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In seach of elusive inflation insurance

Bitcoin is not the protection against inflation that some of its advocates claim it is – but nor are several other assets.

This is one lesson of the current inflation scare. Since last April the five-year breakeven inflation rate (the gap between conventional and index-linked gilt yields and a measure of market fears of inflation) has risen from 3.4 to 4.1 percentage points. That’s close to its highest level since 1995. During this time, however, Bitcoin has fallen 25 per cent in sterling terms.

Which brings into doubt one of the claims made by its supporters. They say that the fact that its supply is limited whereas that of conventional money is potentially boundless should mean that Bitcoin will hold its value better than conventional money. With the value of the latter now falling more quickly than usual – which is just another way of saying inflation is high – you’d expect Bitcoin to have held up relatively well. But it hasn’t. It has failed on its first contact with meaningfully rising inflation expectations.

But it is not the only asset to have failed the test. It is sometimes said that gold is protection against inflation. Not now, it’s not. In sterling terms, gold is no higher than it was last spring, and is lower than it was in much of 2020, when nobody was much worried about inflation.

This, however, is not surprising. The gold price tends to fall when bond yields rise simply because higher bond yields make an asset that pays no income (such as gold) less attractive. The rise in bond yields since 2020 has thus hurt gold by more than fears of inflation has helped it – which should not be unexpected.

Nor even have index-linked gilts been great protection. Holders of these have lost money since August even though inflation expectations have risen since then.

Again, this is not so surprising. Higher inflation expectations are ambiguous for index-linked bonds. On the one hand, as people fear inflation they pile into them, pushing up their prices. But on the other hand, fears of inflation lead to expectations of higher real interest rates as the Bank of England tries to reduce inflation. And because the level of index-linked yields should equal the expected path of real short-term interest rates, this means higher yields and thus capital losses.

Bitcoin, then, is not alone in having failed to protect us during this inflation scare.

Perhaps, though, this takes too short-term a view. Over the long-term, any asset that delivers returns above inflation protects us from inflation. And Bitcoin has certainly done that, even after its recent fall. And if we regard Bitcoin as an asset just like any other, we should expect it to continue to beat inflation simply because it is a risky asset and risky assets should over time deliver good returns simply to compensate for those risks. Note that the risk here is not simply that Bitcoin is volatile. The fact that it fell sharply at the start of the pandemic when investors feared recession suggests it is also a cyclical asset. It should therefore deliver a risk premium to compensate for cyclical risk

You can however be forgiven for thinking this insufficient reason to regard Bitcoin as inflation protection. For one thing, it might not be a normal asset but merely a gambling token. And for another risks sometimes materialize – especially for assets as volatile as Bitcoin – so Bitcoin might again fall sharply at a time of rising inflation.

Recent history, however, suggests a more obvious and easier way to protect ourselves against inflation - equities. The rise in inflation expectations since last summer has coincided with a rise in the FTSE All-Share index. Which continues a long tendency for shares to rise and fall with inflation expectations.

If this continues, it’s fantastic. It means we can have protection from inflation without buying a risky asset such as Bitcoin or low-return ones such as index-linked gilts or gold.

If this sounds too good to be true, that’s because it might well be.

This close correlation has existed only because inflation expectations have in recent years been cyclical, rising and falling with economic activity. But this need not always be the case. Higher inflation could lead to fears of slower growth – if it is the result of higher energy prices or if it triggers fears of much higher interest rates. If so, shares could fall and so fail to protect us from inflation. Indeed, before the 2000s, this was often the case: equities often fell as inflation expectations rose.

Also, recent history tells us that equities only do well at times of moderate inflation: a time traveller from the 1970s would laugh at us for considering 5 per cent inflation a problem. We know from the 1970s that genuine high inflation is bad for equities. It might be so again. And in such an environment, Bitcoin’s limited supply might indeed prove to be valuable. Relationships between asset prices and inflation expectations need not be linear or stable.

Of course, we cannot quantify the probability of such serious inflation. Personally, I think it is low, but nobody should base an investment strategy upon anybody’s opinion.

And this is why inflation is so nasty, even at moderate levels. The last few months have taught (or reminded) us that assets we think of as inflation hedges need not be, whilst the assets that have recently protected us from inflation need not do so in future. Insuring ourselves against inflation is tricky. Which is why we must hope that it does indeed fall later this year.