Bitcoin’s biggest test to occur if interest rates rise higher than expected

Bitcoin is a hedge against inflation, and quantitative easing say its supporters, but just supposing inflation and then interest rates rise, will Bitcoin surge or crash?

When stock markets crash, things turn nasty. Unless you have experienced it first hand, it is hard to understand. If irrational exuberance permeates the air in a boom, it turns to irrational pessimism after a crash. In the immediate aftermath of the dotcom crash and for around 18-months, the internet became synonymous with swampland. Especially in the UK, the internet was suddenly seen as yesterday’s foolishness. The idea of online shopping was dismissed as outright stupidity. Things turned bleak.

It had happened before; in 1987 and 1929, for example. The 1929 crash was followed by a Great Depression, while central banks reacted to the 1987 crash by slashing interest rates fuelling an unsustainable property boom which led to a crash in house prices that, at the time, didn’t seem likely to end.

There is no certainty that we will see a crash in stock markets, but there are good reasons to think we might.

• For one thing, the CAPE — or cyclically adjusted P/E ratio  — which compares the value of the S&P 500 with earnings over the previous ten years is perilously close to an all-time high.
• For another, if the inflation scare proves prophetic and inflation does creep up and not reverse as this column has often suggested, central banks may have to increase interest rates much higher than expected. Right now, rates are absurdly low. The Fed says it may hike rates three times. If it did that, rates would still be extremely low. But if inflation proves worse than the Fed expects, it may have to increase rates to a much higher level. They say that once inflation takes hold, defeating it is akin to squeezing toothpaste back into its tube. If (and this is a big if) inflation persists and then increases, rates may have to increase too much higher levels. If this were to happen, the net current value of anticipated future earnings would fall, and stocks would look massively overvalued.
• Thirdly, the 'this time it's different' crowd have come out of the woodwork saying that the high value of the CAPE is justified. For example, Goldman Sachs recently stated: “While valuations feature importantly in our toolbox to estimate forward equity returns, we should dispel an oft-repeated myth that equity valuations are mean-reverting.”  Sorry, but this is classic bubble talk. It is akin to the IMF saying in 2006 that the risk of a banking crisis has significantly reduced thanks to mortgage securitisation. It may sound like superstition to say that when institutions try to justify high asset values, this is a sign of a crash in the making, but actually, it is just the way human nature works. The only way the high value of the CAPE can be justified is if you believe interest rates will stay close to zero forever or if you think economic growth is about to become much greater than the historic average.

So, there is a good chance stock will crash. It is not certain; Techopian has long argued that thanks in part to technology, the long-run trajectory of prices is down and economic growth is up. But there are always time lags, inflation may persist for longer than we have predicted, and rates may indeed rise to much higher levels, if only for a short while.

Now turn to Bitcoin. The price has lost around a third of its value since November last year. That itself is odd since Bitcoin enthusiasts see it as a hedge against inflation, so it is quite surprising that the price has fallen so dramatically just as inflation has picked up.

There is nuance. Bitcoin supporters often cite central banks and money printing (or quantitative easing, which isn’t really money printing but set that quibble aside) as a reason to buy Bitcoin.

They argue that Bitcoin because its total maximum supply is limited to 21 million coins, is more reliable than currencies such as the dollar, also called FIAT currencies, whose supply can be increased indefinitely.

So here is the challenge for Bitcoin.

If its supporters are right about central banks, if they are correct, that thanks to central banks, inflation will surge, interest rates will also rise significantly, and stock markets will probably crash.

In other words, if the rationale behind Bitcoin is correct, then that leads to the inevitable conclusion that stocks will crash.

In the circumstances of a stock market crash, when investor sentiment becomes incredibly negative, do you think Bitcoin will rise or might it crash? If it can survive a stock market crash, that would mean Bitcoin has passed the test.