Worst case scenarios for the cryptocurrency space could be very ugly
Thursday 12 May 2022 Author: Steven Frazer

In one corner there is the co-founder of PayPal (PYPL:NASDAQ) and secretive data analysis platform Palantir (PLTR:NYSE). In the other, arguably the best investment double act ever. Peter Thiel and Warren Buffett/Charlie Munger respectively have been throwing cryptocurrency brickbats at each other in recent weeks.

The former says crypto is a transformation that will change how we move and even think about money forever. The latter believe bitcoin and its ilk are a bigger scam than Bernie Madoff funds.

At this year’s Bitcoin 2022 conference in Miami in April, billionaire investor and entrepreneur Thiel talked about the potential of bitcoin, why it is not achieving that potential, and the way we value money – which he illustrated by throwing $100 bills into the crowd. Oh, the theatre.

He also labelled Buffett bitcoin’s enemy number one, calling him the ‘sociopathic Grandpa from Omaha’.

UNCHARTED TERRITORY

Running in the background remains the ongoing debate about whether bitcoin or any cryptocurrency can emerge as the transactional utility they are designed to be.

The immediate conversation is less esoteric and centres on something all investors can understand; how will bitcoin and other cryptocurrencies react to rising US interest rates?

Unusually, it’s a question for which there is little precedent.

Interest rates in the US averaged 5.44% between 1971 until 2022, according to data from Trading Economics, reaching an all-time high of 20% in March 1980 and a record low of 0.25% in December 2008.

Last week’s 0.5 percentage point rate rise by the Fed is expected to be the latest of many given that inflation is running at 40-year highs, potentially creating an environment that predates Satoshi Nakamoto’s whitepaper (the pseudonym used by bitcoin’s creator or creators) on 28 October 2008.

But in 2018, the last calendar year in which we saw more than two increases in US interest rates, bitcoin fell by nearly 70%.



Numerous analysts have identified the Fed’s bearish stance as the main factor in recent asset downswings, with Blockchain Coinvestors chief executive Lou Kerner saying rates continues to wield power over the market. ‘Tightening by central banks is the biggest macro issue driving both the stock and crypto markets today, which is why we’re seeing a very high correlation between the markets,’ he said.

These rates obviously affect borrowers, but they also provide higher returns for lenders, including in some relatively safe assets. That competition for capital, among other factors, has already led to big falls for more speculative assets. This includes growth stocks and, in particular, technology firms.

Rising rates are already changing the risk/reward calculation for investors. It’s a complex calculus, because a ‘safe’ investment like a bond can easily attract money that otherwise would have gone to a higher-return but also higher-risk assets such as cryptocurrencies.

Consider ARK Innovation (ARKK:NYSEARCA), the aggressively future-forward fund managed by Cathie Wood. ARK Innovation has lost 72% of its 2021 peak value, with Wood betting heavily on many speculative tech, fintech and biotech growth firms, such as online commerce enabler Shopify (SHOP:NYSE), payments firm Block (SQ:NYSE), Zoom (ZM:NASDAQ) and Tesla (TSLA:NASDAQ), the fund’s largest stake.

These are firms which either aren’t profitable yet (most of the biotechs), were expected to become much more profitable (Zoom) or are only profitable thanks to aggressive accounting (Tesla).

CATHIE WOOD VERSUS CRYPTOS

ARK Innovation has lost 53% since the start of 2022, more than twice the fall in the Nasdaq Composite (down 23%) and this compares to a 10% drop in the Dow Jones Industrial Average, which is relatively heavier in slower-growing banking, retail and manufacturing stocks.

The cryptocurrency is down 31% year-to-date or 51% from its $67,582 peak last November. Ethereum and XRP, other popular cryptos, are down 27% and 37% respectively in 2022.



‘It’s stunning to see crypto hold up better than a more conventional technology growth fund,’ says David Z Morris, the author of Bitcoin is Magic. ‘Certainly part of that is continuing investor optimism about crypto and blockchain.’

Yet this space still faces similar dangers if investors are less inclined to take risk. Put simply, the overall effect of three (or more) consecutive rate rises may be to increasingly weigh down bitcoin and crypto in general, ensuring that 2022 becomes another bear market year for cryptocurrency.

The market is different now than it was in 2017, so there’s an argument to be had that it will do a better job of preserving its highs. But some economists and analysts have recently predicted that higher rates of inflation will last longer than initially predicted, with Allianz’s Mohamed El-Erian arguing in late 2021 that high inflation will ‘last for a while’ and that the Fed is losing credibility over its (currently) soft policy.

Put differently, inflation may get worse before it gets better, with the Fed potentially forced to initiate multiple rate rises this year. If so, the negative effect on crypto could be substantial. How far prices may actually fall is anyone’s guess but the limited historical precedent is not encouraging.


What is Bitcoin?

Bitcoin is a digital currency and a protocol that enables instant worldwide payment transactions with low or zero processing fees.

Unlike typical currencies, bitcoin operates with no central bank or authority. Instead, the task of managing transactions and issuing bitcoins is carried out collectively by the network of users. The software is a community-driven, free, open-source project. Basically, it uses cryptography to control its creation and transactions.

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