Bitcoin: Digital currency, digital gold, or digital tulip?

by Kristina Hooper, Chief Global Strategist, Invesco Canada

Weekly Market Compass: Bitcoin has gained credibility over the past three years, but I believe its use as a currency, a diversifier or an inflation hedge is a bit off the mark.

The last time I wrote about bitcoin was back in December 2017. Back then there was a lot of excitement around bitcoin and other cryptocurrencies because both the Chicago Board Options Exchange and CME Group had begun offering bitcoin futures. Investors were excited about this opportunity, sending up the price of a single bitcoin thousands of dollars higher over the several previous weeks. In late December 2017, bitcoin hit a peak of more than $19,783 before falling precipitously in the ensuing weeks and months.¹ It didn’t again reach that level until December 2020.² But this time, the bitcoin excitement is a bit different. Today, some institutional investors are starting to dip their toes into cryptocurrencies — or are at least considering it. And last week, U.S. Treasury Secretary Janet Yellen lent credibility to cryptocurrencies as an investment by recognizing their popularity and assuring that they will be more heavily regulated to ensure investors are protected.

Not surprisingly, I have received a flurry of questions in recent days and weeks about whether bitcoin is suitable for an institutional or retail investor’s portfolio. In particular, clients are wondering if 1) bitcoin can be considered a currency or 2) if bitcoin can be considered a commodity such as gold. Let’s explore both assertions:

Digital currency?

Let’s start with the first question. Proponents of bitcoin point to it as “the people’s currency” because it’s a peer-to-peer system that doesn’t involve any central banks or third-party administrators. In fact, it was launched in early 2009, a swift response to the global financial crisis and the loss of trust in institutions. It’s also touted as being “fraud-proof” in that transactions are recorded in a distributed ledger; in other words, when a transaction occurs, it’s verified and then copied and transmitted to other computers. In an environment in which central banks are pursuing very accommodative monetary policy and are “printing money,” bitcoin investors believe bitcoin is a better store of value than fiat currencies because bitcoin, like gold, has a finite supply and should hold its value better.

However, I believe bitcoin is not really a realistic, useable currency. Transaction speeds for bitcoin are much slower than for financial transactions performed by MasterCard or Visa. Merriam-Webster defines a currency as “something (such as coins, treasury notes, and banknotes) that is in circulation as a medium of exchange.” It’s difficult for bitcoin to be used as a medium of exchange given the dramatic price fluctuations it experiences. After all, why buy a car with bitcoin if the price of bitcoin might go up significantly in the next week?

Digital gold?

I would argue that bitcoin has characteristics that make it less like a currency and more like a commodity, especially gold. Like gold, bitcoin has to be “mined,” a laborious digital process that unleashes blocks on a blockchain. Like gold, bitcoin’s value is dictated by the laws of supply and demand – how much traders are willing to pay for it. The gold supply has increased in recent years an average of 1.2% per year.²  While bitcoin supply is currently increasing about 1.7% per year, that percentage will continue to fall until the year 2140, when no more bitcoin can be mined.³  Some investing pundits are suggesting that gold is falling in price because money that would have been allocated there is now being invested in bitcoin because it serves the same role in one’s portfolio. Others suggest that older investors will continue to invest in gold while younger investors will choose to invest in “digital gold” because it has many of the same investment attributes as gold.

But is that really the case? Bitcoin may be considered a digital commodity, but investors need to compare its potential role in a portfolio versus a traditional commodity like gold. Let’s explore:

• Typically, gold is held in a portfolio for diversification purposes. It’s not clear that bitcoin could offer similar diversification benefits given that its correlation with the S&P 500 has been 0.72 in the last year.⁴ By contrast, gold had a correlation of just 0.38 for the same time period. ⁴
• Some hold gold because it’s viewed as an inflation hedge, and in certain time periods — but not all — it has exhibited some inflation-hedging qualities. However, bitcoin hasn’t been around long enough for there to be a performance record in periods of higher inflation. In other words, investors shouldn’t assume it’s an effective inflation hedge.
• Gold is also held in portfolios as a hedge on geopolitical risk. And historically, gold has offered better relative performance than stocks in times of crisis. For example, between the failure of Lehman Brothers in September 2008 and the stock market bottom in early March 2009, the price of gold actually rose although it exhibited significant volatility.⁵ In contrast, as the pandemic spread in February 2020, bitcoin fell along with stocks and rebounded with stocks, exhibiting little in the way of hedging qualities. (I must add that while gold held up in February, it did fall in March until rebounding along with stocks and bitcoin.)
• Unlike bitcoin, gold arguably has some intrinsic value in that it is used in electronics and similar goods as well as jewelry. For example, many microchips use gold as a conductor.

Digital tulip?

And so, it appears that price appreciation is the main reason investors want to hold bitcoin in their portfolios. In other words, the “fear of missing out” could very well be the driving force behind bitcoin investing. Yes, bitcoin has exhibited strong price appreciation in recent months. However, investors need to be aware of its longer-term price history. Since 2011, bitcoin has spent 93.6% of days trading beneath its highs versus 86.6% for the S&P 500.⁶ What’s more, on the days when bitcoin was beneath its highs, it traded an average 53.5% below those highs. ⁶ On the days when the S&P 500 traded below its highs, it traded an average 3.8% below those highs.⁶

The price of bitcoin recently has been driven by scarcity of supply and increasing interest in its upward momentum. As more investors note the rising price and buy into this trend, the cycle continues, pushing prices upward. Given that bitcoin is a digital asset with no income streams and poor ability to scale in terms of transactions capacity — and that enormous energy consumption comes with running the bitcoin blockchain — one is left to wonder what pricing dynamics should back bitcoin once buyers stop bidding the price upward.

In short, I believe bitcoin and other cryptocurrencies could very well remain popular, but they’re a very risky investment. While bitcoin has gained significant credibility in recent months because of interest from institutional investors, it could still be the digital equivalent of “tulip mania,” which gripped Holland in the 1600s and sent the price of tulip bulbs to astronomical and unsustainable highs before their inevitable crash. Given that bitcoin has no intrinsic value, it’s difficult to predict just how high it may rise or how low it may fall in coming months — although I suspect it will be very volatile. And given its limited track record, it’s difficult to predict if bitcoin could be an effective hedge against risks such as inflation.

In closing, I am keeping all of my friends and colleagues in Texas in my thoughts, and praying for everyone who has suffered from the severe winter weather conditions over the last week.

With contributions from Ashley Oerth

1 Source: Fortune, “Bitcoin Hits a New Record High, But Stops Short of $20,000,” Dec. 17, 2017

2 Source: Fitch Solutions, 2016-2019 statistics

3 Source: Bitcoin Wiki, “Controlled Supply: Projected Bitcoins Short Term,” May 11, 2020

4 Sources: Bloomberg, L.P.; author calculations using monthly data.

5 Source: Bloomberg, L.P.

6 Source: Bloomberg, L.P. The analysis runs from Jan. 3, 2011, to Feb. 15, 2021, comparing the S&P 500 price index and Bloomberg’s composite measure for bitcoin.  The analysis considers U.S. trading days only to maintain a like-for-like comparison (bitcoin can and does trade on weekends, whereas the S&P 500 constituents do not).

This post was first published at the official blog of Invesco Canada.