noting that the bitcoin crash in itself does not seem to have caused any major headaches or driven any big firesales in any market outside of crypto.

The question then is: is bitcoin a canary in the coalmine here? If we assume that bitcoin is one of the most liquidity-sensitive assets around right now, then what other assets might be in for harder times?

What other assets might be vulnerable right now?

To me, the most obviously vulnerable major stock market looks like the US Nasdaq. It’s been one of the biggest beneficiaries of the lockdown days. Those days are coming to an end. So while it’s simplistic, it doesn’t feel wrong to imagine that the winners will become the losers and – perhaps – vice versa.

The Nasdaq is also one of the most highly valued markets, which makes it very vulnerable to both rising interest rates and rising inflation (because even if rates don’t rise, investors still increase the “discount rate” they use to value stocks to compensate for inflation).

In terms of what might do well – as I’ve already mentioned a lot, value stocks are certainly in a better position than growth stocks, because they’re not as overvalued and therefore less vulnerable to changes in the discount rate. They also tend to be in sectors that actively benefit from a more inflationary world (raw materials companies and banks). So the FTSE 100 is a good example of an index that has a lot of this stuff.

Gold is an interesting one to look at too. You probably know I’m a fan of gold as a diversifier in your portfolio. But what’s particularly interesting is that gold has been going up even as bitcoin has been crashing. What happened to “gold 2.0”?

Long story short, bitcoin and gold aren’t driven by the same things. Gold is starting to benefit from inflation concerns. If inflation goes up and interest rates go up, it’ll just generally be bad for tech stocks and for crypto – there’s less liquidity either way.

But if inflation goes up faster than interest rates, gold is just fine. It’s not so much the liquidity that drives gold, as the fall in “real” interest rates (that is, interest rates after inflation). So even if rates do rise, as long as the central bank is “behind the curve”, gold should still thrive.

Charlie Morris wrote in MoneyWeek a couple of months ago about why bitcoin and gold aren’t the same asset. Recent weeks have clearly proven him right. (Charlie also makes the case for owning some bitcoin in an inflationary environment).

By the way, if you’re keen to hear more on crypto, Merryn and I debated the drivers of bitcoin’s value on the podcast last week – if you missed it, have a listen here.

For more on all these topics, subscribe to MoneyWeek magazine and get your first six issues free. 

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