With high inflation, falling stock markets and investors worried about the Federal Reserve’s bold new monetary policy stance, you would think this would be an ideal time to bet on Bitcoin. What is the best time to have a decentralized currency that retains its value?
Still, the world’s most famous cryptocurrency has lost more than 37% of its value so far this year, falling to nearly $26,000 today. Just six months ago, Bitcoin reached an all-time high of around $69,000.
By comparison, the S&P 500 is down about 17% since the start of 2022. Why is BTC recording such heavy losses in 2022?
Bitcoin is now a risky asset
Risk assets are assets that are subject to significant volatility under normal market conditions. Stocks, commodities, and high-yield bonds are considered risk assets because you can expect their prices to rise and fall frequently in almost any market condition.
Until recently, Bitcoin was considered a store of value, somewhat immune to fluctuations in the value of risky assets. This is no longer the case. Today, BTC has fallen prey to factors that affect the value of risky assets — such as inflation, the stock market, and the Federal Reserve’s monetary policy.
“The reason this particular decline is happening now is because the [crypto] market narrative has shifted from risk to risk,” said Dr. Richard Smith, author of Risk Ritual Newsletter. “As the Fed and other central banks begin to taper off overstimulation, and ordinary people start to realize that Covid-19 is waning, we’re going to get back to work, and we’re not all buying NFTs and entering the metaverse tomorrow.”
But there’s another, more esoteric factor at play in the cryptocurrency market lately, which is helping to push Bitcoin lower.
Terraform lab failure
Terra (LUNA) experienced a major disruption over the weekend, losing 90% of its value and wreaking havoc on the crypto world.
LUNA is the native token of the Terra protocol. It is part of the peg mechanism for TerraUSD (UST), another native token of the Terra protocol. Until recently, UST was a relatively popular stablecoin.
As the name suggests, the purpose of stablecoins is to provide a “safe” cryptoasset that maintains a stable valuation. They are managed by pegging their value to the price of fiat currencies such as the US dollar. The goal is for the stablecoin to maintain the same value pegged to it – for example, a coin should always be worth one dollar.
UST is down more than 30% this week, questioning the validity of algorithmic stablecoins.
It appears that the Luna Foundation Guard is trying to back UST with Bitcoin before the weekend run. Earlier this month, the Luna Foundation Guard (LFG), a nonprofit that supports Terra’s blockchain, acquired $1.5 billion worth of bitcoin.
On Monday, LFG said it would borrow hundreds of millions of dollars worth of bitcoin to defend its peg to stablecoin UST.
Bitcoin is off to a rough start in 2022
Bitcoin ends 2021 up nearly 70%. That’s a staggering return for any asset class. Still, the 70% annual return represents a bit of a downturn for Bitcoin as it surged over 300% amid the 2020 lockdown.
Investors are in a risk-off mood in 2022, welcoming “a general risk-off in most asset classes,” said Alex Refet, co-founder of wealth management firm East Paces Group. “Overall, investors are showing greater interest in value investing and less interest in speculative equities and alternative ‘store of value’ investments.”
One reason for this is that the Federal Reserve has been raising interest rates in the U.S. on an unprecedented scale for four decades to fight inflation. Analysts expect the central bank to continue raising interest rates until 2023.
When the Fed raises interest rates, it reduces demand for more growth companies like tech stocks and speculative risk assets like bitcoin. It is an open question to assess how much demand for cryptocurrencies will remain amid dwindling liquidity.
“There is no historical precedent for the performance of Bitcoin and other cryptocurrencies as we enter a sustained period in which central banks are actively withdrawing liquidity,” said Steve Sosnick, chief strategist at Interactive Brokers. These are typically difficult times for those who do not, and riskier assets tend to underperform than safer ones.”
Bitcoin has become a volatile beast
Add to that the market turmoil caused by Russia’s invasion of Ukraine.
“Geopolitical issues are driving market volatility in many tradable asset classes, and Bitcoin has shown itself to be somewhat correlated with broader market movements rather than a direct hedge against equities,” Reffit said.
The problem is that Bitcoin has not proven to be a good hedge against anything. After all, with inflation at a four-year high, one would expect a currency that claims to retain its purchasing power and be independent of any central bank to gain more support. If this description applies to Bitcoin, wouldn’t demand be off the charts?
Instead, Bitcoin appears to find followers when prices rise and skeptics when sellers dominate — just like a risk asset.
In fact, since 2009, Bitcoin has fallen 50% eight times from its previous all-time high. “Anyone who doesn’t agree with at least a 50% drop should not use Bitcoin,” Dr. Smith. “It’s perfectly normal for Bitcoin to drop 50%. It’s the entry fee.”
Should you own bitcoin?
Buying Bitcoin used to be something reserved for tech-savvy first-time adopters, a genre of news that briefly popped up explaining to ignorant readers how to trade dollars for Bitcoin and then Bitcoin for normal things like pizza. (In hindsight, pizza was very expensive.)
Bitcoin has become more mainstream and easier to buy over the years through relatively safe exchanges like Coinbase. Today, no-nonsense, level-headed money managers like the Minneapolis-based money management firm Leuthold Group think a percentage or two of your portfolio could go to bitcoin.
“Eventually the market will figure out the value of cryptocurrencies and factor that information into the high price of these assets,” economist Tyler Cowen wrote in a Bloomberg op-ed. “From then on, the expected returns will be — dare I say it. –normal.”
By investing in Bitcoin now, you anticipate that the speculative frenzy has not abated, and you can sell it back later for a higher price than you paid. But recent history should show that such a plan, while tempting, is no mean feat.
You never know when the thrill of speculative investing will wear off.
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