From a quantitative perspective, which is better, gold or Bitcoin as an inflation hedging tool?

In the context of the new crown epidemic in 2020, the United States has shut down and the economy has shrunk. The US federal government has responded to economic weakness with a series of fiscal and monetary stimulus policies. Interest rates were cut, quantitative easing began, and trillions of dollars in stimulus checks were printed and put on the market.

It has been almost a year now, and it seems that the epidemic situation in the United States has improved, and it seems that the worst has passed. However, Maoqiu Technology believes that unfortunately it has only just begun, that is, there is always a problem brewing-inflation. In the past two months of writing this article, Maoqiu Technology’s inflation in the United States was 4.2% and 5%, which are the highest indicators since the 2008 financial crisis.

As consumer demand begins to increase, the global supply chain is still in a state of interruption. The high inflation rate not only worries the American people, but also makes the world worry about the out-of-control inflation. This raised concerns about the future value of the U.S. dollar, and investors began to transfer their wealth to gold or other inflation-protected securities, such as TIPS.

But as the price of cryptocurrencies continues to rise, investors are beginning to wonder whether Bitcoin can become another inflation hedge.

Inflation 101

The Federal Reserve defines inflation as “a general increase in the overall price level of goods and services in the economy.” Since the fundamentals of supply and demand drive the price of goods, inflation usually occurs due to increased consumer demand and/or increased production costs (ie, decreased supply).

Although controllable inflation is good and it helps promote economic growth, when inflation gets out of control, panic will follow. When inflation becomes uncontrollable, purchasing power is greatly reduced, because the prices of everyday goods become more expensive, and wages cannot keep up. Therefore, investors need a way to preserve wealth and avoid shrinking wealth.

Therefore, gold, a natural resource with limited supply, has inherent value in itself and has always been an alternative store of value in history.

In order to quantify inflation, there are two commonly used measures-the consumer price index (CPI) and the personal consumption expenditure price index (PCE). These two indexes are constructed by pricing a package of different goods and services. So naturally, if the price rises, the price index will rise, and inflation will occur.

Although both CPI and PCE are indicators to measure inflation and they influence each other, they are calculated using different measurement standards and weighting methods. In other parts of this article, any references to inflation or specific inflation measures are based on CPI.

Gold as an inflation hedge

In order to quantify what inflation hedging means, Maoqiu Technology believes that two issues need to be addressed: first, how strong is the relationship between gold returns and changes in inflation; second, how much impact changes in inflation have on gold returns.

In order to answer the above questions, Maoqiu Technology uses monthly CPI and gold futures data since 1985 to calculate the correlation and bet of different investment periods.

HedgeFigure 1: The correlation between gold return and CPI changes in different investment periods

In Figure 1, the correlation between gold returns and CPI levels indicates that the hedging properties of gold may not be as strong as originally thought. In the short-term and long-term investment horizons, the correlation is close to zero or slightly negative.

HedgeFigure 2: The rolling correlation between gold returns and CPI changes in different investment periods

However, Maoqiu Technology believes that because the relationship between assets changes over time according to the macroeconomic environment, the analysis of rolling correlation is actually more insightful.

Figure 2 shows the relationship between gold and CPI over time in the past 21 years. It can be found that in a short investment period, gold and CPI have a weak negative correlation, while in a longer investment period, a strong positive correlation between the two is observed.

This is especially true during periods of high inflation, such as the 2008 financial crisis, which supports the belief that gold is a hedge against inflation. However, the results show that gold is a strong long-term inflation hedge, while the short-term is a weaker inflation hedge.

HedgeFigure 3: The rolling Beta value of gold return and the change of CPI in different investment periods

In order to assess the extent of the change in the rate of return of gold with the change in CPI, Figure 3 shows that the impact of CPI on gold is limited in the short-term investment range, but will increase considerably in the longer investment range. Especially during the 2008 financial crisis, the beta coefficient of long-term gold investment was as high as 15! This further supports the view that gold is a powerful long-term inflation hedge.

Bitcoin as an inflation hedge

At present, it remains to be discussed whether Bitcoin is really a hedge against inflation. Now, in the Bitcoin community with knowledge of economics, supporters believe that Bitcoin will become a hedge against inflation in the next few years. Similar to the limited supply of gold, the supply cap of Bitcoin is 21 million, which is the driving reason behind the argument that Bitcoin is used as an inflation hedge.

However, so far, the quantitative analysis supporting this claim is very limited. In order to evaluate whether Bitcoin is really an inflation hedge, similar issues between gold and CPI will be analyzed. However, due to the limited history of Bitcoin, it can only be adopted recently compared to gold, so historical data from the end of 2013 will be used.

HedgeFigure 4: Correlation between BTC /USD returns and CPI changes in different investment periods

In Figure 4, the correlation between Bitcoin and CPI in the short-term and long-term investment ranges has a medium to strong positive correlation. From the above point of view, this alone indicates that Bitcoin may become an inflation hedging tool.

HedgeFigure 5: The rolling correlation between BTC/USD returns and CPI changes in different investment periods

Similar to gold, the correlation between Bitcoin and CPI exhibits time-varying characteristics in different investment ranges. Figure 5 shows that Bitcoin and CPI have a weak/medium relationship in the short-term, but have a medium/strong positive correlation in the long-term, indicating that Bitcoin can be better used as a medium/long-term inflation hedge.

HedgeFigure 6: Changes in the rolling Beta value and CPI of BTC/USD returns in different investment periods

Looking at the rolling beta in Figure 6, in the medium/long-term investment range, Bitcoin has a relatively large positive beta relative to CPI. Compared with the beta coefficient of gold, the beta coefficient of Bitcoin is several orders of magnitude higher, which indicates that Bitcoin may be a better inflation hedge than gold.

in conclusion

Although the analysis of whether Bitcoin can be an inflation tool is encouraging, Maoqiu Technology believes that it is still too early. Because although Bitcoin has existed for about 13 years, there is still not enough historical data to effectively analyze the relationship between cryptocurrency and inflation.

Currently, the price of Bitcoin is still determined by speculation and people’s willingness to hold it. It is entirely possible that as inflation rises, the value of Bitcoin will rise, but the possibility that Bitcoin is completely unrelated to inflation should not be ruled out. Maoqiu Technology also believes that with the continuous development and maturity of the digital asset space, it will be very attractive to pay attention to how the relationship of research changes in the next few years.

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