With inflation high and stock markets sinking, you might expect that Bitcoin would be a good investment. After all, what could be better than owning a decentralized currency that holds its value? However, BTC has lost more than 37% of its value so far this year, falling to almost $26,000 earlier today. Just six months ago, Bitcoin was hitting an all-time high of around $69,000. By way of comparison, the S&P 500 has only dropped about 17% since the start of the year. So what explains BTC’s much steeper losses in 2022?
Bitcoin Is a Risk Asset Now
Risk assets are investments that tend to see a lot of ups and downs in value. For example, stocks, commodities, and high-yield bonds are all considered risk assets, because their prices can change quite a bit under almost any market conditions.Until recently, Bitcoin was seen as somewhat different from other risk assets. Investors considered it a store of value that wasn’t as affected by things like inflation, stock markets, and Fed monetary policy. However, that’s changed in recent months, and now Bitcoin is starting to be influenced by the same factors that move the value of other risk assets. Dr. Richard Smith, author of the Risk Rituals Newsletter, believes that the recent decline in the [crypto] market is due to a shift in narratives from risk-on to risk-off. He states that as the Fed and other central banks begin to reduce stimulus, and as people start to realize that Covid-19 is coming to an end, the liquidity in the market is drying up. However, there is another less obvious factor influencing cryptocurrency markets that has contributed to Bitcoin’s decline.
Terraform Labs Breakdown
There was a major disruption over the weekend on the Terra protocol, causing the value of the LUNA token to drop by 90%. This has caused chaos in the cryptocurrency world, as TerraUSD (UST), another native token on the protocol, is a popular stablecoin.A stablecoin is a cryptocurrency that is designed to maintain a stable value. They are usually pegged to the value of a fiat currency, such as the US dollar. The goal of the stablecoin is to maintain the same value as its peg. For example, one coin should always be valued at one U.S. dollar.
The most popular stablecoins, Tether (USDT) and USD Coin (USD), maintain their pegs by owning large reserves of U.S. dollars and other assets to back them up and keep their value from fluctuating wildly like some other cryptocurrencies. But UST works in tandem with LUNA in a totally different fashion—it’s an algorithmic stablecoin.
Algorithmic stablecoins have come under fire this week as UST has dropped more than 30%. This has called into question the validity of this type of stablecoin. Additionally, it appears that the Luna Foundation Guard was trying to prop up US. The Luna Foundation Guard (LFG) recently acquired $1.5 billion in Bitcoin, which brings its total reserves to around $3 billion. The LFG is planning to reach $10 billion in Bitcoin by the end of this year. On Monday, the organization announced that it would be lending out hundreds of millions of dollars worth of Bitcoin to help stabilize the price of the UST stablecoin.
Bitcoin Had a Rough Start to 2022
Bitcoin had a great year in 2021, gaining nearly 70%. Although this is an amazing return for any asset class, it’s a bit of a drop from Bitcoin’s 300% return in 2020. According to Alex Reffett, co-founder of wealth management firm East Paces Group, this is because investors are in a more risk-averse mood and are investing more in reliable, value-based stocks rather than speculative alternative investments.
One reason for the recent decline in Bitcoin prices is the US Federal Reserve’s decision to raise interest rates. This policy makes it more expensive to borrow money, thus decreasing demand for growth companies and speculative assets like Bitcoin. With the Fed expected to continue rate hikes into 2023, it is unclear how much demand for cryptocurrency will remain. Sosnick said that central banks actively draining liquidity is something that has never happened before, so it’s difficult to predict how Bitcoin and other cryptocurrencies will react. Headded that this kind of environment is generally tough for investors, and that riskier assets usually don’t perform as well as safer ones in these conditions.
Bitcoin Has Become a Volatile Beast
Adding to the market disruptions caused by Russia’s invasion of Ukraine are concerns about Bitcoin.“Bitcoin has proven to be somewhat correlated to broad market movements and less of a direct hedge against equity markets,” said Reffett. The trouble is that Bitcoin hasn’t proven itself to be much of a hedge against anything.Even though inflation is at four-decade highs, Bitcoin is not gaining more followers. One would expect that a currency that is independent of any central bank and maintains its buying power would be more popular, but Bitcoin only seems to find adherents when the price is rising. When sellers dominate, Bitcoin doubters appear, just like with any other risk asset. Surprisingly, Bitcoin has had eight 50% drops from a prior all-time high since 2009. “If you can’t handle a 50% decline in value, then you shouldn’t be in Bitcoin,” said Dr. Smith. “Falls of 50% are perfectly normal for Bitcoin. It’s just the price you have to pay.”
Should You Own Bitcoin?
When Bitcoin first surfaced, it was something that only tech-savvy individuals would invest in. A new genre of journalism rose to try and explain to readers how to trade their dollars for Bitcoin. At the time, it was seen as something normal, like buying a pizza. However, looking back, the pizza was very expensive.
As time has gone on, Bitcoin has become more mainstream. Now, it is easier to buy Bitcoin through exchanges like Coinbase. Money managers today are increasingly considering Bitcoin as part of a diversified portfolio. Tyler Cowen, an economist, argues that the market will eventually determine the value of cryptocurrency, at which point expected returns will be “normal.” If you invest in Bitcoin now, you are counting on the fact that the recent frenzy has not died down and that you will be able to sell it later at a much higher price. However, history has shown that such plans are rarely easy to achieve. It is hard to predict when the excitement of speculative investing will be gone.