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With inflation peaking, could the worst be over for digital assets?

The digital-assets sector has recently experienced its worst period since it came to prominence. The price of bitcoin fell from over $64,000 in November 2021 to a low of just under $17,000 in January 2023. Meanwhile, scandals such as the November 2022 collapse of FTX, previously regarded as a reliable crypto exchange, have rocked confidence in the sector. Like many other assets, crypto came under pressure in 2022 when the US Federal Reserve (the Fed) started to hike interest rates to combat inflation. But as evidence grows that global inflationary pressures are peaking, could brighter times lie ahead for digital assets?

Digital lights pattern Source: Getty Images

Crypto loses its glister

Although prices fell sharply towards the end of 2021, the crypto sector began 2022 full of confidence. Prices rallied strongly in the first quarter, shrugging off the impact of Russia’s invasion of Ukraine, while companies spent tens of millions of dollars on marketing around the world, swamping the US Super Bowl with adverts, for example. Institutions had already been warming to the sector for some time – in a March 2021 paper, Bloomberg analysts wrote, ‘The process of bitcoin replacing gold (as a hedge against inflation) in portfolios is accelerating, and we see risks tilted toward more of the same.’ Bloomberg cited the expectation of increasing crypto-asset regulation, ‘notably on stable coins tracking the US dollar’, as further evidence that the sector was entering the mainstream. 1

However, the fall – when it came – was swift and almost exactly mirrored the downward turn in equities and fixed income. Rather than proving a diversifier, digital assets appeared highly correlated with traditional instruments, behaving as a speculative risk asset and certainly not as a gold-like hedge against inflation, as shown in the chart below. Reinforcing that point, just as equities and fixed income have rallied towards the end of 2022 and into 2023 on signs that inflation may be peaking, so too have digital assets.

There’s plenty of evidence that inflationary pressures – triggered by global demand/supply imbalances after Covid-19 lockdowns ended, and surging commodity prices caused by the impact of the Ukraine war – are ebbing. Headline inflation in the eurozone fell for the third consecutive month in January, to 8.5%, down from 9.2% in December. 2 Meanwhile, US inflation fell for the sixth straight month in January, registering an annual increase of 6.5%, the lowest level in a year. 3 Moreover, following guidance that it was considering reducing the pace of monetary tightening, the Fed raised the overnight borrowing rate by just half a percentage point, taking it to a range of between 4.25% and 4.5%, following four straight three-quarter point moves.

The growing correlation between digital assets and equities

Bitcoin and S&P index chart Source: IMF
Bitcoin and S&P index chart Source: IMF

The long road back

The yield on ten-year US Treasuries has been on a downward path since peaking last November – a sign that investors are speculating that interest rates will begin to fall in 2023. That suggests the upturn in the price of cryptos and other digital assets can continue. Lower interest rates make speculative assets more attractive to investors, partly because bonds won’t offer such high returns, and partly because lower rates signal an expanding money supply.

Market yield on US Treasury securities at a ten-year constant maturity, quoted on an investment basis

Market yield on US Treasury securities chart Source: FRED
Market yield on US Treasury securities chart Source: FRED

While the upturn in the fortunes of digital assets in 2023 is welcome, winning back the trust of institutions could prove a more arduous task than attracting retail investors, with FOMO helping to lure the latter back into the market. By contrast, Bloomberg reports that many institutions now believe the case for crypto as a portfolio diversifier or ‘digital gold’ has been debunked. Moreover, some asset managers – including BlackRock, Temasek Holdings, the venture-capital fund Tiger Global and Sequoia Capital – suffered significant losses as a result of the FTX collapse.4

Bloomberg quoted Salman Ahmed, chief investment strategist at Fidelity International, as saying the FTX debacle raised questions about the viability of the entire crypto ecosystem.5 Indeed, 72% of institutional e-traders signalled ‘no plans to trade crypto/digital coins’ in 2023, according to a survey conducted by JPMorgan in February 2023.6

But it may be too early to write off crypto entirely. The International Monetary Fund (IMF) has said:

‘The correction in crypto asset markets has added extra urgency to the call for comprehensive and consistent regulation and adequate supervision. Policymakers need to address risks to users and investors, to market and financial integrity, and to macro-financial stability. The regulatory framework should cover all critical activities and entities. Crypto asset service providers that deliver core functions and generate key risks should be licensed, registered or authorised.’7

That would certainly bring the greater clarity and stability craved by institutional investors. Meanwhile, the case for digital assets remains solid, with an increasing number of countries exploring and adopting cryptocurrencies as a legitimate asset class. In February, for example, the Bank of England (BoE) and the Treasury were reported to be aiming to create a central-bank digital currency later this decade. The European Central Bank (ECB) is also working on a digital version of its currency. The Bank of International Settlements (BIS), a forum for central banks, said in June 2022 that digital currencies controlled by central banks are needed to modernise finance and ensure Big Tech does not take control of money.8

1 https://assets.bbhub.io/promo/sites/12/1029441_Crypto-Mar2021Outlook.pdf
2 https://www.cnbc.com/2023/02/01/inflation-euro-zone-january-2023-print-ahead-of-ecb-rate-meeting.html
3 https://www.ft.com/content/db2a72b2-879b-4dbc-a215-6acd6851ebf0
4 https://www.reuters.com/technology/blackrocks-fink-says-there-may-have-been-misbehaviors-ftx-2022-11-30/
5 https://www.bloomberg.com/news/articles/2022-11-13/big-investors-are-giving-up-on-crypto-markets-going-mainstream
6 https://beincrypto.com/crypto-market-entered-toughest-stage-analysts-weigh-in-recovery-scenarios/
7 https://www.elibrary.imf.org/display/book/9798400219672/CH001.xml
8 https://www.reuters.com/world/uk/boe-treasury-think-uk-is-likely-need-digital-currency-telegraph-2023-02-04/

Publication date: 2023-03-16T13:37:40+0000

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